Overview

We are an independent provider of EMS for OEMs. Our core strengths include innovative design and engineering expertise in SMT, electronics, mechanical engineering, precision molding, design and build of molding tools, combined with high-quality, low-cost production and assembly on a global basis. Our global production capability provides customers with benefits of improved supply-chain management, reduced inventories, lower transportation costs, and reduced product fulfillment time. We continue to make investments in our Mexico and China facilities to give us the production capacity and logistical advantages to continue to win new business. The following information should be read in conjunction with the consolidated financial statements included herein and with Item 1A, Risk Factors.

The EMS industry has historically experienced growth as more OEMs shift to outsourced manufacturing. However, our revenue, like that of other EMS providers, can fluctuate significantly due to our reliance on a concentrated base of customers. New customer programs combined with continued product demand from our largest existing customers resulted in an increase in revenues during fiscal years 2008 and 2007.

Overall, our sales of $204.1 million in fiscal year 2008 increased by 1.2% over sales of $201.7 million in fiscal 2007. This growth was driven by increased demand from new customer programs which are continuing to ramp up. During the year, eight new customers contributed approximately 13% of total revenue, and in fiscal 2009 we expect to have revenue from 10 additional new customers. We expect these 18 new customers to contribute approximately 40% of our revenue in fiscal 2009, offsetting the anticipated decline in demand from some of our existing customers. Sales for the first quarter of fiscal 2009 are expected to be within the range of $45 million to $48 million, as we are expecting lower demand from a number of established customers while these new programs ramp up. Results will depend on actual levels of customers' orders and the timing of the start up of production of new product programs. We believe that we are well positioned in the EMS industry to continue expansion of our customer base and continue long-term growth.

The concentration of our largest customers decreased during fiscal 2008 with the top five customers' sales decreasing slightly to 68% of total sales in 2008 from 73% in 2007 and 71% in 2006. Our current customer relationships involve a variety of products, including consumer electronics, electronic storage devices, plastics, household products, gaming devices, specialty printers, exercise equipment, telecommunications, industrial equipment, fuel cell technology and computer accessories. The total number of our customers continued to increase during fiscal 2008. Some of these new customers have programs that represent small annual sales while others have multi-million-dollar potential.

Gross profit as a percent of sales was 8.2% in fiscal 2008 compared to 8.8% for the prior fiscal year. The decrease in gross profit percentage is related mainly to start-up costs incurred throughout the year in association with new customer programs, inefficiencies of overtime and expedite costs associated with accelerated customer demand, increased freight costs, and increasing costs of raw materials.

Net income for fiscal 2008 was $5.6 million or $0.54 per diluted share, up from $5.2 million net income or $0.51 per diluted share for fiscal 2007. The results of both years were affected by unusual events. We realized a gain on the sale of real estate of $951,000 in fiscal 2008 and $1.5 million in fiscal 2007. The gain in 2007 was offset by $460,000 in costs incurred during the year in connection with a potential acquisition that the Company chose not to pursue and the write off of $404,000 of inventory and tooling and an associated write-off of $536,000 in bad debt of a customer that filed bankruptcy.

We maintain a strong balance sheet with a current ratio of 2.27 and a long-term debt to equity ratio of 0.25. Total cash used in operations was $718,000 during fiscal year 2008. We maintain sufficient liquidity for our expected future operations and had approximately $12.7 million available from our revolving line of credit based on eligible collateral at June 28, 2008. We believe that internally generated funds, our revolving line of credit, and leases on equipment should provide adequate capital for planned growth over the long term.

The EMS industry is intensely competitive. We estimate that we have less than 1% of the potential market. We believe that we can acquire new business in the future, particularly those programs that require flexibility in forecasting, innovative design and engineering, short lead times, or small initial volumes. Our competitiveness is enhanced by our capacity to provide SMT, plastic injection molding, and final assembly. We are planning for long term growth by utilizing current capacity, improving manufacturing processes, and investing in additional manufacturing equipment. Current challenges facing us include:
continuing to win new programs, improving operating efficiencies, controlling costs and developing new competitive price strategies.

Results of Operations

The following table sets forth for the periods indicated certain items of the consolidated statements of income expressed as a percentage of net sales. The financial information and discussion below should be read in conjunction with the consolidated financial statements and notes contained in this Annual Report.

                                                                    Years Ended
                                               June 28, 2008       June 30, 2007       July 1, 2006
Net sales                                              100.0 %             100.0 %            100.0 %
Cost of sales                                           91.8                91.2               90.8

Gross profit                                             8.2                 8.8                9.2

Operating expenses (income)
Research, development and engineering                    1.3                 1.6                1.5
Selling                                                  0.8                 0.9                1.1
General and administrative                               3.2                 3.6                3.5
Gain on sale of real estate held for sale               (0.4 )              (0.7 )              0.0

Total operating expenses                                 4.9                 5.4                6.1


Operating income                                         3.3                 3.4                3.1

Interest expense                                         0.5                 0.7                0.6

Income before income taxes                               2.8                 2.7                2.5

Income tax provision (benefit)                           0.1                 0.1               (2.7 )

Net income                                               2.7 %               2.6 %              5.2 %

Net Sales

Net sales in fiscal 2008 were $204.1 million compared to $201.7 million and $187.7 million in fiscal years 2007 and 2006 respectively.

The increase in net sales during fiscal 2008 relates to an increase in sales revenue from new customer programs offset by a moderate decrease in the demand from some of our existing customers. New customer programs contributed approximately 13% of our total revenue in fiscal 2008. We anticipate that several more new customer programs will enter production in fiscal year 2009 and begin contributing to revenue.

The increase in net sales during fiscal 2007 compared to fiscal 2006 resulted from an increase in the demand for certain of our largest existing customers' products along with revenue from new customers' programs. Customer demand will fluctuate based on changes in the sell-through of customers' products.

The table below shows the revenue by industry sectors as a percentage of revenue for the following fiscal years:

                                                   Years Ended
                                June 28, 2008     June 30, 2007     July 1, 2006
      Commercial Printer                   16 %              19 %             18 %
      Communication                         9 %               9 %              8 %
      Computer and Peripheral               8 %               3 %              4 %
      Consumer                              9 %              14 %             16 %
      Gaming                               19 %              17 %             18 %
      Industrial                            3 %               2 %              2 %
      Transaction Printer                  36 %              36 %             34 %

      Total                               100 %             100 %            100 %

We provide services to customers in a number of industries and produce a variety of products for our customers in each industry. As we continue to diversify our customer base and win new customers we may see a change in the industry concentrations of our revenue.

Sales to foreign customers represented 5.6% of our total net sales in fiscal year 2008 and 9.0% in fiscal year 2007. The decrease in foreign customer sales was due to exiting production of a consumer product for a customer in Asia.

Cost of Sales

Total cost of sales as a percentage of net sales was 91.8%, 91.2%, and 90.8% in fiscal years 2008, 2007, and 2006, respectively.

Total cost of materials as a percentage of sales was approximately 66.9%, 65.4%, and 64.6% in fiscal years 2008, 2007, and 2006, respectively. The change from year-to-year is directly related to changes in product mix and increased costs of raw materials. Products sold in fiscal 2008 contained higher materials costs, thereby increasing costs of materials as a percentage of sales compared to fiscal 2007 and 2006.

Direct production costs (direct labor and manufacturing overhead) were 13.0% of total sales in fiscal 2008 compared to 13.7% of total sales in fiscal 2007 and 13.2% of total sales in 2006. The decrease in 2008 compared to 2007 and 2006 is related to product mix and utilization of excess manufacturing capacity (both equipment and indirect support costs). Additionally, included in production costs of fiscal 2007 were start-up costs associated with the installation and start up of an SMT line at our headquarters in Spokane Valley, Washington. The SMT production line in Spokane Valley was developed for complex or low volume production and for new product introduction.

We provide for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage. The amounts charged to expense for these inventories were $159,000, $544,000, and $361,000 in fiscal years 2008, 2007, and 2006, respectively. Approximately $240,000 of the provision in fiscal 2007 was related to a specific customer filing bankruptcy during the year. The majority of the remaining provision in each year related to stocked computer keyboards and other computer peripherals, and various inventory items that were deemed obsolete during the period.

We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. The amounts charged to expense are determined based on an estimate of warranty exposure. Warranty expense (recovery) was approximately $196,000, $31,000, and $(10,000) in fiscal years 2008, 2007, and 2006, respectively. Warranty expense for fiscal years 2008 and 2007 is related to workmanship claims on keyboards and certain EMS products. The recovery in 2006 related to lower than expected warranty expense related to a previously identified workmanship issue with a particular EMS product and a decrease in the estimated future keyboard warranty costs.

Gross Profit

In fiscal year 2008, gross profit on sales was 8.2% of revenues compared to 8.8% in fiscal year 2007 and 9.2% in fiscal year 2006.

The decrease in gross profit is related mainly to start-up costs we incurred throughout the year in association with new customer programs, inefficiencies of overtime and expedite costs associated with accelerated customer demand, increased freight costs, and increasing costs of raw materials. The decrease in fiscal year 2007 relates to certain customer sales price decreases in the aggregate in excess of achieved cost savings, a write off of $240,000 in inventory and $164,000 tooling related to a customer that filed for bankruptcy, and the additional costs incurred with the installation and start up of a new SMT line in Spokane Valley. We took early pay discounts to suppliers that totaled $51,000, $211,000, and $431,000 in fiscal years 2008, 2007 and 2006, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.

Changes in gross profit margins reflect the impact of a number of factors that can vary from period to period, including product mix, start-up costs and efficiencies associated with new programs, product life cycles, sales volumes, capacity utilization of our resources, management of inventories, component pricing and shortages, end market demand for customers' products, fluctuations in and timing of customer orders, and competition within the EMS industry. These and other factors can cause variations in operating results. There can be no assurance that gross margins will not decrease in future periods.

Research, Development and Engineering

Research, development and engineering expenses (RD&E) consists principally of employee related costs, third party development costs, program materials, depreciation and allocated information technology and facilities costs. The decrease in RD&E in fiscal 2008 from fiscal 2007 is related to transferring engineers and support personnel from RD&E to manufacturing costs of sales as their job roles changed to support the new SMT line in Spokane Valley, Washington. As a percentage of net sales, RD&E increased slightly in fiscal 2007 to 1.6% of sales compared to 1.5% of sales in fiscal 2006. The increase is related to the hiring of new program managers to service new customer programs. In each of the fiscal years presented, we have focused most of our RD&E efforts on development of new and current customers' EMS programs.

Selling

Sales and marketing expenses consist principally of salaries and benefits for sales and marketing personnel, advertising and marketing programs, sales commissions, and travel expenses. Similar to RD&E expenses, selling expenses change as a percent of sales relative to the allocated fixed costs in each of the years presented. Approximately half of selling expense relates to salary costs of our employees.

Our total selling expenses were $ 1.7 million, $1.8 million, and $2.1 million in fiscal years 2008, 2007, and 2006, respectively. The decrease in selling expenses in fiscal 2008 compared to fiscal 2007 is mainly the result of a decrease in incentive and bonus expenses. The decrease in selling expenses in fiscal 2007 compared to fiscal 2006 was due to us decreasing our outside marketing service expense.

General and Administrative

General and administrative expenses "G&A" consist of employee related costs, travel expenses and allocated information technology and facilities costs for finance, legal, human resources and executive functions, outside legal and accounting fees, provision for doubtful accounts and business insurance costs. As a percent of sales G&A was 3.2%, 3.6%, and 3.5% in fiscal years 2008, 2007, and 2006, respectively.

Total G&A was $6.6 million, $7.4 million and $6.6 million in fiscal years 2008, 2007, and 2006, respectively. The increase in G&A in fiscal 2007 was the result of our having approximately $555,000 in bad debt expense in fiscal 2007, of which $536,000 was related to a customer filing bankruptcy during the year. G&A included a provision for bad debt of $122,000 in fiscal 2008 and $6,000 in fiscal 2006. In addition $460,000 and $120,000 of due diligence expenses, attorneys' fees, and bank fees were expensed in fiscal 2007 and 2006, respectively, as we decided not to proceed with a potential acquisition.

Gain on Real Estate Held for Sale

During the fourth quarter of fiscal 2007, we sold our under-utilized Las Cruces, New Mexico facility. The total sales price for the facility and adjacent vacant land was $4.3 million. Sales proceeds were in the form of $2.8 million in cash and an additional $1.5 million note from the buyer. The cash received was for the purchase of the building and approximately 9 acres of land while the note was to pay for the adjacent 14 acres of additional land. The note was payable within 45 days of the flood plain designation being removed from the adjacent vacant land. Due to the contingent nature of the note, we recognized a $1.5 million gain on real estate held for the sale of the building and 9 acres of land in fiscal 2007 and deferred the gain on sale of the adjacent land. During the second quarter of fiscal 2008, the flood plain designation was removed on the adjacent 14 acres of land resulting in a gain on sale of real estate of $951,000, with the cash proceeds being received in January 2008.

Interest Expense

We had net interest expenses of $1.0 million, $1.4 million, and $1.1 million in fiscal years 2008, 2007, and 2006, respectively. Interest expense decreased in fiscal 2008 when compared to fiscal 2007 and 2006 as the average balance of the revolving line of credit was lower along with a decrease in variable interest rates. The Company does not currently use derivatives to hedge interest rate risk. Starting in 2006, we began to utilize short-term fixed LIBOR rates on portions of its revolving line of credit for short-term interest savings in anticipation of rate increases. We successfully negotiated a variable rate decrease on interest charged by our lender on our revolving line of credit and term debt during fiscal year 2007.

Income Tax Provision

We had an income tax provision of $261,000 in fiscal 2008 compared to a provision of $206,000 in fiscal 2007 and a $(5.0) million benefit in fiscal 2006. The tax provision in fiscal 2008 is primarily related to income taxes paid in China and Mexico. The income tax expense of fiscal 2007 primarily related to income taxes in the United States, which was primarily caused by a one-time repatriation of earnings from our Mexico subsidiaries. We applied certain tax credits to offset tax liabilities of our Mexican subsidiaries during calendar years 2006 and 2007. We expect to pay income taxes in calendar year 2008 due to recently enacted tax laws in Mexico. The large income tax benefit in 2006 related to reducing the valuation allowance on our net deferred tax asset in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. We have domestic tax net operating loss carryforwards (NOLs) of approximately $42.9 million at June 28, 2008. In accordance with SFAS No. 109, we assessed our recent operating levels and the sources of future taxable income to estimate a deferred tax asset. A valuation allowance against deferred tax assets is required if it is more likely than not that some of the deferred tax assets will not be realized. We have determined that the $10.8 million valuation allowance is appropriate at this time.

International Subsidiaries

We offer customers a complete global manufacturing solution. Our facilities provide our customers the opportunity to have their products manufactured in the facility that best serves specific cost, product manufacturing, and distribution needs. The locations of active foreign subsidiaries are as follows:

• Key Tronic Juarez, SA de CV owns an SMT, assembly, and molding facility and two assembly and storage facilities in Juarez, Mexico. This subsidiary is primarily used to support our U.S. operations.

• Key Tronic Reynosa, SA de CV leases manufacturing and warehouse facilities in Reynosa, Mexico. This subsidiary is used exclusively to manufacture products for one EMS customer.

• Key Tronic Computer Peripherals (Shanghai) Co., Ltd. leases a facility with SMT and assembly capabilities in Shanghai, China, which began operations in 1999. Its primary function is to provide EMS services for export; however, it is also currently manufacturing certain electronic keyboards.

Foreign sales (based on location of customer) from our worldwide operations, including domestic exports, were $11.4 million in fiscal year 2008 compared to $18.5 million and $13.7 million in fiscal years 2007 and 2006, respectively. The decrease in fiscal year 2008 foreign sales is mainly related to a specific foreign customer program. Products and manufacturing services provided by our subsidiary operations are sold to customers directly by the parent company. Key Tronic Computer Peripherals (Shanghai) Co., Ltd., our subsidiary in Shanghai, China, had only minimal sales to customers in China during the past three fiscal years.

Capital Resources and Liquidity

Cash flows used by operating activities were $(718,000) in fiscal year 2008 compared to $(1.9) million used in operating activities in fiscal year 2007 and $(34,000) used in fiscal year 2006.

The decrease in cash used by operating activities in fiscal year 2008 from 2007 was primarily due to an increase in accounts payable. Accounts payable increased by $5.4 million during fiscal 2008, but it was more than offset by an increase of inventory of $5.6 million. The increase in accounts payable and inventory at the end of fiscal 2008 was related to our increasing inventory for new customers. In addition, trade receivables increased $5.6 million as the result of higher sales during our fourth quarter.

The increase in cash used by operating activities in fiscal year 2007 from 2006 was due primarily to a $7.1 million decrease in accounts payable offset in part by a decrease in inventory of $3.4 million. The decrease in accounts payable at the end of fiscal 2007 was related to decreasing inventory purchases and a change in vendors' terms as certain new customer programs had new supply channels that required earlier payments. Even though the Company had $9.8 million in net income in fiscal 2006, $5.0 million was in the form of a non-cash deferred income tax benefit.

Cash used in investing activities includes capital expenditures and proceeds from the sale of property and equipment. Capital expenditures were $1.2 million, $3.1 million, and $1.6 million in fiscal years 2008, 2007, and 2006, respectively. Our capital expenditures are primarily for purchases of manufacturing assets to support our operations in Spokane Valley, Washington, Mexico and China. The increase in capital expenditures in fiscal 2007 was the result of purchasing a facility in Juarez to replace a leased manufacturing location. We have also continued to use a variety of operating leases to fund the purchase of manufacturing equipment.

Our primary financing activity in fiscal years 2008, 2007, and 2006 was borrowing and repayment under our financing agreement with CIT Group/Business Credit, Inc. (CIT). Our financing agreement with CIT provides a revolving credit facility of up to $25 million. The revolving loan is secured by our assets. The interest rate provisions allow for a variable rate based on either the prime rate or LIBOR rate. The agreement specifies four alternative levels of margin to be added to these base rates depending on compliance with certain financial covenants. The range of interest being paid to CIT on outstanding balances was 4.38% - 6.71% as of June 28, 2008. The financing agreement contained financial covenants that relate to total equity, earnings before interest, taxes, depreciation and amortization, and a minimum fixed charge ratio. All but one of the financial covenants, the fixed charge ratio, have been removed by subsequent amendments to the financing agreement. The revolving loan matures August 22, 2009, but we will likely renew the revolving loan prior to that date with CIT or another lender. As of June 28, 2008, we were in compliance with our remaining loan covenant. At June 28, 2008, the outstanding revolving loan balance was $12.3 million compared to $13.1 million at fiscal year end June 30, 2007. The loan balance decreased as we generated positive cash flow from operations. Based on eligible collateral, approximately $12.7 million was available for drawdown from the revolving line of credit as of June 28, 2008.

Contractual Obligations and Commitments

In the normal course of business, we enter into contracts which obligate us to make payments in the future.

The table below sets forth our significant future obligations by fiscal year:

Payments Due by Fiscal Year (in thousands)

                                      Total      2009       2010      2011      2012      2013
  CIT revolving loan (1)             $ 12,348   $    -    $ 12,348   $    -    $    -    $    -
  Capital and operating leases (2)      7,796     3,212      2,804     1,748        27         5
  Purchase orders (3)

(1) The terms of the CIT revolving loan are discussed in the consolidated financial statements at Note 4, "Long-Term Obligations". Our current financing agreement with CIT terminates on August 22, 2009, at which time the unpaid balance of the revolving loan will become immediately payable. However, we will likely extend or replace our revolving loan agreement prior to that date. The amount payable on our revolving loan changes daily depending upon the amount of cash borrowed to support our operations and the amount of customer payments received. The amount presented does not include any interest payable. Under the terms of our agreement with CIT, customers' payments are applied against the outstanding revolving loan balance as soon as the amounts clear through the banking system.

Under the terms of the revolving credit agreement, we must meet a fixed coverage ratio financial covenant. As of June 28, 2008 we were in compliance with our loan covenant. Breaching this covenant could have a material impact on our operations or financial condition.

(2) We maintain vertically integrated manufacturing operations in Mexico and Shanghai, China. Such operations are heavily dependent upon technically superior manufacturing equipment including molding machines in various tonnages, SMT lines, clean rooms, and automated insertion and test equipment for the various products we are capable of producing.

In addition, we lease some of our administrative and manufacturing facilities. A complete discussion of properties can be found in Part 1, Item 2 at "Properties". Leases have proven to be an acceptable method for us to acquire new or replacement equipment and to maintain facilities with a minimum impact on our short term cash flows for operations. Amounts presented above include interest and principal, if applicable.

(3) As of June 28, 2008, we had open purchase order commitments for materials and other supplies of approximately $28.3 million. Included in the open purchase . . .