Description 

Data I/O manufactures programming machines which deploy data like firmware, identifiers and other data into chips (used in memory, microcontroller and logic devices) which eventually get used in electronic devices like auto electronics e.g., advanced driver assist, medical devices, consumer electronics etc. 

Data I/O is the largest chip programming business in a very fragmented industry. Data I/O is more than two times larger than its nearest competitor. DAIO has global workforce with global support, transparent public company with no debt and invests a lot in technology through R&D which differentiates DAIO from its nearest competitors. DAIO invested $70 mill in R&D spend in the last decade. In the last couple of years, it added security provisioning of chips differentiating it from its competitors. 

Customers who buy their programming equipment include OEMs (original equipment manufacturers) that make automotive electronics e.g., Bosch OR their programming center partners e.g., Arrow, Avnet OR contract electronic manufacturers. Automotive electronics customers make 56% of its revenues. DAIO supplies to 8 out of the top 9 automotive electronic suppliers. More than half of its sales are equipment sales, about a quarter in adapter sales and about ~15% in software and maintenance. A little over 90% of sales are international.

Because DAIO sells its programming machines to customers who buy more when semiconductor capex goes up, DAIO’s business has traditionally been lumpy and dependent on semiconductor capital expenditure cycle. When the capex increased last time in 2017, its revenue increased ~50% and given the operating leverage the stock increased from ~$4 to ~$15. 

In order to reduce the cyclicality and make more of its revenues recurring, DAIO has developed Sentrix machines where it gives the Sentrix machine for free and charges customers on a per chip programmed  basis. In addition, Sentrix can also provision the chips with security software.

DAIO finished the Covid year without burning any cash and without stopping to invest in R&D. We can also see that this last trough in business cycle was better than the prior trough in 2012 when the business had a large operating loss.

CEO Anthony Ambrose joined DAIO in 2012 and has transitioned the business to focus on automotives. This is important because the chip programming business doesn’t have significant barriers to entry. That said multinational auto suppliers would not want to deal with a startup. More recently, through Sentrix, the CEO added security provisioning of chips to DAIO’s machines which widened its competitive advantage.

Here is what the CEO mentioned during the semiconductor capex down cycle in 2019and displays his long-term orientation 

“As I mentioned earlier, I believe we're in a capital equipment recession. This is the seventh or eighth recession during my professional lifetime in a secular 10 times expansion upward for the overall semiconductor market. While these recessions are never pleasant, good companies take advantage of recessions to improve themselves and improve their competitive position to prepare for the next recovery and up cycle. Some may think that simple spending reductions are all that's required. While we have adjusted spending to reflect our updated view of the business, that's just the beginning. 

We have a structured plan for recessions as we did 7 years ago. First, you maintain R&D focus on new products as these are the products that clients will buy when the cycle turns. Second, you focus on operational excellence even more perhaps than during normal times. You improve your products, finances, processes, and people, and you hone your systems for better performance in an up cycle. Third, you focus on selling everywhere with a special focus on new customer acquisition to broaden the base when the economy turns. And fourth, you continue to build your team with the best gens and make it stronger. We believe the industry will cycle back as it always does. And when it does, we'll be very well positioned. We expect long- term growth in overall semiconductor content per car as well as strong growth in gigabit content of flash memory per car over the long-term.”

Anthony Ambrose is adamant about using the down cycle to prepare for the up cycle. As a result, they didn’t slow down their R&D effort and are ready for the cycle upturn. Here is what he said more recently at the Q1 2021 earnings call, “During the quarter, we won 6 new customers in Asia, across all markets. This illustrates our global strength, and the desire of customers in challenging times to establish a long-term relationship with the resilient market leader.  In Q1, our sales pipeline added significant new opportunities from many new prospects and repeat customers alike.  We see APAC and Americas regions leading the recovery, with EMEA following 1-2 quarters behind.” During the Q&A he indicated that the surge in the business continued in April and is fairly broad based across customers. 

The current management is doing a few things differently than the competitors. It is going after more highly valued customers and doesn’t stop R&D at the bottom of the cycle. In the last 8 years DAIO spent ~$8 mill for stock repurchases. Stock repurchases were done at low stock prices of ~$4-5 per share which shows good capital allocation judgment. 

Renaissance technologies is a new investor which filed a 13G and owns ~8% of the business. Management and Directors own ~13% of the shares outstanding. The current CEO thinks that “he would like to participate in the race he is running” and as a result the CEO took half of his compensation in stock in the last few years. 

In our base case, we assume that the business participates in the cyclical semiconductor capex recovery broadly and especially auto electronics which are expected to jump in 2021 and then the revenues grow in line with the automotive electronics at 10-15% per year for the next decade. With flat R&D expense and the associated operating leverage, and we could see the EPS increase and stock double in the next two to three years. The 2017 was the last peak of the semi capex cycle which the business experienced and is a relevant benchmark. The CEO tells the employees that the business could double in ~5 years and quadruple in ~10 years.

In the upside scenario, business model transforms  to more recurring revenue and  more customers adopt the security provisioning from Sentrix. In this case, revenues increase a lot and the stock could be a multi bagger.

Reason for Undervaluation

The semiconductor capex cycle turned up last year in 2020 but DAIO has not participated in this up cycle yet. This is because semi capex has exposure of ~10% to autos whereas DAIO’s business is more than 50% exposure to autos and overall auto semiconductors  decreased last year. In 2021, auto electronics demand will catch up and then is expected to increase after 2021 which should work in favor of DAIO. The business has spent fair bit of money ~$70 mill on R&D but has seen no returns. Market may think that is all sunk money and may not have any impact on the business. Management appears shrewd and at least some of the R&D spent has widened DAIO’s competitive advantage like the development of security provisioning which competitors don’t have. 

Downside

Over the long-term, the technology of programming  could change, and chips could be better programmed using something other than DAIO’s machines. However, chip programming has been around for a few decades and DAIO has maintained its business through tech changes ensuring that its machines remain most efficient at chip programming.