Data I/O Corp (DAIO) 2010 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Data I/O third-quarter financial results conference call. At this time all lines are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. As a reminder, this conference is being recorded.

I would now like to turn this conference over to our host, Mr. Fred Hume. Please go ahead.

Thank you and welcome to the Data I/O Corporation third-quarter 2010 results conference call. With me today is Joel Hatlen, Vice President and Chief Financial Officer of Data I/O. This afternoon, Joel and I will discuss the third quarter of 2010 operating results.

Before we begin, I would like to remind you that statements made in this conference call concerning future revenues, results from operations, financial position, economic conditions, product releases, and any other statement that may be construed as a prediction of future performance or event are forward-looking statements which involve known and unknown risks, uncertainties and other factors which may cause actual results to differ materially from those expressed or implied by such statements.

These factors include uncertainties as to levels of orders, ability to record revenues based upon the timing of product deliveries and installations, market acceptance of new products, changes in economic conditions and market demand, pricing and other activities by competitors, and other risks including those described from time to time in the Company's filings on Forms 10-K and 10-Q with the Securities and Exchange Commission, press releases and other communications. The accuracy and completeness of forward-looking statements should not be unduly relied upon. Data I/O is under no duty to update any of these forward-looking statements.

With that out of the way, I am pleased to say that we had another great quarter. Revenue was $6.6 million, up 24% over last year. New orders were $7.3 million, up 44% from the third quarter of last year and up 12% sequentially from the second quarter of 2010, showing significant momentum in our business.

A significant Q3 shipment was deferred into Q4 at the customer's request. As a result, deferred revenue increased by $0.5 million to a total of $1.9 million in the quarter. Backlog at the end of the quarter stood at $1.7 million, up $300,000 from $1.4 million at the end of the previous quarter.

Gross margin was 57.9% of sales. Excluding the reclassification of some nonrecurring engineering expense to cost of goods, gross margin would have been 60%. Operating expenses were $2,859,000, up $23,000 or approximately 0.8 of 1% from the $2,836,000 recorded in the second quarter. Operating income was $1 million or 14.6% of sales. Net income was $833,000 or $0.09 per share.

Cash at the end of the quarter was $17.5 million, up from $16.8 million at the end of the second quarter. Joel will share more detail on the financial results in a moment, but first some high-level remarks.

Asia was a very bright spot in the financial results. Orders from customers in Asia were up 72% sequentially from the second quarter of 2010, and up 122% compared to the same quarter of last year. This is a new record.

The Asia sales team cracked a record number of 11 new accounts with much of the business coming from advanced devices such as smartphones and tablet computers. Orders from customers in Europe were down from the record level we witnessed in the previous quarter, but still up 11% compared to the same quarter of last year. The European team cracked three new accounts, one in the automotive sector, one in industrial control, and one in the semiconductor space.

Orders from customers in the Americas were up 16% compared to the same quarter of the last year. The Americas sales team with its expanded footprint succeeded in penetrating nine new accounts in the quarter. While some of their new account activity was relatively small, there is good long-term potential with these customers.

The strength in global demand was spread across all of our customer segments with significant levels of activity in consumer, wireless and automotive accounts. Orders for our automated programming systems were up 88% over the third quarter of 2009, consistent with the strengthening industry recovery.

Orders for consumables were up 16% over the same period of last year. Our new FlashCORE III programming technology contributed significantly to the third-quarter results as well.

Overall, we believe that the electronics industry is continuing its recovery. New durable goods orders for computers and electronics products as reported by the U.S. Census Bureau were $28.4 billion in August, the most recent month for which data are available. That compares with $24.7 billion reported for August of last year, and up from $27.7 billion in May of this year as mentioned in the last quarter's call.

Now I will ask Joel to give you more detail on the financial results for the third quarter.

Thank you, Fred. Good day to everyone. Revenues for the third quarter of 2010 were $6.6 million, up 24% compared to $5.3 million in the third quarter of 2009, and essentially flat sequentially compared to $6.6 million in the second quarter of 2010.

International sales represented 86% of total sales for the quarter, with a revenue increase in Asia of 102% and a decline in Europe of 1% and a decline in the Americas of 6%, compared to the third quarter of 2009. However, orders actually increased in all regions as Fred discussed, with orders in Asia up 112%, Europe up 11% and the Americas up 16% when you are looking at the bookings.

The variation in sales percentage versus the order bookings percentage relates to changes in backlog and deferred revenues. Backlog at the end of the quarter was $1.7 million, up from $1.4 million at the start of the quarter. And as Fred mentioned, the change in deferred revenue during the third quarter was $528,000 and was primarily due to one large PS system that was shipped and invoiced. But due to the customer's timing of installation and acceptance, it remained recorded in deferred revenue and in inventory until its scheduled completion next month.

We saw our FLX and our PS families as particularly benefiting from the growth in demand from Asia, with smartphones, tablet computers and automotive applications driving a more than 40% increase in our automated product lines.

The gross margin as a percentage of sales was 57.9% for the third quarter of 2010, up 170 basis points from 56.2% for the third quarter of 2009. The primary causes for the percentage change were due to the effect of increased sales volume relative to fixed factory and service costs, the product and price mix, and then lower factory variances.

Partially offsetting this was the inclusion of additional development cost charged to operations associated with software contract revenues, that [CNRE] Fred mentioned.

Operating income was $965,000 or 14.6% of sales, up from $348,000 or 6.5% of sales a year ago. Operating expenses were $2.86 million in the third quarter of 2010, an 8.1% increase compared to $2.64 million in the third quarter of 2009.

The third quarter of 2010 had additional pay-related costs due to less vacation usage, employee hires, raises, incentive compensation, recruiting fees, healthcare costs, and expenses relating to upgrading our information system version.

I am actually pleased to note that the upgrade conversion was completed this past weekend, and up and working on Monday morning. I actually look forward to benefiting from the added capabilities and enhancements this new software version will provide for us.

In accordance with US generally accepted accounting principles, GAAP, net income was $833,000 or $0.09 per diluted share for the third quarter of 2010, compared with a net income of $331,000 or $0.04 per share for the third quarter of 2009. Earnings per share included the impact of equity compensation expense of $0.01 per share for both the third quarter of 2010 and 2009.

We had an income tax provision for the quarter due to taxable profits in foreign locations as well as certain states. We have net operating loss carryforwards, NOLs, of $16 million as well as other credit carryforwards in the United States that are available to continue to offset our future US net income, and we will continue to analyze and manage taxes as the year progresses.

Data I/O's cash increased to $17.5 million at the end of the third quarter. Accounts receivable increased to $5.5 million from $4.8 million last quarter, primarily due to the increase in invoiced deferred revenue as well as sales taking place relatively later in the quarter. Inventories increased to $3.9 million at the end of the third quarter compared to $3.4 million last quarter, and largely occurred to support the increased backlog in deferred revenue.

At this point, I will turn the discussion back to Fred.

Thank you, Joel. I am pleased to report that the Company continues to make good progress on its new products and new business initiatives. Combined with a favorable business climate anticipated by most industry analysts for 2011, we expect to see revenue growth next year.

At this time, we will open the lines for your questions.

(Operator Instructions) Dennis Van Zelfden, Brazos Research.

Thanks, good afternoon, gentlemen.

Good afternoon.

First off, Joel, quickly what was the depreciation in the quarter?

I don't have that right at my fingertips, but it was almost exactly what it was last quarter.

Okay, fair enough. The second question is a big picture question. Actually before I get to that, Fred, if I understood correctly if that one customer had not deferred the order, you would have generated approximately $7.1 million in revenue in the quarter; is that correct?

Well, the customer didn't defer the order. We got the order. The customer delayed acceptance of the product for their own reasons and as a result, we were able to go ahead and ship the system and actually invoice the customer. But we won't actually recognize it as revenue until the fourth quarter. Joel, the exact amount?

A little bit less than the $500,000, because there is a couple other small machines that were in there as well.

I see. So just under $500,000.

Okay. So my point is that is a little abnormal, and had it not happened, revenue would have been about $7 million.

Yes. You know, Dennis, that is right. Honestly, we say it is abnormal but with our business the way it is, these situations do happen where we get toward the end of the quarter and there is a situation where it gets deferred. But you are right, the revenues would have been $7 million otherwise.

Okay. Now going to the big picture question, in your documents you say you have roughly 20% of the market, and you are going to do in the neighborhood of $25 million to $26 million in revenue this year, at least according to my estimates; just using round numbers here. That implies a $130 million market. Am I to assume that that is only the non-in-house market you are talking about?

Yes, yes. I think a better way to look at it, Dennis, is to think about the fact that there is 20 billion programmable devices shipped each year, and we touch about 20% of those with our equipment. So that gives you a sense that there is this other land of devices out there.

It is difficult to put a number on that because some of those devices use very, very expensive programming techniques. So if you were to convert those devices into dollars, it would be hundreds of millions of dollars in terms of available market.

And again, that is the non-in-house. That 20 billion shipped is the non-in-house or is that the total?

That is the total. That is the total number of programmable devices shipped.

Okay, and you think you touch right now 20% of that amount?

Between all of the equipment that we have shipped over the years, yes.

Okay. Given that, your revenue growth this year has been approximately 43% year to date. How much of that business has come from previously in-house business? Have you taken anything away from previous in-house business?

Yes, we continue to do that. We launched a major initiative to start that a year ago, Dennis, and we have been making very good progress on that with a number of accounts. We haven't explicitly broken out that number, and we may in the future, but we haven't as of yet in terms of actual dollars of revenue that we have generated from that.

Okay, but you are telling me that you are taking share away from those companies who previously did it in-house?

That is correct.

Okay. Of these, I think I heard 11 new accounts somewhere -- maybe it was in Asia, I am not sure where. Of those, how many of those were previously in-house customers and how many are just plain old brand-new?

I want to be just a little careful on this because when we use the words in-house, most of the ones that are buying, for example, our PS or our RoadRunner families, those are actually doing the programming in-house themselves. The really qualifying piece is who is outsourcing to a programming center or factory programming, or who is using an alternative of in-system programming or some other way of programming later on in the manufacturing process. And those are the ones that we have actually been getting winds against.

We have had people that no longer decided to use outsourcing, but have decided that they want to take control of that and to save the costs by doing it in their own programming center in-house, or they have adopted our RoadRunner for online programming.

The other piece is people who previously had bottlenecks in doing it maybe inline are now going to, for example, the RoadRunner or one of our off-line processes in order to deal with the bottlenecks created by these growing files.

Okay, your business is kind of complicated, so it is a little hard to understand.

It is, it really is.

Let me ask this, during the quarter, say, or the last six months or so, have you lost any business to someone saying, no, you are too expensive or you are not quick enough; I'm going to do it all myself in-house?

Wow. Joel, how would we answer that one?

I think I am not aware of any that said I'm going to do it in-house that wasn't already doing it in-house. But we did actually have a few systems where a competitor, for example, just went much lower on their pricing than we were interested in going for that particular piece of business. So there is a couple of those but not too much.

Okay, just continuing on this pricing question, is there pressure on pricing overall or was that a specific job or specific this or that?

I think, Dennis, maybe the way to say this is we operate in many geographies around the world, and we compete with different competitors in different geographies. The set of competitors that we compete with in China typically are different from the ones that we compete within Europe, in Eastern Europe or in Mexico or other geographies.

And different competitors in different regions, you know, they may have a strategy which says we are going to basically buy business on the basis of low cost. So that is an issue that we face all the time. There has been no fundamental change in the competitive environment with respect to pricing pressure in the last quarter. Does that answer your question?

Yes. You are not terribly worried about pricing pressures going forward then?

No. If we look at our gross margin, for example, in the third quarter and we readjust for the fact that we reclassified some engineering expense into cost of goods, we balance that -- back that out, we're right back at our 60% gross margin.

So if there was any significant increase in pricing pressure that was affecting our margins, that would have shown up, and it is not there.

Okay, last question and I will let somebody else ask a question. How much visibility do you have in your revenue? How far out can you look with what degree of certainty?

That is a good question. I think it is pretty easy to deal with that. For example, we look at our backlog. And our backlog and the combination of it which stood at $1.7 million at the end of the third quarter, and then we look at deferred revenue which was $1.9 million.

So it is really the combination of those which is up there at $3.6 million. That we look at as our business in hand. That is sort of the business we have in hand when we are starting the quarter. Not all of that will be recognized in the upcoming quarter, but a substantial amount of it will be.

So that is sort of one piece of it. And some of it comes from our consumables, which is an ongoing item which is relatively stable in terms of its procurements related to the utilization of the equipment that we have already shipped, and from the renewal of software update agreements that we have on our equipment that is out in the field.

So we have a certain base of business that we have that we can count on going into the quarter. Then over and above that, the other 50% or 60% depending on the quarter, those are the systems orders that we are going to get in the quarter. And we have a very rigorous funnel process by which we track all of the sales opportunities.

We track them at the stage, what stage they are in the order process, whether or not funding has been approved; and when orders are expected whether or not our proposals have been accepted, whether or not we are in negotiations with purchasing. So we monitor that and that gives us visibility of what is actually happening on the ground.

And then we are constantly looking at the more macro environment for the industry overall in terms of what is happening with our end markets, things like what is happening with consumer electronics, what is happening with wireless handsets, what is happening with automotive electronics, what is happening with consumer electronics. So that is how we build our visibility of what our business is going forward.

Okay, thanks. I will jump back in the queue.

Michael Potter, Monarch Capital Group.

Congratulations on another good quarter.

Thank you, Mike.

Fred, can you give us a little more color on our software strategy, the value proposition behind it, and when we go from a customization to a more commercial launch of the software product?

Well, Mike, we don't actually publicly disclose our strategy in terms of specific time frames on new products. But I can tell you that we have had a very systematic effort going on to build our strength in software.

We got another six-figure order in the third quarter for software related to things that we're going to be bringing out in 2011. We feel very good about that software strategy. We have hired a new software development manager that brings tremendous expertise with him to further accelerate our software efforts. So that strategy is in place.

Software adds a tremendous amount of value to our customers. For example, if a customer mis-programs a part, it can have huge financial implications of literally millions and millions of dollars. So providing software solutions that protect their intellectual property, that control their process to minimize the chance of making any type of a mistake, and to make sure that they are able to roll out their software at their production facilities around the world in a uniform and controlled manner, those are things that have very high value to our customers.

Those are customers in high-volume space like the wireless space as well as in the automotive space, and so that is the strategy that we are following.

Joel, do you want to add anything to that?

No, I think it is just one of those ones where we try and find ways of knocking off and satisfying individual customers and then figuring out how to extend that to a much larger group, so that we can essentially productize these developments that are sort of paid for as we go.

Fred, is this -- again, we are in a hot button area here where we're adding -- this is security software, correct?

Yes.

Which is obviously very valuable, hopefully valuable to our customers. Is this an area that is going to be growing as a percentage of revenue for our company?

Well, it certainly has been growing this year, Mike. We expect it to be a significant driver of growth in 2011, yes.

And I am assuming we will be hearing hopefully more about it in the coming quarters?

Yes, you will.

Terrific, guys. Thank you.

Steve Spence, RBC Capital Management.

Good afternoon, gentlemen. Wondering if you can help us a little bit and you've sort of touched on these things. We have sort of become splendidly accustomed to the growing share of software and its contribution to gross margin.

Yes.

And it's starting to feel a little bit like maybe you have sort of reached a tipping point where it is going to be a little harder to see the software component grow a great deal more against the existing sales base. Is that fair to say or how might you characterize it?

No, Steve, I think I would say the opposite. We expect software sales to continue to increase and become a larger and larger percentage of the Company's business.

Okay. Is there anything about the last couple of quarters -- because your first quarter is seasonally a little slow if I recall correctly. So looking at the second and third quarter, the gross margin, there was a slight erosion in it. And I know this is a very limited period of time in which to measure it, but was there anything going on in that area maybe in terms of product mix or other things within the hardware side that created any noise? I am just trying to put that in context.

Well, from a software standpoint, some of the nonrecurring engineering charges that in essence were associated with those contracts, we're doing this on a percentage of completion method. So that means that we actually reclassify those R&D engineers up to a cost of goods sold piece associated with that revenue. So you don't have on some of these contracts the typical software revenue where the margin is a $10 disc and that is it.

Here we are actually reclassifying those engineering hours, so that is a bit of the reason why Fred made the comment that without that reclassification, we would have been at a 60% gross margin this quarter.

Okay, I now follow you. I am sorry to be so slow.

No, no, Steve, it is okay. It is a challenging issue, and I think it is one that it is worth exploring a bit. I think what I would like to say is that what we have been doing this year and at the end of last year is we have been developing this software base, the software infrastructure.

And we have been doing a lot of work with customers, specialized customers, to implement pieces of this for them, and they have been paying us for that development. So in a sense, we have been having customers offset some of the development expense that is leading us to the software solution that we want to roll out.

When we ultimately roll that out in 2011, we won't be having any more of these charges back into cost of goods. In fact, what you will be seeing instead is you will be seeing the recognition of the actual -- the revenue and the very favorable impact of having a commercially available product which no longer has this engineering development expense associated with it.

Okay, that is very helpful. Second question for you. You guys have really spoiled us over the years with respect to really vigilant cost controls, and I can't imagine what would happen in your shop if we didn't copy on both sides of a piece of paper. But there seems to have been a little bit of stall in SG&A; a considerable increase in sales from a year ago, but SG&A stayed stuck at 29%.

Is there something that's unusual going on in those numbers that are holding them up, and is there any plan to try to gain more leverage out of sales?

We did have some significant G&A expenses, one-time expenses, in the third quarter, Steve. I will let Joel comment on that.

Yes, we had, for example, compared to last year in 2009 where we had some very favorable variances that went through, this year we actually had a lot of people not taking as much vacation. So we got some charges associated with that that built up.

We hired some people, so we had some additional recruiting costs and some headcount increase. There were raises that were done in July 1, so that had an effect. Healthcare costs have gone up a bit. And then we have had some expenses relating to the upgrading of our information system version that I referred to during the call, and that is added to some G&A that as of last Monday we won't be having any incremental costs associated with that any further.

Okay, and that is fair to say, but of course --.

The answer is we did have some extra G&A this quarter that we don't expect to repeat next quarter, for example.

Right. Well, you had a pretty good acceleration in sales, and I would hope and expect that on a year-over-year basis that that would have created some additional margin and gross dollars for expenses. Do you guys have a target for SG&A?

Yes, we have a target that says that we want to be under 30% in our SG&A expenses.

Okay, all right. It won't be news to you that I have a question on this. Your ROE is at 13.8%, and that would put you I think versus other technology companies, particularly those who are software-intensive businesses, without a lot of capital plant. That puts you guys well back in the pack. Have you any plans to address that? And in particular, obviously, the amount of cash that you are holding on your balance sheet?

Steve, the answer is cash is something that we discuss really at every board meeting, and we discussed it in depth at yesterday's board meeting. And I can tell you that we secured the services of an outside financial expert as well as an SEC attorney to help us make sure that we reviewed all aspects of our cash policy.

And I can report and I am very pleased that we had a very comprehensive discussion. We covered just about every aspect that you can imagine with respect to the Company's financial strategy, its cash position, its utilization of cash, the demands of growth, the opportunities for further corporate development, just every aspect. And particularly the Company's financial position with respect to its peer group of 13 companies and how it fits in the overall industry.

So I can tell you that the issue has been thoroughly discussed. It is something that is an important thing, but I really can't reveal anything else.

And I appreciate and respect that. I would also share with you at the same time as a shareholder that at the end of the day as you're working at growing these earnings, and one of these days hopefully having something like $0.60 in sight, for you guys to get a peer group multiple when your ROE is under 14% is hard to see. And I would hope that among the metrics that you are managing against, it is driving that ROE up through 20%.

That is clearly in our targets. Yes, Steve, that is music to our ears, yes.

Okay. You have a big fan down here in Portland.

Okay, thank you.

[Tom Maguire], private investor.

Good afternoon, gentlemen. Good quarter, and thanks for taking my questions. When I first looked at the press release, I read it and looked at the tables and I thought everything was very, very good, but the top line was a little unsettling. Now with the call, you explained the shipment, the deferring the revenue, so that makes me feel a lot better.

But I am a bit deficient in fully understanding your sales cycle. I think you're doing a marvelous job with operating the business. You have the breakeven point way down and you can generate a 15% operating margin on $7 million in sales. But the disconnect that I have is I read about all of these iPhone shipments and tablet computing taking off, and recovery in autos and such.

And my question is -- and this is what I thought when I first saw the top line of $6.6 million -- I was saying, why isn't the top line even more than it is? And of course, you mentioned about the big order there. But can you kind of direct me to fully understand the implications of the underlying drivers and how that will affect the top line, so I don't get too carried away in terms of expectations?

Sure. Tom, I think that is a good question, and it's been a challenge for a lot of people to get their thoughts around. And I think one of the simple ways to explain it is this; that if demand is growing linearly, that is that you look out there at the number of programmable devices being shipped each quarter, if that demand is growing linearly, the capacity required to support that additional growth is a fixed amount. Because you have already shipped equipment, there is already equipment in place or customers already have solutions to program the parts that have been shipped in the past.

So the capacity that is being added is only the capacity that is required for the increment that has been shipped. So if there is a growth, a linear growth in the overall shipment of programmable devices, that translates to fixed demand essentially for programming equipment.

So it is really only when there is a second derivative effect on the growth of shipments that you get demand for more capacity. So that is the issue of capacity and how it relates.

Now fortunately for us, there are other things than just sheer capacity that drive demand. One is cost savings, cost reduction, process improvement, quality control, security. There is a lot of other reasons why we are able to sell equipment. If it was only pure demand based on the shipments of devices, we wouldn't have the level of revenue that we have.

The other factor that is growing is, of course, the density of the devices, the actual sizes of the devices that get shipped are growing. And you pick up a tablet computer, maybe six months ago it came with 8 GB or 16 GB and now it is at 32 or 64 GB, and that is going to continue to grow.

The amount of software that is actually being programmed in it grows, and that is another factor, of course, that drives our business. So there are several factors. But you can't just immediately look at the growth in shipments of devices and correlate that directly with, okay, that means that the demand for Data I/O's equipment should grow 16%. Does that help?

Yes, that really helps. Thanks a lot, and that actually leads into another question I was going to ask, perfectly, I think. I am a newer shareholder here and I have kind of gone back and looked at some of the old Ks. And a K back from the mid 90s, I looked there and I looked like in the first half of the 90s, Data I/O was turning out like $60 million to $70 million in sales, and margins weren't as good as they are now.

In the good years, they were in the higher single digits. And then by the late 90s, your business was kind of cut in half to around the mid-$30 million level from I guess the peak in the early 90s of $70 million. So my question is what was Data I/O doing then to have such a high revenue base, and why did business fall off so much?

And then how is the Data I/O of today different than the Data I/O back then? Finally, if this cycle continues can we envision somewhere down the road to get back to revenues in that ballpark? That is a big question.

No, I think this is good. It's fun to kind of revisit that. So I think it is interesting to look at Data I/O's history from the early 70s and up and through 1990; early '70, '72 when Milt Zulchel's [grant record] founder of the Company and how it grew during that period of time when really programmers were used primarily by engineers in development.

And around 1990, the market really shifted away from engineering and there were so many other solutions for programming devices in engineering to the point that today, virtually all of Data I/O's original marketplace and the engineering community is pretty well evaporated.

The semiconductor companies provide very, very inexpensive tools, $100, $200 type of tools that can be used to do that job of programming devices during the early development stage. So what was a substantial amount of Data I/O's growth between the founding of the Company and let's say the period of the early 1990s, that has basically all gone away.

The other thing that happened were there were a significant number of acquisitions. So the Company diversified into a number of areas and that created some substantial amount of business in the early 90s. And one of those acquisitions was really related to software space, EDA, electronic design automation, and really those tools really have impacted a lot the way that some of those parts were programmed in engineering as well.

And the Company divested itself of many of these acquisitions. By '97, they were basically all gone, Tom. So when I came in in '99, it was really basically to start rebuilding the Company, rebuilding the business in a new footing, and get it back into some stability; bring the management team together, get some fundamental processes and things in place that we could build from for the future.

And that has largely been done now, and what we have really been focusing on now is areas for growth that are outside of the traditional put a part in a socket and program it, which is sort of if you think about it in terms of an old way of doing things, that is really in the decline. And there is just a lot of other opportunities now that we have to take advantage of as a company. So that is the big shift.

Joel, do you want to make any other comment?

Yes, I think the other shift is during the last 10 years, we have shifted to really supporting and focusing on flash memories and then flash-based micros. So that has been a technology focus which included things like the NAND flash.

And the other piece is that where Fred mentioned before we were primarily an engineering-based company, we have really shifted so that we are really primarily a manufacturing targeted customer set. And if anything, many of the things that we are looking at doing and working on helps us to try and go back and reconnect with some of those R&D engineering.

Okay, great. Thank you very much. Just one follow-on to the software question. You expect that to become a significant part of the business in like all software, it carries higher margins which is great. But is that a very lumpy part of the business now? I remember the first-quarter press release when you had two big sales. I don't remember what you said in the second quarter.

And now in the third quarter you mentioned you completed one contract, and then we got an order for another one. So it seems to me it is small and lumpy now, but over time that should level out to be fairly stable and hopefully growing.

Yes, we think ultimately we will be shipping it with all of our products, that it will go out with every single product. And that certainly isn't the case right now, Tom, because as we said, we are still in the development phase.

We really haven't launched a product commercially yet that we are selling to our customer base at large. And once we do that, we expect virtually all of our customers to use elements of this new software.

Okay, good. Then one final question. Joel, when you ran through the numbers, you ran through them very fast, and I don't mind that. But you said something to the extent -- and I hope I am paraphrasing correctly -- you said that sales occurring later in the quarter, you mentioned that.

Now I am thinking -- because I didn't hear the first part, I am thinking the question, is business accelerating? Meaning the sales started growing or came in later in the quarter, and is that an acceleration of the business? And if that is, is it continuing in the fourth quarter in acceleration, or am I just wishful thinking?

Well, it is a little wishful thinking. I think a big chunk of this relates to two or three items. The first one is that traditionally in the third quarter, Europe goes to sleep and goes on vacation during July and August. So that means we get a disproportionate amount of our business in the month of September. So there is a big driver in Europe.

And then in both the Americas and Asia, we really did a lot of stuff to get sales funnels built up early in the quarter but didn't really get the orders in or get the shipments out until basically September. So what happened is I had more than half of my business all getting shipped out in the month of September, so I didn't get a chance to collect very much of it.

And that is the context of it is why did our receivables build compared to last quarter when we had roughly the same amount of revenue.

Okay, thanks. Finally, is the fourth quarter usually the seasonally slowest quarter or not?

Well, the first quarter, Tom, is typically our seasonally weakest quarter. It is really hard to talk about seasonality right now, I think, because the industry is still in a recovery phase. So I think -- I still think all bets are off really in terms of where the industry is going to return back to a normal seasonal pattern. So I think it is just hard to talk about anything being normal right now.

I think we are still -- executives are still cautious with respect to spending capital. Everybody has adopted a certain amount of wait-and-see attitude, and the wonderful thing is that the data keeps coming in substantiating the fact that despite some of the highest level macroeconomic factors, the kinds of products that we support with our equipment -- tablet computers and e-readers and mobile computing devices and global smartphones and super phones and consumer electronics, those things are still, despite the macroeconomic factors, still continuing to grow and exhibit strong growth.

Okay. Thank you very much, Fred and Joel, and I look forward to a great fourth quarter and 2011 coming on.

Thank you very much.

[David Cannan], [First Midwest].

Good evening, gentlemen. First question is what were the orders, and you may have mentioned this, but what were the orders for the quarter?

$7.3 million.

Okay, so by far that was your best quarter of the year in terms of orders, correct?

Yes.

Okay. I noticed deferred revenue was up $525,000 sequentially and backlog was up $300,000. What were the drivers there and based on the past does this not point towards a stronger sequential Q4?

I think the answer is yes. Typically, we ship a significant amount of the backlog in the next quarter so the fact that backlog went up just indicates that we are likely going to ship more in the fourth quarter out of backlog.

Then the deferred revenue, we have talked about that. That was basically a large system that we actually shipped in the third quarter and invoiced the custom but decided not to, for acceptance reasons, not to recognize it in the third quarter but instead to recognize it in the fourth quarter. So it gets carried on the balance sheet as deferred revenue.

I see. Okay, so --

And that is about $0.5 million.

I see, okay. Is the balance of that deferred revenue related to software or a combination of software and maintenance contracts? If you can give me a little more detail.

Joel, go ahead.

On the deferred revenue, the vast majority of the rest of it relates to our software and maintenance agreements where we basically take an order and collect the cash up front and then have to amortize it over the 12-month period that it covers. So that is the majority of it.

There are some other -- every quarter there is some amounts that we ship an item but haven't done all of the parts of installation and so we might have to defer 5% of it for some installation purposes. But most of it is that -- of the rest of it is that deferred software maintenance and contract revenue.

Okay. And then in the press release you said that in Asia you cracked 11 new accounts, smartphones and tablets. Now tablet computers this is really a new market for you guys. What can you tell us about these particular customers and the bulk of these products? And what can you share with us about these customer requirements going forward?

Well, Dave, the key element that these devices contain is an embedded flash memory and it's a special kind of embedded flash memory. It's what we call embedded flash media.

We launched a flash media initiative about three years ago and you may recall that we introduced our first product in the flash media space -- it was at least two years ago, Joel, maybe three. So it's an area that we have been working on because we believe that this would be an important element of company's product architecture in the future.

I am sorry, Fred. Fred, just I need to clarify something. When I say requirements I am talking about mostly capacity; I don't mean technical requirements.

Okay. Well, most of these devices, Dave, were built on new lines and so we got orders from customers that we hadn't been dealing with before for these particular types of devices. It's a new market as you know, so I am not quite sure what else I can tell you. Joel, what --?

No, I think that is -- mostly it's the fact that these kind of devices that they are doing are generally much larger in their size and so that means it takes a lot of programming so that means there is a lot of equipment. In particular, as Fred had alluded to with our Flash Media Duplicator, that sort of got taken over by our new FlashCORE III technology which is just optimized for this type of stuff.

And so the throughput and the capability of being able to do these devices and the amount of speed on handling the size of these devices have meant that we have positioned ourselves pretty well for being able to capitalize on this type of business.

Now because in particular tablets is a new market for you guys, I guess what I am trying to drill down to and get more color on is requirements in terms of capacity additions. Are these -- these particular new customers that you cracked are these high-volume producers? Are you early on? If we had to measure it by terms of a baseball game, what inning are we in? How much expansion do you guesstimate exists with these customers?

Well, the market is growing, Dave, and there is a -- I am looking at a sheet right in front of me. IDC published a report that said tablet PCs will grow to 18 million units in 2011.

Here is another report -- mobile computing devices, including tablets, will grow at 19.1% compounded annual growth rate through 2014 growing to a 400 million units. [In-stat] published that report. Here is another report from displaced search notebook that says tablet PC shipments are expected to increase 30% year-over-year in the fourth quarter of 2010.

So we are in a rapidly growing market. It's still in its infancy, but, as Joel pointed out, it's a pretty important space to us because the biases, the embedded flash media devices that are in these handheld tablets have very large file sizes and it requires a lot of programming.

Joel, orders for the quarter were $7.3 million. I don't remember what they were in Q2. Can you just refresh my memory please?

Yes, let me just double-check to make sure I have the right --.

I think it was at $5.5 million, wasn't it?

In Q2, for orders?

Oh, no, no, no. It had to be better than that.

In Q2 the orders were $6.5 million.

$6.5 million, okay. So you had about an $800,000 sequential increase because of the deferred revenue we didn't see it flow through. Okay, so the quarter really would have been north of $7 million and probably like $0.16.

So now, we will pick that up this current quarter related to that particular customer?

Yes, with regard to the deferred revenue. The other items, they are just sitting in the backlog that we are going into the quarter, this next quarter where we can ship them out very quickly.

Okay. And then you made a comment about security software, you expect it to be (inaudible) significant driver in 2011. Can you give me a little more color on that and sort of sketch it out for me, give me a sense as to what you think the opportunity is in 2011? Are we talking 20% of revenue, 10%? What do you think would be reasonable?

Dave, we really can't comment on that, but I think I should make it really clear that there is much more involved with what we are doing in our software offerings other than just security. Security is a very important piece to certain customers and is becoming an important piece to many, many more customers.

We had customers that when we went out and surveyed them a year ago and asked them about their security concerns they said they didn't have any. When we surveyed them this most recent summer again a very surprisingly large number of them came back and said they had very serious security concerns. It's either over the security of their processes, the security of their intellectual property, or the security of the actual devices themselves that they are shipping to their customers.

But the software we are developing has many more aspects to it than just security. It has actually got a portfolio of capabilities.

Okay, thanks. Good luck in Q4.

Thanks very much.

Walter Ramsley, Walrus Partners.

Thanks for taking my call. I have got a few questions, if you can believe it. There is still some left. In the third quarter or maybe for all nine months, whichever way you might have it, do you have a geographic breakdown of the revenues by Asia, I guess, Europe, and North America, or however you keep track?

Walter, we don't actually publish that information. We will sometimes allude to certain pieces of it, for example with where things are growing, but that isn't something other than in our 10-K at the end of the year we actually publish that information in terms of the overall geographic breakdowns. We do indicate, however, much of them are international sales and there it was 86% for the quarter.

Okay. Well, that is good enough I think. Okay. And as far as the overall revenue breakdown is concerned, do you break that down by maintenance and consumables and system sales?

Traditionally we do not do that. We do give information with regard to how much are automated sales and we will give some stuff on our non-automated sales, which we talked about the fact the automated sales were up 40% this quarter. Then what we kind of do that is a little bit tricky is we talk about our adapter orders but those are broken also further into the automated and non-automated so it's a little hard to break that out.

But our adapter sales and our software maintenance sales are something that really represents about 25% of the business and -- actually the adapter sales represent about 25% of the business. Then the, I will call it the software maintenance updates piece, is really running about another 10% beyond that.

Okay. Well, that is good. Okay, great. That covers that one. Do you tell what the size of your installed base is, how many systems are out there?

You know, we have never really reported that information. I can tell you we have hundreds of automated systems out in the field. We have single customers with more than 100. So there is -- I just, in terms of actual pieces of our equipment that is out in the field that is actually operating it's really in the thousands. I don't know how else to say, to give you anything other than that.

The piece that is a little bit more difficult on that side is so much of our business is international and done through distributors that we have a difficult time of knowing how many systems that we have sold and placed through them are actually in use at those customers. We do a fairly decent job of tracking the really big systems, but even those are hard when -- our PS family has been in existence for 10 years now. In that ten years most of those have upgraded but some of them are either sitting idle or some of them are used only as backups.

I see. Can't you kind of guess just from the maintenance contracts or is that just too roundabout of a process?

Well, it doesn't always work. It works for some of our products pretty well, Walter.

No, that is fine. All right, that is fine. I am just trying to see in general if there is an opportunity to sell some of these new products to your installed base and how big of an impact that could have on your revenues. So you can look at it from that standpoint.

I think, Walter, one of the things I can definitely tell you about that is when we introduced FlashCORE III in the fall of last year we anticipated that we would get a substantial amount of revenue over the next three years from customers upgrading from our old FlashCORE I and FlashCORE II technology to FlashCORE III. And we are definitely getting an acceleration of business related to customers upgrading based on this new capability that we are providing.

So they have the capability of taking some of their existing systems and putting our new FlashCORE III technology in it and they get a lot more life then -- more capability out of their existing investment. And we think that is going to continue to accelerate over the coming quarters.

That makes sense. Okay. In the past few quarters the stock option expense, the [one, two, three R] has been going about [80,000]. Is that what it was in the third quarter and is that likely to continue?

To be honest I don't know the exact number but it's almost identical. We typically do our option grants in May of each year in conjunction with the annual shareholders meeting. So other than a little bit of a change that might relate to a new hire there is really no change quarter to quarter.

Okay. And with 86% of the sales international do you price it all in dollars or is there some currency ups and downs?

There is some currency ups and downs. We price to our international distributors virtually all in US dollars other than in the territories in Europe where our German subsidiary does business direct. And that covers parts of Eastern Europe; it covers the German-speaking countries of Germany, Austria, Switzerland. Then certain other areas like Denmark might be covered by the German office directly.

So the dollar --

Those are all done in euros.

The dollar crashing these days that should help the fourth quarter?

It does help the translation of those euro-based sales into more dollars.

Okay. Somebody asked earlier about the pile of money that you have in the bank. Are there potential acquisitions that make sense or is that just not something that is likely to happen?

I think what I can see, Walter, is that we do have very significant corporate development activities. We are constantly looking at other areas in which to expand. Companies come to us and we go looking for other companies and we have lots of discussions. I can't disclose any specific things other than to say at any point in time there are always opportunities on the table that we are considering.

Okay. Well, that is good to hear. Anyway, appreciate you taking the calls. Looks to me like you are doing great. Thanks.

Thank you very much.

Dennis Van Zelfden, Brazos Research.

Just a few follow-up questions, guys. Going back to these 11 new accounts, wherever they were, in Asia I think, can you give us an order of magnitude as to how much business that might represent?

My goodness, I can certainly tell you right off the top, Dennis, that some of them amounted to hundreds of thousands of dollars so they were not insignificant. Some were smaller --.

They have already generated business or that is what they might generate in the future?

No, they have already generated that much. So not all of them are of the same magnitude but some of the ones in the United States and North America were smaller than some of the ones in Asia.

Sometimes you crack into a new account and it takes a while to build the volume. In other cases you crack into an account and you start getting volume immediately. And in the case of some of the new accounts in Asia we got very significant orders in the third quarter.

Is that 11 -- can we expect like a lot of new accounts every quarter? Is that what you are -- obviously you are hoping to get them, but --.

Well, I think we have made that a focus of our efforts. I think one of the earlier questions dealt with the notion of how are we trying to grow the business and we talked about growing the business by converting customers that have other alternatives, such as outsourcing programming or programming after placement using their automatic test equipment or relying on factory programming.

We have really worked hard at helping those customers re-evaluate their programming strategy in the hopes of actually getting some of them to adopt our solutions. And that has been a very effective strategy and that is one of the things that is helping us create new customers.

It's also one of the things that we wanted to measure because we added so many new sales channels and representatives this past year and a half that we were expecting that we were going to get introduced to new customers. And we are seeing that that is actually taking place.

Okay. A couple of other model type questions. R&D costs, they were $960,000 in the quarter. Is that dollar amount expected to stay about level or are you planning on hiring more people?

Well, I think that I would say -- first of all, we are very selective with our hiring. For example, we had to replace our general manager in China earlier this year when the former fellow resigned and so we launched a search and we hired a new president for our China subsidiary, Dr. Qinghua Ma. And Qing is adding a tremendous amount to the organization.

I mentioned that we hired a new software manager to help accelerate some of our software development plans and increase some of the capabilities that we have got in software engineering. And that was a very strategic hire. And so we are continuing to look at very specific cases where a strategic hire can make a big difference in how soon we can introduce a new product or how much capability we can introduce in that new product.

But that said, we are also pretty cautious with respect to the overall level of spending. And I think, as I pointed out in my comments earlier, when you look at our spending in the third quarter they were $2.859 million compared to $2.836 million in the second quarter. So they were only up 23% or less than 1% between the second quarter and the third quarter.

So it gives you a little sense of kind of overall how we keep the expenses in control, so it's something we are looking at all the time.

Okay. With respect to the gross profit margin in the second quarter, third quarter, you said it would have been 60% had there not been this reclassification. Is that reclassification going to be permanent such that we should expect a little bit less than 60% on the same level of business?

No. No, it's not permanent. We have had -- it has been unusual this year because up until this year we really have had very limited amounts of reclassification of any engineering cost into cost of goods. And it has really been the result of a lot of these contracts, software contracts, that we have got that has caused that.

In many cases we have relied on outside contractors so it isn't all fixed R&D expense either. A significant portion of it is variable. Is that helpful?

Yes, yes. Last question. On the second-quarter conference call after you through up sales growth of 69% after a 43% in the first quarter, I asked you could we expect those types of levels going forward. And you said no because you were still kind of rebounding from the economic recession over the last two years or something like that.

Okay. So this quarter we are at 24% growth, I guess, excluding that deferred revenue, and maybe 33% if you include it. But my question is are we now, do you think, at kind of a steady state expected growth rate going forward?

Well, you know, I don't think the Company will ever have what you might think of as a steady growth rate because it's too dependent upon the timing of new product introductions and when we roll those out and the impact of those new product introduction. So some quarters, if we don't introduce any new products in a particular quarter, there may not be so much growth. In some cases when we introduce new products and there is an immediate demand for it and it goes right into place, that can result in some anomalies and some spurts in growth.

And that said of course there is base comparison which as we get down now toward the end of the recovery, the real outstanding comparisons aren't going to be quite as big as they were. Joel, do you want to add?

The only other thing is just when you are dealing with things where you have $100,000 to $500,000 type equipment the lumpiness of when we get an order, one quarter or a week later, can really distort. That is a 5% type -- 5% to 10% type growth change just from a one-order timing.

Okay, so I guess what I am saying is I guess you feel that you are still rebounding from the depths of the recession rather than at a steady state at this point?

That is correct.

Okay, thanks.

Steve Spence, RBC Capital.

Gentlemen, a quick follow-up question. From the standpoint within the EMS community of the installed base of programming equipment and the software that supports it is the scale of the product that these drivers for growth such that it requires a CapEx cycle on the part of the EMS community? And if that is the case, have you seen that impact yet?

Well, Steve, actually it's a very interesting question. The EMS community behaves quite a bit differently from our traditional OEM customer. For example, let's suppose that a wireless handset manufacturer gives a contract to an EMS company to build two million handsets or 10 million handsets or increases the demand on that EMS partner to increase production by adding some additional production lines.

That can translate into an order on us in a very short period of time, because if they bring on a new line they have to have our product on that line. And so they -- it's just one of those things. It's one of the conditions of getting the order from the handset manufacturer they have to have this equipment and so they place the order right away.

In other cases where an OEM customer is planning to develop a new product and they are in the development cycle of the new product and they plan to use our equipment when they roll out that product, very often that is a long lead time decision for them. They know many months in advance and so then we are on a fairly long cycle -- three months, six months, even as long as nine months before the equipment is ultimately procured.

So there is quite a bit of difference in the behavior between the EMS companies and our traditional OEM companies.

I guess the driver of my question is that it seems like most of the high-volume units, whether it's handsets or notepads, would be EMS based. That the companies are not manufacturing for themselves. Assuming that assumption is the case, is your installed base of equipment and the software that supports it capable of handling the type of POBs that are demanded in the state-of-the-art devices or does it drive a replacement cycle on that portion of your business?

So is that POB such that your old equipment, old meaning three, four years, cannot program it or is it adaptable?

So let me try and respond to that. With regard to EMS versus OEM, it is mixed. So we have some customers that maintain their own factories or a mix of their own factories and EMSes and others that are just using EMSes.

With regard to the equipment capability, many of them are upgrading to FlashCORE III very specifically to deal with these types of tablets and smartphones and the GPSes and the different things that really are dealing with these dense devices and these, I will call it these embedded flash memories or medias, as the case may be.

I think the other thing that is what may be underlying a part of your question is the EMSes in terms of whether it's going to drive a round of capital spending. The answer is it's mixed on that one as well because the recovery has not fully gotten up to the level of business in some cases as we were at in 2008. However, many of them actually are at that point where they are actually having to buy new programming equipment when they add the new lines. Period was the show?

Let me just add one other thought on it, Joel, that may help, too. So, Steve, let's say that we have a handset manufacturer that has outsourced manufacturing to five EMS partners and each of those EMS partners have our road runners on their production lines. If that OEM account brings out a new product which has much higher density flash and much larger software content, the EMS partners may be forced to upgrade their road runners on their production lines to FlashCORE III programmers to be able to keep the [tack] time or the beat rate of their production lines in line.

So in many cases it's the technology driver as you are suggesting with the programmable device that the OEM is adopting that is forcing the EMS companies to upgrade their equipment.

Thank you. That is very helpful.

There are no additional questions or comments at this time. Please continue.

Well, thank you very much for joining us today. We enjoyed all of the questions and we had good questions. We look forward to talking to you again at the end of the fourth quarter.

Ladies and gentlemen, this conference will be available for replay after 4 p.m. today through October 28. You may access the AT&T teleconference replay system by dialing 800-475-6701 and entering the access code 173923. The numbers again are 800-475-6701 and the access code is 173923.

That does conclude our conference for today. Thank you for your participation. You may now disconnect.