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; the impact and integration of acquisitions; 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, 2011 describe some, but not all, of the factors that could cause these differences.

OVERVIEW

Starting during the second half of 2011 and continuing during the first half of 2012, we experienced a decrease in customer demand. We believe the decline in orders and revenue is due primarily to overcapacity in the installed base of programming equipment causing reduced capital spending. We believe the underlying decrease in demand is due to a downturn in Asia-based electronics manufacturing caused in part by the economic uncertainty related to the European sovereign debt situation. We continued to focus on our primary goal of profitably managing the business, while developing, launching and enhancing products to drive revenue and return to profitability.

Our challenge continues to be operating in a cyclical and rapidly evolving industry environment. Although our solutions address the growing flash and microcontroller markets and the resulting need for programming, our opportunity to experience significant growth occurs when there is increased capacity needed to address the combination of growing file sizes and the growth in the flash and microcontroller markets. However, we compete for this capacity growth against alternative methods of loading data, such as programming after placement, or the increased efficiency of the installed base of equipment, which has and continues to constrain the programming equipment market. Additional factors impacting demand for our solutions other than capacity, include quality, process, technology and integration. We are continuing our efforts to balance market forces, business geography shifts, increasing costs and strategic investments in our business with the level of demand and mix of business we expect.

We continue to focus on extending the capabilities and support for our FlashCORE architecture, and the 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 or customized to address the specific requirements of individual customers. We believe by adding these features to our strategic product platforms, we will continue to set ourselves apart from other product suppliers and elevate our relationships with our customers to a partner level. We consider the Azido technology, which we acquired in April 2011, to be a strategic platform for programmer and product development. During the quarter we completed enhancements for FLXHD, an automated duplication system for e-MMC flash memories, launched in the first quarter.

Our customer focus has been on strategic high volume manufacturers in key market segments like wireless, automotive, industrial controls and programming centers and supporting e-MMC, NAND Flash and microcontrollers on our newer products to gain new accounts. We also provide product solutions used by electronics design engineers. We continued to leverage our China operations to take advantage of the growth of manufacturing in China and to operate close to our customers. We continued to address the effectiveness of our sales and marketing organization and sales channels by adding and changing channels and providing our channel partners with extensive product, sales and service training. 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. We believe these channel actions help us grow our business more rapidly, both by adding new customers and by increasing penetration of existing accounts.

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 revenue recognition, estimating the percentage-of-completion on fixed-price professional engineering service contracts, 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: Data I/O generally recognizes revenue at the time products are shipped. We have determined that our programming equipment has 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 deemed as 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 the customer and the history provided by our installed base of products upon which the current versions were based.

The amount of revenue recognized is affected by our judgments as to the collectability of the transaction, the existence of an acceptance clause or whether an arrangement includes multiple elements and if so, whether specific objective evidence of selling price exists for those elements. Allocation between multiple elements is done based on objective evidence of selling price based on a selling price hierarchy, including discounts.

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 customers 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. The measure of standalone fair value of the product versus the service installation value component is by the amount we pay to independent representative service groups or the amount of additional discount given to independent distributors to provide the service installation (published price).

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. Service revenue from time and materials contracts and training services is recognized as services are performed. We recognize software revenue upon shipment provided that no significant obligations remain on our part, substantive acceptance conditions, if any, have been met and when the fee is fixed and determinable and when collection is deemed probable.

Certain fixed-price engineering service contracts that require significant production, modification, or customization of software, are accounted for using the percentage-of-completion method. We use the percentage-of-completion method of accounting because it is the most accurate method to recognize revenue based on the nature and scope of our fixed-price professional engineering service contracts; it is a better measure of periodic income results than other methods and it better matches revenue recognized with the costs incurred. Percentage of completion is measured based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. Significant judgment is required when estimating total hours and progress to completion on these arrangements, which determines the amount of revenue we recognize as well as whether a loss is recognized if one is expected to be incurred upon project completion. Revisions to hour and cost estimates are incorporated in the period the amounts are recognized if the results of the period have not been reported; otherwise, the revision of estimates are recognized in the period in which the facts that give rise to the revision become known.

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. For us to recognize revenue, 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 and we have no 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. Adjustments are made to standard cost, which approximates actual 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 inventory adjustments 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 account for share-based awards made to our employees and directors, including employee stock option awards and restricted and performance share awards, using the estimated grant date fair value method of accounting. 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 were granted. Employee Stock Purchase Plan ("ESPP) shares were issued under provisions that do not require us to record any equity compensation expense.

Results of Operations



Net Sales

                            Three Months Ended                 Six Months Ended
Net sales by product    June 30,           June 30,       June 30,          June 30,
line                      2012    Change     2011           2012    Change    2011
(in thousands)
Automated programming
systems                    $3,590 (11.4%)     $4,050         $5,620 (36.4%)    $8,832
Non-automated
programming systems         1,770 (36.8%)      2,799          3,419 (32.4%)     5,060
Total programming
systems                    $5,360 (21.7%)     $6,849         $9,039 (34.9%)   $13,892


                            Three Months Ended                 Six Months Ended
                        June 30,           June 30,       June 30,          June 30,
Net sales by location     2012    Change     2011           2012    Change    2011
(in thousands)
United States                $756  29.5%        $584         $1,226  10.1%     $1,114
% of total                  14.1%               8.5%          13.6%              8.0%

International              $4,603 (26.5%)     $6,265         $7,812 (38.9%)   $12,778
% of total                  85.9%              91.5%          86.4%             92.0%

Revenues for the second quarter of 2012 were $5.4 million, down 22% compared with $6.8 million in the second quarter of 2011, but up 46% sequentially from $3.7 million in the first quarter of 2012. We believe the decline in revenue compared to last year relates primarily to reduced capital spending resulting from a downturn in Asia-based electronics manufacturing and economic uncertainty related to the European sovereign debt situation. Our revenues were impacted by the change in the Euro translation rate, compared to one year ago, with the Euro devaluation resulting in $291,000 less revenue in the second quarter of 2012. Backlog at June 30, 2012 was $1.1 million.

On a regional basis, Asia had the largest revenue decline of 59%, while Europe declined 4% and the Americas increased 13% compared to revenues in the second quarter of 2011. On a product basis, the revenue decrease was primarily from our automated PS and FLX families as well as FlashPak which was the most impacted by the drop in Asian demand compared to the second quarter of 2011.

For the first six months of 2012 compared to 2011, the decrease in revenues are primarily attributed to the same factors as the second quarter of 2012. However, revenues for the second quarter were sequentially up 46% from the first quarter of 2012.

Gross Margin

                           Three Months Ended           Six Months Ended
                        June 30,         June 30,   June 30,         June 30,
                          2012   Change    2011       2012   Change    2011
(in thousands)
Gross margin              $2,941 (26.6%)   $4,008     $4,882 (40.3%)   $8,172
Percentage of net sales    54.9%            58.5%      54.0%            58.8%

Gross margin as a percentage of sales in the second quarter of 2012 was 54.9%, compared with 58.5% in the second quarter of 2011. The decrease compared to the second quarter of 2011 was primarily due to the decreased sales volume in relation to fixed manufacturing costs, offset in part by favorable variances. Gross margin improved by 2 percentage points compared to 52.8% in the first quarter of 2012, primarily due to the sales volume increase.

Gross margin decreased in dollars for the first six months of 2012 primarily due to the decreased sales volume. The gross margin as a percentage of sales decline was primarily due to the decreased sales volume in relation to fixed manufacturing costs.

Research and Development

                            Three Months Ended          Six Months Ended
                         June 30,        June 30,   June 30,        June 30,
                           2012   Change   2011       2012   Change   2011
(in thousands)
Research and development   $1,427 11.8%    $1,276     $2,819  7.3%    $2,627
Percentage of net sales     26.6%           18.6%      31.2%           18.9%

Research and development ("R&D") spending in the second quarter of 2012 increased by $152,000 compared to the same period in 2011 primarily due to higher Azido related costs of $120,000, $73,000 less engineering charged to cost of goods sold, and $52,000 higher patent related costs, offset in part by a reduction in consultant and contractor expense of $150,000.

R&D expenses increased $192,000 for the first six months of 2012 compared to the same period in 2011, primarily due to same factors as in the second quarter of 2012.

Selling, General and Administrative

                                     Three Months Ended          Six Months Ended
                                  June 30,        June 30,   June 30,        June 30,
                                    2012   Change   2011       2012   Change   2011
(in thousands)
Selling, general & administrative   $1,996 (9.9%)   $2,215     $4,245 (3.3%)   $4,388
Percentage of net sales              37.2%           32.3%      47.0%           31.6%

Selling, general and administrative ("SG&A") expenses in the second quarter of 2012 decreased by $219,000 compared to the same period in 2011 primarily attributable to $158,000 lower professional fees and $76,000 lower incentive compensation, offset in part by $42,000 higher sales commissions primarily resulting from sales channel mix. The CEO search firm fees included in SG&A in the second quarter were $38,000 and there are not expected to be any further fees to expense under this fixed fee engagement.

Excluding the non-recurring CEO search firm and separation pay of $462,000 this year, SG&A expenses for the first six months of 2012 decreased by $604,000 compared to the same period in 2011, primarily due to the same factors as the second quarter of 2012.

Interest

                   Three Months Ended          Six Months Ended
                June 30,        June 30,   June 30,        June 30,
                  2012   Change   2011       2012   Change   2011
(in thousands)
Interest income     $174 815.8%      $19       $207 546.9%      $32

Interest income for the second quarter of 2012 increased by $155,000 compared to the same period in 2011 primarily related to interest received related to a German tax refund and higher invested balances in foreign accounts.

Interest income for the first six months of 2012 increased by $175,000 compared to the same period in 2011, primarily due to the same factors as in the second quarter of 2012.

Income Taxes

                                 Three Months Ended            Six Months Ended
                             June 30,          June 30,   June 30,          June 30,
                               2012    Change    2011       2012    Change    2011
(in thousands)
Income tax (expense) benefit     $296 (381.9%)   ($105)       $276 (244.5%)   ($191)

Income tax (expense) benefit recorded for the second quarter and first six months of 2012 and 2011 resulted primarily from foreign taxes on income and tax refunds in our foreign subsidiaries. During the second quarter of 2012, we prevailed in tax issues from the 1995-1998 years related to an acquisition and we received refunds from German tax authorities of approximately $318,000.

The effective tax rate differed from the statutory tax rate primarily due to the effect of valuation allowances, as well as foreign taxes. Data I/O has a valuation allowance of $9.7 million as of June 30, 2012. Our deferred tax assets and valuation allowance have been reduced by approximately $117,000 associated with the requirements of accounting for uncertain tax positions as of June 30, 2012. Given the uncertainty created by our past loss history and the cyclical nature of the industry in which we operate, we expect to continue to limit the recognition of net deferred tax assets and maintain the tax valuation allowances.

Financial Condition



Liquidity and Capital Resources


                June, 30          December 31,
                  2012    Change      2011
(in thousands)
Working capital  $15,265 ($7,090)      $22,355

The Company's cash position at June 30, 2012 decreased $1.3 million during the second quarter to $11.0 million. In the second quarter of 2012, cash was primarily used to fund a $1.7 million increase in accounts receivable to $3.6 million at June 30, 2012. Inventories were at $4.6 million at June 30, 2012, up from $4.5 million at March 31, 2012. Deferred revenue was $1.4 million at June 30, 2012, compared to $1.2 million at March 31, 2012. This increase was primarily due to a PS system shipped, but not yet recognizable as revenue. The Company remains debt free.

For the six months ending June 30, 2012, the decrease in working capital primarily relates to cash used in our share repurchase programs of $6 million completed in the first quarter of 2012.

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 or offsetting in part costs rising over time, 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. Approximately $9 million of our cash is located in foreign subsidiary accounts and, although we have no current repatriation plans, there may be tax and other impediments to repatriating the cash to the United States. Our working capital may be used to fund growth initiatives including acquisition, which could reduce our liquidity. 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.

Share Repurchase Programs

The $1 million dollar share repurchase plan announced in October of 2011 resulted in $42,000 of stock buybacks during the first quarter of 2012. This program was cancelled in January 2012, after the new expanded $6 million dollar repurchase program announced in January 2012 went into effect. Share repurchases for $6 million were made during the first quarter of 2012, completing this program. These programs were made under 10b5-1 plans that allowed purchases to take place at any time. See accompanying consolidated financial statements Note 11, "Share Repurchase Programs".

OFF-Balance sheet arrangements

Except as noted in the accompanying consolidated financial statements in Note 6, "Operating Lease Commitments" and Note 7, "Other Commitments", Data I/O had no off-balance sheet arrangements.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220):
Presentation of Comprehensive Income ("ASU 2011-05"). This ASU amends requirements for the presentation of other comprehensive income (OCI), requiring presentation of comprehensive income in either, a single, continuous statement of comprehensive income or on separate but consecutive statements, the statement of operations and the statement of OCI. We have adopted this amendment effective for the year ended December 31, 2011. The adoption of this guidance did not impact our financial position, results of operations or cash flows and only impacts the presentation of OCI on the financial statements.

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure . . .