10-Q 1 dataio_10q-09302005.txt FOR PERIOD ENDED 9/30/2005 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Or the transition period from ___________ to ______________ Commission File No. 0-10394 DATA I/O CORPORATION -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Washington 91-0864123 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10525 Willows Road N.E., Redmond, Washington 98052 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (425) 881-6444 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's classes of stock, as of the last practicable date: 8,275,421 shares of no par value of the Registrant's Common Stock were issued and outstanding as of November 10, 2005. DATA I/O CORPORATION FORM 10-Q For the Quarter Ended September 30, 2005 INDEX Page ---- Part I - Financial Information Item 1. Financial Statements (unaudited) ..............................3 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ..........................10 Item 3. Quantitative and Qualitative Disclosures About Market Risk ...16 Item 4. Controls and Procedures ......................................17 Part II - Other Information Item 1. Legal Proceedings ............................................17 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities ...............................17 Item 3. Defaults Upon Senior Securities ..............................17 Item 4. Submission of Matters to a Vote of Security Holders ..........17 Item 5. Other Information ............................................17 Item 6. Exhibits .....................................................18 Signatures ...................................................................21 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements DATA I/O CORPORATION CONSOLIDATED BALANCE SHEETS -------------------------------------------------------------------------------------------------------- Sept. 30, Dec. 31, 2005 2004 -------------------------------------------------------------------------------------------------------- (in thousands, except share data) (unaudited) ASSETS CURRENT ASSETS: Cash and cash equivalents $2,632 $5,534 Marketable securities 1,200 1,037 Trade accounts receivable, less allowance for doubtful accounts of $203 and $155 6,588 4,489 Inventories 3,852 4,139 Other current assets 291 652 -------------- -------------- TOTAL CURRENT ASSETS 14,563 15,851 Property and equipment - net 2,321 1,970 Other assets 18 26 -------------- -------------- TOTAL ASSETS $16,902 $17,847 ============== ============== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $1,260 $1,688 Accrued compensation 963 991 Deferred revenue 1,213 1,706 Other accrued liabilities 1,088 1,126 Accrued costs of business restructuring 25 86 Income taxes payable 89 4 -------------- -------------- TOTAL CURRENT LIABILITIES 4,638 5,601 Deferred gain on sale of property 485 776 -------------- -------------- TOTAL LIABILITIES 5,123 6,377 COMMITMENTS -- -- STOCKHOLDERS' EQUITY: Preferred stock - Authorized, 5,000,000 shares, including 200,000 shares of Series A Junior Participating Issued and outstanding, none -- -- Common stock, at stated value - Authorized, 30,000,000 shares Issued and outstanding, 8,265,471 and 8,064,696 shares 19,218 19,001 Accumulated deficit (7,799) (8,018) Accumulated other comprehensive income 360 487 -------------- -------------- TOTAL STOCKHOLDERS' EQUITY 11,779 11,470 -------------- -------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $16,902 $17,847 ============== ==============
See accompanying notes to consolidated financial statements. 3 DATA I/O CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) Three Months Ended Nine Months Ended ------------------------------------------------------------------------------------------------------------------- Sept. 30, Sept. 30, Sept. 30, Sept. 30, 2005 2004 2005 2004 (in thousands, except per share data) Net sales $6,587 $7,765 $19,966 $21,495 Cost of goods sold 2,831 3,533 8,263 10,040 ----------- ----------- ----------- ----------- Gross margin 3,756 4,232 11,703 11,455 Operating expenses: Research and development 1,218 1,262 3,905 3,642 Selling, general and administrative 2,411 2,405 7,421 6,700 Net provision for business restructuring 17 432 73 502 ----------- ----------- ----------- ----------- Total operating expenses 3,646 4,099 11,399 10,844 ----------- ----------- ----------- ----------- Operating income 110 133 304 611 Non-operating income (expense): Interest income 37 14 81 42 Interest expense (4) (6) (16) (13) Other income (expense) -- (20) -- - Foreign currency exchange (21) (27) (44) (45) ----------- ----------- ----------- ----------- Total non-operating income (expense) 12 (39) 21 (16) ----------- ----------- ----------- ----------- Income before income taxes 122 94 325 595 Income tax expense (benefit) (5) 1 106 103 ----------- ----------- ----------- ----------- Net income $127 $93 $219 $492 =========== =========== =========== =========== Basic and diluted earnings per share $0.02 $0.01 $0.03 $0.06 =========== =========== =========== =========== Weighted average basic shares outstanding 8,244 8,046 8,200 8,019 =========== =========== =========== =========== Weighted average diluted shares outstanding 8,468 8,384 8,501 8,361 =========== =========== =========== ===========
See accompanying notes to consolidated financial statements. 4 DATA I/O CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) ----------------------------------------------------------------------------------------------------- Sept. 30, Sept. 30, 2005 2004 ----------------------------------------------------------------------------------------------------- (in thousands) OPERATING ACTIVITIES: Net income $219 $492 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 833 506 Write-off of assets 11 2 Equipment transferred to cost of goods sold 491 629 Amortization of deferred gain on sale (291) (247) Net change in: Deferred revenue (532) (77) Trade accounts receivable (2,289) (1,386) Inventories 96 1,143 Other current assets 339 116 Accrued costs of business restructuring (62) 204 Accounts payable and accrued liabilities (477) (478) ---------- ---------- Net cash provided by (used in) operating activities (1,662) 904 INVESTING ACTIVITIES: Purchases of property and equipment (1,640) (1,684) Purchase of other assets - (30) Purchases of marketable securities (1,250) (933) Proceeds from sales of marketable securities 1,092 1,985 ---------- ---------- Net cash provided by (used in) investing activities (1,798) (662) FINANCING ACTIVITIES: Sale of common stock 132 154 Proceeds from exercise of stock options 85 24 ---------- ---------- Net cash provided by (used in) financing activities 217 178 ---------- ---------- Increase/(decrease) in cash and cash equivalents (3,243) 420 Effects of exchange rate changes on cash 341 136 Cash and cash equivalents at beginning of period 5,534 4,380 ---------- ---------- Cash and cash equivalents at end of period $2,632 $4,936 ========== ==========
See accompanying notes to consolidated financial statements. 5 DATA I/O CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - FINANCIAL STATEMENT PREPARATION Data I/O prepared the financial statements as of September 30, 2005 and September 30, 2004, according to the rules and regulations of the Securities and Exchange Commission ("SEC"). These statements are unaudited but, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary to present fairly the results for the periods presented. The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date. We have condensed or omitted certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America according to such SEC rules and regulations. Operating results for the nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. These financial statements should be read in conjunction with the annual audited financial statements and the accompanying notes included in the Company's Form 10-K for the year ended December 31, 2004. During the third quarter, Data I/O changed its method of accounting for revenue recognition in accordance with the provisions of SAB 104 which allows revenue recognition for sales with multiple deliverables to be separated and the revenue recognized upon shipment for those products delivered, which previously had been recognized upon installation. The revenue recognition for the undelivered installation service remains deferred. We made this change 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 each of the multiple deliverables has an established fair market value. This change benefits Data I/O by reducing late quarter end expedite fees, premium travel costs and labor charges for installation personnel. It also benefits the customer relationship by reducing installation schedule conflicts. The table below reflects the effect of this change in accounting method. Two transactions were impacted by this change for the periods presented. A delivery in the second quarter of 2004 that was not installed until the third quarter of 2004 resulted in a change in the pro forma third quarter 2004 results, but had no impact on the nine-month period ending September 30, 2004. A delivery in the third quarter of 2005 that was not installed until the fourth quarter of 2005 resulted in the change to the third quarter and nine-month period ending September 30, 2005 results. The effect of the change is as follows: (in thousands, except per share amounts) Operating Net Earnings Per Income Income Share --------------------------------------- Quarter ending Sept. 30, 2004 before change in $133 $93 $0.01 accounting method Quarter ending Sept. 30, 2004 after change in accounting method $2 ($38) -- Nine months ending Sept. 30, 2004 before change in accounting method $611 $492 $0.06 Nine months ending Sept. 30, 2004 after change in accounting method $611 $492 $0.06 Quarter ending Sept. 30, 2005 before change in accounting method ($23) ($6) -- Quarter ending Sept. 30, 2005 after change in accounting method $110 $127 $0.02 Nine months ending Sept. 30, 2005 before change in accounting method $171 $86 $0.01 Nine months ending Sept. 30, 2005 after change in accounting method $304 $219 $0.03
6 Stock-Based Compensation ------------------------ Data I/O has stock-based employee compensation plans. We apply APB Opinion 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for our plans. The following table illustrates the effect on net income and earnings per share if Data I/O had applied the fair value recognition provisions of FASB Statement 123, Accounting for Stock-Based Compensation. Data I/O's pro forma information follows (in thousands, except per share data): Three Months Ended Nine Months Ended Sept. 30, Sept. 30, Sept. 30, Sept. 30, 2005 2004 2005 2004 ---------- ---------- ---------- ---------- Net income - as reported $127 $93 $219 $492 Deduct: Total stock-based employee compensation expense determined under fair value based method for awards granted, modified, or settled, net of related tax effects (109) (105) (291) (268) ---------- ---------- ---------- ---------- Net income (loss) - pro forma $18 ($12) ($72) $224 ========== ========== ========== ========== Basic and diluted income per share - as reported $0.02 $0.01 $0.03 $0.06 Basic income (loss) per share - pro forma $0.00 $0.00 ($0.01) $0.03 Diluted earnings (loss) per share - pro forma $0.00 $0.00 ($0.01) $0.03
NOTE 2 - RECLASSIFICATIONS Certain prior period balances have been reclassified to conform to the presentation used in the current period. NOTE 3 - INVENTORIES Inventories consisted of the following components (in thousands): Sept. 30, Dec. 31, 2005 2004 ----------- ----------- Raw material $2,110 $2,381 Work-in-process 910 899 Finished goods 832 859 ----------- ----------- $3,852 $4,139 =========== =========== We continued to reduce the overall level of inventory based upon the level of sales we have been experiencing and are forecasting. During the quarter we did not significantly change the net carrying values of our inventory. NOTE 4 - PROPERTY AND EQUIPMENT - NET Property and equipment - net consisted of the following components (in thousands): Sept. 30, Dec. 31, 2005 2004 ----------- ----------- Leasehold improvements $343 $291 Equipment 10,368 10,065 ----------- ----------- 10,711 10,356 Less accumulated depreciation 8,390 8,386 ----------- ----------- $2,321 $1,970 =========== =========== 7 NOTE 5 - BUSINESS RESTRUCTURING For fiscal year 2004, we took restructuring related charges of $562,000 primarily related to severance and a small office closure. These actions were taken to lower production and operating costs to reduce the level of revenue required for our net income breakeven point, particularly in view of the reduced margins in the second quarter of 2004; the continued need to control costs in North America and Europe; and the need to build staff serving China and Eastern Europe. At December 31, 2004, $86,000 remained accrued as restructure charges. During the first nine months of 2005, approximately $133,000 was paid out and an additional $72,000 was accrued ($17,000 in the third quarter and $55,000 in the second quarter) for severance related charges. The balance accrued at September 30, 2005 is $25,000 which is expected to be paid out in 2005. NOTE 6 - OTHER ACCRUED LIABILITIES Other accrued liabilities consisted of the following components (in thousands): Sept. 30, Dec. 31, 2005 2004 ----------- ----------- Product warranty liability $469 $494 Sales return reserve 180 250 Other 439 382 ----------- ----------- $1,088 $1,126 =========== ============ The changes in Data I/O's product warranty liability are as follows (in thousands): Sept. 30, 2005 ---------- Liability, beginning balance $494 Net expenses 572 Warranty claims (572) Accrual revisions (25) ---------- Liability, ending balance $469 ========== NOTE 7 - EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share (in thousands except per share data): Three Months Ended Nine Months Ended Sept. 30, Sept. 30, ---------------------- ---------------------- 2005 2004 2005 2004 ---------- ---------- ---------- ---------- Numerator for basic and diluted earnings per share: Net income $127 $93 $219 $492 ---------- ---------- ---------- ---------- Denominator: Denominator for basic earnings per share - weighted-average shares 8,244 8,046 8,200 8,019 Employee stock options 224 338 301 342 ---------- ---------- ---------- ---------- Denominator for diluted earnings per share - Adjusted weighted-average shares and assumed conversions of stock options 8,468 8,384 8,501 8,361 ---------- ---------- ---------- ---------- Basic and diluted earnings per share Total basic and diluted earnings per share $0.02 $0.01 $0.03 $0.06 ========== ========== =========== ===========
8 At September 30, 2005 and 2004 there were 1,317,855 and 1,462,711 shares, respectively, of outstanding options potentially issueable as common stock. NOTE 8 - ACCOUNTING FOR INCOME TAXES Tax benefit for the third quarter of 2005 relates to a reduction in the current year's foreign tax obligations. Tax expense for the first nine months of 2005 relates to foreign and state tax obligations. The Company's effective tax rate for the third quarter and for the first nine months of 2005 differed from the statutory 34% tax rate primarily due to the tax valuation allowances and domestic net operating loss carryforwards. The tax valuation allowance decreased by approximately $71,000 during the quarter ended September 30, 2005 and $26,000 for the first nine months of 2005. As of September 30, 2005, the Company has a valuation allowance of $9,782,000. NOTE 9 - COMPREHENSIVE INCOME Total comprehensive income (loss) was comprised of the following (in thousands): Three Months Ended Nine Months Ended Sept. 30, Sept. 30, ---------------------- ---------------------- 2005 2004 2005 2004 ---------- ---------- ---------- ---------- Net income $127 $93 $219 $492 Foreign currency translation gain/(loss) 49 94 (132) 5 Unrealized gain on marketable securities - - 5 - ---------- ---------- ---------- ---------- Total comprehensive income/(loss) $176 $187 $92 $497 ========== ========== =========== ===========
NOTE 10 - FOREIGN CURRENCY TRANSLATION AND DERIVATIVES We translate assets and liabilities of foreign subsidiaries at the exchange rate on the balance sheet date. We translate revenues, costs and expenses of foreign subsidiaries at average rates of exchange prevailing during the year. We charge or credit translation adjustments resulting from this process to other comprehensive income (a component of stockholders' equity), net of taxes. Realized and unrealized gains and losses resulting from the effects of changes in exchange rates on assets and liabilities denominated in foreign currencies are included in non-operating expense as foreign currency transaction gains and losses. We account for our hedging activities in accordance with SFAS No. 133, Accounting for Derivatives and Hedging Activities. This statement establishes accounting and reporting standards for derivative instruments and requires recognition of derivatives as assets or liabilities in the statement of financial position and measurement of those instruments at fair value. We utilize forward foreign exchange contracts to reduce the impact of foreign currency exchange rate risks where natural hedging strategies cannot be effectively employed. All hedging instruments held by us are fair value hedges. Generally, these contracts have maturities less than one year and require us to exchange foreign currencies for U.S. dollars at maturity. The change in fair value of the open hedge contracts as of September 30, 2005 is an unrealized gain of $2,453 and is included in accounts payable on the balance sheet. We do not hold or issue derivative financial instruments for trading purposes. The purpose of our hedging activities is to reduce the risk that the valuation of the underlying assets, liabilities and firm commitments will be adversely affected by changes in exchange rates. Our derivative activities do not create foreign currency exchange rate risk because fluctuations in the value of the instruments used for hedging purposes are offset by fluctuations in the value of the underlying exposures being hedged. NOTE 11 - RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payments." SFAS No. 123R requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by APB Opinion No. 25, and allowed under the original provisions of SFAS No. 123. SFAS No. 123R requires the use of an option pricing model for estimating fair value, which is amortized to expense over the service periods. In March 2005, the SEC issued SAB 107, "Share-Based Payments," which gives guidance on the application of SFAS No. 123R and extends the required adoption date to January 1, 2006 for Data I/O. The adoption of SFAS No. 123R is expected to have a significant effect on the consolidated financial statements of Data I/O. See Note 1 for the pro forma impact on net earnings (loss) and earnings (loss) per share from calculating stock-related compensation costs under the fair value alternative of SFAS No. 123. However, the calculation of compensation cost for share-based payment transactions after the effective date of SFAS No. 123R and under SAB 107 may be different from the calculation of compensation cost under SFAS No. 123. Such potential differences have not yet 9 been quantified. Also, past usage of option plans and stock purchase plans may not reflect our practices in future periods. In March 2005 and October 2005, the Securities and Exchange Commission announced that the compliance date for non-accelerated filers and foreign private issuers pursuant to Section 404 of the Sarbanes-Oxley Act has been extended. Under the latest extension, a company that is not required to file its annual and quarterly reports on an accelerated basis must begin to comply with the requirements for the assessment and the reporting on internal control over financial reporting for its first fiscal year ending on or after July 15, 2007. Data I/O expects that it will continue to be a non-accelerated filer and that it will, therefore, be required to comply with Section 404 of the Sarbanes-Oxley Act as of December 31, 2007. In May 2005, the FASB issued Statement No. 154, "Accounting Changes and Error Corrections." This Statement replaces APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. Statement No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. In June 2005, the FASB issued staff position ("FSP") FSP FAS 143-1, "Accounting for Electronic Equipment Waste Obligations Pursuant to a European Union Directive." FSP FAS 143-1 provides guidance related to the costs associated with historical electrical and electronic waste equipment ("WEEE"), based on the European Union Directive. The guidance takes effect the later of the first reporting period ending after June 8, 2005, or, for an applicable EU-member country, upon the adoption of a law that complies with the Directive. The adoption of FSP FAS 143-1 has not had a significant effect on our consolidated financial statements. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 level of expense; future results of operations 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; effect of implementing a new information system; and any other guidance on future periods are forward-looking statements. Forward-looking statements reflect management's current expectations and are inherently uncertain. Although we believe 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 we nor anyone else assumes responsibility for the accuracy and completeness of these forward-looking statements. We are 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 in the section entitled "Business - Cautionary Factors That May Affect Future Results" in Item 1 in the Company's Annual report on Form 10-K for the year ended December 31, 2004, and in Exhibit 99.1 of this report describe some, but not all, of the factors that could cause these differences. OVERVIEW Our goal is to continue to focus on managing the business to achieve profitable operations, while developing and enhancing products to drive revenue and earnings growth. Our challenge continues to be operating in the uncertain economic environment, while positioning Data I/O through new product development to take advantage of market opportunities in our strategic market segments, and with our new programming technology, in-system programming ("ISP") ImageWriter, business and service operation. We are continuing our efforts to balance increasing costs and strategic investments in our business with the level of demand and mix of business we expect. We are focusing our research and development efforts in our strategic growth markets, namely the ISP technology, and automated programming systems for the manufacturing environment, particularly extending the capabilities and support for our FlashCORE architecture and the ProLINE-RoadRunner and PS families. To better support our customers in their geographic areas and time zones, we continue to invest in tools and device support operations in Germany, India and China. 10 Our customer focus has been on strategic high volume manufacturers and programming centers and supporting NAND Flash and microcontrollers on our newer products to gain new accounts and break into new markets, such as microcontrollers for the automotive market. We are increasing our focus on service and aftermarket opportunities. We continue to expand our China operations to take advantage of the growth of manufacturing in China. We are also increasing our global sales efforts related to the Japanese market, an important influence for sales in China and the rest of Asia. We continue our efforts to partner with the semiconductor manufacturers to better serve our mutual customers. RESTRUCTURE ACTIONS For fiscal year 2004, we accrued restructuring charges that totaled $562,000 with a remaining balance of $86,000 at December 31, 2004. The restructuring charges related primarily to severance and a small office closure. These actions were taken to lower production and operating costs to reduce the level of revenue required for our net income breakeven point, particularly in view of our reduced margins during 2004; the continued need to control costs in North America and Europe; and the need to build staff serving China and Eastern Europe. During the first nine months of 2005, approximately $133,000 was paid out and an additional $72,000 was accrued ($17,000 in the third quarter and $55,000 in the second quarter) for severance related charges. The balance accrued at September 30, 2005 is $25,000 which is expected to be paid out in 2005. 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. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition: Sales of our semiconductor programming equipment products 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. Installation that is considered perfunctory includes any installation that can be performed by other parties, such as distributors, other vendors, or in most cases customers themselves. This takes into account the complexity, skill, and training needed as well as customer expectations regarding installation. The revenue related to these products is recognized at the time of shipment. 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. If the actual future returns differ from historical levels, our revenue could be adversely affected. Beginning in the third quarter of 2005, Data I/O changed its method of recognizing revenue for products requiring installation by us from the completion of installation to the time of shipment. This change in method of accounting for revenue recognition is in accordance with the provisions of SAB 104 which allows revenue recognition for sales with multiple deliverables to be separated and the revenue recognized upon shipment for those products delivered, which previously had been recognized upon installation. The revenue recognition for the undelivered installation service remains deferred. Allowance for Doubtful Accounts: We base the allowance for doubtful accounts receivable on our assessment of the collectibility 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 us could be adversely affected. Inventory Provisions: We base inventory purchases and commitments upon future demand forecasts and historic usage. 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, we may be required to increase our inventory provision adjustments and our gross margin could be adversely affected. Warranty Accruals: We accrue 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. 11 Tax Valuation Allowances: Given the uncertainty created by our loss history, Data I/O expects to continue to limit the recognition of net deferred tax assets and maintain the tax valuation allowances. We expect, therefore, that reversals of the tax valuation allowance will take place for the next few years 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. Results of Operations NET SALES ----------------------------------------------------------------------------------------------------------------------- (in thousands) Three Months Ended Nine Months Ended ------------------------------------------ -------------------------------------- Sept. 30, Sept. 30, Sept. 30, Sept. 30, Net sales by product line 2005 % Change 2004 2005 % Change 2004 ------------------------------------------------------------------------------ -------------------------------------- Automated programming systems $3,528 (30.4%) $5,071 $11,635 (15.8%) $13,819 Non-automated programming systems $3,059 13.5% $2,694 $8,331 8.5% $7,676 ------------------------------------------ -------------------------------------- Total programming systems $6,587 (15.2%) $7,765 $19,966 (7.1%) $21,495 ========================================== ======================================
Three Months Ended Nine Months Ended ------------------------------------------ -------------------------------------- Sept. 30, Sept. 30, Sept. 30, Sept. 30, Net sales by location 2005 % Change 2004 2005 % Change 2004 ------------------------------------------------------------------------------ -------------------------------------- United States $1,110 (25.0%) $1,480 $4,848 10.7% $4,378 % of total 16.9% 19.1% 24.3% 20.4% International $5,477 (12.9%) $6,285 $15,118 (11.7%) $17,117 % of total 83.1% 80.9% 75.7% 79.6% -------------------------------------------------------------------------------------------------------------------------------
Revenues for the third quarter of 2005 decreased approximately 15% from the third quarter of 2004. The revenue decrease relates primarily to the decrease in sales to the wireless handset manufacturers, generally our largest customer segment. The third quarter of 2004 reflected a strong demand for automation capacity in the wireless segment, which largely went away in the fourth quarter of 2004 and continued to be relatively weak for shipments through the third quarter of 2005. The decrease in demand may also be partially influenced by the industry consolidation, causing a pause in equipment orders. Overall, orders were $7.8 million during the third quarter of 2005, which was similar to the third quarter of 2004. However, this was a significant improvement over the order levels for the prior three quarters. During the third quarter of 2005, we increased our backlog of orders from $770,000 to $1,980,000. We saw an increase in the demand from the wireless customer group during the third quarter of 2005, but it related primarily to non automated and aftermarket products rather than automation products. We saw an upturn in our business from programming centers late in the quarter, which accounts for a large part of the backlog increase. Finally, we made our first strategic sale of an automated programming system to a semiconductor manufacturer for factory programming. Domestic sales in the third quarter of 2005 declined compared to the third quarter of 2004 by 25%. This was offset in full by higher sales in the rest of the Americas and the Brazilian programming services operation. International sales decreased approximately 12.9% primarily due to weaker automation sales in Asia, and Japan in particular. The U.S. dollar strengthened slightly in the third quarter of 2005 compared to the third quarter of 2004, and in particular against the Euro, with the effect of increasing the overall decrease in international sales by $48,678. Overall, international sales were 83% of revenues for the quarter. The revenue decline for the first nine months of 2005 compared to 2004 was primarily related to the continued overall decrease in capacity demand by wireless handset manufacturers as noted earlier, offset by improved sales, in the automotive customer group. 12 In 2004, we introduced the PS 588 and PS 288 FlashCORE automated programming systems, ImageWriter, our ISP solution, eDSS tool suite for device support, and a version of our ProLINE-RoadRunner designed for Panasonic CM402 machines. We began shipping Beta units of our ImageWriter 200 in 2004, began regular shipments of the ImageWriter 200 in the second quarter of 2005, and in September introduced the ImageWriter 300. We expect these products to increase our revenues; however, partially offsetting this expected increase is the continued trend of declining sales of certain older non-automated product lines. GROSS MARGIN Three Months Ended Nine Months Ended ------------------------------------------------------------------------- (in thousands) Sept. 30, 2005 Sept. 30, 2004 Sept. 30, 2005 Sept. 30, 2004 -------------------------------------------------------------------------------------------------------- Gross Margin $3,756 $4,232 $11,703 $11,455 Percentage of net sales 57.0% 54.5% 58.6% 53.3% --------------------------------------------------------------------------------------------------------
Gross margins decreased in dollars due to the lower sales volume but increased as a percentage of sales compared to the third quarter of 2004. The overall gross margin percentage increase relates to the product and channel mix as well as a favorable average selling price variance of approximately $220,000 and favorable inventory related variances of approximately $200,000. Finally, the restructuring activities in the third quarter of 2004 lowered our labor and overhead costs in our U.S. and Canada operations. We expect the margin percentages for the fourth quarter to be in line with the current quarter's level. Gross margin as a percentage of sales for the first nine months of 2005 has increased over 2004 due to increased product average selling price and channel mix as well as favorable inventory variances and savings related to the business restructuring. RESEARCH AND DEVELOPMENT Three Months Ended Nine Months Ended ------------------------------------------------------------------------- (in thousands) Sept. 30, 2005 Sept. 30, 2004 Sept. 30, 2005 Sept. 30, 2004 -------------------------------------------------------------------------------------------------------- Research and development $1,218 $1,262 $3,905 $3,642 Percentage of net sales 18.5% 16.3% 19.6% 16.9% -------------------------------------------------------------------------------------------------------
Research and development ("R&D") spending for the third quarter of 2005 compared to the third quarter of 2004 decreased in dollars due to lower personnel costs relating to open positions and less R&D materials, but increased as a percentage of sales due to the lower sales volume. During the third quarter of 2005, we introduced our new ImageWriter 300 product. We expect R&D spending to increase as we fill open positions. Our R&D spending also fluctuates based on the number and the development stage of projects. The increase in R&D expenses for the first nine months of 2005 compared to the same period in 2004 relates to our new product initiatives, particularly the ImageWriter, our new in-system programming solution, the new automation solution, and the start of engineering operations in China. SELLING, GENERAL AND ADMINISTRATIVE Three Months Ended Nine Months Ended -------------------------------------------------------------------------------- (in thousands) Sept. 30, 2005 Sept. 30, 2004 Sept. 30, 2005 Sept. 30, 2004 -------------------------------------------------------------------------------------------------------------- Selling, general & administrative $2,411 $2,405 $7,421 $6,700 Percentage of net sales 36.6% 31.0% 37.2% 31.2% --------------------------------------------------------------------------------------------------------------
Selling, general and administrative ("SG&A") expenses were approximately the same for the third quarter of 2005 compared to the third quarter of 2004. A few significant expense changes include reduced USA selling expenses of $133,000, which offset increased expenses associated with the new information system of $95,000 and a custom duties settlement cost of $35,000. The increase in SG&A expenses for the first nine months of 2005 compared to the same period in 2004 relates to additional marketing personnel and launch costs of $257,000, expenses associated with the new information system of $113,000, additional accounting 13 personnel and auditor costs of $178,000, Sarbanes-Oxley internal control related costs of $52,000, additional China administration costs of $52,000, a reduction of allocated out facility costs of $52,000, and additional investor relations costs of $50,000. INTEREST Three Months Ended Nine Months Ended -------------------------------------------------------------------------------- (in thousands) Sept. 30, 2005 Sept. 30, 2004 Sept. 30, 2005 Sept. 30, 2004 -------------------------------------------------------------------------------------------------------------- Interest income $37 $14 $81 $42 Interest expense ($4) ($6) ($16) ($13) --------------------------------------------------------------------------------------------------------------
Interest income increased in the third quarter of 2005 and nine month period compared to the same periods in 2004 due to higher yields. INCOME TAXES Three Months Ended Nine Months Ended -------------------------------------------------------------------------------- (in thousands) Sept. 30, 2005 Sept. 30, 2004 Sept. 30, 2005 Sept. 30, 2004 -------------------------------------------------------------------------------------------------------------- Income tax expense (benefit) ($5) $1 $106 $103 --------------------------------------------------------------------------------------------------------------
Tax benefit for the third quarter of 2005 relates to a reduction in the current year's foreign tax obligations. Tax expense for the first nine months of 2005 relates to foreign and state tax obligations. The Company's effective tax rate for the third quarter and for the first nine months of 2005 differed from the statutory 34% tax rate primarily due to the tax valuation allowances and domestic net operating loss carryforwards. The tax valuation allowance decreased by approximately $71,000 during the quarter ended September 30, 2005 and $26,000 for the first nine months of 2005. As of September 30, 2005, the Company has a valuation allowance of $9,782,000. Financial Condition ------------------- LIQUIDITY AND CAPITAL RESOURCES Sept. 30, June 30, Dec. 31, (in thousands) 2005 Change 2005 Change 2004 ---------------------------------------------------------------------------------------------------- Working capital $9,925 $294 $9,631 ($619) $10,250 ----------------------------------------------------------------------------------------------------
At September 30, our principal sources of liquidity consisted of existing cash, cash equivalents and marketable securities. Our working capital for the nine month period decreased by $325,000 and our current ratio increased from 2.8 at December 31, 2004 to 3.1 at September 30, 2005. Our cash and cash equivalents decreased by $2.9 million during the first nine months of 2005 primarily due to the increase in cash used for operating activities including the funding for the Brazilian operation totaling $1.7 million. The $1.7 million of cash used for operations primarily included a $2.3 million increase in accounts receivable, $477,000 decrease in accounts payable and accrued liabilities, and a $532,000 decrease in deferred revenue partially offset by a $96,000 decrease in inventory, $491,000 of demonstration equipment transferred to cost of goods sold, and $833,000 of depreciation and amortization. The increase in accounts receivable results from increased sales especially late in the quarter and the longer collection times we are experiencing with increased international sales, especially in China. We used $1.8 million of cash in investing activities during the third quarter of 2005, which primarily relates to the purchase of property, plant and equipment totaling $1.6 million. The capital purchases included approximately $515,000 related to the Brazilian operation and approximately $306,000 related to the purchase of our new information system. During the second quarter, we entered into an agreement to purchase a worldwide information system. As of September 30, 2005, we incurred approximately $306,000 related to the software and maintenance for our new information system and we expect to incur additional hardware, software and implementation costs during the next few quarters. We expect that we will continue to make capital expenditures to support our business and anticipate that present working capital will be sufficient to meet our operating requirements. 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 require substantial working capital to fund our operations. Over the last few years, we restructured our operations to lower our costs 14 and operating expenditures in certain geographic 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 September 30, 2006. 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. Aggregate Contractual Obligations and Commitments ------------------------------------------------- We have purchase obligations for inventory and production costs as well as other obligations such as capital expenditures, service contracts, marketing, and development agreements. Arrangements are considered purchase obligations if a contract specifies all significant terms, including fixed or minimum quantities to be purchased, a pricing structure and approximate timing of the transaction. Most arrangements are cancelable without a significant penalty, and with short notice, typically less than 90 days. Any amounts reflected on the balance sheet as accounts payable and accrued liabilities are excluded from the below table. We have no long-term debt. We have commitments under non-cancelable operating leases and other agreements, primarily for factory and office space, with initial or remaining terms of one year or more as follows: As of September 30, 2005 (in thousands): During year Purchase Operating Ending Sept. 30, obligations leases --------------------------- --------------- ------------ 2006 $1,146 $1,577 2007 202 581 2008 - 165 2009 - 54 2010 and thereafter - - --------------- ------------ Total $1,348 $2,377 ================ ============ RECENT ACCOUNTING PRONOUCEMENTS In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payments." SFAS No. 123R requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by APB Opinion No. 25, and allowed under the original provisions of SFAS No. 123. SFAS No. 123R requires the use of an option pricing model for estimating fair value, which is amortized to expense over the service periods. In March 2005, the SEC issued SAB 107, "Share-Based Payments," which gives guidance on the application of FAS 123R and extends the required adoption date to January 1, 2006 for Data I/O. The adoption of SFAS No. 123R is expected to have a significant effect on the consolidated financial statements of Data I/O. See Note 1 for the pro forma impact on net earnings (loss) and earnings (loss) per share from calculating stock-related compensation costs under the fair value alternative of SFAS No. 123. However, the calculation of compensation cost for share-based payment transactions after the effective date of SFAS No. 123R and under SAB 107 may be different from the calculation of compensation cost under SFAS No. 123. Such potential differences have not yet been quantified. Also, past usage of option plans and stock purchase plans may not reflect our practices in future periods. In March 2005 and October 2005, the Securities and Exchange Commission announced that the compliance date for non-accelerated filers and foreign private issuers pursuant to Section 404 of the Sarbanes-Oxley Act has been extended. Under the latest extension, a company that is not required to file its annual and quarterly reports on an accelerated basis must begin to comply with the requirements for the assessment and the reporting on internal control over financial reporting for its first fiscal year ending on or after July 15, 2007. Data I/O expects that it will continue to be a non-accelerated filer and that it will, therefore, be required to comply with Section 404 of the Sarbanes-Oxley Act as of December 31, 2006. In May 2005, the FASB issued Statement No. 154, "Accounting Changes and Error Corrections." This Statement replaces APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. Statement No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. In June 2005, the FASB issued staff position ("FSP") FSP FAS 143-1, "Accounting for Electronic Equipment Waste Obligations Pursuant to a European Union Directive." FSP FAS 143-1 provides guidance related to the costs associated with historical electrical and electronic waste equipment ("WEEE"), based on the European Union Directive. The guidance takes effect the later of the first 15 reporting period ending after June 8, 2005, or, for an applicable EU-member country, upon the adoption of a law that complies with the Directive. The adoption of FSP FAS 143-1 has not had a significant effect on our consolidated financial statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including fluctuations in foreign exchange rates and interest rates. INTEREST RATE RISK We invest our cash in a variety of short-term financial instruments, including government bonds, commercial paper and money market instruments, which are classified as available-for-sale. Our investments are made in accordance with an investment policy approved by our board of directors. Our portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. Cash balances in foreign currencies are operating balances and are invested in demand or short-term deposits of the local operating bank. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted because of a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations because of changes in interest rates or we may suffer losses in principal if forced to sell securities that have seen a decline in market value because of changes in interest rates. We do not attempt to reduce or eliminate our exposure to interest rate risk through the use of derivative financial instruments due to the short-term nature of the investments. The table below provides information about our marketable securities, including principal cash flows and the related weighted average interest rates (in thousands): Principal Estimated Fair Principal Estimated Fair Cash Flows Value at Cash Flows Value at to Sept. 30, December 31, For Q4 2005 Sept. 30, 2005 2005 2004 ------------- ---------------- ------------- ---------------- Corporate Bonds -- -- $787 $787 Taxable Auction Securities 1,200 1,200 250 250 3.783% 2.352% ------------- ---------------- ------------- ---------------- Total portfolio value $1,200 $1,200 $1,037 $1,037 ============== ================ ============= ================
FOREIGN CURRENCY RISK We have operations in Germany, Canada, China, and Brazil. Therefore, we are subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially adversely affected by changes in these or other factors. Our sales and corresponding receivables are substantially in U.S. dollars other than sales made in our subsidiaries in Germany, Canada, and China. Through our operations in Germany, Canada, China, and Brazil, we incur certain product costs; research and development; customer service and support costs; selling, general and administrative expenses in local currencies. We are exposed, in the normal course of business, to foreign currency risks on these expenditures and on related foreign currency denominated monetary assets and liabilities. We have evaluated our exposure to these risks and believe that our only significant exposure to foreign currencies at the present time is primarily related to Euro-based receivables. We use forward contracts to hedge and thereby minimize the currency risks associated with certain transactions denominated in Euros. If our actual currency requirement or timing in the period forecasted differs materially from the notional amount of our forward contracts and/or the natural balancing of receivables and payables in foreign currencies during a period of currency volatility or if we do not continue to manage our exposure to foreign currency through forward contracts or other means, we could experience unanticipated foreign currency gains or losses. In addition, our foreign currency risk management policy subjects us to risks relating to the creditworthiness of the commercial banks with which we enter into forward contracts. If one of these banks cannot honor its obligations, we may suffer a loss. We also invest in our international operations, which will likely result in increased future operating expenses denominated in those local currencies. In the future, our exposure to foreign currency risks from these other foreign currencies may increase and if not managed appropriately, we could experience unanticipated foreign currency gains and losses. 16 The purpose of our foreign currency risk management policy is to reduce the effect of exchange rate fluctuation on our results of operations. Therefore, while our foreign currency risk management policy may reduce our exposure to losses resulting from unfavorable changes in currency exchange rates, it also reduces or eliminates our ability to profit from favorable changes in currency exchange rates. At September 30, 2005, we had two forward contracts to sell Euros in exchange for $936,495 with rates ranging from 1.2008 to 1.2170 all scheduled to be due within the next quarter and with a value at maturity of $934,042. ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, Data I/O evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act) as of the end of the period covered by this report (the "Evaluation Date"). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective in timely alerting them to the material information relating to Data I/O (or its consolidated subsidiaries) required to be included in our periodic SEC filings and Form 8-K reports. (b) Changes in internal controls. There were no changes made in our internal controls during the period covered by this report that have materially affected or are reasonably likely to materially affect our internal control over financial reporting except as described below. During the preparation of our 2004 year-end financial statements, we identified a calculation error that had resulted in the understatement of inter-company expense eliminations on foreign subsidiary demonstration inventory equipment depreciation, with a corresponding overstatement of demonstration inventory equipment accumulated depreciation. While we believe the impacts of this calculation error are not material to any previously issued financial statement, we determined that this calculation error was most appropriately corrected through restatement of previously issued financial statements. We have restated the annual report on Form 10-K for the fiscal year ended December 31, 2003. Process changes have been instituted to appropriately eliminate the inter-company foreign subsidiary demonstration inventory equipment depreciation amounts. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None 17 ITEM 6. EXHIBITS (a) Exhibits The following list is a subset of the list of exhibits described below and contains all compensatory plans, contracts or arrangements in which any director or executive officer of Data I/O is a participant, unless the method of allocation of benefits thereunder is the same for management and non-management participants: (1) Amended and Restated 1982 Employee Stock Purchase Plan. See Exhibit 10.18. (2) Amended and Restated Retirement Plan and Trust Agreement. See Exhibit 10.2, 10.3, 10.4, 10.8, 10.11, 10.12, and 10.13. (3) Summary of Amended and Restated Management Incentive Compensation Plan. See Exhibit 10.9. (4) Amended and Restated 1983 Stock Appreciation Rights Plan. See Exhibit 10.1. (5) Amended and Restated 1986 Stock Option Plan. See Exhibit 10.15. (6) Change in Control Agreements. See Exhibit 10.22 and 10.23. (7) 1996 Director Fee Plan. See Exhibit 10.14. (8) Letter Agreement with Frederick R. Hume. See Exhibit 10.17. (9) Amended and Restated 2000 Stock Compensation Incentive Plan. See Exhibit 10.19. (10) Form of Option Agreement. See Exhibit 10.21. (11) Data I/O Corporation Tax Deferral Retirement Plan. See Exhibit 10.20. 3 Articles of Incorporation: 3.1 Data I/O's restated Articles of Incorporation filed November 2, 1987 (Incorporated by reference to Exhibit 3.1 of Data I/O's 1987 Annual Report on Form 10-K (File No. 0-10394)). 3.2 Data I/O's Bylaws as amended and restated as of October 2003 (Incorporated by reference to Data I/O's 2003 Annual Report on Form 10-K (File No. 0-10394)). 3.3 Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock (Incorporated by reference to Exhibit 1 of Data I/O's Registration Statement on Form 8-A filed March 13, 1998 (File No. 0-10394)). 4 Instruments Defining the Rights of Security Holders, Including Indentures: 4.1 Rights Agreement, dated as of April 4, 1998, between Data I/O Corporation and ChaseMellon Shareholder Services, L.L.C. as Rights Agent, which includes: as Exhibit A thereto, the Form of Right Certificate; and, as Exhibit B thereto, the Summary of Rights to Purchase Series A Junior Participating Preferred Stock (Incorporated by reference to Data I/O's Current Report on Form 8-K filed on March 13, 1998). 4.2 Rights Agreement, dated as of March 31, 1988, between Data I/O Corporation and First Jersey National Bank, as Rights Agent, as amended by Amendment No. 1 thereto, dated as of May 28, 1992 and Amendment No. 2 thereto, dated as of July 16, 1997 (Incorporated by reference to Data I/O's Report on Form 8-K filed on March 13, 1998). 18 4.3 Amendment No. 1, dated as of February 10, 1999, to Rights Agreement, dated as of April 4, 1998, between Data I/O Corporation and ChaseMellon Shareholder Services, L.L.C. as Rights Agent (Incorporated by reference to Exhibit 4.1 of Data I/O's Form 8-A/A dated February 10, 1999). 10 Material Contracts: 10.1 Amended and Restated 1983 Stock Appreciation Rights Plan dated February 3, 1993 (Incorporated by reference to Exhibit 10.23 of Data I/O's 1992 Annual Report on Form 10-K (File No. 0-10394)). 10.2 Amended and Restated Retirement Plan and Trust Agreement (Incorporated by reference to Exhibit 10.26 of Data I/O's 1993 Annual Report on Form 10-K (File No. 0-10394)). 10.3 First Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by reference to Exhibit 10.21 of Data I/O's 1994 Annual Report on Form 10-K (File No. 0-10394)). 10.4 Second Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by reference to Exhibit 10.26 of Data I/O's 1995 Annual Report on Form 10-K (File No. 0-10394)). 10.5 Purchase and Sale Agreement dated as of July 9, 1996 (Relating to the sale of Data I/O Corporation's headquarters property in Redmond, Washington consisting of approximately 79 acres of land and an approximately 96,000 square foot building. (Portions of this exhibit have been omitted pursuant to an application for an order granting confidential treatment. The omitted portions have been separately filed with the Commission) (Incorporated by reference to Exhibit 10.32 of Data I/O's 1996 Annual Report on Form 10-K (File No. 0-10394)). 10.6 Letter dated as of December 20, 1996, First Amendment and extension of the Closing Date under that certain Purchase and Sale Agreement dated as of July 9, 1996 (Portions of this exhibit have been omitted pursuant to an application for an order granting confidential treatment. The omitted portions have been separately filed with the Commission) (Incorporated by reference to Exhibit 10.33 of Data I/O's 1996 Annual Report on Form 10-K (File No. 0-10394)). 10.7 Letter dated as of February 17, 1997, Second Amendment and extension of the Closing Date under that certain Purchase and Sale Agreement dated as of July 9, 1996 (Portions of this exhibit have been omitted pursuant to an application for an order granting confidential treatment. The omitted portions have been separately filed with the Commission) (Incorporated by reference to Exhibit 10.34 of Data I/O's 1996 Annual Report on Form 10-K (File No. 0-10394)). 10.8 Third Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by reference to Exhibit 10.35 of Data I/O's 1996 Annual Report on Form 10-K (File No. 0-10394)). 10.9 Amended and Restated Management Incentive Compensation Plan dated January 1, 1997 (Incorporated by reference to Exhibit 10.25 of Data I/O's 1997 Annual Report on Form 10-K (File No. 0-10394)). 10.10 Amended and Restated Performance Bonus Plan dated January 1, 1997 (Incorporated by reference to Exhibit 10.26 of Data I/O's 1997 Annual Report on Form 10-K (File No. 0-10394)). 19 10.11 Fourth Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by reference to Exhibit 10.27 of Data I/O's 1997 Annual Report on Form 10-K (File No. 0-10394)). 10.12 Fifth Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by reference to Exhibit 10.28 of Data I/O's 1997 Annual Report on Form 10-K (File No. 0-10394)). 10.13 Sixth Amendment to the Data I/O Tax Deferred Retirement Plan (Incorporated by reference to Exhibit 10.29 of Data I/O's 1997 Annual Report on Form 10-K (File No. 0-10394)). 10.14 Amended and Restated Data I/O Corporation 1996 Director Fee Plan (Incorporated by reference to Exhibit 10.32 of Data I/O's 1997 Annual Report on Form 10-K (File No. 0-10394)). 10.15 Amended and Restated 1986 Stock Option Plan dated May 12, 1998 (Incorporated by reference to Exhibit 10.37 of Data I/O's 1998 Annual Report on Form 10-K (File No. 0-10394)). 10.16 Sublease dated December 22, 1999 between Data I/O Corporation and Imandi.com, Inc. (Incorporated by reference to Exhibit 10.34 of Data I/O's 1999 Annual Report on Form 10-K (File No. 0-10394)). 10.17 Letter Agreement with Fred R. Hume dated January 29, 1999 (Incorporated by reference to Exhibit 10.35 of Data I/O's 1999 Annual Report on Form 10-K (File No. 0-10394)). 10.18 Amended and Restated 1982 Employee Stock Purchase Plan dated May 16, 2003 (Incorporated by reference to Data I/O's 2003 Proxy Statement dated March 31, 2003). 10.19 Amended and Restated 2000 Stock Compensation Incentive Plan dated May 20, 2004 (Incorporated by reference to Data I/O's 2004 Proxy Statement dated April 12, 2004). 10.20 Data I/O Corporation Tax Deferred Retirement Plan, as amended (Incorporated by reference to Exhibit 10.20 of Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.21 Form of Option Agreement (Incorporated by reference to Exhibit 10.21 of Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.22 Change in Control Agreement with Fred R. Hume dated April 22, 2004 (Incorporated by reference to Exhibit 10.22 of Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.23 Change in Control Agreement with Joel S. Hatlen dated April 22, 2004 (Incorporated by reference to Exhibit 10.23 of Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 31 Certification - Section 302: 31.1 Chief Executive Officer Certification .........................22 31.2 Chief Financial Officer Certification .........................23 32 Certification - Section 906: 32.1 Chief Executive Officer Certification .........................24 32.2 Chief Financial Officer Certification .........................25 99 Other Exhibits 99.1 Risk Factors ..................................................26 20 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DATA I/O CORPORATION (REGISTRANT) DATED: November 10, 2005 By: //S//Joel S. Hatlen ------------------------ Joel S. Hatlen Vice President - Finance Chief Financial Officer Secretary and Treasurer (Principal Financial Officer and Duly Authorized Officer) By://S//Frederick R. Hume ------------------------ Frederick R. Hume President Chief Executive Officer (Principal Executive Officer and Duly Authorized Officer) 21 EXHIBIT 31.1 SECTION 302 CERTIFICATION I, Frederick R. Hume, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Data I/O Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date November 10, 2005 /s/ FREDERICK R. HUME ------------------------------------- Frederick R. Hume President and Chief Executive Officer (Principal Executive Officer) ------------------------------------- 22 EXHIBIT 31.2 SECTION 302 CERTIFICATION I, Joel S. Hatlen, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Data I/O Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date November 10, 2005 /s/ JOEL S. HATLEN ------------------------------------- Joel S. Hatlen Vice President and Chief Financial Officer Principal Financial Officer) ------------------------------------- 23 Exhibit 32.1 Certification by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the quarterly Report of Data I/O Corporation (the "Company") on Form 10-Q for the period ended September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Frederick R. Hume, Chief Executive Officer of the Company, certify, that pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Frederick R. Hume ---------------------------- Frederick R. Hume Chief Executive Officer (Principal Executive Officer) November 10, 2005 24 Exhibit 32.2 Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the quarterly Report of Data I/O Corporation (the "Company") on Form 10-Q for the period ended September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Joel S. Hatlen, Chief Financial Officer of the Company, certify, that pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Joel S. Hatlen ------------------------------ Joel S. Hatlen Chief Financial Officer (Principal Financial Officer) November 10, 2005 24 Exhibit 99.1 Cautionary Factors That May Affect Future Results -------------------------------------------------------------------------------- Data I/O's disclosure and analysis in this Report contain some forward-looking statements. Forward-looking statements include our current expectations or forecasts of future events. The reader can identify these statements by the fact that they do not relate strictly to historical or current facts. In particular, these include statements relating to future action, prospective products, new technologies, establishing foreign operations, future performance or results of current and anticipated products, sales efforts, expenses, outsourcing of functions, outcome of contingencies, impact of regulatory requirements, restructure actions and financial results. Any or all of the forward-looking statements in this Report or in any other public statement made may turn out to be wrong. They can be affected by inaccurate assumptions we might make, or known or unknown risks and uncertainties can affect these forward-looking statements. Many factors -- for example, product competition and product development -- will be important in determining future results. Moreover, neither Data I/O nor anyone else assumes responsibility for the accuracy and completeness of these forward-looking statements. Actual future results may materially vary. We undertake no obligation to publicly update any forward-looking statements after the date of this Report, whether as a result of new information, future events or otherwise. The reader should not place undue reliance on such forward-looking statements. The reader is advised, however, to consult any future disclosures Data I/O makes on related subjects in our 10-Q, 8-K and 10-K reports to the SEC and press releases. Also, note that Data I/O provides the following cautionary discussion of risks, uncertainties and possible inaccurate assumptions relevant to our business. These are factors that we think could cause Data I/O's actual results to differ materially from expected and historical results. Other factors besides those listed here could also adversely affect Data I/O. This discussion is permitted by the Private Securities Litigation Reform Act of 1995. RISK FACTORS Delays in development, introduction and shipment of new products may result in a decline in sales. -------------------------------------------------------------------------------- Data I/O currently is developing new engineering and automated programming systems. Significant technological, supplier, manufacturing or other problems may delay the development, introduction or production of these products. For example, we may encounter these problems: o technical problems in the development of a new programming system platform or the robotics for new automated handling systems o inability to hire qualified personnel o delays or failures to perform by third parties involved in our development projects Delays in the development, completion and shipment of new products, or failure of customers to accept new products, may result in a decline in sales. Quarterly fluctuations in our operating results may adversely affect our stock price. -------------------------------------------------------------------------------- Data I/O's operating results tend to vary from quarter to quarter. Our revenue in each quarter substantially depends upon orders received within that quarter. Conversely, our expenditures are based on investment plans and estimates of future revenues. We may, therefore, be unable to quickly reduce our spending if our revenues decline in a given quarter. As a result, operating results for that quarter will suffer. Our results of operations for any one quarter are not necessarily indicative of results for any future periods. Other factors, which may cause our quarterly operating results to fluctuate, include: o increased competition o timing of new product announcements o product releases and pricing changes by us or our competitors o market acceptance or delays in the introduction of new products o production constraints 26 o labor or material shortages o the timing of significant orders o the sales channel mix of direct vs. indirect distribution o war or terrorism o health issues (such as SARS) o customers' budgets o adverse movements in exchange rates, interest rates or tax rates o cyclical nature of demand for our customers' products o general economic conditions in the countries where we sell products o expenses and obtaining authorizations in setting up new operations or locations Due to all of the foregoing factors, it is possible that in some future quarters, our operating results will be below expectations of analysts and investors. Failure to adapt to technology trends in our industry may hinder our competitiveness and financial results. -------------------------------------------------------------------------------- Product technology in Data I/O's industry evolves rapidly, making timely product innovation essential to success in the marketplace. Introducing products with improved technologies or features may render our existing products obsolete and unmarketable. Technological advances that may negatively impact our business include: o new device package types, densities, and technologies requiring hardware and software changes in order to be programmed by our products o electronics equipment manufacturing practices, such as widespread use of in-circuit programming o customer software platform preferences different from those on which our products operate o more rigid industry standards, which would decrease the value-added element of our products and support services If we cannot develop products in a timely manner in response to industry changes, or if our products do not perform well, our business and financial condition may be adversely affected. Also, our new products may contain defects or errors that give rise to product liability claims against us or cause our products to fail to gain market acceptance. Our future success depends on our ability to successfully compete with other technology firms in attracting and retaining key technical personnel. A decline in economic and market conditions may result in decreased capital spending by our customers. -------------------------------------------------------------------------------- Our business is highly impacted by capital spending plans and other economic cycles that affect the users and manufacturers of ICs. These industries are highly cyclical and are characterized by rapid technological change, short product life cycles, fluctuations in manufacturing capacity and pricing and gross margin pressures. As we experienced in recent years, our operations may in the future reflect substantial fluctuations from period-to-period as a consequence of these industry patterns, general economic conditions affecting the timing of orders from major customers, and other factors affecting capital spending. These factors could have a material adverse effect on our business and financial condition. We have a history of recent operating losses and may be unable to generate enough revenue to achieve and maintain profitability. -------------------------------------------------------------------------------- We have incurred net losses in two of our last three fiscal years. We will continue to examine our level of operating expense based upon our projected revenues. Any planned increases in operating expenses may result in larger losses in future periods if projected revenues are not achieved. As a result, we may need to generate greater revenues than we have recently to achieve and maintain profitability. However, we cannot provide assurance that our revenues will increase and our strategy may not be successful, resulting in future losses. 27 Our recent restructuring activities may have a negative impact on our future operations. -------------------------------------------------------------------------------- Our restructuring plans may yield unanticipated consequences, such as increased burden on our administrative, operational, and financial resources and increased responsibilities for our management personnel. As a result, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. In addition, many of the employees that were terminated as a part of our restructuring possessed specific knowledge or expertise, and that knowledge or expertise may prove to have been important to our operations. In that case, their absence may create significant difficulties, particularly if our business experiences significant growth. Also, the reduction in workforce related to our restructuring may subject us to the risk of litigation, which could result in substantial cost. Any failure by us to properly manage this rapid change in workforce could impair our ability to efficiently manage our business, to maintain and develop important relationships with third-parties, and to attract and retain customers. It could also cause us to incur higher operating cost and delays in the execution of our business plan or in the reporting or tracking of our financial results. We may need to raise additional capital and our future access to capital is uncertain. -------------------------------------------------------------------------------- Our past revenues have been and our future revenues may continue to be insufficient to support the expense of our operations and any expansion of our business. We may therefore need additional equity or debt capital to finance our operations. If we are unable to generate sufficient cash flows from operations or to obtain funds through additional debt or equity financing, we may have to reduce some or all of our development and sales and marketing efforts and limit the expansion of our business. We believe our existing cash and cash equivalents will be sufficient to meet our working capital requirements for at least the next twelve months. Thereafter, depending on the development of our business, we may need to raise additional cash for working capital or other expenses. We may also encounter opportunities for acquisitions or other business initiatives that require significant cash commitments, or unanticipated problems or expenses that could result in a requirement for additional cash before that time. Therefore, we may seek additional funding through public or private debt or equity financing or from other sources. We have no commitments for additional financing, and we may experience difficulty in obtaining funding on favorable terms, if at all. Any financing we obtain may contain covenants that restrict our freedom to operate our business or may require us to issue securities that have rights, preferences or privileges senior to our Common Stock and may dilute your ownership interest. We may face increased competition and may not be able to compete successfully with current and future competitors. -------------------------------------------------------------------------------- Technological advances have reduced the barriers of entry into the programming systems market. We expect competition to increase from both established and emerging companies. If we fail to compete successfully against current and future sources of competition, our profitability and financial performance will be adversely impacted. If our relationship with semiconductor manufacturers deteriorates, our business may be adversely affected. -------------------------------------------------------------------------------- We work closely with most semiconductor manufacturers to ensure that our programming systems comply with their requirements. In addition, many semiconductor manufacturers recommend our programming systems for use by users of their programmable devices. These working relationships enable us to keep our programming systems product lines up to date and provide end-users with broad and current programmable device support. Our business may be adversely affected if our relationships with semiconductor manufacturers deteriorate. Our reliance on a small number of suppliers may result in a shortage of key components, which may adversely affect our business. -------------------------------------------------------------------------------- Certain parts used in our products are currently available from either a single supplier or from a limited number of suppliers. If we cannot develop alternative sources of these components, if sales of parts are discontinued by the supplier or we experience deterioration in our relationship with these suppliers, there may be delays or reductions in product introductions or shipments, which may materially adversely affect our operating results. Because we rely on a small number of suppliers for certain parts, we are subject to possible price increases by these suppliers. Also, we may be unable to accurately forecast our production schedule. If we under estimate our production schedule, suppliers may be unable to meet our demand for components. This delay in the supply of key components may materially adversely affect our business. Over estimation of demand will lead to excess inventories that may become obsolete. 28 The non-automated programming system products we acquired when we acquired SMS in November 1998 are currently manufactured to our specifications by a third-party foreign contract manufacturer. We may not be able to obtain a sufficient quantity of these products if and when needed, which may result in lost sales. If we are unable to attract and retain qualified third-party distributors, our business may be adversely affected. -------------------------------------------------------------------------------- Data I/O has an internal sales force and also utilizes third-party representatives, and distributors. Therefore, the financial stability of these representatives and distributors is important. Highly skilled professional engineers use most of our products. To be effective, third-party distributors must possess significant technical, marketing and sales resources and must devote their resources to sales efforts, customer education, training and support. These required qualities limit the number of potential third-party distributors. Our business will suffer if we cannot attract and retain a sufficient number of qualified third-party distributors to market our products. In addition, global customers require coordination between these various sales channels and a lack of responsiveness or coordination could adversely affect our business with these increasingly global customers. Our international operations may expose us to additional risks that may adversely affect our business. -------------------------------------------------------------------------------- International sales represented 80% of our net revenue for the fiscal year ended December 31, 2004 and 76% for the nine months ended September 30, 2005. We expect that international sales will continue to be a significant portion of our net revenue. International sales may fluctuate due to various factors, including: o migration of manufacturing to low cost geographies o changes in regulatory requirements o tariffs and taxes o difficulties in establishing, staffing and managing foreign operations o longer average payment cycles and difficulty in collecting accounts receivable o fluctuations in foreign currency exchange rates o compliance with applicable export/import requirements o product safety and other certification requirements o difficulties in integrating foreign and outsourced operations o political and economic instability The European Community and European Free Trade Association ("EU") has established certain electronic emission and product safety requirements ("CE"). Although our products currently meet these requirements, failure to obtain either a CE certification or a waiver for any product may prevent us from marketing that product in Europe. The EU also has directives concerning the Reduction of Hazardous Substances ("RoHS") which becomes effective later in 2006 (China has recently established a similar requirement). Failure to meet directives may prevent us from marketing certain products in Europe or other territories with similar requirements. We operate subsidiaries in Germany, China, Canada, and Brazil. Our business and financial condition is sensitive to currency exchange rates or any other restrictions imposed on their currencies. Currency exchange fluctuations in Canada, China, Brazil and Germany may adversely affect our investment in our subsidiaries. If we are unable to protect our intellectual property, we may not be able to compete effectively or operate profitably. -------------------------------------------------------------------------------- Data I/O relies on patents, copyrights, trade secrets and trademarks to protect our intellectual property, as well as product development and marketing skill to establish and protect our market position. We attempt to protect our rights in proprietary software products, including TaskLink and other software products, by retaining the title to and copyright of the software and documentation, by including appropriate contractual restrictions on use and disclosure in our licenses, and by requiring our employees to execute non-disclosure agreements. Because of the rapidly changing technology in the semiconductor, electronic equipment and software industries, portions of our products might possibly infringe upon existing patents or copyrights, and we may, therefore, be required to obtain licenses or discontinue the use of the infringing technology. We believe that any exposure we may have regarding possible infringement claims is a reasonable business risk similar to that assumed by other companies in the electronic equipment and software industries. 29 However, any claim of infringement, with or without merit, could be costly and a diversion of management's attention, and an adverse determination could adversely affect our reputation, preclude us from offering certain products, and subject us to substantial liability. We may pursue business acquisitions that could impair our financial position and profitability. -------------------------------------------------------------------------------- We may pursue acquisitions of complementary technologies, product lines or businesses. Future acquisitions may include risks, such as: o burdening management and our operating teams during the integration of the acquired entity o diverting management's attention from other business concerns o failing to successfully integrate the acquired products o lack of acceptance of the acquired products by our sales channels or customers o entering markets where we have no or limited prior experience o potential loss of key employees of the acquired company o additional burden of support for an acquired programmer architecture Future acquisitions may also impact Data I/O's financial position. For example, we may use significant cash or incur additional debt, which would weaken our balance sheet. We may also capitalize goodwill and intangible assets acquired, the impairment of which would reduce our profitability. We cannot guarantee that future acquisitions will improve our business or operating results. The loss of key employees may adversely affect our operations. -------------------------------------------------------------------------------- We have employees located in the U.S., Germany, Canada and China. We also utilize independent contractors for specialty work, primarily in research and development and in our Brazilian operation, and utilize temporary workers to adjust capacity to fluctuating demand. Many of our employees are highly skilled and our continued success will depend in part upon our ability to attract and retain employees who can be in great demand within the industry. None of our employees are represented by a collective bargaining unit and we believe relations with our employees are favorable though no assurance can be made that this will be the case in the future. Refer to the section captioned "Our recent restructuring activities may have a negative impact on our future operations" above. Failure to comply with regulatory requirements may adversely affect our stock price and business. -------------------------------------------------------------------------------- We are subject to numerous governmental and stock exchange requirements as a public company, which we believe we are in compliance with. The Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission (SEC) and the Public Company Oversight Accounting Board (PCOAB) have requirements that we may fail to meet by required deadlines or we may fall out of compliance with, such as the internal controls assessment, reporting and auditor attestation required under Section 404 of the Sarbanes-Oxley Act of 2002 for which we are relying on not being an accelerated filer. We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our Independent Auditors addressing these assessments. The compliance date for non-accelerated filers has been extended to the first fiscal year ending on or after July 15, 2007. Data I/O assumes it will continue to have the status of a non-accelerated filer based on the aggregate market value of the voting and non-voting shares held as of June 30, 2005. During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act of 2002 for compliance with the requirements of Section 404. In addition, if we fail to achieve and maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to help prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly. Our failure to meet regulatory requirements and exchange listing standards may result in actions such as the delisting of our stock impacting our stock's liquidity; SEC enforcement actions; and securities claims and litigation. 30 Our stock price may be volatile and, as a result, you may lose some or all of your investment. -------------------------------------------------------------------------------- The stock prices of technology companies tend to fluctuate significantly. We believe factors such as announcements of new products by us or our competitors and quarterly variations in financial results may cause the market price of Data I/O's Common Stock to fluctuate substantially. In addition, overall volatility in the stock market, particularly in the technology company sector, is often unrelated to the operating performance of companies. If these market fluctuations continue in the future, they may adversely affect the price of Data I/O's Common Stock. Failure to successfully implement a new worldwide information system may adversely affect our operations and sales. -------------------------------------------------------------------------------- We have recently acquired and are in the process of implementing a new worldwide information system. Our operations and financial results could be adversely affected if we are unable to implement the system without significant interruptions in accounting systems, order entry, billing, manufacturing and other customer support functions. In addition, the costs associated with the implementation and training could exceed budgeted amounts and adversely affect our profitability and liquidity. System implementation delays could cause difficulties in our complying with the internal controls assessment, reporting and auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002. 31