General

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about themselves as long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact made in this Quarterly Report on Form 10-Q are forward-looking. In particular, statements herein regarding industry prospects or trends; expected revenues; expected level of expense; future results of operations, restructuring implications; breakeven point, or financial position; changes in gross margin; integration of acquired products and operations; market acceptance of our newly introduced or upgraded products; development, introduction and shipment of new products; and any other guidance on future periods are forward-looking statements. Forward-looking statements reflect management's current expectations and are inherently uncertain. Although Data I/O believes that the expectations reflected in these forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, achievements, or other future events. Moreover, neither Data I/O nor anyone else assumes responsibility for the accuracy and completeness of these forward-looking statements. Data I/O is under no duty to update any of these forward-looking statements after the date of this report. The reader should not place undue reliance on these forward-looking statements. The discussions above and in the section in Item 1A. Risk Factors "Cautionary Factors That May Affect Future Results" in the Company's Annual report on Form 10-K for the year ended December 31, 2008 describe some, but not all, of the factors that could cause these differences.

OVERVIEW

We continued to focus on our primary goal of managing the business to achieve profitable operations in these difficult economic times, while developing, launching and enhancing products to drive revenue and earnings growth. Our challenge continues to be operating in a cyclical and challenging industry environment.

We experienced in the fourth quarter of 2008 a significant decline in business, which together with an uncertain economic outlook caused us to determine that additional cost and expense reduction measures were necessary. We took a restructuring charge of $535,000 in the fourth quarter of 2008, primarily related to severance, to further lower the revenue breakeven point for Data I/0. This business decline continued during the first and second quarters of 2009 and we took additional restructuring actions that resulted in a net charge of $22,000 and $158,000, respectively. We are continuing our efforts to balance business geography shifts, increasing costs and strategic investments in our business with the level of demand and mix of business we expect. Complicating these efforts is the current economic uncertainty. With operating costs at approximately $2.5 million we expect our current quarterly revenue breakeven point to be around $4.7 million.

We are focusing our research and development efforts in our strategic growth markets, namely new programming technology, and automated programming systems for the manufacturing environment. We continue to focus on extending the capabilities and support for our FlashCORE architecture, and the ProLINE-RoadRunner, FLX, PS, and FlashPAK product lines. Our applications innovation strategy provides complete solutions to target customer's business problems. These solutions generally have a larger software element, may involve third-party components, and in many cases, will be developed to address a specific customer's requirements. We believe by adding these features to our strategic product platforms, we will be able to set ourselves apart from other product suppliers and elevate our relationships with our customers to a partner level. We recently announced that the next generation of our programmer architecture, FlashCORE III, is being introduced and is part of the PS 388, a new member of our PS family of automated programming systems. We have received our first orders for these new products and shipped them in the second quarter of 2009. In July, we received our first repeat orders for these new products.

Our key customer focus is on strategic high volume manufacturers in key market segments such as wireless, automotive, industrial controls and programming centers. Our strategy includes supporting new NAND Flash and microcontrollers on our newer products to gain new customers and expand into newer areas. For example, our new PS 388 with FlashCORE III focuses on users of large density flash memory devices like wireless handset manufacturers and our new ProLINE-RoadRunner XLF provides a new solution for the types of microcontrollers used in the automotive market. We have continued to expand our China operations to take advantage of the growth of manufacturing in China and to operate close to our customers. During 2007, 2008 and the first half of 2009, we have continued to address the effectiveness of our sales and marketing organization and sales channels by adding, training and changing channels. We recognize the need to diversify our customer base and are continuing to take steps to broaden our channels of distribution and representation to reach a greater number of customers. This decision regarding our China sales operations, made at

On March 18, 2008, the Company completed the sale of selected patents and patent applications to Leannoux Properties AG L.L.C. Net proceeds were approximately $3.3 million with a net gain of approximately $2.1 million.

BUSINESS RESTRUCTURING

The restructuring activities started during the second half of 2006 to reduce expenses and improve margins continued during the first and second quarters of 2007, to further improve our operating results and the effectiveness of our sales and marketing organization and sales channels. These actions included re-engineering some internal processes, integrating some activities, transferring some activities to our lower cost base of operations in China, reducing resources applied to declining legacy products, moving some engineering positions to production, reducing the number of taxable entities, outsourcing some functions such as payroll, combining some positions, eliminating some functions, and shifting some responsibilities and resources to our channels. During 2007 restructuring charges totaled $725,000 and were primarily severance related, along with some exiting facility related costs.

As a result of the business down turn we were experiencing in the fourth quarter of 2008 and the uncertain business outlook, additional actions to reduce expenses were taken. This resulted in a restructuring charge primarily related to severance during the fourth quarter of $535,000 and total of $542,000 for the year 2008. During the first quarter of 2009, restructure activities resulted in net additional charges of $22,000 representing severance and costs associated with terminating vehicle leases. During the second quarter, we consolidated our operations into a smaller portion of our leased space, resulting in a lease abandonment restructure charge of $208,000, partially offset by reductions in previously accrued personnel, automobile leases and legal restructuring costs. At June 30, 2009, $256,000 remains accrued and is expected to be paid out during 2009 except for the lease abandonment period amounts which will be fully paid out in July 2011.

CRITICAL ACCOUNTING POLICY JUDGMENTS AND ESTIMATES

The Company's critical accounting policies are disclosed in the Company's Form 10-K for the year ended December 31, 2008 and have not materially changed as of June 30, 2009.

Results of Operations



NET SALES



                                     Three Months Ended                     Six Months Ended
Net sales by product line       June 30,                    June     June 30,               June 30,
                                  2009                       30,       2009                   2008
                                                % Change    2008                % Change
Automated programming            $2,374       (52.1%)      $4,957    $5,149    (39.3%)      $8,485
systems
Non-automated programming        1,518        (50.5%)      3,066     3,127       (45.4%)    5,726
systems
Total programming systems        $3,892       (51.5%)      $8,023    $8,276      (41.8%)    $14,211

                                     Three Months Ended                     Six Months Ended
Net sales by location      June 30, 2009                June 30,     June 30,              June 30,
                                           % Change       2008         2009    % Change      2008
United States              $496          (60.5%)         $1,255      $961       (56.7%)     $2,219
% of total                     12.7%                     15.6%        11.6%                 15.6%
International              $3,396        (49.8%)         $6,768      $7,315     (39.0%)    $11,992
% of total                     87.3%                        84.4%    88.4%                   84.4%

The revenue decrease of $4.1 million or 52% for the second quarter of 2009 compared to the second quarter of 2008 is primarily due to the current economic downturn with the associated excess capacity and general reduction in capital spending. We experienced decreased sales in all geographies and in each of our product lines. However, revenues did include shipments of our new FlashCORE III programmers in the new PS 388 and in our PS 588. The backlog of orders totaled $1.3 million at the end of the second quarter of 2009, a decrease compared to the backlog at June 30, 2008 of $2.5 million, but a slight increase compared to backlog at March 31, 2009.

For the first six months of 2009 compared to the same period of 2008, sales decreased by approximately 42% and we experienced sales declines in all geographies and for all of our product lines, which we primarily attribute to the economic conditions described above.

Typically we have experienced higher seasonal sales in the second half of the year especially for capacity related sales, which may not be typical this year given the excess capacity caused by the economic downturn. However our trend in booking orders while down substantially from the first and second quarter of last year in all geographies, showed growth over the first quarter of 2009 in both Asia and the Americas. Orders from Asian customers were up over 100% from the first quarter and orders from customers in the Americas were up 16%. Orders from customers in Europe, especially in the automotive business, continued the expected downward trend, down 33% compared with the first quarter of 2009. At the start of the third quarter we are seeing some improvement in orders and are seeing progressively stronger worldwide sales funnels now in the third quarter. We expect our new products including FlashCORE III to provide revenue growth and expect new revenues from our new sales channels as they gain experience with our product lines.

GROSS MARGIN



                             Three Months Ended               Six Months Ended
(in thousands)          June 30, 2009   June 30, 2008   June 30, 2009   June 30, 2008
Gross Margin               $1,882          $4,558          $4,325          $8,320
Percentage of net sales     48.4%           56.8%           52.3%           58.5%

Gross margins during the second quarter of 2009 decreased in both dollars and as a percentage of sales compared to the second quarter of 2008. The overall gross margin decrease in dollars was primarily due to the lower sales volume. The gross margin as a percentage of sales declined primarily due to the impact of the lower sales volume relative to fixed factory costs and inventory write downs of $188,000, offset in part by favorable warranty experience for the quarter. Direct materials as a percentage of sales slightly improved in the second quarter of 2009 compared to either the second quarter of 2008 or the first quarter of 2009. This indicates that our actual product material cost margins had not eroded.

For the first six months of 2009 compared to the same period of 2008, the higher gross margin dollars and gross margin as a percentage of sales are due to the same factors as those described for the second quarter of 2008.

RESEARCH AND DEVELOPMENT



                              Three Months Ended               Six Months Ended
(in thousands)           June 30, 2009   June 30, 2008   June 30, 2009   June 30, 2008
Research and development    $1,008          $1,166          $2,041          $2,265
Percentage of net sales      25.9%           14.5%           24.7%           15.9%

Research and development ("R&D") spending for the second quarter of 2009 compared to the second quarter of 2008 decreased by approximately $158,000 primarily due to the restructure actions and the re-engineering of internal processes. R&D as a percentage of net sales increased primarily due to the decrease in sales for the second quarter of 2009. We have completed the transition of the majority of device support operations to our China team. New products include the new software shipped in March 2009 used to manage and control

R&D spending for the first six months of 2009 compared to the first six months of 2008 decreased by approximately $224,000 due primarily to the same factors described above.

SELLING, GENERAL AND ADMINISTRATIVE



                               Three Months Ended                     Six Months Ended
(in thousands)          June 30, 2009       June 30, 2008     June 30, 2009       June 30, 2008
Selling, general &         $1,506              $2,287            $3,182              $4,315
administrative
Percentage of net sales     38.7%               28.5%             38.4%               30.4%

Selling, general and administrative ("SG&A") expenses decreased approximately $781,000 for the second quarter of 2009 compared to the second quarter of 2008. This was due primarily to no bonus expense in the second quarter of 2009 compared to $300,000 for bonus expense for the second quarter of 2008 and approximately $210,000 personnel savings from restructure actions, as well as lower: sales commissions on the decreased sales volume, bad debt expense, marketing expense, depreciation, travel cost, and employee benefit charges.

During the first six months of 2009 compared with the same period in 2008, SG&A expense decreased approximately $1,133,000. This was due primarily to no bonus expense in the first half of 2009 compared to $364,000 for bonus expense for the first half of 2008 and approximately $360,000 personnel savings from restructure actions, as well as lower: sales commissions on the decreased sales volume, bad debt expense, marketing expense, depreciation, travel cost, and employee benefit charges.

INTEREST



                      Three Months Ended               Six Months Ended
(in thousands)   June 30, 2009   June 30, 2008   June 30, 2009   June 30, 2008
Interest income       $15             $46             $18             $86
Interest expense     $(5)            ($8)            $(12)           $(16)

Interest income decreased during the second quarter of 2009 and for the first six months of 2009 compared to the same period in 2008 due to the lower yields on investments. Interest expense decreased in the second quarter of 2009 and the first six months of 2009 compared to the same period in 2008 due to the lower balance on the equipment capital lease.

INCOME TAXES

Three Months Ended Six Months Ended (in thousands) June 30, 2009 June 30, 2008 June 30, 2009 June 30, 2008 Income tax expense $8 $19 $136 $52

Income tax expense recorded for the second quarter of 2009 and 2008 resulted from foreign and state taxes. The tax effective rate differed from the statutory tax rate primarily due to the effect of valuation allowances and state taxes. Data I/O has a valuation allowance of $9,194,990 as of June 30, 2009. Our deferred tax assets and valuation allowance are reduced by approximately $74,000 associated with the requirements of FIN 48 accounting for uncertain tax positions.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2009, Data I/O's principal sources of liquidity consisted of existing cash and cash equivalents which continued to increase during the quarter. Our working capital decreased by $668,000 from December 31, 2008 and our current ratio increased from 4.3 at December 31, 2008 to 5.4 at June 30, 2009.

Our cash and cash equivalents increased by approximately $1.5 million during the six months ended June 30, 2009 primarily due to collection of customer receivables and inventory reductions, offset in part by the loss from operations and payment of accrued liabilities. Cash provided by operations primarily included a $3.1 million decrease in accounts receivable due the lower sales volume and improved collections and a $431,000 decrease in inventories.

We expect that we will continue to make capital expenditures to support our business. Capital expenditures are expected to be funded by existing and internally generated funds or lease financing.

As a result of our significant product development, customer support, international expansion and selling and marketing efforts, we have required substantial working capital to fund our operations. Over the last few years, we restructured our operations to lower our costs and operating expenditures in some geographic regions, while investing in other regions, and to lower the level of revenue required for our net income breakeven point, to preserve our cash position and to focus on profitable operations. We believe that we have sufficient working capital available under our operating plan to fund our operations and capital requirements through at least the next one year period. Any substantial inability to achieve our current business plan could have a material adverse impact on our financial position, liquidity, or results of operations and may require us to reduce expenditures and/or seek additional financing.

LONG-TERM DEBT

During the third quarter of 2006, the Company entered into a five year capital lease agreement in the amount of $591,145. The lease was used to fund new equipment and installation associated with our move to the new headquarters facility in July of 2006. See Note 9, "Long-Term Debt."

OFF-BALANCE SHEET ARRANGEMENTS

Except as noted above in Note 7, "Operating Lease and Other Commitments", Data I/O had no off-balance sheet arrangements.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1, Financial Statement Preparation, Recent Accounting Pronouncements.