PART I

In order to accommodate the expanding variety and quantities of programmable devices being manufactured today, we offer multiple solutions for the numerous types of device mix and volume usage by our customers in the various market segments and applications.  We work closely with leading manufacturers of programmable devices to develop our products to meet the requirements of a particular device.  Our products are positioned and viewed as the “gold standard” for advanced programming equipment and intellectual property management solutions.  Our new PSV7000 Automated Programming System won the Global Technology Award at Productronica in November 2013.  Our RoadRunner3 with Factory Integration Software won the Circuits Assembly NPI Award in February of 2012.

Our programming solutions include a broad range of products, systems, modules and accessories, grouped into two general categories: automated programming systems and manual programming systems.  We provide two main categories of automated programming systems: off-line and in-line.  Our automated systems have list selling prices ranging from $65,000 to $628,100 and our manual systems have list selling prices ranging from $675 to $32,400.  Our common programming platform, FlashCORE™, and our universal job setup tool, Tasklink™ for Windows®, are available in each family of our automated programming systems and FlashPAK™.  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 software algorithms for devices and developing socket adapters to hold and connect to the device for programming.

Our products have both an upfront solution sale and recurring revenue elements.  Adapters are a consumable item and software and maintenance are typically recurring under annual subscription contracts.  We experienced a larger percentage of capital equipment sales in 2013 compared to 2012, which we believe was primarily due to a rebound in capital spending.

The table below presents our main products and the key features that benefit our customers:

Our solutions address the programming of devices.  Semiconductor devices are a large, growing market, both in terms of devices and bits programmed.  According to World Semiconductor Trade Statistics (“WSTS”) in February 2014, semiconductor device revenues experienced a 4.8% increase for the full year 2013 compared to 2012, primarily spurred by consistent, steady growth across nearly all regions and product categories.  For 2014, a 4.1% semiconductor revenue growth is forecast according to WSTS.  Semiconductor Industry Association (“SIA”), which represents U.S. semiconductor companies, recently reported the highest ever sales for the month of January, which marks over 11 straight months of year over year growth.  Markets that are expected to be key growth drivers include smartphones, tablets, e-readers, portable media players, set top boxes, televisions, automotive electronics, and new household appliances filled with electronics.  The demand for more electronics is a trend, and this growth is driving the semiconductor industry.

We believe that our sales are driven by many of the same forces that propel the semiconductor industry.  We sell to the same firms that buy the semiconductors.  When their business grows, they buy more semiconductors which, in turn, require additional programming equipment to maintain production speeds or program new device technologies, driving demand for our products or alternative programming methods.

Our device programming solutions currently target two high growth, high volume markets: flash for mobile wireless and consumer electronic devices and microcontrollers for automotive electronics and industrial controls.

Growth drivers of flash in Mobile Devices

·          Flash unit volume experiencing explosive growth

·          Increasing usage of NAND, especially managed NAND like e-MMC

·          Densities continue to increase, driving the need for more advanced and secure programming capabilities

·          Higher densities driving new usage models such as tablet computers

·          The continuing shift to smartphones like iPhone, Android and new low cost smartphones

·          Shift to lower process geometries for eMMC flash, requiring more advanced data retention strategies

Growth drivers of microcontrollers and flash in Automotive

·          Consumers desire advanced car features requiring higher levels of sophistication including infotainment products (audio, radio, satellite, navigation and wireless connectivity) as well as increased safety features and optimized engine functionality

·          ~60 microcontrollers per vehicle

·          Proliferation of programmable microcontrollers to support the next-generation electronic car systems

·          Increasing use of high-density flash to provide memory for advanced applications that require programming

Increasingly, OEMs in consumer electronics are outsourcing their device programming needs to EMS contract manufacturers to reduce capital expense and maximize profit margins.  At the same time, these OEMs are also increasing their proprietary software content to accelerate new product introductions with more feature-rich, application-specific versions.  While the outsourcing of manufacturing processes is essential to maximizing an OEM’s profit margin, maintaining the integrity and control of the software, the OEM’s core intellectual property, is increasingly complex in this outsourced environment, especially given the global nature of the manufacturing supply chain.  Data I/O, with its comprehensive programming solutions, provides OEMs with the ability to manage, monitor, audit and secure the software supply chain. 

During 2013, we sold products to over 500 customers throughout the world. The following customers represented greater than 10% of sales in the applicable year:

2013      Two customers, Data Copy Limited, our distributor in China and Di-Tek Corporation, our distributor in Korea accounted for approximately 14% and 13% of 2013 net sales, respectively.  Blackberry (formerly Research in Motion) did not directly account for greater than 10% of sales in 2013.  However, they influenced business through their EMS contract manufacturing partners that we believe combined accounted for between 10-15% of 2013 net sales.

2012       Data Copy Limited accounted for approximately 11% of 2012 net sales.

2011       Data Copy Limited accounted for approximately 11% of 2011 net sales.

The following customers represented greater than 10% of our consolidated accounts receivable balance as of December 31 of the applicable year:

2013       Avnet accounted for approximately 12% of our consolidated accounts receivable.

2012      Three customers, Data Copy Limited, Delphi and Jabil accounted for approximately 16%, 11% and 10% of our consolidated accounts receivable, respectively.

2011       Panasonic accounted for approximately 10% of our consolidated accounts receivable.

Geographic Markets and Distribution

We market and sell 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 and realign them as necessary to ensure that we reach our existing and potential customers in the most effective and efficient manner possible.

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 direct telesales.  Our U.S. independent sales representatives obtain orders on an agency basis, with shipments made directly to the customer by us.  Net sales in the United States for 2013, 2012 and 2011 were $2,331,000, $2,835,000 and $2,724,000, respectively.

International Sales

International sales represented approximately 88%, 83%, and 90% of net sales in 2013, 2012 and 2011, respectively.  We make foreign sales through our wholly-owned subsidiaries in Germany and China, as well as through independent distributors and sales representatives located in 46 other countries.  Our independent foreign distributors purchase our 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 international sales for 2013, 2012 and 2011 were $16,386,000, $14,250,000 and $23,942,000, respectively.  We determine total international 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.  International 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 difficulties to date as a result of these requirements.  We have not made sales to Iran or any Iranian governmental entities.

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 international sales.  We cannot predict the effect of such factors on our business, but we try to consider and respond to changes in these factors, particularly as the majority of our costs are U.S. based while the vast majority of our sales are international. 

Competition

The competition in the programming systems market is highly fragmented with a large number of smaller organizations offering inexpensive solutions.  In particular, low cost automated solutions have gained market share in recent years, where the competition is primarily based on price.  Typically, their equipment meets a “good enough” standard, but with reduced quality, traceability, and other software features such as factory integration software.  Many of these competitors compete on a regional basis, with local language and support.  While we are not aware of any published industry market information covering the programming systems market, according to our internal analysis of competitors’ revenues, we believe we continue to be the largest competitor in the programming systems equipment market.

We primarily focus on automated programming solutions and believe our solutions offer numerous advantages over alternative solutions as described in the following table:

* Data I/O also offers manual programming solutions.

Manufacturing, Raw Materials and Backlog

We strive to manufacture and provide the best solutions for advanced programming.  We primarily assemble and test our products at our principal facility in Redmond, Washington and we outsource our circuit board manufacturing and fabrication.  Most of our FlashCORE adapter production is produced in China.  We use a combination of standard components, proprietary custom integrated circuits (“ICs”) and fabricated parts manufactured to our specifications.  Most components used are available from a number of different suppliers and subcontractors but certain items, such as some handler and programmer subassemblies, custom integrated circuits, 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 price increases, minimum order quantities and 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.  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 $1,900,000, $900,000 and $800,000 as of December 31, 2013, 2012 and 2011, respectively.  The size of backlog at any particular date is not necessarily a meaningful indicator of the trend of our business.

Research and Development

We believe 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.  Where possible, we may pursue partnerships to add new products, capabilities and services.  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 new programmer technologies, support for the latest flash memories and microcontrollers, and new software capabilities.  We also continue to focus on increasing our capacity and responsiveness for new device support requests from customers and programmable integrated circuit manufacturers by revising and enhancing our internal processes and tools.  In 2013, our research and development efforts resulted in the release of our new PSV7000, the world’s most advanced programming system. The PSV7000 can cut the cost of programming by up to 50% and represents new capabilities to handle and program small parts.

During 2013, 2012 and 2011, we made expenditures for research and development of $4,586,000, $5,564,000 and $5,470,000, respectively, representing 24.5%, 32.6% and 20.5% of net sales, respectively.  Research and development costs are expensed as incurred.

Patents, Copyrights, Trademarks and Licenses

We rely on a combination of 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 have continued to add new patents to our patent portfolio over the past few years as we developed strategic new technologies.

We attempt to protect our rights in proprietary software products, including TaskLink, Factory Integration Software 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 typically sold separately from sales of programming systems.  However, on those occasions where software is sold separately, revenue is recognized when a sales agreement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable.  For certain contract software development projects, revenue is recognized using the percentage-of-completion methodology.

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 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, 2013, we had a total of 82 employees, of which 37 were located outside the U.S. and 8 of which are part time.  We also utilize independent contractors for specialty work, primarily in research and development, and utilize temporary workers to adjust capacity to fluctuating demand and for special projects.  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.  In foreign countries we have employment agreements or, in China, the Shanghai Foreign Services Co., Ltd. (“FSCO”) labor agreement.

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.

Anthony Ambrose joined Data I/O in October 2012 and is our President and Chief Executive Officer.  He was appointed to the Board of Directors of Data I/O in October 2012.  Prior to Data I/O, Anthony was Owner and Principal of Cedar Mill Partners, LLC, a strategy consulting firm.  Until 2011, he was Vice President and General Manager at RadiSys Corporation where he led three product divisions and worldwide engineering.  At RadiSys, he established the telecom platform business and grew it to over $125M in annual revenues.  Until 2007, Anthony was general manager and held several other progressively responsible positions at Intel Corporation, where he led development and marketing of standards based telecommunications platforms, and grew the industry standard server business to over $1B in revenues.  Anthony holds a Bachelors of Science in Engineering from Princeton University.

Joel S. Hatlen joined Data I/O in September 1991 and is our Vice President, Chief Financial Officer, Secretary and Treasurer since January 1998.  He served as Chief Accounting Officer since February 1997 and served as Corporate Controller from December 1993 to December 1997.  Previously, he was Tax Manager and Senior Tax Accountant.  From September 1981 until joining Data I/O, Mr. Hatlen was employed by Ernst & Young LLP as a Certified Public Accountant, where his most recent position was Senior Manager.  Joel holds a Masters in Taxation from Golden Gate University and a Bachelors in Business Administration in Accounting from Pacific Lutheran University.

Rajeev Gulati joined Data I/O in July 2013 and is our Chief Technology Officer and Vice President of Engineering.  Prior to Data I/O, Rajeev served as Director of Software Engineering for AMD responsible for tools, compiler strategy and execution from 2006 to 2013.  He has an extensive background in software, systems and applying technology to develop new markets.  Previously, he served as Director of Strategy and Planning at Freescale from 2004 to 2006; as Director of Embedded Products at Metrowerks (acquired by Motorola) from 2000 to 2004 and Director of Compilers, Libraries & Performance Tools from 1997 to 2000; and engineering and programmer positions at Apple Computer, IBM and Pacific-Sierra Research.  Rajeev holds a Master of Science in Electrical & Computer Engineering from the University of Texas, Austin and a BE in Electrical Engineering from Delhi College of Engineering, New Delhi.

A decline in economic and market conditions may result in decreased capital spending and delayed or defaulted payments from our customers.

Our business is highly impacted by capital spending plans and other economic cycles that affect the users and manufacturers of integrated circuits.  These industries are highly cyclical and are characterized by rapid technological change, short product life cycles and fluctuations in manufacturing capacity and pricing and gross margin pressures.  As we experienced in recent years and are currently experiencing, 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.  In a difficult economic climate it may take us longer to receive payments from our customers and some of our customers’ business may fail, resulting in non-payment.    These factors could have a material adverse effect on our business and financial condition.

Delays in development, introduction and shipment of new products or services may result in a decline in sales or increased costs.

We develop new engineering and automated programming systems and services.  Significant technological, supplier, manufacturing or other problems may delay the development, introduction or production of these products or services.

For example, we may encounter these problems:

·      technical problems in the development of a new programming system platform or the robotics for new automated handing systems

·       inability to hire qualified personnel or turnover in existing personnel

·       delays or failures to perform by us or third parties involved in our development projects

·       development of new products or services that are not accepted by the market

These problems may result in a decline in sales or increased costs.

Quarterly fluctuations in our operating results may adversely affect our stock price.

Our 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:

·          increased competition

·          timing of new product announcements and timing of development expenditures

·          product or service releases and pricing changes by us or our competitors

·          market acceptance or delays in the introduction of new products or services

·          production constraints

·          quality issues

·          labor or material

·          timing of significant orders

·          sales channel mix of direct vs. indirect distribution

·          civil unrest, war or terrorism

·          health issues (such as the outbreak of a virus impacting workers or travel)

·          customers’ budgets

·          adverse movements in exchange rates, interest rates or tax rates

·          cyclical and seasonal nature of demand for our customers’ products

·          general economic conditions in the countries where we sell products

·          expenses and obtaining authorizations in setting up new operations or locations

Due to any of the foregoing factors, it is possible that in some future quarters, our operating results will be below expectations of analysts and investors.

Government regulations regarding the use of "conflict" minerals could adversely affect our prospects and results of operations.

Regulatory requirements regarding disclosure of our use of “conflict” minerals mined from the Democratic Republic of Congo and adjoining countries could affect the sourcing and availability of minerals used in the manufacture of certain products. Although we do not buy raw materials, manufacture, or produce any electronic equipment using conflict minerals directly, some components provided by our suppliers and contained in our products contain conflict minerals.  Our goal is for our products to be conflict free.  As a result, there may only be a limited pool of suppliers who provide conflict free metals, and we cannot assure you that we will be able to obtain products in sufficient quantities or at competitive prices.  Single source suppliers may not respond or respond negatively regarding conflict mineral sourcing and we may be unable to find alternative sources to replace them.  Also, because our supply chain is complex, we may face reputational challenges with our customers and other stakeholders if we are unable to sufficiently verify the origins for all metals used in the products that we sell.  Further, if we are unable to comply with the new laws or regulations or if our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us.  We may need to incur additional costs and invest additional resources, including management’s time, in order to comply with the new regulations and anticipated additional reporting and disclosure obligations.

Failure to adapt to technology trends in our industry may hinder our competitiveness and financial results.

Product and service technology in our industry evolves rapidly, making timely product innovation essential to success in the marketplace.  Introducing products and services with improved technologies or features may render our existing products obsolete and unmarketable.  Technological advances and trends that may negatively impact our business include: 

·         new device package types, densities and technologies requiring hardware and software changes in order to be programmed by our products, particularly certain segments of the high density NAND and e-MMC markets where after placement programming is recommended by the semiconductor manufacturers

·         Reduction in semiconductor process geometries for Multi Level Cell (MLC) and Triple Level Cell (TLC) NAND and eMMC FLASH memories impact the product data retention through SMT reflow.  Improper SMT process control can negatively impact the end customer’s ability to successfully program devices prior to placement in manufacturing.  This can cause them to change their programing methods away from pre-programming to post placement programming techniques, including ISP.  Data I/O is working with semiconductor manufacturers to develop best practices to minimize the impact of reflow induced data loss.

·          electronics equipment manufacturing practices, such as widespread use of in-circuit programming

·          customer software platform preferences different from those on which our products operate

·          more rigid industry standards, which would decrease the value-added element of our products and support services

If we cannot develop products or services in a timely manner in response to industry changes, or if our products or services do not perform well, our business and financial condition may be adversely affected.  Also, our new products or services 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.

We have incurred operating losses in three of the last five years and five of the last ten years.  We operate in a cyclical industry.  We will continue to examine our level of operating expense based upon our projected revenues.  Any planned increases in operating expenses may result in losses in future periods if projected revenues are not achieved.  As a result, we may need to generate greater revenues than we have recently in order to achieve and maintain profitability.  However, we cannot provide assurance that our revenues will increase and our business strategies may not be successful, resulting in future losses.

We may need to raise additional capital and our future access to capital is uncertain.

Our past revenues have sometimes been, and our future revenues may again 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, lease 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 that we have sufficient cash or working capital available under our operating plan to fund our operations and capital requirements through at least the next one-year period.  We may require additional cash for U.S. operations, causing potential repatriation of cash from the $8.3 million held in our foreign subsidiaries.  Although we have no current repatriation plans, there may be tax and other impediments to any repatriation actions.  Our working capital may be used to fund possible losses, business growth, project initiatives, share repurchases and business development initiatives including acquisitions, which could reduce our liquidity and result in a requirement for additional cash before that time.  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.

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 given the current economic climate and our financial results, 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.  As technology changes occur that limit the effectiveness of pre-placement programming, particularly for very small high density NAND and e-MMC devices, certain semiconductor manufacturers are not recommending or may not continue recommending our programming systems for these devices.  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, and our suppliers may experience financial difficulties which could impact their ability to service our needs.

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, if we experience deterioration in our relationship with these suppliers, or if these suppliers require financing, which is not available, there may be delays or reductions in product introductions or shipments, which may materially adversely affect our operating results.

Certain of our sockets, parts and boards are currently manufactured to our specifications by third-party foreign contract manufacturers and we are sourcing certain parts or options from foreign manufacturers.  We may not be able to obtain a sufficient quantity of these products if and when needed or the quality of these parts or options may not meet our standards, which may result in lost sales.

If we are unable to attract and retain qualified third-party distributors and representatives, our business may be adversely affected.

We have an internal sales force and also utilize third-party distributors and representatives.  Therefore, the financial stability of these distributors and representatives is important.  Their ability to operate, timely pay us, and to acquire any necessary financing may be affected by the current economic climate.  Highly skilled professional engineers use most of our products.  To be effective, third-party distributors and representatives 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 and representatives.  Our business will suffer if we cannot attract and retain a sufficient number of qualified third-party distributors and representatives to market our products.

Our international operations may expose us to additional risks that may adversely affect our business.

International sales represented approximately 88%, 83% and 90% of our net revenue for the fiscal years ended December 31, 2013, 2012 and 2011, respectively.  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:

·          economic uncertainty related to the European sovereign debt situation

·          migration of manufacturing to low cost geographies

·          unexpected changes in regulatory requirements

·          tariffs and taxes

·          difficulties in establishing, staffing and managing foreign operations

·          longer average payment cycles and difficulty in collecting accounts receivable

·          fluctuations in foreign currency exchange rates

·          compliance with applicable export licensing requirements

·          product safety and other certification requirements

·          difficulties in integrating foreign and outsourced operations

·          civil unrest, political and economic instability

Because we have customers located throughout the world, we have significant foreign receivables.  We may experience difficulties in collecting these amounts as a result of payment practices of certain foreign customers, economic uncertainty and regulations in foreign countries, the availability and reliability of foreign credit information, and potential difficulties in enforcing collection terms. 

The European Union and European Free Trade Association (“EU”) has established certain electronic emission and product safety requirements (“CE”).  As applicable, our products currently meet these requirements; however, 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”) and we believe we are classified within the EU RoHS Directive category list as Industrial Monitoring and Control Equipment (category 9), which is out of scope until the enforcement date of July 2017.  Failure to meet applicable directives or qualifying exemptions may prevent us from marketing certain products in Europe or other territories with similar requirements. 

We have subsidiaries in Germany, China, Hong Kong, Brazil and Canada.  Our business and financial condition is sensitive to currency exchange rates and any restrictions imposed on their currencies including restrictions on repatriations of cash.  Any repatriation of cash could result in tax costs and corresponding deferred tax assets with related tax valuation allowances.  Currency exchange fluctuations in these countries 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.

We rely 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 our user interface, product firmware, software module options 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 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.

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:

·          burdening management and our operating teams during the integration of the acquisition

·          diverting management’s attention from other business concerns

·          failing to successfully integrate or monetize the acquired products or technologies

·          lack of acceptance of the acquired products by our sales channels or customers

·          entering markets where we have no or limited prior experience

·          potential loss of key employees of the acquired company

·          additional burden of support for an acquired programmer architecture

Future acquisitions may also impact our 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 and China.  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, though no assurance can be made that this will be the case in the future.  In China, our workers are “leased” with the arrangements made under the “FSCO” labor agreement and we could be adversely affected if we were unable to continue that arrangement.

As a public company, we are subject to numerous governmental and stock exchange requirements, with which we believe we are in compliance.  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.

The Sarbanes-Oxley Act of 2002 and the Securities and Exchange Commission (SEC) have requirements that we may fail to meet or we may fall out of compliance with, such as the internal controls auditor attestation required under Section 404 of the Sarbanes-Oxley Act of 2002, with which we are not currently required to comply as we are a smaller reporting company.  We assume that we will continue to have the status of a smaller reporting company based on the aggregate market value of the voting and non-voting shares held as of June 30, 2013.  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. 

While we have policies and procedures in place designed to prevent corruption and bribery, because our business is significantly international, violations of the Foreign Corrupt Practices Act (FCPA) could have a significant adverse effect on our business due to the disruption and distraction of an investigation, financial penalties and criminal penalties.

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 or services by us or our competitors and quarterly variations in financial results may cause the market price of our 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 our Common Stock. 

Cyber security breaches or terrorism could result in liabilities or costs as well as damage to or loss of our data or customer access to our website and information systems.  The collection, storage, transmission, use and disclosure of user data and personal information, if accessed improperly, could give rise to liabilities or additional costs as a result of laws, governmental regulations and evolving views of personal privacy rights.  

Cyber security breaches or terrorism could result in the exposure or theft of private or confidential information as well as interrupt our business, including denying customer access to our website and information systems.  We transmit, and in some cases store, end-user data, including personal information.  In jurisdictions around the world, personal information is becoming increasingly subject to legislation and regulations intended to protect consumers’ privacy and security.  The interpretation of privacy and data protection laws and regulations regarding the collection, storage, transmission, use and disclosure of such information in some jurisdictions is unclear and evolving.  These laws may be interpreted and applied in conflicting ways from country to country and in a manner that is not consistent with our current data protection practices.  Complying with these varying international requirements could cause us to incur additional costs and change our business practices.  Because our services are accessible in many foreign jurisdictions, some of these jurisdictions may claim that we are required to comply with their laws, even where we have no local entity, employees or infrastructure.  We could be forced to incur significant expenses if we were required to modify our products, our services or our existing security and privacy procedures in order to comply with new or expanded regulations.

In addition to the Redmond facility, approximately 11,000 square feet is leased at two foreign locations, including our German sales, service and engineering operations located in Munich, Germany, under a five-year lease starting in 2010, and a sales, service, operations and engineering office located in Shanghai, China under a one-year lease starting in 2013.

On October 20, 2011, we announced a stock repurchase program to buy back up to $1 million dollars of stock over four quarters.  Through December 31, 2011, we repurchased 62,916 shares of stock at an average price of $3.97 for a total repurchase amount of $249,986 plus $2,517 in commissions.  On January 9, 2012, our board of directors approved a new and expanded 2012 share repurchase program with provisions to buy back up to $6 million dollars of stock.  The program included establishing a Rule 10b5-1 plan under the Exchange Act to provide flexibility to make purchases at any time.  The 10b5-1 trading plan allows us to repurchase our common stock in the open market during periods in which stock trading is otherwise closed for us.  On January 13, 2012, the October 2011 stock repurchase program was terminated and the new expanded program went into effect.  On March 26, 2012 this program was terminated and no further stock repurchase programs went into effect during the remainder of 2012 or 2013.

DATA I/O CORPORATION

The majority of our 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 receivable outstanding longer than the contractual payment terms are considered past due.  We determine the allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the industry and geographic payment practices involved, our previous bad debt experience, the customer’s current ability to pay their obligation to us, and the condition of the general economy and the industry as a whole.  We write off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.  Interest may be accrued, at the discretion of management and 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 estimate changes to inventory for obsolete, slow-moving, excess and non-salable inventory by reviewing current transactions and forecasted product demand.  We evaluate our inventories on an item by item basis and record an adjustment (lower of cost or market) accordingly.

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.

We regularly review all of our long-lived assets, including property, plant and equipment and amortizable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.  If the total of future undiscounted cash flows is less than the carrying amount of these assets, an impairment loss, if any, based on the excess of the carrying amount over the fair value of the assets, is recorded.  Based on this evaluation, other than the intangible asset software technology impairment noted in Intangible Assets below, no other impairment was noted for long-lived assets for the years ended December 31, 2013 and 2012. 

Intangible Assets

Intangible assets include capitalized costs, technical and product rights, patent, trademarks and other intellectual property.  Intangible assets are stated at cost and amortized to operations over their estimated useful lives or statutory lives, whichever is shorter.  Capitalized intangible assets are included in other long term assets on the balance sheet.  We evaluate our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable using a fair value approach.  Based on this evaluation, impairment charges of $31,000 and $2.3 million were taken against the software technology acquired in April of 2011 (the Azido technology) for the years ending December 31, 2013 and 2012, respectively.  As of December 31, 2013, the Azido technology net carrying value is $0.

Patent Costs

We expense external costs, such as filing fees and associated attorney fees, incurred to obtain initial patents, but capitalize as intangible assets acquired patents. We also expense costs associated with maintaining and defending patents subsequent to their issuance.

Income Taxes

Income taxes are computed at current enacted tax rates, less tax credits using the asset and liability method.  Deferred taxes are adjusted both for items that do not have tax consequences and for the cumulative effect of any changes in tax rates from those previously used to determine deferred tax assets or liabilities.  Tax provisions include amounts that are currently payable, changes in deferred tax assets and liabilities that arise because of temporary differences between the timing of when items of income and expense are recognized for financial reporting and income tax purposes, and any changes in the valuation allowance caused by a change in judgment about the realizability of the related deferred tax assets.  A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized. 

Share-Based Compensation

All stock-based compensation awards are measured based on estimated fair values on the date of grant and recognized as compensation expense on the straight-line single-option method.  Our share-based compensation is reduced for estimated forfeitures at the time of grant and revised as necessary in subsequent periods if actual forfeitures differ from those estimates. 

Revenue Recognition

We recognize revenue at the time the product is shipped.  We have determined that our programming equipment has reached a point of maturity and stability such that product acceptance can be assured by testing at the factory prior to shipment and that the installation meets the criteria to be considered a separate element.  These systems are standard products with published product specifications and are configurable with standard options.  The evidence that these systems could be deemed as accepted was based upon having standardized factory production of the units, results from batteries of tests of product performance to our published specifications, quality inspections and installation standardization, as well as past product operation validation with the customer and the history provided by our installed base of products upon which the current versions were based.

The revenue related to products requiring installation that is perfunctory is 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.  This takes into account the complexity, skill and training needed as well as customer expectations regarding installation.

We enter into multiple deliverables arrangements that arise during the sale of a system that includes an installation component, a service and support component and a software maintenance component.  We allocate the value of each element based on relative selling prices.  Relative selling price is based on the selling price of the standalone system.  For the installation and service and support components, we use what we charge to distributors who perform these components.  For software maintenance components, we use what we charge for annual software maintenance renewals after the initial year the system is sold.  Revenue is recognized on the system sale based on shipping terms, installation revenue is recognized after the installation is performed, and hardware service and support and software maintenance revenue is recognized ratably over the term of the agreement, typically one year.

When we sell software separately, we recognize software revenue upon shipment provided that only inconsequential obligations remain on our part, and substantive acceptance conditions, if any, have been met.

We recognize revenue when persuasive evidence of an arrangement exists, shipment has occurred, the price is fixed or determinable, the buyer has paid or is obligated to pay, collectability is reasonably assured, substantive acceptance conditions, if any, have been met, the obligation is not contingent on resale of the product, the buyer’s obligation would not be changed in the event of theft, physical destruction or damage to the product, the buyer acquiring the product for resale has economic substance apart from us and we do not have significant obligations for future performance to directly bring about the resale of the product by the buyer.  We establish a reserve for sales returns based on historical trends in product returns and estimates for new items.

Sales were recorded net of actual sales returns and changes to the associated sales return reserve.  Sales return reserves were $50,000 and $60,000 at December 31, 2013 and 2012, respectively. 

We transfer certain products out of service from their internal use and make them available for sale.  The products transferred are our standard products in one of the following areas: service loaners, rental or test units; engineering test units; or sales demonstration equipment.  Once transferred, the equipment is sold by our regular sales channels as used equipment inventory.  These product units often involve refurbishing and an equipment warranty, and are conducted as sales in our normal and ordinary course of business.  The transfer amount is the product unit’s net book value and the sale transaction is accounted for as revenue and cost of goods sold.

Research and Development

Research and development costs are expensed as incurred.

Advertising Expense

Advertising costs are expensed as incurred.  Total advertising expenses were approximately $152,000 and $107,000 in 2013 and 2012, respectively.

Warranty Expense

We record a liability for an estimate of costs that we expect 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 normally provide a warranty for our products against defects for periods ranging from ninety days to one year.  We provide for the estimated cost that may be incurred under our product warranties and periodically assess the adequacy of our warranty liability based on changes in the above factors.  We record 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.  The common stock equivalent shares from equity awards used in calculating diluted earnings per share were 0 for the years ended December 31, 2013 and 2012, respectively.  Options to purchase 904,656 and 1,158,405 shares of common stock were outstanding as of December 31, 2013 and 2012, respectively, but were excluded from the computation of diluted EPS for the period then ended because the options were anti-dilutive. 

Diversification of Credit Risk

Financial instruments, which potentially subject us to concentrations of credit risk, consist primarily of trade receivables.  Our trade receivables are geographically dispersed and include customers in many different industries.  As of December 31, 2013, one customer, Avnet, accounted for more than 12% of our consolidated accounts receivable balance.  As of December 31, 2012, three customers, Data Copy Limited, Delphi and Jabil accounted for 16%, 11% and 10% of our consolidated accounts receivable balance, respectively.  Our consolidated accounts receivable balance as of December 31, 2013 and 2012 includes foreign accounts receivable in the functional currency of our foreign subsidiaries amounting to $886,000 and $950,000, respectively.  We generally do business with our foreign distributors in U.S. dollars.  We believe that 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, or prepayment whenever deemed necessary.

New Accounting Pronouncements

In July 2013, the FASB issued ASU 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists,” (“ASU 2013-11”), an amendment to ASC 740, “Income Taxes.”  ASU 2013-11 clarifies that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax benefit is disallowed.  In situations where a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction or the tax law of the jurisdiction does not require, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be netted with the deferred tax asset.  The amendments in ASU 2013-11 are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013.  Early adoption is permitted.  The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted.  We are currently evaluating the impact that the adoption will have on the determination or reporting of our financial results.

In March 2013, the FASB issued ASU 2013-05, “Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity,” (“ASU 2013-05”).  The objective of ASU 2013-05 is to clarify the applicable guidance for the release into net income of the cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity.  ASU 2013-05 is effective for annual and interim reporting periods beginning after December 15, 2013 with early adoption permitted.  We are currently evaluating the impact that the adoption will have on the determination or reporting of our financial results.

In February 2013, the FASB issued ASU No. 2013-02, “ Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. ”  Under ASU 2013-02, an entity is required to provide information about the amounts reclassified out of Accumulated Other Comprehensive Income (“AOCI”) by component.  In addition, an entity is required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of AOCI by the respective line items of net income, but only if the amount reclassified is required to be reclassified in its entirety in the same reporting period.  For amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures that provide additional details about those amounts.  ASU 2013-02 does not change the current requirements for reporting net income or other comprehensive income in the financial statements.  ASU 2013-02 is effective for us on January 1, 2013.  The adoption of this update did not have a material impact on our financial statements.

NOTE 2-PROVISION FOR BUSINESS RESTRUCTURING

As a result of the business downturn we experienced in the second half of 2011 and in 2012, as well as the uncertain business outlook at the time, we took restructuring actions in September 2012 to reduce quarterly operating expenses and production costs.  These actions included reductions in personnel and the use of contractors, professionals, and consultants, as well as focusing our development efforts on a smaller number of projects. The net restructuring charge in 2012 associated with these actions was $207,000 and was primarily related to severance.  The remaining 2012 restructuring actions were completely paid out during the first quarter of 2013. 

During the second quarter of 2013, we took additional restructuring actions to reduce our excess office space and eliminate certain job positions.  These actions resulted in restructuring costs of $642,000 for the second quarter.  The positions eliminated will allow us to have the flexibility to add other critical positions or change fixed to variable costs through outsourcing.

During the fourth quarter of 2013, we took additional restructuring actions focused primarily on reducing layers of management and moving management closer to sales channels and customers.  The restructure actions will eliminate certain job positions and in some cases allow the company to have the flexibility to add other critical positions.  These actions resulted in restructuring costs of $541,000 for the fourth quarter. 

The portion of the restructure reserve expected to be paid during 2014 is $723,000.  The long term portion is $150,000 and relates to the lease abandonment payments that are expected to be completely paid by July 2016. 

An analysis of the restructuring is as follows:

Total depreciation expense recorded for 2013 and 2012 was $612,000 and $821,000, respectively.

NOTE 6 – INTANGIBLE SOFTWARE TECHNOLOGY, NET

On April 29, 2011, we purchased software technology (the Azido technology) for $2 million in cash and issuance of 163,934 shares of our common stock, valued at $1 million on the date of purchase.  Acquisition costs of $89,000 were capitalized as part of the transaction.  The transaction was accounted for as an asset purchase.

In 2012 and again in 2013, year-end impairment evaluations were performed.  We evaluated changes in Azido projects and projected cash flows which decreased or eliminated our expected future cash flows related to Azido technology’s use or disposition.  Based on these evaluations, impairment charges of $31,000 and $2.3 million were taken against this software technology for the years ending December 31, 2013 and 2012, respectively.  As of December 31, 2013, the Azido technology net carrying value is $0.

The following is a summary of the Company’s intangible software technology: