FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K 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 Annual Report on Form 10-K are forward-looking. In particular, statements herein regarding economic outlook, industry prospects and trends; future results of operations or financial position; breakeven revenue point; integration of acquired products and operations; market acceptance of our newly introduced or upgraded products or services; development, introduction and shipment of new products or services; changing foreign operations; 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 Annual Report. The Reader should not place undue reliance on these forward-looking statements. The following discussions and the section entitled "Risk Factors - Cautionary Factors That May Affect Future Results" describes 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, 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.

In response to losses in the first half of 2006, we launched an initiative during the third quarter of 2006 to lower the quarterly revenue breakeven point. We again experienced losses during the first half of 2007 with declining revenues and gross margins and, as such, we decided to take additional expense reductions to lower our expected quarterly revenue breakeven point to below $5.3 million when fully implemented during 2007. During the fourth quarter of 2007, we successfully completed these actions consisting of a combination of margin improvements and expense reductions. We have taken actions to improve the effectiveness of our sales and marketing organization. We have reduced expenses by reducing personnel costs, re-engineering some internal processes, and transferring some activities to our lower cost base of operations in China. These restructuring actions taken in the first half of 2007, resulted in our financial operation for the five following quarters at approximately our business model.

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. 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. Tempering these efforts is the current economic uncertainty regarding forecast business in certain geographic and customer segments.

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.

Our customer focus has been on strategic high volume manufacturers in key market segments like wireless, automotive, industrial controls and programming centers and supporting NAND Flash and microcontrollers on our newer products to gain new accounts and in newer areas, such as microcontrollers for the automotive market with our new ProLINE-RoadRunner XLF. 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. We continue to address the effectiveness of our sales and marketing organization and sales channels by adding and changing channels during 2007 and 2008. We recognized 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, in regard to our China sales operations, made at the end of the first quarter of 2007, included

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 PROGRESS

The restructuring activities started during the second half of 2006 to reduce expenses and improve margins were 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. During the first quarter of 2007, we recorded restructuring charges of approximately $200,000 primarily related to severance charges. During the second quarter of 2007, we recorded an additional $632,000 of restructuring charges. 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 the third quarter of 2007, we recorded a net expense reversal of $107,000 comprised of $54,000 of additional expense, primarily relating to facilities, and a reversal of $161,000 of previously accrued severance primarily because certain employees who had been scheduled for termination had their termination notice rescinded.

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. At December 31, 2008, $390,000 remains accrued and is expected to be largely paid out during the first quarter of 2009.

CRITICAL ACCOUNTING POLICY JUDGMENTS AND ESTIMATES

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires that we make estimates and judgments, which affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, Data I/O evaluates our estimates, including those related to sales returns, bad debts, inventories, investments, intangible assets, income taxes, warranty obligations, restructuring charges, contingencies such as litigation, and contract terms that have multiple elements and other complexities typical in the capital equipment industry. We base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Data I/O believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements:

Revenue Recognition: Sales of Data I/O's semiconductor programming equipment requiring installation by us that is other than perfunctory were previously recorded when installation was complete, or at the later of customer acceptance or installation, if an acceptance clause is specified in the sales terms. Beginning in the third quarter of 2005, Data I/O began recognizing revenue for these products at the time of shipment. We began recognizing revenue at the time of shipment after we determined that our automated products have reached a point of maturity and stability such that product acceptance can be assured by testing at the factory prior to shipment and that the installation meets the criteria to be considered a separate element. These systems are standard products with published product specifications and are configurable with standard options. The evidence that these systems could be accepted was based upon having standardized factory production of the units, results from batteries of tests of product performance to our published specifications, quality inspections and installation standardization, as well as past product operation validation with customer and the history provided by our installed base of products upon which the current versions were based. When arrangements include multiple elements, we use objective evidence of fair value to allocate revenue to the elements pursuant to EITF 00-21, "Revenue Arrangements with Multiple Deliverables," and recognize revenue when the criteria for revenue recognition have been met for each element according to SAB 104, "Revenue Recognition." The amount of revenue recognized is affected by our judgments as to the collectability of the transaction or whether an arrangement includes multiple elements and if so, whether specific objective evidence of fair value exists for those elements. The measure of standalone fair value of the product versus the service installation value component is determined by the amount Data I/O pays to independent representative service groups or the amount of additional discount given to independent distributors, to provide the service installation. Changes to the elements in an arrangement and the ability to establish specific objective evidence for those elements could affect the timing of the revenue recognition. These conditions could be subjective and actual results could vary

Installation that is considered perfunctory includes any installation that can be performed by other parties, such as distributors, other vendors, or in most cases the customer themselves. This takes into account the complexity, skill, and training needed as well as customer expectations regarding installation. The revenue related to products requiring installation that is perfunctory is recognized at the time of shipment provided that persuasive evidence of an arrangement exists, shipment has occurred, the price is fixed or determinable, and collectability is reasonably assured.

We record revenue from the sale of service and update contracts as deferred revenue and we recognize it on a straight-line basis over the contractual period, which is typically one year. We establish a reserve for sales returns based on historical trends in product returns and estimates for new items. Data I/O has a stated return policy that customers can return standard products for any reason within 30 days after delivery provided that the returned product is received in its original condition, including all packaging materials, for a refund of the price paid less a restocking charge of 30% of the total amount invoiced for the product returned, unless such restocking charge is waived in writing by Data I/O. In accordance with SFAS 48, "Revenue Recognition When Right of Return Exists," provisions for revenue recognition, the price is fixed or determinable at the date of the sale. The buyer has paid or is obligated to pay and the obligation is not contingent on resale of the product. The buyer's obligation would not be changed in the event of theft, physical destruction or damage to the product. The buyer acquiring the product for resale has economic substance apart from Data I/O. We do not have contractual obligations for future performance to directly bring about the resale of the product by the buyer.

Allowance for Doubtful Accounts: We base the allowance for doubtful accounts receivable on our assessment of the collectability of specific customer accounts and the aging of accounts receivable. If there is deterioration of a major customer's credit worthiness or actual defaults are higher than historical experience, our estimates of the recoverability of amounts due to us could be adversely affected.

Inventory: Inventories are stated at the lower of cost or market ("locom") with cost being currently adjusted at standard cost which approximates cost on a first-in, first-out basis. We estimate reductions to inventory for obsolete, slow-moving, excess and non-salable inventory by reviewing current transactions and forecasted product demand. We evaluate our inventories on an item by item basis and record locom adjustment accordingly. If there is a significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, Data I/O may be required to increase our inventory adjustments and our gross margin could be adversely affected.

Warranty Accruals: Data I/O accrues for warranty costs based on the expected material and labor costs to fulfill our warranty obligations. If we experience an increase in warranty claims, which are higher than our historical experience, our gross margin could be adversely affected.

Tax Valuation Allowances: Given the uncertainty created by our loss history, as well as the current uncertain economic outlook for our industry and capital spending, Data I/O expects to continue to limit the recognition of net deferred tax assets and accounting for uncertain tax positions and maintain the tax valuation allowances. We expect, therefore, that reversals of the tax valuation allowance will take place only as we are able to take advantage of the underlying tax loss or other attributes in carry forward. The transfer pricing and expense or cost sharing arrangements are complex areas where judgments, such as the determination of arms-length arrangements, can be subject to challenges by different tax jurisdictions.

Share-based Compensation: We accounted for share-based awards made to our employees and directors including employee stock option awards, employee stock purchases made under our Employee Stock Purchase Plan ("ESPP) and restricted and performance share awards using the estimated grant date fair value method of accounting in accordance with SFAS, No. 123 (revised 2004), "Share-Based Payment (SFAS No. 123(R)," which was effective January 1, 2006 for Data I/O. We estimate the fair value using the Black-Scholes valuation model which requires the input of highly subjective assumptions, including the option's expected life and the price volatility of the underlying stock. The expected stock price volatility assumption was determined using the historical volatility of the Company's common stock. Changes in the subjective assumptions required in the valuation model may significantly affect the estimated value of the awards, the related stock-based compensation expense and, consequently, our results of operations. Beginning in the second quarter of 2006, restricted stock awards and performance-based stock awards were granted. The vesting of the performance-based stock awards is based on attaining a particular revenue growth target during the three year period ending December 31, 2008. However, during the third quarter of 2007, we reversed the compensation expense related to the performance-based stock awards, based upon the likelihood of not meeting the performance goal for the year ending December 31, 2008. Beginning August 2006, ESPP shares were issued under provisions that do not require expense under SFAS 123(R).

NET SALES




(in thousands)
Net sales by product line:            2008    Change    2007
Automated programming systems        $16,822   0.7%   $16,710
Non-automated programming systems    10,775    7.3%    10,042
Totals                               $27,597   3.2%   $26,752

Net sales by location:
United States                        $4,070   (17.4%)  $4,925
       % of total                       14.7%            18.4%
International                        $23,527   7.8%   $21,827
       % of total                       85.3%            81.6%

For the year ended December 31, 2008 compared to the same period of 2007, sales increased by approximately $845,000 or 3.2% with the increase occurring during the first three calendar quarters of 2008, offset by a decline in the fourth quarter. The increase relates primarily to higher sales of aftermarket adapters as well as RoadRunner, FLX, and FlashPAK product lines Partially offsetting the increase were reduced sales of PS systems, ImageWriter, and our legacy non-automated programmers Unifamily and Sprint. The decline in sales of 11% in our legacy non-automated programmers is a continuing trend for these older product lines. Our backlog was roughly the same at $2.0 million on December 31, 2008 compared to $2.1 million on December 31, 2007.

International sales for the year ended 2008 were 85.3% of sales and increased by approximately 7.8% compared to the same period in 2007. During the year ended 2008, sales in Asia increased by approximately 46% compared to 2007, reflecting the improvements made in our China channels and Asian sales management during the second half of 2007 as well as what we believe to be a continued shift to international markets of manufacturing capacity related demand. The increase in Asia, especially in China, was offset in part by decreases in sales of 4% in Europe and 2% in Americas. Asia sales growth was strong in FLX, adapters, FlashPAK, and PS systems.

During 2008, our development team delivered a new version of RoadRunner the ProLINE-RoadRunner XLF aimed at large sized microcontroller users particularly in automotive electronics. We expect this to be an important product in this market, however the economic climate for capital spending is very uncertain currently in the automotive market. Our FLX-FMD had sales primarily to our initial development partner, a handset manufacturer, but has not been widely adopted at this point. During 2009, we plan to introduce additional new product solutions and product enhancements that provide both vehicles for growth as well as substantial value to our customers. We are also are making changes and increasing territory coverage with new representative sales channels, especially in the U.S.A. We also expect our new products and channels to increase our revenues, however, offsetting these increases are the expected continuing trend of declining sales of our older non-automated product lines and the current market conditions for decreased spending on capital equipment.

GROSS MARGIN



(in thousands)           2008   Change  2007
Gross margin            $16,233  8.2%  $15,007
Percentage of net sales  58.8%          56.1%

Gross margins increased in dollars by approximately $1.2 million and increased as a percentage of sales by 2.6 percentage points for the year ended December 31, 2008 compared to the same period in 2007. The overall gross margin percentage increase relates primarily to savings from restructuring actions taken during the first half of 2007 to lower factory costs; more favorable factory variances including: manufacturing variances of $309,000, and the labor and overhead variance of $171,000; and the effect of higher sales volume relative to fixed manufacturing costs. The current economic climate implications of decreased sales volume would typically imply a resulting lower gross margin percentage. Offsetting this is the potential for new representative sales channels to add sales which typically have a higher gross margin than our sales to distributors, but have an associated selling commission expense.

RESEARCH AND DEVELOPMENT



(in thousands)              2008    Change  2007
Research and development   $4,464   (5.3%) $4,716
Percentage of net sales      16.2 %         17.6%

Research and development ("R&D") spending for the year ended December 31, 2008 compared to the same period in 2007 decreased in both dollars and as a percentage of sales due to the decreased spending associated with the platform development especially the FLX500. R&D also decreased due to the restructure actions and the re-engineering of internal processes including shifts of engineering work to our China based operations. Data I/O's R&D objectives continue to focus on platform enhancements and application engineering development on the FLX500, PS, ProLINE-RoadRunner and our FlashCORE programmer architecture. Our R&D spending also fluctuates based on the number and the development stage of projects. New products introduced in 2008 include the ProLINE-RoadRunner XLF, a new larger format RoadRunner version.

We believe it is essential to invest in R&D to significantly enhance our existing products and to create new products as markets develop and technologies change. In addition to product development a significant part of R&D spending is on creating software and support for new devices introduced by the semiconductor companies. We are focusing our R&D efforts in our strategic growth markets, namely new programming technology and automated programming systems for the manufacturing environment, particularly extending the capabilities and support for our FlashCORE programmer architecture and automated handling solutions.

SELLING, GENERAL AND ADMINISTRATIVE

(in thousands) 2008 Change 2007 Selling, general and administrative $8,106 (7.9%) $8,801 Percentage of net sales 29.4% 32.9%

For the year ended December 31, 2008 compared with the same period in 2007, SG&A expenses decreased by approximately $695,000. The expense reduction was due primarily to lower commissions to channels of $665,000 especially due to certain representatives becoming distributors; a decrease in net personnel costs of approximately $307,000 related primarily to the 2008 and 2007 restructure actions; and a decrease in trade show expenses of $148,000. Partially offsetting these expense reductions was 2008 bonus incentive compensation of $580,000 where there was none in 2007. For 2009, increased sales channel territory coverage by new representatives is expected to add variable cost selling commissions for sales that they generate.

INTEREST

(in thousands) 2008 Change 2007
Interest income $153 25.4% $122
Interest expense ($30) (21.1%) ($38)

Interest income increased by $31,000 for the twelve month period ending December 31, 2008 compared to the same period in 2007 due to the increase in the cash balance. Interest expense decreased for the twelve month period ending December 31, 2008 compared to the same period in 2007 due to paying down the equipment capital lease associated with the move to a new facility during the third quarter of 2006.

(in thousands) 2008 2007 Income tax (expense) benefit ($79) ($8)

Income tax expense for 2008 relates to federal alternative minimum tax as well as foreign and state income taxes. Impacting the effective tax rate was the usage of previously reserved deferred tax assets like net operating losses in carryforward that we were able to recognize based upon the current year taxable income. For 2007, income tax expense related to foreign and state income taxes. The effective tax rate for 2007 was impacted by the valuation allowances on tax losses. We had income in 2007 in some foreign operations partially offset by losses in other countries.

For financial reporting purposes, Data I/O established tax valuation reserves against our deferred tax assets because of the uncertainty relating to the realization of such asset values. We had valuation allowances of $8.7 million and $9.5 million at December 31, 2008 and 2007, respectively. Given the uncertainty created by our past loss history as well as the current uncertain economic outlook for our industry and capital spending, we expect to continue to limit the recognition of net deferred tax assets and maintain the tax valuation allowances.

INFLATION AND CHANGES IN FOREIGN CURRENCY EXCHANGE RATES

Sales and expenses incurred by foreign subsidiaries are denominated in the subsidiary's local currency and translated into U.S. Dollar amounts at average rates of exchange during the year. We recognized foreign currency transaction gains and (losses) of ($153,000) and ($9,000) in 2008 and 2007, respectively. The transaction gains or losses resulted primarily from inter-company sales which were not hedged; sales by our German subsidiary to certain customers, which were invoiced in US dollars; and unhedged Brazilian currency balances. We hedge our foreign currency exposure on sales of inventory to our foreign subsidiaries through the use of foreign currency exchange contracts. See Note 1 of "Notes to Consolidated Financial Statements."

Financial Condition

LIQUIDITY AND CAPITAL RESOURCES

(in thousands) 2008 Change 2007
Working capital $18,715 $5,653 $13,062

At December 31, 2008, Data I/O's principal sources of liquidity consisted of existing cash and cash equivalents. Our working capital increased by $5.7 million and our current ratio increased from 3.5 in 2007 to 4.3 in 2008.

Our cash and cash equivalents increased by $5.7 million during the year ended December 31, 2008 primarily due to the cash received from operating activities totaling approximately $4.6 million. Cash received from operations primarily included net income for the year, excluding the $2.1 million from the patent sale, as well as adding back depreciation and amortization of approximately $1 million.

We added approximately $438,000 of cash from investing activities during the year ended December 31, 2008 including the $2.1 million net proceeds from the . . .