December 24, 2009

Economists tell us that the great recession began at the end of 2007. Our little slice of the economy, capital equipment for the electronics industry, however, lags the macro economy; in fact, we had our greatest quarter six months later when we reported $8.8M in orders for the quarter ending June 30, 2008. When the economic winds finally reached us in the fall of last year they had gained hurricane force. Within a few days of Lehman’s fall on September 14th, the captains of the electronics industry locked their checkbooks away in the vault to ride out the storm. Capital spending was virtually non-existent and our orders fell precipitously.

The fourth quarter of 2008 turned out much better than I expected with orders down only 30% from the peak of the second quarter. While our orders outside of Europe fell nearly 50% from that level, our orders in Europe were buoyed by year-end spending and fell a modest 9%. But, it also meant that Europe’s sales funnels were empty as we entered 2009 and the sales funnels outside of Europe were very nearly dry as well. I feared the worst for Q1 and it came out pretty much that way with orders falling to $3.5M. Jassen Totev who runs our European sales organization expected Q2 to be the worst ever for Europe and it came out pretty much as he expected. His orders in Q2’08 were down 71% from what they had been a year earlier.

We began to see the reins on capital spending loosen by the end of the second quarter. Our sales funnels started to grow again and by mid-summer had reached a new high. But while many customers had new projects in planning, spending was restrained. This would be a cautious recovery. Inventories would remain low and companies would only spend when they had confidence in the future.

Now we see the signs of recovery everywhere. I saw them first-hand at the Productronica trade show for electronics manufacturing in Munich in early November. While the trade show attendance was down 31% (28,000 vs. 40,514 two years earlier) and our leads were also down 31%, the quality of our leads was up. Here’s what Munich’s trade show organizer said about it. “As the world’s leading trade fair, the Productronica also fulfilled another key function, that of industry barometer. The trade fair started on a bleak note but slowly moved into more promising waters by the end! Medium-sized businesses signaled that investment budgets were available and decisions were being made.” We are now seeing that investment enthusiasm spread to the large companies.

Just this week, the distribution firm Arrow Electronics raised its outlook for the fourth quarter to revenues between $3.8B and $4.2B on the basis of stronger than expected performance in components sales. Those of you that follow the semiconductor industry have seen the remarkable rebound in that industry. TSMC, the giant semiconductor firm in Taiwan that was laying-off workers in large numbers a year ago is now operating near capacity and just gave its workers a 15% salary increase.

As we look forward into 2010 we do so with confidence that the recovery will continue and the year will be a good one for Data I/O. As Tom Buehrer, Senior Vice President of a leading research company puts earlier this week, “Increased consumer confidence, pent-up demand and a raft of new smartphones have created conditions akin to a ‘perfect storm’ for 2010, and the industry stands to make out handsomely. Purchase intent is at unprecedented levels. . . . “ Delphi, the major automotive electronics supplier that recently emerged from bankruptcy is back in the investing and hiring mode. We see positive signs in all of our segments and our sales funnels reflect it. We are even seeing the programming centers that have been on the sidelines for the past 2-3 years purchasing equipment. It is another clear sign that capacity utilization has rebounded.

While the business environment is clearly improving, we want to keep our expectations within the bounds of reason. And, there are clear reasons for caution despite Jim Cramer’s claim that Q1 2010 could be a “monster quarter” for tech stocks. For example, ChangeWave Research reported today that capital spending has improved for its fourth consecutive survey, but that said, only 14% of their respondents expect to increase their capital spending in the first quarter of 2010. We built our plan for 2010 with conservatism and with hope that as the year progresses we can exceed it.

Now I want to tell you what we did during the downturn. We had a structure that was appropriate for a company with our revenue levels, but knew we were top heavy with management for the lower levels of revenue that we could expect in the downturn. So, starting in October of last year, we began to streamline the management structure. We eliminated three vice president positions and reduced the number of outside directors from five to three. With fewer levels from the bottom to the top, we improved the flow of information and increased the speed of decision making. That also helped reduce our breakeven. We reduced our financial exposure by managing down inventories and receivables, which generated cash.

Then we increased our investment in state-of-the-art development tools for our engineers. We implemented options to our enterprise requirements planning system to provide more and timelier information for our sales force. We increased the amount of time our entire management team (approximately 25% of our total number of employees) was in the field in front of customers during the downturn. Every member of our management team from supervisor to vice president including purchasing, accounting, engineering, marketing, production, human resources, and administration with the possible exception of one or two individuals has been in the field calling on customers and non-customers so we understand the needs that we are meeting and those we aren’t. That information is shared widely within the organization and it guides our investment to ensure that we are meeting the customer needs today and into the future.

Here are a few of the things we did not do. We did not resort to mass layoffs. We did not cut working hours, and although we delayed scheduled salary increases, we did not cut salaries. We did not cut back on investment in the company’s key strategic initiatives; instead we increased it. We added people with critical skills, particularly in software, to strengthen our ability to execute our plans.

Two years ago, we implemented a new planning system that forces us to address all three time horizons of the company’s activities concurrently. At our quarterly management meeting, the team reviews the plans for the current quarter. That is the very near-term horizon. We examine those plans in light of the results from the previous quarter. We tie our financials and sales forecasts to specific accounts and opportunities. We assess the impact of new products as well as changing price and cost structures. This shorter-term planning is focused primarily on the existing business as it is the source of profit and cash used to fund new business development.

As important as this quarter’s sales and earnings may be to the shareholders of a publicly traded company such as ours, we also know that if we allow the present to consume all of our time, we will fail to create the future. This is a very dangerous trap and it is easy to fall into it, particularly during a downturn when you are fighting for every dollar of revenue and profit. So, at the same time, we spend considerable time planning the next four quarters, the intermediate-term horizon. Here we review the new product initiatives and identify emerging opportunities. Our cross-functional teams overseeing each of the major initiatives report on their progress and we take action to align our resources in marketing, sales, operations, engineering, and service with the priorities.

But there is a third and very important horizon of growth that must be considered as well – that horizon takes us out two to three years or more. That is the horizon where we take options on the future. This is the area of corporate development where we consider adjacent markets; explore the impact of emerging technologies, and where we consider acquisitions of technologies, product lines, or even other firms that could transform our business. Many of these options require cash to pursue and it is one of the reasons we have worked hard to generate and accumulate cash even during this downturn. The cash provides options to drive growth, to automate and drive down our cost of goods, to create barriers to entry that block competitors, and to fund the working capital requirements of our business as it rebounds from the recession.

Our business niche is small and we have many competitors that follow our moves closely that there are limits to what we can say without compromising the company’s future. At times we can lift the cloak of secrecy and provide some insight with respect to our strategic initiatives in the intermediate time horizon. With respect to the longer-range planning horizon, unfortunately, we can say nothing because of the competitive risks.

During the downturn we have maintained our balance of focus on all three horizons of growth. We discussed our plans for all three horizons all the time and in-depth at our quarterly management meetings. We refused to let the economic downturn as severe as it was distract us from our intermediate and long-range goals. As a result, our plans remain intact and the company as one team together is executing on those plans.

We wish you a joyous holiday season and look forward to a prosperous 2010 together.

Sincerely,

Fred Hume

President and CEO of Data I/O Corporation