10-K 1 dataio_10k-12312005.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the 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 Incorporation) Employer Identification Number) P.O. Box 97046, 10525 Willows Road N.E., Redmond, Washington, 98073-9746 (425) 881-6444 -------------------------------------------------------------------------------- (Address, including zip code, of registrant's principle executive offices and telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: -------------------------------------------------------------------------------- NONE Securities registered pursuant to Section 12(g) of the Act: -------------------------------------------------------------------------------- Common Stock (No Par Value) Series A Junior Participating Preferred Stock Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes [ ] No [X] 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes [ ] No [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer ____ Accelerated filer ___ Non-accelerated filer [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] Aggregate market value of voting and non-voting Common Stock held by non-affiliates of the registrant as of June 30, 2005 $20,342,406 8,410,961 shares of Common Stock, no par value, outstanding as of March 27, 2006 DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's Proxy Statement relating to its May 24, 2006 Annual Meeting of Shareholders are incorporated into Part III of this Annual Report on Form 10-K. DATA I/O CORPORATION FORM 10-K For the Fiscal Year Ended December 31, 2005 INDEX Part I Page ---- Item 1. Business ....................................................3 Item 1A. Risk Factors ...............................................10 Item 1B. Unresolved Staff Comments ..................................15 Item 2. Properties .................................................15 Item 3. Legal Proceedings ..........................................15 Item 4. Submission of Matters to a Vote of Security Holders ........15 Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities .................................................16 Item 6. Selected Financial Data ....................................17 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations .......................18 Item 7A. Quantitative and Qualitative Disclosures About Market Risk ................................................25 Item 8. Financial Statements and Supplementary Data ................25 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .......................45 Item 9A. Controls and Procedures ....................................45 Item 9B. Other Information ..........................................45 Part III Item 10. Directors and Executive Officers of the Registrant .........45 Item 11. Executive Compensation .....................................46 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters ................46 Item 13. Certain Relationships and Related Transactions .............46 Item 14. Principal Accounting Fees and Services .....................46 Part IV Item 15. Exhibits, Financial Statement Schedules ....................47 Signatures .................................................................51 PART I ITEM 1. BUSINESS ----------------- This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on current expectations, estimates and projections about Data I/O(R) Corporation's industry, management's beliefs and certain assumptions made by management. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Statements." GENERAL Data I/O Corporation ("Data I/O") designs, manufactures, and sells programming systems used by designers and manufacturers of electronic products. Our programming system products are used to program integrated circuits ("ICs" or "devices" or "semiconductors") so that the ICs will function as desired in the customer's electronic product. They are an important tool for the electronics industry experiencing growing use of programmable ICs. Data I/O markets and distributes our programming systems worldwide, and is the global leader in this market. Data I/O incorporated in the State of Washington in 1969. Data I/O Mission. Data I/O's mission is to design and deliver innovative customer-focused programming solutions, which enable customers to manage their firmware supply chain, getting their products to market faster, while reducing costs in their process. We align our products and services to make programming easy, delight our customers and satisfy their whole product needs. Helping Customers Manage their Firmware Supply Chain. Much of the innovation and competitive advantage of today's electronic products comes from the software buried inside the product, which is commonly referred to as "firmware." Companies use firmware to differentiate their products from their competitors' products, constantly writing new code to add features. This allows them to build multiple models with identical hardware and many versions of firmware, all on one production line. Any improvement in production efficiency boosts the profitability of all products on that line. Many original equipment manufacturers ("OEMs") now outsource production to specialists in electronic manufacturing services ("EMS") to maximize the profit impact from highly efficient production. The challenges of managing the firmware supply chain remain, however, and can even increase with this additional interface. Our systems allow our customers - both OEM and EMS companies - to build products with the exact firmware features that consumers specify, virtually real-time with the latest software release. We help our customers eliminate inventory risks, delays, rework, and lost market opportunities while enabling them to better serve their customers. Connected Strategy. There are many providers of device programming tools on the market today. However, experienced design, test and manufacturing engineering teams need a comprehensive approach to process management that will assure the integrity of the product data files from design through manufacturing, assuring that the production line builds the product in the most cost-effective way, precisely as designed. Data I/O solutions provide a consistent device programming methodology from design through prototype and new product introduction and finally in the high volume manufacturing phase. We call this approach the `Connected Strategy'. Data I/O's Connected Strategy leverages network capable products to easily move the customer's intellectual property securely up and down the supply chain. Business Restructuring. During 2005, we took restructuring related charges of $96,000 primarily related to severance and completing actions that had been started in the second half of 2004. This aligned management operations with the changes made in 2004 to control costs in North America and Europe and the need to build staff serving China and Eastern Europe. INDUSTRY BACKGROUND Data I/O enables companies to improve productivity and reduce costs by providing device programming solutions that enable our customers to take intellectual property (design and data files) and program it into memory, microcontroller and logic devices. Companies that design and manufacture electronic products that utilize programmable devices purchase these solutions from us. These companies, our primary customers, design and manufacture a broad range of electronic products for both consumer and industrial use. Data I/O also provides services related to hardware support, system installation and repair, and device programming. According to several industry reports, there continues to be forecasted growth of semiconductors used in consumer electronic products, automotive electronics, and industrial controls which we believe should continue to drive demand for programming equipment and services. Programmable devices continue to be significant and growing segments of the semiconductor industry according to several published industry reports. Flash memory and programmable micro-controllers are typical types 3 of these devices. Programmable devices offer advantages to the electronic product designer allowing them to bring products to market more quickly and inexpensively than using fixed-function devices, and can offer the advantage of simpler rapid product upgrades. Programmable devices also offer attractive functionality to the user of the electronic product, such as storing personal information or customizing product functionality. As a result, use of programmable devices is growing rapidly in both high-volume consumer electronic products and more complex electronic systems. More than 100 semiconductor manufacturers offer thousands of different programmable devices. The technology trends driving the programmable device market result in a broad range of requirements for programming information into these devices. Programmable memory devices continue to have higher capacity and occupy smaller circuit board space. Programmable microcontroller devices are now more prevalent because semiconductor vendors are standardizing their manufacturing processes. These technology advances require advanced programming equipment like Data I/O manufactures. Our automated programming systems integrate programming and handling functions into one product solution. Quality conscious customers continue to drive this portion of our business, which includes high-volume manufacturing and high-volume programming center customers. PRODUCTS In order to accommodate the expanding variety and quantities of programmable devices being manufactured today, Data I/O offers multiple solutions for the numerous types of devices used by our customers in the various market segments and applications. We work closely with major manufacturers of programmable devices to develop our products to meet the requirements of a particular device. Data I/O's line of programming systems includes a broad range of products, systems, modules, and accessories, which we group into two general categories: automated programming systems and non-automated programming systems. We provide automated programming systems in two categories: off-line and in-line (including In-system Programming). In addition, we provide device support and service on all of our products. Device support is a critical aspect of our business and consists of writing algorithms for devices and developing socket adapters to hold and connect to the device for programming. Within the categories of automated and non-automated systems, Data I/O targets specific solutions at specific market segments. Data I/O optimizes the solution based on the customer's device, process and business needs. Data I/O's flagship programming platform, FlashCORE(TM), has the speed and pricing to provide the best value in the industry, making it the leading choice for high volume production. Data I/O technical teams work closely with semiconductor manufacturers to actively plan for programming support of new devices and physical packages. The FlashCORE platform is used worldwide to program NOR Flash devices from all providers, including market leaders, Intel, Renesas, Spansion and Toshiba. Data I/O leads the industry in providing solutions for NAND flash programming from Hynix, Micron, Samsung, ST Microelectronics, Toshiba, M Systems DiskOnChip and others. The dynamics of the flash market are changing, blurring the distinction of NAND and NOR technologies and the emergence of converged offerings, including Samsung's OneNAND and Spansion's ORNAND, also supported on FlashCORE systems. Data I/O's strong partnerships with leading semiconductor companies greatly enhance our ability to serve our mutual customers. Target customers include electronic product OEM manufacturers of consumer products, like the fast-growing portable/wireless devices, cellular handsets and smart appliances. These applications are high volume users of programmable flash memory devices. In portable electronics products, shrinking form factors are driving the shrinkage of device packages. Manual programming and handling of these tiny packages is increasingly not practical due to quality issues. This trend toward small packages should drive demand for Data I/O's automated programming systems in 2006. Applications targeted for these tiny devices include automotive, consumer appliances, remote controls, medical devices, portable/personal electronics, PC peripherals, hand-held and wearable PCs, telecommunications including phones and pagers, security alarms and sensors. TaskLink(R) for Windows provides a universal job set-up tool that intuitively guides users in preparing product data files for programming. TaskLink is also a key element of our Connected Strategy. Leveraging network connectivity, Data I/O's TaskLink provides monitoring and control over programming systems anywhere on the network - providing global companies with greater visibility and control over remote production lines or contract manufacturing processes. 4 AUTOMATED PROGRAMMING SYSTEMS Data I/O provides our manufacturing and programming center customers with automated programming systems solutions that include robotic handlers, a variety of programmers, input and output media handling (such as tray stackers, tubes, loaders or taping), and marking solutions. Our ProLINE-RoadRunner(TM) is a unique in-line programming system with programming speed capability, which approaches the speed at which Flash devices can currently accept data. Many of our customers need to program Flash and microcontroller devices in large quantities and very quickly. ProLINE-RoadRunner mounts directly on the assembly machine in the production line (Siemens, Fuji, Universal, Panasonic and Assembleon machines) and delivers programmed parts from reels of blank devices to the production line in a just-in-time fashion. Our ProLINE-RoadRunner eliminates production bottlenecks associated with high-density Flash and microcontroller devices, allowing last minute firmware changes and eliminating programmed part inventories, ultimately streamlining and reducing the customer's production and process costs. ProLINE-RoadRunner enables customers to implement lean processes and is a key element in Data I/O's Connected Strategy, allowing customers and partners to more effectively manage their firmware supply chain. ProLINE-RoadRunner currently retails from $72,500 to $118,000, depending on programming capability. Data I/O's PS family of automated programming solutions offers highly flexible solutions for off-line batch programming. Data I/O can configure PS systems to support not only Flash devices, but also a wide variety of other devices, such as microcontrollers. These systems provide a number of marking, labeling, and input/output options. Most importantly, customers can make changeovers extremely fast. This feature allows the customer to rapidly respond to diverse demands with very little downtime. Customers can optimize the PS family systems for any job to maximize throughput and, when combined with fast changeover times and high reliability, provide the highest levels of output during a production shift. Our latest product, the PS588, integrates the same FlashCORE programmer we use in our PS288, PS300 FlashCORE, ProLINE-RoadRunner and FlashPAK(TM) and builds on our Connected Strategy and common architecture. The PS588 significantly improves throughput and lowers the cost per programmed part. The PS family products range in price from $129,500 to $469,000. We introduced the ImageWriter 200, our solution for in-systems programming of programmable microcontrollers serial memory mounted on the printed circuit board, in the fourth quarter of 2004 and introduced the ImageWriter 300 in 2005. This solution is designed to be integrated into the line but does no handling. The primary markets for ImageWriter are microcontroller applications in automotive electronics, industrial automation and consumer electronics. Pricing for the ImageWriter starts at approximately $2,000 for the first unit with most installations requiring multiple units. NON-AUTOMATED PROGRAMMING SYSTEMS Our line of non-automated programming systems provides solutions for both engineering and low to medium-volume manufacturing customers. Non-automated programming systems require a user to physically handle the devices being programmed. These types of programmers are also sometimes referred to as "manual" or "desktop" programmers. We now have three families of non-automated programmers: Sprint, UniSystem and FlashPAK. Engineering customers typically use single-site programming systems during the prototype phase of a new design, and may purchase inexpensive systems for limited device needs or more expensive systems to support more complex devices or a large variety of device types. Single-site programming systems can perform programming on only one programmable device at a time. Data I/O offers a range of high quality, universal single socket manual programming solutions through our UniSystem family of programming systems. Our UniSite and 3980 xpi programming systems offer the highest levels of signal integrity, which ensure the highest programming standards. Popular in military, aerospace, telecommunications and other mission critical applications, the systems range from $15,000 to $35,000. For more cost constrained or higher volume applications, the Sprint family of products offers excellent value for the money and versatility. The Sprint Quad and Octal programming systems offer 4 and 8 socket universal programming configurations for higher volume applications. The Sprint family of products range in price from under $1,000 to $20,000 for the multiple socket solutions. Our newest programmer, the FlashPAK, leverages the high-speed proprietary FlashCORE programming technology in the ProLINE-RoadRunner system. We believe FlashPAK, starting at approximately $7,000, is the world's fastest programming architecture, limited today only by the speed at which Flash devices can accept data. FlashPAK is another key element of Data I/O's connected strategy, providing OEMs and new product introduction facilities with a high performance Flash programming system that can be used to validate designs before moving down the firmware supply chain. For manufacturing applications, the FlashPAK, a high speed, multi-socket, small footprint desktop solution, provides manual programming operations with the highest level of flexibility at the lowest cost per part. Manufacturers that use manual programming because of lower labor costs in areas like Asia find FlashPAK an attractive solution. 5 Data I/O supports and completes our product offering with a full range of software and device update products and worldwide service and repair capability. CUSTOMERS Data I/O sells our products to customers worldwide in a broad range of industries, including wireless handset manufacturers and other telecommunication companies, consumer electronics, computers, test and measurement, medical, transportation, military, aerospace, electronic contract manufacturing, programming centers, and semiconductors. Our principal customers include Motorola, Nokia, and Siemens. Our customers either design and/or manufacture electronic products that incorporate programmable devices or provide device programming services. During 2005, we sold products to over 1,600 customers throughout the world. There were no customers that accounted for more than 10% of our 2005 net sales and one customer, Siemens, accounted for 14.5% and 18% of our 2004 and 2003 net sales, respectively. Programmable device consumption continues to grow as more and more electronic product manufacturers take advantage of the flexibility and cost effectiveness of programmable memory, microcontroller and logic devices. Electronic products today utilize programmable technology in one form or another, from microcontrolled home appliance devices to set top boxes and wireless devices, which use increasingly vast amounts of memory for Internet connectivity and new leading edge features. Therefore, our customers come from virtually all industries manufacturing electronic products, and include the consumer electronic products, cell phone, personal data assistants ("PDAs") and other wireless device manufacturers, home entertainment product sectors, aerospace and military applications, the personal computer ("PC") and the PC peripheral industry, automotive electronics and industrial automation and control. Flash memory growth. The Flash memory customer segment is experiencing some of the most impressive growth of all programmable devices. As cell phones, PDAs, games consoles, set top boxes and other consumer devices become more capable, powerful and compact, the demand for Flash units and megabytes continues to grow. Microcontroller growth. As the demand for smarter electronic devices increases, demand for greater numbers of microcontroller devices increases. Many household appliances today contain a microcontroller to control the critical functions of the product and provide new features. Examples of these appliances include toasters, refrigerators, garage door openers and even thermostats. This growth creates new market opportunities for us and we have added support for these devices in our FlashCORE architecture and our ImageWriter product. In addition, the number of microcontrollers in automotive electronic applications is growing rapidly, with some cars having as many as 80 or more microcontrollers that control functions from airbag and ABS systems to air conditioning, information centers and entertainment and communication systems. We are also targeting the automotive segment as a critical and growing target segment for our solutions. GEOGRAPHIC MARKETS AND DISTRIBUTION Data I/O markets and sells our products through a combination of direct sales, internal telesales, and indirect sales representatives and distributors. We continually evaluate our sales channels against our evolving markets and customers. Sales of Data I/O's 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. After we determined that our programming equipment has reached a point of maturity and stability such that product acceptance can be assured by testing at the factory prior to shipment, and each of the multiple deliverables has an established fair market value pursuant to EITF 00-21, Data I/O began in the third quarter of 2005 recognizing revenue for these products at the time of shipment if all of the other criteria for revenue recognition exist in accordance with SAB 104, Revenue Recognition. Revenue for the undelivered installation service remains deferred at time of shipment and is recognized upon completion of the installation. Revenue for products where installation is considered perfunctory continues to be recognized at the time of shipment. Installation that is considered perfunctory includes any installation that can be performed by other parties, such as distributors, other vendors, or in most cases the customers themselves. We recognize 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. U.S. SALES We market our products throughout the U.S. using a variety of sales channels, including our own field sales management personnel, independent sales representatives, and a direct telesales organization. Our U.S. independent sales representatives obtain orders on an agency basis, with shipments made directly to the customer by Data I/O. Net sales in the United States for 2005, 2004, and 2003 were $6,386,000, $5,434,000, and $7,263,000, respectively. 6 FOREIGN SALES Foreign sales represented approximately 78%, 80%, and 70%, of net sales of our programming systems in 2005, 2004, and 2003, respectively (see Note 15 of "Notes to Consolidated Financial Statements"). We make foreign sales through our wholly-owned subsidiaries in Germany, China and Canada, as well as through independent distributors and sales representatives located in 35 other countries. Our independent foreign distributors purchase Data I/O products in U.S. Dollars for resale and we recognize the sale at the time of shipment to the distributor. As with U.S. sales representatives, sales made by international sales representatives are on an agency basis with shipments made directly to the customer by us. Net foreign sales for 2005, 2004, and 2003 were $21,935,000, $21,876,000, and $17,424,000, respectively. We determine total foreign sales by the international geographic area into which the products are sold and delivered, and include not only sales by foreign subsidiaries but also export sales from the U.S. to our foreign distributors and to our representatives' customers. Foreign sales do not include transfers between Data I/O and our foreign subsidiaries. Export sales are subject to U.S. Department of Commerce regulations. We have not, however, experienced any difficulties to date as a result of these requirements. Fluctuating exchange rates and other factors beyond our control, such as international monetary stability, tariff and trade policies, and U.S. and foreign tax and economic policies, affect the level and profitability of foreign sales. We cannot predict the effect of such factors on our business. COMPETITION The competition in the programming systems market is highly fragmented with a large number of smaller organizations offering inexpensive solutions. While we are not aware of any published industry market information covering the programming systems market, according to our inside analysis, we estimate that the total number of programming systems sold during 2005 has been approximately $110 million, with Data I/O capturing an estimated 25% of the global market. Over the last four years, based on our analysis, we believe that Data I/O has gained market share versus our significant competitors. Competitive factors often include prices, features, device support and programming speed, as the programming process impacts more on the major manufacturers' total production process. However, competitive factors are changing. The added value for customers is becoming the whole product solution that fits the customer's business processes. As an example, ProLINE-RoadRunner offers a unique solution, which best addresses the customer's process needs in high volume Flash applications. To this extent, the value proposition of this specific programming solution is very different from traditional solutions. Therefore, addressing customers' process needs is critical to increasing the opportunity for programming solutions beyond the current amount in this market niche. We estimate that customers are spending between $2.0 billion to $2.5 billion a year on programming memory, microcontroller and logic devices and much of this programming is achieved through the use of the customers' test equipment offered by companies like Agilent and Teradyne or homegrown solutions for specific markets like automotive. The main competitive solution in the programmable market is, therefore, the in-house solution, and the opportunity exists to substitute customers' solutions with more economical and more easily maintainable solutions to solve the problems, which traditional programmers do not address. Boundary scan tools also fall into this category, although still a small market with a number of small companies participating who principally focus on test solutions. We expect that our new ImageWriter product will offer a competitive solution for the consumer electronics, automotive electronics and industrial automation customers in this market. MANUFACTURING, RAW MATERIALS, AND BACKLOG Data I/O performs primarily assembly and testing of our products at our principal facility in Redmond, Washington and we outsource our circuit board manufacturing and fabrication. We use a combination of standard components, proprietary custom ICs and fabricated parts manufactured to Data I/O specifications. An outside supplier located in Germany manufactures our Sprint non-automated programming systems. Most components used are available from a number of different suppliers and subcontractors but certain items, such as some handler and programmer subassemblies, custom ICs, hybrid circuits and connectors, are purchased from single sources. We believe that additional sources can be developed for present single-source components without significant difficulties in obtaining supplies. We cannot be sure that single-source components will always continue to be readily available. If we cannot develop alternative sources for these components, or if we experience deterioration in relationships with these suppliers, there may be delays or reductions in product introductions or shipments, which may materially adversely affect our operating results. In accordance with industry practices, generally all orders are subject to cancellation prior to shipment without penalty, except for contracts calling for custom configuration. To date, such cancellations have not had a material effect on our sales volume. 7 To meet customers' delivery requirements, we manufacture certain products based upon a combination of backlog and anticipated orders. Most orders are scheduled for delivery within 1 to 60 days after receipt of the order. Our backlog of pending orders was approximately $1.2 million, $1.5 million, and $1.5 million as of December 31, 2005, 2004, and 2003, respectively. The size of backlog at any particular date is not necessarily a meaningful indicator of the trend of our business. RESEARCH AND DEVELOPMENT Data I/O believes that continued investment in research and development is critical to our future success. We continue to develop new technologies and products and enhance existing products. Future growth is to a large extent dependent upon the timely development and introduction of new products, as well as the development of algorithms to support the latest programmable devices. We are currently focusing our research and development efforts on strategic growth markets, namely new programming technology and automated handling systems for the manufacturing environment, including support for NAND FLASH and for M-Systems DiskOnChip(R) technology, microcontroller support for FlashCORE, additional platforms and improvements for ProLINE-RoadRunner, enhancements for our ImageWriter in-system programming solution and eDSS. We continue to also focus on increasing our capacity and responsiveness for new device support requests from customers and programmable IC manufacturers by revising and enhancing our internal processes and tools. During this past year, our research and development resulted in these new products: PS 588 and ImageWriter 300. During 2005, 2004, and 2003, we made expenditures for research and development of $5,286,000, $5,057,000, and $4,639,000, respectively, representing 18.7%, 18.5%, and 18.8%, of net sales, respectively. Research and development costs are expensed as incurred. PATENTS, COPYRIGHTS, TRADEMARKS, AND LICENSES Intellectual property rights applicable to various Data I/O products include patents, copyrights, trade secrets and trademarks. Data I/O also 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 also grew our patent portfolio over the past few years as we developed strategic technologies like the ProLINE-RoadRunner and FlashCORE that are critical to our Connected Strategy. 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. Our software products are not normally sold separately from sales of programming systems. However, on those occasions where software is sold separately, revenue is recognized when a sales agreement exists, when delivery has occurred, when the fee is fixed or determinable, and when collectibility is probable. 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. 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. EMPLOYEES As of December 31, 2005, we had 130 employees, of which 42 were located outside the U.S. We also utilize independent contractors for specialty work, primarily in research and development, 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. ENVIRONMENTAL COMPLIANCE Our facilities are subject to numerous laws and regulations concerning the discharge of materials or otherwise relating to the environment. Compliance with environmental laws has not had, nor is it expected to have, a material effect on our capital expenditures, financial position, results of operations or competitive position. 8 EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below is certain information concerning the executive officers of Data I/O as of March 27, 2006: Name Age Position ---- --- -------- Frederick R. Hume 63 President and Chief Executive Officer Joel S. Hatlen 47 Vice President Chief Financial Officer Secretary and Treasurer Harald A. Weigelt 46 Vice President Worldwide Sales and Services Frederick R. Hume joined Data I/O as President and Chief Executive Officer in February 1999. He was appointed to the Board of Directors of Data I/O in January 1999. From 1988 until his retirement in 1998, Mr. Hume served as Vice President and General Manager of Keithley Instruments in Cleveland, Ohio. From 1972 to 1988, he held various management positions at Fluke Corporation, including Group Vice President for Manufacturing and Research and Development. Joel S. Hatlen joined Data I/O in September 1991 and became Chief Accounting Officer and Corporate Controller in February 1997. In January 1998, he was promoted to Vice President of Finance and Chief Financial Officer, Secretary and Treasurer. He began his career at Data I/O as a Senior Tax Accountant and became Tax Manager in December 1992. From September 1981 until joining Data I/O, Mr. Hatlen was employed by Ernst & Young LLP, where his most recent position was Senior Manager. Harald A. Weigelt joined Data I/O in 1991, and in October 2005, he was appointed Vice President, Worldwide Sales and Services. Prior to this position, he served as the Vice President, European Operations and as Managing Director of Data I/O's operations in Germany. Prior to joining Data I/O, he was employed with Instrumatic, where he served as Product Manager and was employed with Wavetek as Product Manager. 9 ITEM 1A. RISK FACTORS ----------------------- CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS Data I/O's disclosure and analysis in this Annual Report contains 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 Annual 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 Annual 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 handing 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 10 o production constraints 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 three of the last five 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. 11 OUR PRIOR 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 underestimate 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. 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. 12 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. OUR INTERNATIONAL OPERATIONS MAY EXPOSE US TO ADDITIONAL RISKS THAT MAY ADVERSELY AFFECT OUR BUSINESS. International sales represented 78% of our net revenue for the fiscal year ended December 31, 2005 and 80% for the fiscal year ended December 31, 2004. 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 unexpected 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 licensing 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") from which Data I/O is relying on an exemption for test and measurement companies. Failure to meet applicable directives or qualifying exemption 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. 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. 13 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 prior 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. As a public company, we are subject to numerous governmental and stock exchange requirements, with which we believe we are in compliance. The Sarbanes-Oxley Act of 2002 and the Securities and Exchange Commission (SEC) have requirements that we may fail to meet by the 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, with which we are not yet required to comply as we are not an accelerated filer. 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. We may also incur additional costs in order to comply with 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. 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. 14 FAILURE TO SUCCESSFULLY IMPLEMENT A NEW WORLDWIDE INFORMATION SYSTEM MAY ADVERSELY AFFECT OUR OPERATIONS AND SALES. We have recently acquired and are currently implementing a new worldwide information system. Our corporate office began use of the new system in February 2006. We are now in the process of implementing the new system at our subsidiary locations. Our operations and financial results could be adversely affected if we are unable to complete the system implement 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. MOVING OUR HEADQUARTERS AND MANUFACTURING OPERATION MAY ADVERSELY AFFECT OUR OPERATIONS AND SALES. We anticipate moving our Redmond headquarters and manufacturing operation in mid-year 2006 from our current location to a smaller location in Redmond, Washington. If we are not able to timely and successfully complete the move, our short-term ability to manufacture and ship products and our sales could be adversely affected. ITEM 1B. UNRESOLVED STAFF COMMENTS ----------------------------------- None. ITEM 2. PROPERTIES ------------------- In May 1997, Data I/O completed the sale of the land and building comprising our Redmond, Washington corporate headquarters and is currently leasing the 96,000 square foot building on a 10-year leaseback agreement with an option to renew the lease for an additional 10 years. This lease required base annual rental payments in 2005 of approximately $1,138,000. See Note 7 of "Notes to Consolidated Financial Statements." On February 28, 2006, Data I/O entered into a termination agreement for the Redmond headquarters facility and a five year lease agreement for a 40,000 square foot office space also located in Redmond, Washington. We anticipate a mid-year move of our corporate headquarters to this new location. We also expect to enter into a new lease agreement during the first quarter of 2006 for our offices in Shanghai, China. In addition to the Redmond facility, approximately 13,000 square feet is leased at five foreign locations, including our German sales, service and engineering operations located in Munich, Germany, and three sales and service offices and an engineering location in China. ITEM 3. LEGAL PROCEEDINGS -------------------------- As of the date of this Annual Report, Data I/O is not a party to any legal proceedings, the adverse outcome of which in management's opinion, individually or in the aggregate, would have a material adverse effect on our results of operations or financial position. From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------------------------------------------------------------ No matters were submitted for a vote of shareholders of Data I/O during the fourth quarter of the fiscal year ended December 31, 2005. 15 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The following table shows, for the periods indicated, the high and low bid information for Data I/O's Common Stock as reported by the NASDAQ Capital Market tier of The NASDAQ Stock Market (NASDAQ symbol is DAIO). Period High Low ------ ---- --- 2005 Fourth Quarter $5.00 $2.08 Third Quarter 2.89 2.20 Second Quarter 4.00 2.02 First Quarter 3.38 2.81 2004 Fourth Quarter $3.85 $2.38 Third Quarter 2.97 1.92 Second Quarter 3.15 2.17 First Quarter 3.70 2.76 The approximate number of shareholders of record as of March 27, 2006 was 689. Except for a special cash dividend of $4.15 per share paid on March 8, 1989, Data I/O has not paid cash dividends on our Common Stock and does not anticipate paying regular cash dividends in the foreseeable future. No sales of unregistered securities were made by Data I/O during the periods ended December 31, 2005, December 31, 2004 and December 31, 2003. See Item 12 for the Equity Compensation Plan Information. 16 ITEM 6. SELECTED FINANCIAL DATA ------------------------------- The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes thereto and the information contained herein in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." Historical results are not necessarily indicative of future results. Year Ended ------------------------------------------------------------------------------------------------------------------------------- Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31, (in thousands, except employee and per share data) 2005(3) 2004 2003 2002 2001(2) ------------------------------------------------------------------------------------------------------------------------------- For The Year: Net sales $28,321 $27,310 $24,687 $22,838 $26,826 Cost of goods sold 12,230 12,726 11,008 11,556 15,078 ------------------------------------------------------------------ Gross margin 16,091 14,584 13,679 11,282 11,748 Research and development 5,286 5,057 4,639 5,331 6,740 Selling, general and administrative 10,085 9,036 7,715 8,254 9,707 Net provision (reversal) for business restructuring(1) 96 562 (39) 632 1,211 ------------------------------------------------------------------ Operating income (loss) 624 (71) 1,364 (2,935) (5,910) Non-operating income (loss) 78 (35) (25) (232) 124 ------------------------------------------------------------------ Income (loss) 702 (106) 1,339 (3,167) (5,786) Income tax (expense) benefit (120) 14 (33) 61 (224) ------------------------------------------------------------------ Net income (loss) $582 ($92) $1,306 ($3,106) ($6,010) At Year-end: Working capital $9,994 $10,250 $11,032 $9,125 $12,010 Total assets $18,137 $17,847 $18,100 $16,414 $20,387 Stockholders' equity $12,283 $11,470 $11,200 $9,332 $12,201 Number of employees 130 122 127 125 155 ------------------------------------------------------------------------------------------------------------------------------- Common Stock Data(3): Basic earnings (loss) per share $0.07 ($0.01) $0.17 ($0.40) ($0.79) Diluted earnings (loss) per share $0.07 ($0.01) $0.16 ($0.40) ($0.79) Book value per share at year-end $1.47 $1.42 $1.40 $1.20 $1.60 Shares outstanding at year-end 8,362 8,065 7,976 7,768 7,614 Weighted-average basic shares outstanding 8,226 8,029 7,910 7,704 7,572 Weighted-average diluted shares outstanding 8,532 8,029 8,117 7,704 7,572 ------------------------------------------------------------------------------------------------------------------------------- Key Ratios: Current ratio 2.7 2.8 2.9 2.6 2.9 Gross margin to sales 56.8% 53.4% 55.4% 49.4% 43.8% Operating income (loss) to sales 2.2% (.3%) 5.5% (12.9%) (22.0%) Income (loss) to sales 2.5% (.3%) 5.3% (13.6%) (22.4%) Return on average stockholders' equity 4.9% (.8%) 12.7% (28.8%) (39.7%) ------------------------------------------------------------------------------------------------------------------------------- Footnotes: (1) For further discussion, see Note 3 of "Notes to Consolidated Financial Statements." (2) In 2001, Data I/O converted to reporting on a calendar year-end basis. The first quarter of 2001 covered the period December 29, 2000 to March 31, 2001. (3) The company began recognizing revenue for certain of its equipment requiring installation at the time of shipment beginning in the third quarter of 2005. See Note 1 of "Notes to Consolidated Financial Statements."
17 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about themselves as long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact made in this Annual Report on Form 10-K are forward-looking. In particular, statements herein regarding industry prospects and trends; future results of operations or financial position; integration of acquired products and operations; market acceptance of our newly introduced or upgraded products; development, introduction and shipment of new products; establishing foreign operations; and any other guidance on future periods are forward-looking statements. Forward-looking statements reflect management's current expectations and are inherently uncertain. Although Data I/O believes that the expectations reflected in these forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, achievements, or other future events. Moreover, neither Data I/O nor anyone else assumes responsibility for the accuracy and completeness of these forward-looking statements. Data I/O is under no duty to update any of these forward-looking statements after the date of this Annual Report. The Reader should not place undue reliance on these forward-looking statements. The following discussions and the section entitled "Risk Factors - Cautionary Factors That May Affect Future Results" describes some, but not all, of the factors that could cause these differences. OVERVIEW In 2005, we continued to focus on our primary goal of 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 to take advantage of an anticipated recovery in capital spending. We began to see a recovery in the first quarter of 2005 which continued throughout the year. We expect that demand for programming capacity should improve in 2006, in part based on third party forecasted increased 2006 unit sales for the semiconductor industry, which should provide improved business opportunities for Data I/O. We are continuing our efforts to balance increasing costs and strategic investments in our business with the level of demand in and mix of business we expect. We are focusing our research and development efforts in our strategic growth markets, namely new programming technology and automated programming systems for the manufacturing environment, particularly extending the capabilities and support for our FlashCORE architecture and the ProLINE-RoadRunner and PS families. In 2004, we obtained the rights to certain in-system programming ("ISP") technology. We have incorporated this ISP technology into our ImageWriter product, and will be required to pay a 4% royalty on product revenues associated with such technology until March 31, 2007. We began shipments of the ImageWriter 200 in the second quarter of 2005, and in September we introduced the ImageWriter 300. The related royalties were not a material amount in 2005. To better support our customers in their geographic areas and time zones, we have expanded device support operations in Germany, India and China. 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 continue to expand our China operations to take advantage of the growth of manufacturing in China. We continue to focus on building a services business expanding from our existing service operation model in Brazil. We also increased our efforts to recapture the Japanese market and have entered into a distribution agreement with Toyo Corporation in Japan. We continue our efforts to partner with the semiconductor manufacturers to better serve our mutual customers. BUSINESS RESTRUCTURING PROGRESS During 2005, we took restructuring related charges of $96,000 primarily related to severance and completing actions that had been started in the second half of 2004. This aligned management operations with the changes made in 2004 to control costs in North America and Europe and the need to build staff serving China and Eastern Europe. At December 31, 2005, $33,000 remained as accrued but unpaid restructure charges, which will be paid in 2006. During 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 our 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. 18 During 2003, we completed the restructuring that began during 2001, which included actions taken to reduce the level of revenue required for our net income breakeven point and realign Data I/O with our market opportunities. This restructuring included the following: a reduction in our global workforce; discontinuance or reallocation of numerous projects and activities not essential to our long-term goals; streamlining discretionary activities; consolidation of numerous functions across the organization to create a team, which was more productive and able to respond faster to global customer needs; and closure of a facility in Germany and moving our operations to other locations within Data I/O. We required this operational repositioning because of the impact of the economic slowdown and the decline in capital spending across a high number of customer groups on general demand for programming equipment over the past few years. Our level of revenue required for our net income breakeven point increased in 2003, primarily due to cost increases resulting from the impact of the weaker dollar on foreign currency based costs and from personnel costs due to raises, incentive compensation and selective hiring of individuals with critical skills to help position us as the continuing technology leader in our market. At December 31, 2003 all restructuring expenses associated with the activities detailed for 2002 and 2001 had been paid and the excess expense accrual of $39,000 was reversed during 2003. 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 telecommunications equipment industry. We base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Data I/O believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements: Revenue Recognition: Sales of Data I/O's semiconductor programming equipment requiring installation by us that is other than perfunctory were previously recorded when installation was complete, or at the later of customer acceptance or installation, if an acceptance clause is specified in the sales terms. Beginning in the third quarter of 2005, Data I/O began recognizing revenue for these products at the time of shipment. We began recognizing revenue at the time of shipment after we determined that our automated products have reached a point of maturity and stability such that product acceptance can be assured by testing at the factory prior to shipment and that the installation meets the criteria to be considered a separate element. When arrangements include multiple elements, we use objective evidence of fair value to allocate revenue to the elements pursuant to EITF 00-21, "Revenue Arrangements with Multiple Deliverables," and recognize revenue when the criteria for revenue recognition have been met for each element according to SAB 104, "Revenue Recognition." The amount of revenue recognized is affected by our judgments as to the collectibility of the transaction or whether an arrangement includes multiple elements and if so, whether specific objective evidence of fair value exists for those elements. Changes to the elements in an arrangement and the ability to establish specific objective evidence for those elements could affect the timing of the revenue recognition. These conditions could be subjective and actual results could vary from the estimated outcome. Installation that is considered perfunctory includes any installation that can be performed by other parties, such as distributors, other vendors, or in most cases the customers themselves. This takes into account the complexity, skill, and training needed as well as customer expectations regarding installation. The revenue related to products requiring installation that is perfunctory is recognized at the time of shipment provided that persuasive evidence of an arrangement exists, shipment has occurred, the price is fixed or determinable, and collectibility is reasonably assured. We record revenue from the sale of service and update contracts as deferred revenue and we recognize it on a straight-line basis over the contractual period, which is typically one year. We establish a reserve for sales returns based on historical trends in product returns and estimates for new items. If the actual future returns differ from historical levels, our revenue could be adversely affected. 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 to us could be adversely affected. Inventory Provision: We base inventory purchases and commitments upon future demand forecasts and historic usage. Such estimates are difficult to make under most economic conditions. If there is a significant decrease in demand for our products 19 or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, Data I/O may be required to increase our inventory provision adjustments and our gross margin could be adversely affected. Warranty Accruals: Data I/O accrues for warranty costs based on the expected material and labor costs to fulfill our warranty obligations. If we experience an increase in warranty claims, which are higher than our historical experience, our gross margin could be adversely affected. Tax Valuation Allowances: Given the uncertainty created by our loss history, 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. 20 RESULTS OF OPERATIONS NET SALES (in thousands) Net sales by product line: 2005 Change 2004 Change 2003 ------------------------------------------------------------------------------------------------------------------------------- Automated programming systems $16,040 (6.3%) $17,116 23.0% $13,920 Non-automated programming systems 12,281 20.5% 10,194 (5.3%) 10,767 ---------------- --------------- --------------- Totals $28,321 3.7% $27,310 10.6% $24,687 ================ =============== =============== Net sales by location: United States $6,386 17.5% $5,434 (25.2%) $7,263 % of total 22.5% 19.9% 29.4% International $21,935 0.3% $21,876 25.6% $17,424 % of total 77.5% 80.1% 70.6% -------------------------------------------------------------------------------------------------------------------------------
2005 vs. 2004 ------------- Revenues increased approximately $1.0 million or 3.7% in 2005 compared to 2004. The increase in revenue reflects strong sales of our PS systems, FlashPAKs and related aftermarket products. We benefited from the programming centers adding capacity during 2005 which represented the major customer group for our PS systems. While we did experience some decline in RoadRunner revenues as the demand for automation capacity in the wireless segment declined, the number of new RoadRunner accounts, especially within the automotive target group, increased in 2005 as compared to 2004. FlashPAK sales were especially strong in Asia where manual programming is most common. International sales increased slightly in total with significant growth in China. However, our overall Asian sales decreased as we experienced declining sales in our Japanese and Korean markets. The U.S. dollar strengthened slightly during 2005, which had an unfavorable effect on our currency translation for sales denominated in foreign currency, and in particular the Euro, which accounted for $290,000 offset to our sales increase. Our U.S. sales increased approximately $950,000 or 17.5%, which we attribute to improved sales to programming centers and automotive electronics manufacturers. In 2005, we began to ship the PS588 FlashCORE automated programming system and the ImageWriter 300, our ISP solution. We expect these products to increase our revenues; however, partially offsetting this expected increase is the continued trend of declining sales of our older non-automated product lines. 2004 vs. 2003 ------------- Revenues increased 10.6% in 2004 over 2003. This increase resulted from our automated systems sales including growth in the ProLINE RoadRunner, the PS family (including the PS288 new in 2004) and the related automated systems aftermarket. Data I/O's non automated systems continued a trend of declining sales in older products; however FlashPAK, our newer FlashCore based programmer, continued to show good growth with sales more than doubling in 2004. International sales grew, particularly in Asia, while sales in the U.S. market continued to decline. The U.S. dollar continued to weaken in 2004, which we believe assisted our export sales, due to increased buying power of foreign currencies and the favorable effect of currency translation for sales denominated in foreign currency, and in particular the Euro, which accounted for $784,000 of the sales growth. We see a continuing trend in migration of customers moving manufacturing operations to low-cost geographies, thereby increasing international sales opportunities. 21 GROSS MARGIN (in thousands) 2005 Change 2004 Change 2003 ----------------------------------------------------------------------------------------------------------------------------- Gross margin $16,091 10.3% $14,584 6.6% $13,679 Percentage of net sales 56.8% 53.4% 55.4% -----------------------------------------------------------------------------------------------------------------------------
2005 vs. 2004 ------------- Gross margins increased in both dollars and as a percentage of sales for 2005 compared to 2004. The increase in gross margin dollars was due primarily to the additional margin from increased sales volume of approximately $1,400,000 especially for the PS family and FlashCore. The increase in the gross margin as a percentage of sales results from a favorable average selling price variance of $807,000, offset by unfavorable currency exchange effects of approximately $280,000. Similar to 2004, the manufacturing overhead application variance was $272,000 unfavorable due primarily to decreasing inventory levels and lowering our rate standards due to productivity. 2004 vs. 2003 ------------- Gross margins increased in dollars but declined as a percentage of sales for 2004 compared to 2003. The increase in gross margin dollars was due primarily to the increase in revenue dollars. The decline in the gross margin as a percentage of sales reflects product mix shifts to those with higher material costs, as well as unfavorable average selling price variance of $465,000 and unfavorable manufacturing overhead variance of $260,000. The manufacturing overhead application variance resulted largely from decreasing our inventory level. RESEARCH AND DEVELOPMENT (in thousands) 2005 Change 2004 Change 2003 ----------------------------------------------------------------------------------------------------------------------------- Research and development $5,286 4.5% $5,057 9.0% $4,639 Percentage of net sales 18.7% 18.5% 18.8% -----------------------------------------------------------------------------------------------------------------------------
2005 vs. 2004 ------------- Research and development ("R&D") spending during 2005 increased by $229,000 or 4.5% over 2004, but remained relatively consistent as a percentage of sales at approximately 19%. The increase in spending relates primarily to new product initiatives, particularly new automation solutions, the ImageWriter, our new in-system programming solution, and the start of engineering operations in China. We shipped the first PS588 in early 2005 and the ImageWriter 300 product during the third quarter of 2005. Data I/O's R&D continues to focus on the FlashCORE architecture, expanding its capability to address newer technologies as well as microcontroller device support. 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. 2004 vs. 2003 ------------- Research and development ("R&D") spending for 2004 as compared to 2003 increased 9%, however, as a percentage of sales, R&D remained about 19%. The increase in spending relates primarily to new product initiatives. In particular, the ImageWriter, our new in system programming solution, and eDSS, a tool suite for device support, were launched in November of 2004. Data I/O's R&D focused on the FlashCORE architecture, expanding its capability to address newer technologies like NAND Flash support for M-Systems DiskOnChip technology as well as microcontroller device support. New products in the PS family of automated systems included the PS288 FlashCORE, and, introduced in early 2005, the PS 588 FlashCORE. Also, we released a ProLINE-RoadRunner version for Panasonic CM402 machines. Finally, we completed our initiative to create "global device support factories" with the creation of our engineering operation in Shanghai, China, which joins our other locations in Redmond, Washington, Germany, Japan, and India. We believe it is essential to invest in R&D to significantly enhance our existing products and to create new products as markets develop and technologies change. We are focusing our R&D efforts in our strategic growth markets, namely new programming technology and automated programming systems for the manufacturing environment, particularly extending the capabilities and support for our FlashCORE and programmer architecture; new automated handling solutions; and enhancing our ImageWriter products. 22 SELLING, GENERAL AND ADMINISTRATIVE (in thousands) 2005 Change 2004 Change 2003 ---------------------------------------------------------------------------------------------------------------------------- Selling, general and administrative $10,085 11.6% $9,036 17.1% $7,715 Percentage of net sales 35.6% 33.1% 31.3% ----------------------------------------------------------------------------------------------------------------------------
2005 vs. 2004 ------------- Selling, General and Administrative ("SG&A") expenses increased by $1,049,000 in 2005 compared to 2004 based primarily on our operations in China which include increased costs of approximately $488,000. In addition, we incurred an additional $148,000 associated with the new information system which we acquired in 2005, as well as additional accounting and the hiring of key personnel costs of approximately $158,000, additional marketing personnel and launch costs of $83,000, unfavorable currency translation impact of $36,000 from European based operating costs, an unfavorable administrative overhead application allocation amount of $254,000 and finally, an increase in senior management incentive pay of $84,000 related to profitability, offset by lower sales channel commissions of $138,000. 2004 vs. 2003 ------------- Selling, General and Administrative ("SG&A") expenses increased by $1,321,000 in 2004 versus the prior year due primarily to our strategic investments in China totaling $343,000 and the hiring of additional key personnel of $336,000, as well as the unfavorable currency translation impact of $160,000 from European based operating costs. In addition, we incurred higher commission costs of $281,000 based on the higher sales volume and a higher mix of representative sales than distributor sales and higher travel and entertainment costs of $184,000. Partially offsetting this was a reduction in bonus incentive compensation of $244,000 related to the 2004 net loss. INTEREST (in thousands) 2005 Change 2004 Change 2003 ---------------------------------------------------------------------------------------------------------------------------- Interest income $116 50.6% $77 (31.3%) $112 Interest expense ($20) 11.1% ($18) (21.7%) ($23) ----------------------------------------------------------------------------------------------------------------------------
2005 vs. 2004 ------------- Interest income for 2005 increased due primarily to higher yields. 2004 vs. 2003 ------------- Interest income for 2004 decreased as compared to 2003 primarily due to the decrease in marketable securities. INCOME TAXES (in thousands) 2005 2004 2003 ---------------------------------------------------------------------------------------------------------------------------- Income tax (expense) benefit ($120) $14 ($33) ----------------------------------------------------------------------------------------------------------------------------
2005 vs. 2004 and 2004 vs. 2003 ------------------------------- Income tax expense or benefit in all years relates to foreign and state income taxes. Impacting the effective tax rate related to foreign income were offsetting losses requiring valuation allowances in other countries. We had income in some foreign operations partially offset by losses in other countries. For financial reporting purposes, Data I/O established tax valuation reserves against our deferred tax assets because of the uncertainty relating to the realization of such asset values. We had valuation allowances of $9.8 million, $9.8 million, and $9.7 million at December 31, 2005, 2004, and 2003, respectively. Given the uncertainty created by our loss history, we expect to continue to limit the recognition of net deferred tax assets and maintain the tax valuation allowances. INFLATION AND CHANGES IN FOREIGN CURRENCY EXCHANGE RATES Sales and expenses incurred by foreign subsidiaries are denominated in the subsidiary's local currency and translated into U.S. Dollar amounts at average rates of exchange during the year. We recognized foreign currency transaction losses of $18,000, $94,000 and $114,000 in 2005, 2004 and 2003, respectively. The transaction losses resulted primarily from sales by our German subsidiary to our main customers, which were invoiced in US dollars. We hedge our foreign currency exposure on sales of inventory and certain loans to our foreign subsidiaries through the use of foreign currency exchange contracts. See Note 1 of "Notes to Consolidated Financial Statements." 23 FINANCIAL CONDITION LIQUIDITY AND CAPITAL RESOURCES (in thousands) 2005 Change 2004 Change 2003 ---------------------------------------------------------------------------------------------------------------------------- Working capital $9,994 ($256) $10,250 ($782) $11,032 ----------------------------------------------------------------------------------------------------------------------------
At December 31, 2005, Data I/O's principal sources of liquidity consisted of existing cash, cash equivalents and marketable securities. Our working capital decreased by $256,000 and our current ratio decreased from 2.8 in 2004 to 2.7 in 2005. Our cash and cash equivalents decreased by $1.2 million during 2005 primarily due to cash used to purchase property, plant and equipment, including software, totaling $2 million. Major capital purchases included approximately $800,000 related to the Brazilian programming service operation and approximately $420,000 related to the purchase and set up of our new worldwide information system. 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. We also used approximately $200,000 of cash for operations which primarily included a $2.6 million increase in accounts receivable, partially offset by a $417,000 decrease in inventory, $644,000 of demonstration equipment transferred to cost of goods sold, as we continually need to update to the latest versions of our equipment. Items not requiring the use of cash in operations were $1.1 million of depreciation and amortization. The increase in accounts receivable resulted from increased sales especially late in the quarter and the longer collection times we are experiencing with increased international sales, especially in China. During 2004, our cash and cash equivalents increased by $1.2 million primarily due to a $520,000 decrease in accounts receivable, $500,000 decrease in inventory, $846,000 of demonstration equipment transferred to cost of goods sold, offset by a $958,000 decrease in accrued expenses. In addition, we used $1.2 million of cash in investing activities during 2004 compared to $1.8 million during 2003. The decrease was driven by the level of investment in marketable securities and the level of cash available from net income. 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 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. Offsetting these actions are our investments in expanded operations in China and Brazil, in new system and equipment and hiring new key personnel. We believe that we have sufficient working capital available under our operating plan to fund our operations and capital requirements through at least December 31, 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 Data I/O has 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 table below. Data I/O has no long-term debt. Data I/O has 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: For the year ending December 31, 2005 (in thousands): 1 Year 2-3 Years 4-5 Years After 5 Years Total ------------- -------------- -------------- ----------------- ------------- Operating leases $1,512 $392 $18 - $ 1,922 Commitments to suppliers 445 854 - - 1,299 Other purchase commitments 175 - - - 175 -------------- -------------- -------------- ----------------- ------------- Total $2,132 $1,246 $18 - $ 3,396 ============== ============== ============== ================= ==============
24 OFF-BALANCE SHEET ARRANGEMENTS Except as noted above in aggregate contractual obligations and commitments, Data I/O had no off-balance sheet arrangements. SHARE REPURCHASE PROGRAM Under a previously announced share repurchase program, Data I/O is authorized to repurchase up to 1,123,800 shares of our outstanding Common Stock. We may execute these purchases through open market purchases at prevailing market prices, through block purchases or in privately negotiated transactions, and we may commence or discontinue at any time. As of December 31, 2005, Data I/O has repurchased 1,016,200 shares under this repurchase program at a total cost of approximately $7.1 million. Data I/O has not repurchased shares under this plan since the second quarter of 1997, although it still has the authority to do so. NEW 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 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 May 2005, the FASB issued Statement No. 154, "Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3." This Statement 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. We have not yet assessed the effect of this Statement on Data I/O. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK ------------------------------------------------------------------- With respect to our foreign currency exchange rate risk, we currently use only foreign currency hedge derivative instruments, which as of December 31, 2005 and 2004, the notional value of our foreign exchange contracts outstanding was approximately $503,000 and $1,239,000, respectively, and the estimated fair value of which was a loss of $3,000 and $33,000, respectively. The weighted average contract rate at December 31, 2005 and 2004 was 1.18 and 1.32, respectively. Data I/O is exposed to interest rate risks. We generally invest in high-grade commercial paper with original maturity dates of twelve months or less and conservative money market funds to minimize our exposure to interest rate risk on our marketable securities, which are classified as available-for-sale as of December 31, 2005 and December 31, 2004. We believe that the market risk arising from holdings of these financial instruments is not material. The table below provides information about our marketable securities, including principal cash flows and the related weighted average interest rates (in thousands): Estimated Fair Estimated Fair Principal Value at Principal Value at Cash Flows December 31, Cash Flows December 31, For 2006 2005 For 2005 2004 --------------- ----------------- --------------- ----------------- Corporate bonds $ - $ - $ 787 $ 787 1.559% Taxable Auction Securities 800 800 250 250 4.264% 4.264% 2.352% --------------- ----------------- --------------- ----------------- Total portfolio value $ 800 $ 800 $ 1,037 $ 1,037
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ---------------------------------------------------- See pages 26 through 44. 25 -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -------------------------------------------------------------------------------- To the Board of Directors and Stockholders, Data I/O Corporation We have audited the accompanying consolidated balance sheets of Data I/O Corporation and subsidiaries as of December 31, 2005 and 2004 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Data I/O Corporation and subsidiaries as of December 31, 2005 and 2004, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedule (Schedule II) is presented for purposes of additional analysis and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. /S/GRANT THORNTON LLP Seattle, Washington March 14, 2006 26 DATA I/O CORPORATION CONSOLIDATED BALANCE SHEETS December 31, ------------------------------------------------------------------------------------------------------- 2005 2004 ------------------------------------------------------------------------------------------------------- (in thousands, except share data) ASSETS CURRENT ASSETS: Cash and cash equivalents $4,362 $5,534 Marketable securities 800 1,037 Trade accounts receivable, net of allowance for doubtful accounts of $165 and $155 6,828 4,489 Inventories 3,529 4,139 Other current assets 329 652 ------------- ------------- TOTAL CURRENT ASSETS 15,848 15,851 Property, plant and equipment - net 2,274 1,970 Other assets 15 26 ------------- ------------- TOTAL ASSETS $18,137 $17,847 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $1,608 $1,688 Accrued compensation 1,249 991 Deferred revenue 1,329 1,706 Other accrued liabilities 1,100 1,126 Accrued costs of business restructuring 33 86 Income taxes payable 147 4 Deferred gain on sale of property 388 - ------------- ------------- TOTAL CURRENT LIABILITIES 5,854 5,601 Deferred gain on sale of property - 776 ------------- ------------- 5,854 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, 8,362,369 and 8,064,696 shares 19,408 19,001 Retained deficit (7,436) (8,018) Accumulated other comprehensive income 311 487 ------------- ------------- TOTAL STOCKHOLDERS' EQUITY 12,283 11,470 ------------- ------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $18,137 $17,847 ============= =============
See notes to consolidated financial statements. 27 DATA I/O CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS -------------------------------------------------------------------------------------------------------------------- For the years ended December 31, 2005 2004 2003 -------------------------------------------------------------------------------------------------------------------- (in thousands, except per share data) Net sales $28,321 $27,310 $24,687 Cost of goods sold 12,230 12,726 11,008 ----------- ------------ ------------ Gross margin 16,091 14,584 13,679 ----------- ------------ ------------ Operating expenses: Research and development 5,286 5,057 4,639 Selling, general and administrative 10,085 9,036 7,715 Net provision (reversal) for business restructuring 96 562 (39) ----------- ------------ ------------ Total operating expenses 15,467 14,655 12,315 ----------- ------------ ------------ Operating income (loss) 624 (71) 1,364 Non-operating income (expense): Interest income 116 77 112 Interest expense (20) (18) (23) Foreign currency transaction gain (loss) (18) (94) (114) ----------- ------------ ------------ Total non-operating income (loss) 78 (35) (25) ----------- ------------ ------------ Income (loss) before income taxes 702 (106) 1,339 Income tax (expense) benefit (120) 14 (33) ----------- ------------ ------------ Net income (loss) $582 ($92) $1,306 =========== ============ ============ Basic earnings (loss) per share $0.07 ($0.01) $0.17 Diluted earnings (loss) per share $0.07 ($0.01) $0.16 Weighted-average basic shares 8,226 8,029 7,910 Weighted-average diluted shares 8,532 8,029 8,117
See notes to consolidated financial statements 28 DATA I/O CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------------------------------------------------------------------------------------------ For the years ended December 31, 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $582 ($92) $1,306 Adjustments to reconcile income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 1,118 953 687 Net loss on dispositions - 4 - Write-off of assets 17 9 - Equipment transferred to cost of goods sold 644 846 172 Amortization of deferred gain on sale (388) (330) (330) Net change in: Trade accounts receivable (2,553) 520 (764) Inventories 417 501 (111) Other current assets 257 (230) 95 Accrued cost of business restructuring (53) 86 (204) Accounts payable and accrued liabilities 210 (517) 609 Deferred revenue (422) 279 (179) ---------------- --------------- -------------- Net cash provided by (used in) operating activities (171) 2,029 1,281 CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant and equipment (1,846) (2,528) (486) Purchase of software (203) (30) - Purchases of available-for-sale securities (1,250) (1,182) (4,815) Proceeds from maturities of available-for-sale securities 1,492 2,495 3,536 ---------------- --------------- -------------- Cash provided by (used in) investing activities (1,807) (1,245) (1,765) CASH FLOWS FROM FINANCING ACTIVITIES Sale of common stock 132 154 119 Proceeds from exercise of stock options 275 50 40 ---------------- --------------- -------------- Cash provided by financing activities 407 204 159 ---------------- --------------- -------------- Increase (decrease) in cash and cash equivalents (1,571) 988 (325) Effects of exchange rate changes on cash 399 166 322 Cash and cash equivalents at beginning of year 5,534 4,380 4,383 ---------------- --------------- -------------- Cash and cash equivalents at end of year $4,362 $5,534 $4,380 ================ =============== ============== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest $20 $18 $23 Income taxes $39 ($14) $33
See notes to consolidated financial statements. 29 DATA I/O CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Accumulated Common Stock Retained Other Total ------------------------ Earnings Comprehensive Stockholders' Shares Amount (Deficit) Income (Loss) Equity ----------- --------- ---------- ----------------- ----------------- (in thousands, except share data) Balance at December 31, 2002 7,767,630 18,638 (9,232) (74) 9,332 Stock options exercised 14,189 40 - - 40 Issuance of stock through Employee Stock Purchase Plan 194,477 119 - - 119 Comprehensive income: Net Income - - 1,306 - 1,306 Translation adjustment - - - 405 405 Unrealized gain on Marketable securities - - - (2) (2) ----------------- Total comprehensive income 1,709 ----------- --------- ---------- ----------------- ----------------- Balance at December 31, 2003 7,976,296 18,797 (7,926) 329 11,200 Stock options exercised 27,179 50 - - 50 Issuance of stock through Employee Stock Purchase Plan 61,221 154 - - 154 Comprehensive income: Net loss - - (92) - (92) Translation adjustment - - - 162 162 Unrealized gain on Marketable securities - - - (4) (4) ----------------- Total comprehensive income 66 ----------- --------- ---------- ----------------- ----------------- Balance at December 31, 2004 8,064,696 19,001 (8,018) 487 11,470 Stock options exercised 240,597 275 - - 275 Issuance of stock through Employee Stock Purchase Plan 57,076 132 - - 132 Comprehensive income: Net income - - 582 - 582 Translation adjustment - - - (181) (181) Unrealized gain on Marketable securities - - - 5 5 ----------------- Total comprehensive income 406 ----------- --------- ---------- ----------------- ----------------- Balance at December 31, 2005 8,362,369 $19,408 ($7,436) $311 $12,283 =========== ========= ========== ================= =================
See notes to consolidated financial statements. 30 DATA I/O CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations -------------------- Data I/O Corporation ("Data I/O") designs, manufactures, and sells programming systems used by designers and manufacturers of electronic products. Our programming system products are used to program integrated circuits ("ICs" or "devices" or "semiconductors") with the specific unique data necessary for the ICs contained in various products, and are an important tool for the electronics industry experiencing growing use of programmable ICs. Customers for our programming system products are located around the world, primarily in the United States, Europe and the Far East. Our manufacturing operations are currently located in the United States. An outside supplier located in Germany currently manufactures our Sprint non-automated programming systems. Principles of Consolidation --------------------------- The consolidated financial statements include the accounts of Data I/O Corporation and our wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates ---------------- The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Stock-Based Compensation ------------------------ Data I/O has stock-based employee compensation plans that are described more fully in Note 12. In accordance with Statement of Financial Accounting Standards, or SFAS 123, Accounting for Stock-Based Compensation ("SFAS 123"), as amended by SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure, we elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board, or APB, Opinion 25, Accounting for Stock Issued Employees, and related interpretations. Compensation cost for employee stock options is measured as the excess, if any, of the market price of our common stock at the date of grant over the stock option exercise price. Any deferred compensation is recognized on a graded vesting method. Under our plan, stock options are generally granted at fair market value. The following table illustrates the effect on net income (loss) and earnings (loss) per share if Data I/O had applied the fair value recognition provisions of SFAS 123, using the assumptions described in Note 12, to our stock-based employee plans. 31 Data I/O's pro forma information follows (in thousands, except per share data): Year Ended December 31, ------------------------------------------------- 2005 2004 2003 --------------- -------------- ---------------- Net income (loss) - as reported $582 ($92) $1,306 Deduct: Total stock-based employee compensation expense determined under fair value based method for awards granted, modified, or settled, net of related tax effects (400) (372) (338) --------------- -------------- ---------------- Net income (loss) - pro forma $182 ($464) $968 =============== ============== ================ Basic earnings (loss) per share - as reported $0.07 ($0.01) $0.17 Diluted earnings (loss) per share - as reported $0.07 ($0.01) $0.16 Basic earnings (loss) per share - pro forma $0.02 ($0.06) $0.12 Diluted earnings (loss) per share - pro forma $0.02 ($0.06) $0.12
Foreign Currency Translation ---------------------------- Assets and liabilities of foreign subsidiaries are translated at the exchange rate on the balance sheet date. Revenues, costs and expenses of foreign subsidiaries are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are charged or credited to stockholders' equity, net of taxes recognized. 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. In an effort to minimize the effect of exchange rate fluctuations on the results of our operations, Data I/O hedges portions of our foreign currency exposure through the use of forward exchange contracts, none of which are speculative. At December 31, 2005, we had a notional value of approximately $503,000 in three foreign exchange contracts outstanding, the estimated loss in fair value was recorded as a liability of $3,000. The contract terms are 30-90 days. The hedges are highly effective, as currency, settlement date and amount of the underlying receivables and of the forward contracts coincide, and as spot rates are the same for both the hedge and the hedged item. Cash and Cash Equivalents ------------------------- Cash and cash equivalents are highly liquid investments with maturities of three months or less at date of purchase. Marketable Securities --------------------- Data I/O generally invests in debt securities with original maturities of twelve months or less and money market funds, all of which are classified as available-for-sale securities and recorded at fair value, as defined below. We record unrealized holding gains and losses, net of any tax effect, as a component of accumulated other comprehensive income (loss) within stockholders' equity. We report interest earned in non-operating income as interest income. Marketable securities are classified in the balance sheet as current and noncurrent based on maturity dates and our expectation of sales and redemptions in the following year. 32 Fair Value of Financial Instruments ----------------------------------- The carrying value of cash, cash equivalents, marketable securities and forward exchange contracts approximates fair value. The fair value of Data I/O's marketable securities is based upon the quoted market price on the last business day of the fiscal year plus accrued interest, if any. Accounts Receivable ------------------- The majority of Data I/O's accounts receivable are due from companies in the electronics manufacturing industries. Credit is extended based on an evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are typically due within 30 to 60 days and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. Data I/O determines our allowance by considering a number of factors, including the length of time trade accounts receivable are past due, Data I/O's previous loss history, the customer's current ability to pay their obligation to Data I/O, and the condition of the general economy and the industry as a whole. Data I/O writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. Interest is allowed to accrue, according to our standard sales terms, beginning on the day after the due date of the receivable. However, interest income is subsequently recognized on these accounts either to the extent cash is received, or when the future collection of interest and the receivable balance is considered probable by management. Inventories ----------- Inventories are stated at the lower of cost or market with cost being the currently adjusted standard cost, which approximates cost on a first-in, first-out basis. We evaluate the need for inventory reserves associated with obsolete, slow-moving, excess and non-salable inventory by reviewing current transactions and forecasted product demand. We evaluate our inventories on an item by item basis and establish reserves accordingly. See Note 6. Property, Plant and Equipment ----------------------------- Property, plant and equipment, including leasehold improvements, are stated at cost and depreciation is calculated over the estimated useful lives of the related assets or lease terms on the straight-line basis. We depreciate substantially all manufacturing and office equipment over periods of three to seven years. We depreciate leasehold improvements over the remaining portion of the lease, or over the expected life of the asset if less than the remaining term of the lease. Long-lived assets are evaluated on an annual basis for impairment. Based on this evaluation, no impairment was noted for the years ended December 31, 2005, 2004, and 2003. Revenue Recognition ------------------- Sales of Data I/O's 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. Beginning in the third quarter of 2005, Data I/O began recognizing revenue for these products at the time of shipment. We began recognizing revenue at the time of shipment after we determined that our programming equipment have reached a point of maturity and stability such that product acceptance can be assured by testing at the factory prior to shipment and that the installation meets the criteria to be considered a separate element. When arrangements include multiple elements, we use objective evidence of fair value to allocate revenue to the elements pursuant to EITF 00-21, "Revenue Arrangements with Multiple Deliverables," and recognize revenue when the criteria for revenue recognition have been met for each element according to SAB 104, "Revenue Recognition." The amount of revenue recognized is affected by our judgments as to the collectibility of the transaction or whether an arrangement includes multiple elements and if so, whether specific objective evidence of fair value exists for those elements. Installation that is considered perfunctory includes any installation that can be performed by other parties, such as distributors, other vendors, or in most cases the customers themselves. This takes into account the complexity, skill, and training needed as well as customer expectations regarding installation. The revenue related to products requiring installation that is perfunctory is recognized at the time of shipment provided that persuasive evidence of an arrangement exists, shipment has occurred, the price is fixed or determinable, and collectibility is reasonably assured. We record revenue from the sale of service and update contracts as deferred revenue and we recognize it on a straight-line basis over the contractual period, which is typically one year. We establish a reserve for sales returns based on historical trends in product returns and estimates for new items. Sales were recorded net of associated sales return reserves, which were $150,000, $250,000, and $300,000 at December 31, 2005, 2004, and 2003, respectively. 33 Data I/O's software products are not normally sold separately from sales of programming systems. However, on those occasions where we sell software separately, we recognize revenue when a sales agreement exists, when delivery has occurred, when the fee is fixed or determinable, and when collection is probable. Research and Development ------------------------ Research and development costs are expensed as incurred. Advertising Expense ------------------- Data I/O expenses advertising costs as incurred. Total advertising expenses were approximately $238,000, $273,000, and $248,000 in 2005, 2004, and 2003, respectively. Warranty Expense ---------------- Data I/O records a liability for an estimate of costs that it expects to incur under our basic limited warranty when product revenue is recognized. Factors affecting our warranty liability include the number of units sold and historical and anticipated rates of claims and costs per claim. We periodically assess the adequacy of our warranty liability based on changes in these factors. Data I/O normally warrants our products against defects for periods ranging from ninety days to one year. The FlashPAK, which at introduction, carried a three-year warranty on some components, now have a one year warranty. We provide currently for the estimated cost that may be incurred under our product warranties. Data I/O records revenues on extended warranties on a straight-line basis over the term of the related warranty contracts. Service costs are expensed as incurred. Earnings (Loss) Per Share ------------------------- Basic earnings (loss) per share exclude any dilutive effects of stock options. Basic earnings (loss) per share are computed using the weighted-average number of common shares outstanding during the period. Diluted earnings per share are computed using the weighted-average number of common shares and common stock equivalent shares outstanding during the period. Options to purchase 396,181 shares of common stock were outstanding as of December 31, 2005, but were excluded from the computation of diluted EPS for the period then ended because the options were anti-dilutive. Options to purchase 1,439,488 shares of common stock as of December 31, 2004 were excluded from EPS as their effect was anti-dilutive. Diversification of Credit Risk ------------------------------ Financial instruments, which potentially subject Data I/O to concentrations of credit risk, consist primarily of trade receivables. Our cash, cash equivalents and marketable securities consist of high quality financial instruments. Data I/O maintains cash balances in financial institutions, which at times may exceed federally insured limits. We have not experienced any losses in such accounts and believe we are not exposed to any significant credit risk on cash and cash equivalents. Our trade receivables are geographically dispersed and include customers in many different industries. We believe that any risk of loss is significantly reduced due to the diversity of our end-customers and geographic sales areas. We perform on-going credit evaluations of our customers' financial condition and require collateral, such as letters of credit and bank guarantees, whenever deemed necessary. Derivatives ----------- Data I/O accounts for our derivatives using 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. 34 Data I/O utilizes forward foreign exchange contracts to reduce the impact of foreign currency exchange rate risks where natural hedging strategies cannot be effectively employed. All of our hedging instruments 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 estimated fair value gain (loss) of the open hedge contracts as of December 31, 2005 is a liability of $3,000 and is included in accounts payable on the balance sheet. Data I/O does 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. We are exposed to credit-related losses in the event of nonperformance by counterparties to forward exchange contracts. However, we have entered into these instruments with creditworthy financial institutions and consider the risk of nonperformance remote. New 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 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 May 2005, the FASB issued Statement No. 154, "Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3." This Statement 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. We have not yet assessed the effect of this Statement on Data I/O. NOTE 2 - CLASSIFICATIONS Certain prior periods' balances have been reclassified to conform to the presentation used in the current period. NOTE 3 - PROVISION FOR BUSINESS RESTRUCTURING During 2005, we took restructuring related charges of $96,000 primarily related to severance and completing actions that had been started in the second half of 2004. This aligned management operations with the changes made in 2004 to control costs in North America and Europe; and the need to build staff serving China and Eastern Europe. At December 31, 2005, $33,000 remained as accrued but unpaid restructure charges, which will be paid in 2006. During 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 our 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. During 2003, we completed the restructuring that began during 2001, which included actions taken to reduce the level of revenue required for our net income breakeven point and realign Data I/O with our market opportunities. This restructuring included the following: a reduction in our global workforce; discontinuance or reallocation of numerous projects and activities not essential to our long-term goals; streamlining discretionary activities; consolidation of numerous functions across the 35 organization to create a team, which was more productive and able to respond faster to global customer needs; and closure of a facility in Germany and moving our operations to other locations within Data I/O. We required this operational repositioning because of the impact of the economic slowdown and the decline in capital spending across a high number of customer groups on general demand for programming equipment over the past few years. Our level of revenue required for our net income breakeven point increased in 2003, primarily due to cost increases resulting from the impact of the weaker dollar on foreign currency based costs and from personnel costs due to raises, incentive compensation and selective hiring of individuals with critical skills to help position us as the continuing technology leader in our market. At December 31, 2003 all restructuring expenses associated with the activities detailed for 2002 and 2001 had been paid and the excess expense accrual of $39,000 was reversed during 2003. An analysis of the restructuring is as follows (in thousands): 2004 2004 Reserve 2005 2005 Reserve Expenses Payments/ Balance at Expenses Payments/ Balance at Description Write-offs Dec. 31, 2004 Write-offs Dec. 31, 2005 ------------------------------------------------------------------------------------------------------------------------ Downsizing U.S. Operations: Employee severance $310 $256 $54 $81 $117 $18 Redmond facility 10 8 2 - 2 - consolidation Consulting and legal 15 15 - 15 15 - expenses Downsizing foreign operations 227 196 30 - 15 15 ------------ ------------ ------------ ------------ ------------ ------------ Total $562 $475 $86 $96 $149 $33 ============ ============ ============ ============ ============ ============
NOTE 4 - MARKETABLE SECURITIES The estimated fair value of marketable securities consisted of the following (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Corporate bonds $ - $ 787 Taxable auction securities 800 250 ------------- ------------- $ 800 $ 1,037 ============= ============= At December 31, 2005, cost approximated market value for Data I/O's portfolio of marketable securities and there were no significant unrealized gains or losses. The marketable securities are all classified as current assets due to their maturity date or because of the available for sale holding intent, as in the case of corporate bonds which had a maturity date in the second quarter of 2005. The cost of securities sold is determined by the specific identification method. 36 NOTE 5 - ACCOUNTS RECEIVABLE, NET Receivables consist of the following (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Trade accounts receivable $6,993 $4,644 Less allowance for doubtful receivables 165 155 ------------- ------------- Trade accounts receivable, net $6,828 $4,489 ============= =============
Trade receivables relate to sales to Data I/O customers, for which credit is extended based on the customer's credit history. Changes in Data I/O's allowance for doubtful accounts are as follows (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Beginning balance $155 $202 Bad debt expense (reversal) 64 (37) Accounts written-off (64) (10) Recoveries 10 - ------------- ------------- Ending balance $165 $155 ============= ==============
NOTE 6 - INVENTORIES Net inventories consisted of the following components (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Raw material $2,076 $2,381 Work-in-process 767 899 Finished goods 686 859 ------------- ------------- Inventories $3,529 $4,139 ============= ==============
Reserves for excess and obsolete inventory were $1,539,000 and $1,915,000 at December 31, 2005 and December 31, 2004, respectively. The $376,000 decline in the reserve related primarily to scrapping and disposal of the related inventory with a reversal of $158,000 in cost of goods sold related to items sold. Our inventory reserve addresses excess and obsolete inventories. The reserve is not part of a current lower of cost or market ("LOCOM") evaluation or provision as the company uses a standard costing system and any associated LOCOM write down would be permanently made to the item cost. Our reserve generally results in items being scrapped or disposed of for a small salvage value; however, some inventory does get eventually used and sold, in which case the reserve would be credited back to cost of goods sold. NOTE 7 - SALE - LEASEBACK In May 1997, Data I/O completed the sale of the land and building comprising our Redmond, Washington, corporate headquarters. The sale included a 10-year leaseback of the building to Data I/O. The sale represented an overall pre-tax gain to Data I/O of $5.6 million. Of this amount, we recognized $2.3 million in 1997, with the remainder being amortized over the life of the lease ending in 2006. 37 NOTE 8 - PROPERTY, PLANT AND EQUIPMENT, NET Property, plant and equipment consisted of the following (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Leasehold improvements $343 $291 Equipment 9,935 10,065 ------------- ------------- 10,278 10,356 Less accumulated depreciation 8,004 8,386 ------------- ------------- Property, plant and equipment, net $2,274 $1,970 ============= ============= Total depreciation recorded for 2005, 2004, and 2003 was $1,107,000, $922,000, and $602,000, respectively. NOTE 9 - OTHER ACCRUED LIABILITIES Other accrued liabilities consisted of the following components (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Product warranty liability $459 $494 Sales return reserve 150 250 Other 491 382 ------------- ------------- Other accrued liabilities $1,100 $1,126 ============= ============= The changes in Data I/O's product warranty liability are as follows (in thousands): Dec. 31, Dec. 31, 2005 2004 ------------- ------------- Liability, beginning of year $494 $563 Net expenses 810 896 Warranty claims (810) (896) Accrual revisions (35) (69) ------------- ------------- Liability, end of year $459 $494 ============= ============= 38 NOTE 10 - AGGREGATE CONTRACTUAL OBLIGATIONS AND COMMITTMENTS Data I/O has 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. Data I/O has no long-term debt. Data I/O has 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: For the years ending December 31, (in thousands): Purchase Operating obligations leases ---------------- ---------------- 2006 $620 $1,512 2007 854 249 2008 - 143 2009 - 18 2010 and thereafter - - ---------------- ---------------- Total $1,474 $1,922 ================ ================ Lease and rental expense before the deduction for the amortization of the deferred gain was $1,227,000, $1,610,000, and $1,476,000 in 2005, 2004, and 2003, respectively. Data I/O has renewal options on substantially all of our major leases. The initial lease on the Redmond facility expires on December 31, 2006. On February 28, 2006, Data I/O and our current landlord concurrently entered into a termination agreement for the Redmond headquarters facility lease and a five year lease agreement for an approximately 40,000 square foot office space also located in Redmond, Washington. We anticipate a mid-year move of our corporate headquarters to this new location. We also expect to enter into a new lease agreement during the first quarter of 2006 for our offices in Shanghai, China. NOTE 11 - STOCK AND RETIREMENT PLANS Stock Option Plans ------------------ At December 31, 2005, there were 1,436,091 shares of Common Stock reserved for issuance of which 280,646 shares are available for future grant under Data I/O's employee stock option plans. Pursuant to these plans, options are granted to our officers and key employees with exercise prices equal to the fair market value of the Common Stock at the date of grant and generally vest over four years. Certain options granted during 1998 and 1999 vest over two years. Options granted under the plans generally have a maximum term of six years from the date of grant, except for certain options granted in January 1999, which have a maximum term of ten years. Employee Stock Purchase Plan ---------------------------- Under the Employee Stock Purchase Plan, eligible employees may purchase shares of Data I/O's Common Stock at six-month intervals at 85% of the lower of the fair market value on the first or the last day of each six-month period. Employees may purchase shares having a value not exceeding 10% of their gross compensation during an offering period. During 2005, 2004 and 2003, a total of 57,076, 61,221, and 194,477 shares, respectively, were purchased under the plan at average prices of $2.31, $2.52, and $0.61 per share, respectively. At December 31, 2005, a total of 157,687 shares were reserved for future issuance. 39 Stock Appreciation Rights Plan ------------------------------ Data I/O has a Stock Appreciation Rights Plan ("SAR") under which each director, executive officer or holder of 10% or more of Data I/O's Common Stock has a SAR with respect to each exercisable stock option. The SAR entitles the SAR holder to receive cash from Data I/O for the difference between the market value of the stock and the exercise price of the option in lieu of exercising the related option. SARs are only exercisable following a tender offer or exchange offer for Data I/O's stock, or following approval by shareholders of Data I/O of any merger, consolidation, reorganization or other transaction providing for the conversion or exchange of more than 50% of the common shares outstanding. As no event has occurred, which would make the SARs exercisable, and no such event is deemed probable, no compensation expense has been recorded under this plan. Director Fee Plan ----------------- Data I/O has a Director Fee Plan, not currently in use, which had provided for payment to directors who are not employees of Data I/O Corporation by delivery of shares of Data I/O's Common Stock. No shares were issued from the plan for 2005, 2004, or 2003 board service and 151,332 shares remain available in the plan. Retirement Savings Plan ----------------------- Data I/O has a savings plan that qualifies as a cash or deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the plan, participating U.S. employees may defer their pre-tax salary, subject to IRS limitations. In fiscal years 2005, 2004 and 2003, Data I/O contributed one dollar for each dollar contributed by a participant, with a maximum contribution of 4% of a participant's earnings. Data I/O's matching contribution expense for the savings plan was approximately $182,000, $178,000, and $161,000 in 2005, 2004, and 2003, respectively. Share Repurchase Program ------------------------ Under a previously announced share repurchase program, Data I/O is authorized to repurchase up to 1,123,800 shares of our outstanding Common Stock. These purchases may be executed through open market purchases at prevailing market prices, through block purchases or in privately negotiated transactions, and may commence or be discontinued at any time. In years prior to 2005, we have repurchased 1,016,200 shares under this repurchase program at a total cost of approximately $7.1 million. We have not repurchased shares under this plan since the second quarter of 1997, although we still have the authority to do so. NOTE 12- STOCK-BASED COMPENSATION Pro forma information regarding net income and earnings per share is required by SFAS 123, and has been determined as if Data I/O had accounted for our employee stock options, employee stock purchase plan options and directors' fee shares under the fair value method of that Statement (see Note 1). The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions: Employee Stock Employee Stock Director Options Purchase Plan Fee Plan ------------------------------- -------------------------------- ------------------------------- 2005 2004 2003 2005 2004 2003 2005 2004 2003 --------- --------- --------- --------- --------- ---------- --------- --------- --------- Risk-free interest rates 3.72% 3.44% 2.21% 2.00% 1.15% 1.14% N/A N/A N/A Volatility factors .79 1.03 1.03 .91 1.04 .97 N/A N/A N/A Expected life of the option 4.61 4.35 4.31 .50 .50 .50 N/A N/A N/A in years Expected dividend yield None None None None None None None None None
For purposes of pro forma disclosures, the estimated fair value of the options granted, which is estimated to be $1.61, $2.15, and $1.01 per share for 2005, 2004 and 2003, respectively, is amortized to expense over the options' vesting period. 40 A summary of Data I/O's stock option activity, and related information follows: December 31, 2005 December 31, 2004 December 31, 2003 ---------------------------- -------------------------- ----------------------------- Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price --------------- -------------- ------------- ------------ --------------- --------------- Outstanding at beginning of year 1,439,488 $2.27 1,326,805 $2.25 1,141,412 $2.56 Granted 295,500 2.52 313,000 2.91 299,500 1.39 Exercised (421,945) 1.99 (27,179) 1.64 (14,408) 2.40 Expired or forfeited (157,598) 2.47 (173,138) 3.28 (99,699) 3.10 --------------- ------------- --------------- Outstanding - end of year 1,155,445 1,439,488 2.27 1,326,805 2.25 =============== ============= =============== Exercisable at end of year 652,573 $2.44 907,533 $2.34 829,572 $2.52
The following table summarizes information about stock options outstanding at December 31, 2005: Options Outstanding Options Exercisable ------------------------------------------------------ --------------------------------- Weighted- Average Weighted- Weighted- Remaining Average Average Range of Number Contractual Exercise Number Exercise Exercise Prices Outstanding Life in Years Price Exercisable Price ------------- --------------- -------------- ------------- ------------- $1.00 - $1.25 187,224 3.14 $1.04 124,043 $1.06 $1.33 - $1.89 189,245 2.49 1.42 161,755 1.42 $1.94 - $2.49 282,132 4.72 2.43 89,118 2.33 $2.24 - $3.04 302,294 4.66 2.82 101,419 2.84 $3.13 - $5.16 194,550 1.24 4.66 176,238 4.17 ------------- ------------- $1.00 - $5.16 1,155,445 3.49 $2.42 652,573 $2.44 ============= =============
NOTE 13 - ACCUMULATED OTHER COMPREHENSIVE INCOME Ending accumulated balances for each item in accumulated other comprehensive income are as follows: (in thousands) Dec 31, Dec 31, 2005 2004 ------------- ------------- Unrealized currency gain $312 $493 Unrealized loss on marketable securities (1) (6) ------------- ------------- Total accumulated other comprehensive income $311 $487 ============= =============
NOTE 14- INCOME TAXES Data I/O accounts for income taxes using the liability method as prescribed by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." 41 Components of income (loss) before taxes: Year Ended December 31, --------------------------------------------------- (in thousands) 2005 2004 2003 -------------- --------------- ---------------- U.S. operations $541 $329 $698 Foreign operations 161 (435) 641 -------------- --------------- ---------------- $702 ($106) $1,339 ============== =============== ================ Income tax expense (benefit) consists of: Current tax expense (benefit): U.S. federal $ - $ - $ - State 5 - - Foreign 115 (14) 33 -------------- --------------- ---------------- 120 (14) 33 Deferred tax expense (benefit) - U.S. federal - - - -------------- --------------- ---------------- Total income tax expense (benefit) $ 120 ($14) $ 33 ============== =============== ================
A reconciliation of Data I/O's effective income tax rate and the U.S. federal tax rate is as follows: Year Ended December 31, ------------------------------------------------ 2005 2004 2003 ----------- ------------ ---------- Statutory rate 34.0% 34.0% 34.0% State and foreign income tax, net of federal income tax benefit (0.1) 27.9 (13.7) Valuation allowance for deferred tax assets (16.8) (48.8) (17.9) ----------- ------------ ---------- 17.1% 13.1% 2.4% =========== ============ ============
The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets are presented below (in thousands): Dec. 31, Dec. 31, 2005 2004 --------------- --------------- Deferred income tax assets: Allowance for doubtful accounts $ 15 $ 24 Inventory and product return reserves 853 1,143 Compensation accruals 189 155 Accrued liabilities 532 573 Book-over-tax depreciation and amortization 799 743 Foreign net operating loss carryforwards 259 194 U.S. net operating loss and credit carryforwards 7,149 6,969 Other, net 7 6 --------------- --------------- 9,803 9,807 Valuation allowance (9,803) (9,807) --------------- --------------- Total deferred income tax assets $ - $ - =============== ================
The valuation allowance for deferred tax assets decreased $4,000 during the year ended December 31, 2005, due primarily to the 2005 book net income that allowed the utilization of tax deferred assets reducing the related valuation allowance. The valuation allowance for deferred tax assets increased $107,000 during the year ended December 31, 2004, due primarily to the 2004 net operating losses generated that have been reserved for by increasing the valuation allowance. The net deferred tax assets have a full valuation allowance provided due to uncertainty regarding Data I/O's ability to utilize such assets in future years. Credit carryforwards consist primarily of research and experimental and alternative minimum tax credits. Net operating loss carryforwards expire in 2019 to 2025. Utilization of net operating loss and credit carryforwards is subject to certain limitations under Section 382 of the Internal Revenue Code of 1986, as amended. 42 NOTE 15 - SEGMENT AND GEOGRAPHIC INFORMATION In 2005, no customer accounted for 10% of Data I/O's consolidated revenues and in 2004 and 2003, one customer, Siemens, accounted for 14.5% and 18.0% of Data I/O's consolidated revenues, respectively, and no other customer accounted for more than 10%. Major operations outside the U.S. include sales and service support subsidiaries in Germany, Brazil, Canada and China. We present geographic information of our operations for the three years ended December 31, 2005 in the table that follows. Net sales, as shown in the table below, are based upon the geographic area into which the products were sold and delivered. Export sales are subject to U.S. Department of Commerce regulations, and to the market conditions in the countries in which the products are sold. For purposes of the table below, the profit on the transfers between geographic areas has been shown in operating income in the geographic area where the final sale to non-affiliated customers took place. Certain general corporate expenses are charged to the U.S. segment. Identifiable assets are those assets that can be directly associated with a particular geographic area. All Company financial instruments, consisting of cash and marketable securities, are included in U.S. operations. Year Ended December ------------------------------------------------------------------ (in thousands) 2005 2004 2003 --------------- -------------- ---------------- Net sales: U.S. $6,386 $5,434 $7,263 Europe 11,340 11,156 10,678 Rest of World 10,595 10,720 6,746 --------------- -------------- ---------------- $28,321 $27,310 $24,687 =============== ============== ================
Included in Europe and Rest of World are the following significant balances: Germany $8,510 $8,989 $8,765 China $4,458 $2,986 $3,149 Operating income (loss): U.S. ($394) ($1,526) ($709) Europe 1,715 2,824 2,848 Rest of World (696) (1,369) (775) --------------- -------------- ---------------- $625 ($71) $1,364 =============== ============== ================ Identifiable assets: U.S. $8,351 $9,202 $11,128 Europe 4,882 4,577 3,949 Rest of World 4,904 4,068 3,023 --------------- -------------- ---------------- $18,137 $17,847 $18,100 =============== ============== ================
NOTE 16 - QUARTERLY FINANCIAL INFORMATION (unaudited) The following table sets forth unaudited selected quarterly financial data for Data I/O for 2005 and 2004. Although our business is not seasonal, growth rates of sales and earnings have varied from quarter to quarter as a result of factors such as stocking orders from international distributors, the timing of new product introductions, business restructuring, and short-term industry and general U.S. and international economic conditions. Information as to any one or more quarters is, therefore, not necessarily indicative of trends in our business or profitability. 43 (in thousands except per share data) Year Ended December 2005 ----------------------------------------------------------------- For the quarters ended Mar 31 June 30 Sept 30 Dec 31 ------------- ------------- ------------- ------------- Net sales(4) $6,737 $6,642 $6,587 $8,355 Gross margin 4,014 3,933 3,756 4,388 Net income (loss) (2) 39 53 127 363 Basic and diluted earnings per share (1) $ 0.00 $ 0.01 $ 0.02 $ 0.07
Year Ended December 2004 (in thousands except per share data) ----------------------------------------------------------------- For the quarters ended: Mar 31 June 30 Sept 30 Dec 31 ------------- ------------- ------------- ------------- Net sales(3) $6,834 $6,896 $7,765 $5,815 Gross margin 3,713 3,510 4,232 3,129 Net income (loss) (2) 296 103 93 (584) Basic and diluted earnings (loss) per share (1) $ 0.04 $ 0.01 $ 0.01 ($0.07) (1) The sum of quarterly per share amounts may not equal per share amounts reported for year-to-date periods. This is due to changes in the number of weighted-average shares outstanding and the effects of rounding for each period. (2) The Company recorded restructure charges of $55,000, $17,000, and $24,000 in the second, third and fourth quarters of 2005, respectively, and $70,000, $432,000 and $60,400 in the second, third and fourth quarters of 2004, respectively, for charges associated primarily with severance related charges and a small office closure. (3) The loss in the fourth quarter of 2004 was primarily related to the quarter's decline in sales to customers in the wireless market. (4) Beginning in the third quarter of 2005, we began recognizing revenue for certain equipment requiring installation at the time of shipment. See Note 1.
NOTE 17 - LONG-TERM DEBT As of December 31, 2005 and December 31, 2004, Data I/O had no long-term debt outstanding. Data I/O established a foreign line of credit for 50,000 Euros in February 2002 that was renewed in January 2003 but not renewed in January 2004. 44 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. 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 our 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 has materially affected or is reasonably likely to materially affect our internal control over financial reporting. We have recently acquired and are currently implementing a new worldwide information system that will result in changes to our internal controls. Our corporate office began use of the new system in February 2006. We are now in the process of implementing the new system at our subsidiary locations. We intend to include process and internal control improvements as part of the implementation process. ITEM 9B. OTHER INFORMATION None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------------------------------ Information regarding the Registrant's directors is set forth under "Election of Directors" in Data I/O's Proxy Statement relating to Data I/O's annual meeting of shareholders to be held on May 24, 2006 and is incorporated herein by reference. Such Proxy Statement will be filed within 120 days of Data I/O's year-end. Information regarding the Registrant's executive officers is set forth in Item 1 of Part I herein under the caption "Executive Officers of the Registrant." Code of Ethics We have adopted an updated Code of Ethics that applies to all directors, officers and employees of Data I/O, including the Chief Executive Officer and Chief Financial Officer. The key principles of the Code of Ethics are to act legally and with integrity in all work for Data I/O. The Code of Ethics is posted on the corporate governance page of our website at http://www.dataio.com/corporate/governance.asp. We will post any amendments to our Code of Ethics on our website. In the unlikely event that the Board of Directors approves any sort of waiver to the Code of Ethics for our executive officers or directors, information concerning such waiver will also be posted on our website. In addition to posting information regarding amendments and waivers on our website, the same information will be included in a Current Report on Form 8-K within four business days following the date of the amendment or waiver, unless website posting of such amendments or waivers is permitted by the rules of The Nasdaq Stock Market, Inc. 45 ITEM 11. EXECUTIVE COMPENSATION -------------------------------- Information called for by Part III, Item 11, is included in Data I/O's Proxy Statement relating to Data I/O's annual meeting of shareholders to be held on May 24, 2006 and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Executive Compensation." Such Proxy Statement will be filed within 120 days of Data I/O's year-end. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Information called for by Part III, Item 12, is included in Data I/O's Proxy Statement relating to Data I/O's annual meeting of shareholders to be held on May 24, 2006 and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Voting Securities and Principal Holders." Such Proxy Statement will be filed within 120 days of Data I/O's year-end. Equity Compensation Plan Information ------------------------------------ The following table gives information about our Common Stock that may be issued upon the exercise of options and rights under all of our existing equity compensation plans as of December 31, 2005. See Notes 11 and 12 of "Notes to Consolidated Financial Statements." (a) Number of securities (c) Number of securities remaining to be issued upon the (b) Weighted-average available for future issuance under exercise of outstanding exercise price of equity compensation plans options, warrants and outstanding options, (excluding securities reflected in rights warrants and rights column (a)) ------------------------ --------------------- ----------------------------------- Equity compensation plans approved by the security holders(1)(3) 1,182,641 $2.41 562,469 Equity compensation plans not approved by the security holders(2) 0 $0.00 0 (1) Represents shares of Data I/O's Common Stock issuable pursuant to our 2000 Stock Incentive Compensation Plan, 1986 Stock Option Plan, 1992 Employee Stock Purchase Plan, and Director Fee Plan. (2) Director option grant represents a one-time option grant to Directors in May 1998 prior to shareholder approval of an option plan covering Directors. (3) Stock Appreciation Rights Plan ("SAR") provides that directors, executive officers or holders of 10% or more of Data I/O's Common Stock have an accompanying SAR with respect to each exercisable option. While the plan has been approved by the security holders, no amounts are included in columns (a), (b), or (c) relating to the SAR.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. ITEM 14. PRINCIPLE ACCOUNTING FEES AND SERVICES The information required by this Item with respect to principal accountant fees and services is incorporated by reference to the section captioned "Principal Accountant's Fees and Services" in the Proxy Statement relating to Data I/O's annual meeting of shareholders to be held on May 24, 2006. Such Proxy Statement will be filed within 120 days of Data I/O's year-end. 46 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES Executive Compensation Plans and Arrangements 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 10.17. (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) Form of Change in Control Agreements. See Exhibit 10.21 and 10.22. (7) 1996 Director Fee Plan. See Exhibit 10.14. (8) Letter Agreement with Frederick R. Hume. See Exhibit 10.16. (9) Amended and Restated 2000 Stock Compensation Incentive Plan. See Exhibit 10.18. (10) Form of Option Agreement. See Exhibit 10.20. (11) Data I/O Corporation Tax Deferral Retirement Plan. See Exhibit 10.19 and 10.24. (12) Harald Weigelt Employment Agreement. See Exhibit 10.23. (a) List of Documents Filed as a Part of This Report: Page (1) Index to Financial Statements: Report of Independent Registered Public Accounting Firm 26 Consolidated Balance Sheets as of December 31, 2005 and 2004 27 Consolidated Statements of Operations for each of the three years ended December 31, 2005 28 Consolidated Statements of Cash Flowsfor each of the three years ended December 31, 2005 29 Consolidated Statement of Stockholders' Equity for each of the three years ended December 31, 2005 30 Notes to Consolidated Financial Statements 31 47 (2) Index to Financial Statement Schedules: Schedule II - Consolidated Valuation and Qualifying Accounts 52 All other schedules not listed above have been omitted because the required information is included in the consolidated financial statements or the notes thereto, or is not applicable or required. (3) Index to Exhibits: 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 February 2006. 3.3 Certification 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). 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)). 48 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)). 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)). 49 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 Letter Agreement with Fred R. Hume dated January 29, 1999. 10.17 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). 10.18 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). 10.19 Data I/O Corporation Tax Deferral Retirement Plan, as amended (Incorporated by reference to Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.20 Form of Option Agreement (Incorporated by reference to Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.21 Change in Control Agreement with Fred R. Hume dated April 22, 2004 (Incorporated by reference to Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.22 Change in Control Agreement with Joel S. Hatlen dated April 22, 2004 (Incorporated by reference to Data I/O's 2004 Annual Report on Form 10-K (File No. 0-10394)). 10.23 Harald Weigelt Employment Agreement. 10.24 Data I/O Corporation Tax Deferral Retirement Plan, as amended. 10.25 Lease Termination Agreement dated February 28, 2006 (Redmond Headquarters). 10.26 Lease, Redmond East Business Campus between Data I/O Corporation and Carr Redmond PLCC dated February 28, 2006. 21.1 Subsidiaries of the Registrant 23.1 Consent of Independent Registered Public Accounting Firm 31 CERTIFICATION - SECTION 302: 31.1 Chief Executive Officer Certification 31.2 Chief Financial Officer Certification 32 CERTIFICATION - SECTION 906: 32.1 Chief Executive Officer Certification 32.2 Chief Financial Officer Certification 50 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: March 29, 2006 By: //S//Frederick R. Hume ------------------------ Frederick R. Hume President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. NAME & DATE TITLE ----------- ----- By: /s/ Frederick R. Hume President and Chief Executive Officer -------------------------- (Principal Executive Officer) Frederick R. Hume By: /s/ Joel S. Hatlen Chief Financial Officer -------------------------- Vice President of Finance Joel S. Hatlen Secretary, Treasurer (Principal Financial and Accounting Officer) By: /s/ Paul A. Gary Director -------------------------- Paul A. Gary By: /s/ Edward D. Lazowska Director -------------------------- Edward D. Lazowska By: /s/ Daniel A. DiLeo Director -------------------------- Daniel A. DiLeo By: /s/ Steven M. Quist Director -------------------------- Steven M. Quist By: /s/ William R. Walker Director -------------------------- William R. Walker 51 DATA I/O CORPORATION SCHEDULE II - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Charged/ (Credited) Balance at to Costs Balance at Beginning and Deductions- End of of Period Expenses Describe Period ---------------- ---------------- --------------- -------------------- (in thousands) Year Ended December 31, 2003: Reserves and allowances deducted from asset accounts: Allowance for bad debts $187 $71 ($56) (1) $202 Inventory reserves $3,267 ($96) ($875) (2) $2,296 Year Ended December 31, 2004 : Reserves and allowances deducted from asset accounts: Allowance for bad debts $202 ($37) ($10) (1) $155 Inventory reserves $2,296 ($80) ($301) (2) $1,915 Year Ended December 31, 2005: Reserves and allowances deducted from asset accounts: Allowance for bad debts $155 64 (54) $165 Inventory reserves $1,915 ($158) ($218) $1,539 (1) Uncollectable accounts written off, net of recoveries. (2) Obsolete inventories disposed of.
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