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; economic conditions and capital spending outlook; 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. The difficult economic conditions of the past year, the downward trend in capital spending and the more recent mixed economic signals have combined to intensify the usual challenges of operating in a highly cyclical industry environment such as ours.

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/O. 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. During the third quarter of 2009, we incurred an additional charge of $23,000 severance-related costs. 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 continued current economic uncertainty. With operating costs at approximately $2.6 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. This year we have introduced and shipped the next generation of our programmer architecture, FlashCORE III, and a new member of our PS family of automated programming systems, the PS 388. During the third quarter we received repeat orders for these new products and have launched and begun shipping FlashCORE III in our other product families.

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 2009, we have continued to address the effectiveness of our sales and marketing organization and sales channels by adding, training and changing channels. We believe that these changes have helped us grow our business in China and Asia while allowing us to convert some of our fixed selling expenses to variable costs. In the

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 facility related exit costs.

As a result of the business downturn 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 of $535,000 during the fourth quarter, primarily related to severance, and total of $542,000 for the year. During the first quarter of 2009, restructure activities resulted in net additional charges of $22,000 representing severance and costs associated with terminating vehicle lease. 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. During the third quarter, we had additional charges of $23,000 in severance related costs. At September 30, 2009, $209,000 remains accrued and is expected to be paid out during 2009, 2010 and 2011. This includes $83,000 in lease abandonment period amounts accrued as other long-term liabilities, 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 September 30, 2009.

Results of Operations



NET SALES



(in thousands)                      Three Months Ended          Nine Months Ended
                                         Sept. 30,                  Sept. 30,
Net sales by product line          2009   % Change  2008     2009    % Change   2008
Automated programming systems     $3,135  (35.9%)  $4,893   $8,284    (38.1%)  $13,378
Non-automated programming systems  2,182  (25.1%)  2,914    5,309    (38.6%)   8,640
Total programming systems         $5,317  (31.9%)  $7,807   $13,593  (38.3%)   $22,018


                                    Three Months Ended          Nine Months Ended
                                         Sept. 30,                  Sept. 30,
Net sales by location              2009  % Change   2008     2009   % Change    2008
United States                      $ 627 (48.6%)   $1,219   $ 1,588  (53.8%)  $ 3,438
% of total                        11.8%            15.6%     11.7%             15.6%
International                     $4,690 (28.8%)   $6,588   $12,005  (35.4%)  $18,580
% of total                        88.2%            84.4%    88.3 %            84.4 %

For the first nine months of 2009 compared to the same period of 2008, sales decreased by approximately 38% 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 the case this year given the excess capacity caused by the economic downturn. Our trend in orders booked, while down substantially from the first, second and third quarters of last year in all geographies, showed third quarter growth over the second quarter of 2009 in all geographies. Orders from Asia were up over 44% from the second quarter of 2009, with orders in Europe up 74% and orders in the Americas up 7%. At the start of the fourth quarter, we are seeing progressively stronger worldwide sales funnels. We expect our new products, including FlashCORE III, to provide revenue growth and expect new revenues from our new sales channels as they gain training and experience with our product lines.

GROSS MARGIN



                          Three Months Ended      Nine Months Ended
                              Sept. 30,               Sept. 30,
(in thousands)            2009         2008        2009       2008
Gross Margin             $2,990       $4,664      $7,315     $12,983
Percentage of net sales   56.2%        59.7%      53.8%       59.0%

Gross margins during the third quarter of 2009 decreased in both dollars and as a percentage of sales compared to the third quarter of 2008. The overall gross margin decrease in both dollars and percentage was primarily due to the lower sales volume, with the percentage decline a result of the lower sales volume relative to fixed factory costs.

Gross margin as a percentage of sales for the third quarter improved 8 percentage points compared to the second quarter of 2009's 48.3%. The improvement was primarily due to the higher third quarter sales volume relative to fixed factory costs, as well as a more favorable mix of price and product cost. Direct materials as a percentage of sales improved in the third quarter of 2009 compared to both the third quarter of 2008 and the second quarter of 2009. This indicates that our actual product material cost margins improved, which has been a major thrust of our restructuring actions, especially utilizing lower cost operations in China to manufacture adapters and source certain inventory.

For the first nine months of 2009 compared to the same period of 2008, the lower gross margin dollars and gross margin as a percentage of sales are due to the same factors as those described for the third quarter of 2009, along with the unfavorable inventory adjustments that had occurred during the second quarter of 2009.

RESEARCH AND DEVELOPMENT



                           Three Months Ended      Nine Months Ended
                               Sept. 30,               Sept. 30,
(in thousands)             2009         2008        2009        2008
Research and development  $1,055       $1,093      $3,096      $3,358
Percentage of net sales    19.9%        14.0%      22.8%       15.3%

Research and development ("R&D") spending for the third quarter of 2009 decreased by approximately $38,000 compared to the third quarter of 2008. This was primarily due to the restructure actions and the re-engineering of internal processes. R&D as a percentage of net sales increased, however, primarily due to the decrease in sales for the third quarter of 2009. We have completed the transition of the majority of device support operations to our China team. New products include FlashCORE III, our new programming architecture, and the PS 388, a new member of the PS family of automated programming system incorporating FlashCORE III as well as FlashPAK III and FlashCORE III upgrades.

R&D spending for the first nine months of 2009 compared to the first nine months of 2008 decreased by approximately $262,000 due primarily to the same factors described above.

SELLING, GENERAL AND ADMINISTRATIVE



                                    Three Months Ended      Nine Months Ended
                                        Sept. 30,               Sept. 30,
(in thousands)                      2009         2008        2009        2008
Selling, general & administrative  $1,577       $2,231      $4,760      $6,545
Percentage of net sales             29.7%        28.6%      35.0%       29.7%

Selling, general and administrative ("SG&A") expenses decreased approximately $653,000 for the third quarter of 2009 compared to the third quarter of 2008. This was due primarily to $180,000 lower bonus expense in the third quarter of 2009 compared to $300,000 for bonus expense for the third quarter of 2008 and approximately $275,000 personnel and other savings from restructure actions, as well as lower: bad debt expense, marketing expense, depreciation, travel cost, facilities expense, employee benefit charges and investor relations expense.

During the first nine months of 2009 compared with the same period in 2008, SG&A expense decreased approximately $1,785,000. This was due primarily to $544,000 lower bonus expense in the first nine months of 2009 compared to $698,000 for bonus expense for the first nine months of 2008 and approximately $680,000 personnel and other savings from restructure actions, as well as lower bad debt expense, marketing expense, depreciation, travel cost, facilities expense, employee benefit charges and investor relations expense.

INTEREST



                  Three Months Ended       Nine Months Ended
                       Sept. 30,               Sept. 30,
(in thousands)    2009         2008       2009         2008
Interest income    $3          $29         $21         $115
Interest expense  ($4)          ($7)      ($16)        ($23)

Interest income decreased during the third quarter of 2009 and for the first nine months of 2009 compared to the same periods in 2008 due to the lower yields on investments despite the higher cash balances. Interest expense decreased in the third quarter of 2009 and the first nine months of 2009 compared to the same periods in 2008 due to the lower balance on the equipment capital lease.

INCOME TAXES



                              Three Months Ended     Nine Months Ended
                                  Sept. 30,              Sept. 30,
(in thousands)                 2009        2008       2009        2008
Income tax expense (benefit)   $96         $90        $231        $142

Income tax expense recorded for the third quarter of 2009 and 2008 resulted from foreign and state taxes. The effective tax 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 $9,725,000 as of September 30, 2009. Our deferred tax assets and valuation allowance are reduced by approximately $79,000 associated with the requirements of accounting for uncertain tax positions as of September 30, 2009.

Financial Condition

LIQUIDITY AND CAPITAL RESOURCES

Our cash and cash equivalents increased by approximately $2 million during the nine months ended September 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 $2.2 million decrease in accounts receivable due the lower sales volume and improved collections and a $700,000 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



               Sept. 30,        Dec. 31,
(in thousands)   2009    Change   2008
Long-term debt    $123   ($96)    $219

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 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" and in Note 14, "Foreign Currency Translation and Derivatives," Data I/O had no off-balance sheet arrangements.

RECENT ACCOUNTING PRONOUNCEMENTS

In October 2009, an update was made by Financial Accounting Standard Board ("FASB") to software revenue recognition.According to this update, tangible products containing software components and non-software components that function together to deliver the tangible product's essential functionality are no longer within the scope of the software revenue guidance. This standard requires that hardware components of a tangible product containing software components always be excluded from the software revenue guidance. It provides additional guidance on how to determine which software, if any, relating to the tangible product also would be excluded from the scope of the software revenue guidance. This standard will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. This standard shall be adopted in the same period using the same transition method as indicated in the update to revenue arrangements with multiple deliverables. We are currently assessing the potential impact that adoption of this standard may have on our consolidated financial statements.

In October 2009, an update was made by FASB to revenue arrangements with multiple deliverables. It provides amendments to the criteria for separating consideration in multiple-deliverable arrangements. This standard establishes a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor-specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. This standard also replaces the term fair value in the revenue allocation guidance with selling price to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a market participant. It also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangements to all deliverables using the relative selling price method. This standard will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. We are currently assessing the potential impact that adoption of this standard may have on our consolidated financial statements.

In December 2008, the FASB issued guidance related to employers' disclosures about postretirement benefit plan assets. It provides guidance on an employer's disclosures about plan assets, including: how investment allocation decisions are made and factors that are pertinent to an understanding of investment policies and strategies; the major categories of plan assets; the inputs and valuation techniques used to measure the fair value of plan assets; the effect of fair value measurements using significant unobservable inputs (level 3) on changes in plan assets for the period, and significant concentrations of risks within plan assets. This standard is effective for fiscal years ending after December 15, 2009. We are currently assessing the disclosure requirements that adoption of this standard may have on the footnotes of our consolidated financial statements.

In May 2009, the FASB established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The impact of adoption this had no financial effect on the accompanying condensed consolidated financial statements. We have evaluated subsequent events up through November 13, 2009.

In June 2009, the FASB issued Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles. The adoption of this standard changes how the Company references various elements of GAAP when preparing its financial statement disclosures, but will have no impact on the Company's financial position, results of operation or cash flows.