FORWARD-LOOKING STATEMENTS

References in this report to "the Company", "Key Tronic", "we", "our", or "us" mean Key Tronic Corporation together with its subsidiaries, except where the context otherwise requires.

This Quarterly Report contains forward-looking statements in addition to historical information. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Risks and uncertainties that might cause such differences include, but are not limited to those outlined in "Management's Discussion and Analysis of Financial Condition and Results of Operations-Risks and Uncertainties that May Affect Future Results." Readers are cautioned not to place undue reliance on forward-looking statements, which reflect management's opinions only as of the date hereof. The Company undertakes no obligation to update forward-looking statements to reflect developments or information obtained after the date hereof and disclaims any obligation to do so. Readers should carefully review the risk factors described in periodic reports the Company files from time to time with the Securities and Exchange Commission, including Year-end Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

OVERVIEW

Key Tronic Corporation (dba: KeyTronicEMS Co.), was organized in 1969 as a Washington corporation that manufactured computer keyboards in the Spokane, Washington area. Our goal was to become the world's largest manufacturer of input devices for terminals, word processors and personal computers. The ability to design, build and deliver a quality product led to a reputation in the industry, that allowed us to become a leading independent manufacturer of keyboards for computers in the United States. Our fully integrated design, tooling and automated manufacturing capabilities enabled us to rapidly respond to customers' needs for keyboards in production quantities worldwide. We supported our sales growth through the development and purchase of international manufacturing facilities. As the computer keyboard market matured with increasing competition from other international providers, we determined that our business could no longer solely rely on keyboard sales.

After assessing market conditions and our strengths and capabilities in 1999, we shifted focus from keyboard manufacturing to contract manufacturing of a wide range of products. Our new strategy was based on our original core strengths of innovative design and engineering expertise in electronics, mechanical engineering and precision plastics combined with high-quality, low cost production and assembly on a global basis. These strengths have made our company a strong competitor in the electronic manufacturing services (EMS) market. As we fully transitioned into an EMS provider, our new customer base became comprised of world-class customers in a wide range of industries.

The EMS industry has experienced growth over the past several years as more original equipment manufacturers (OEMs) seek to outsource manufacturing and this trend is expected to continue in the future. This expansion of the EMS industry has allowed us to continue to expand our customer base and the industries that we serve. We currently offer our customers the following services: integrated electronic and mechanical engineering; precision plastic molding; assembly, component selection, sourcing and procurement; worldwide logistics; and new product testing and production all at competitive pricing due to our global footprint.

We believe that we are well positioned in the EMS industry to continue the expansion of our customer base and achieve long term growth. Our core strengths continue to support our growth and our customers' needs. We operate manufacturing facilities in the United States, Mexico and China. This global production capability provides our customers with the benefits of improved supply-chain management, reduced inventory, lower labor costs, lower transportation costs and reduced product fulfillment time.

The EMS industry is growing and is intensely competitive. We have less than 1% of the potential global market and our revenue can fluctuate significantly due to reliance on a concentrated base of customers. We are planning for growth in the coming quarters by securing new programs, increasing our worldwide manufacturing capacity and continuing to improve our manufacturing processes. Current challenges facing us include the following: continuing to win new programs from new and existing customers, balancing production capacity and key personnel in each of our manufacturing locations, improving operating efficiencies, controlling costs while developing competitive pricing strategies, and successfully transitioning new program wins to full production.

Net income for the first quarter of fiscal year 2009 was $408,000 compared to $183,000 for the first quarter of fiscal year 2008. The increase was related to higher sales as the result of new customer programs and a higher gross margin during the quarter ended September 27, 2008 of 7.1% compared to 6.9% during the quarter ended September 29, 2007.

Sales for the first quarter of fiscal year 2009 increased 8.3% to $48.2 million compared to $44.6 million for the same period of fiscal year 2008. This increase in sales reflects an overall increase from certain existing customer programs that continue to grow and the continued ramp up of our new customer programs. New customer sales contributed approximately $11.3 million for the quarter ended September 27, 2008, compared to $2.9 million for the quarter ended September 29, 2007. The sales to our existing customer base and these new customers have offset the anticipated decline in demand from some of our existing customers. Sales in the second quarter of fiscal year 2009 are expected to be in the range of $42 million to $45 million. We are expecting lower demand as the global economic situation is creating uncertainty and slowdowns in orders and reductions in forecasts from a number of established customers. While our new programs continue to move into production and ramp up, some customers have reduced their forecasts for coming periods. Sales to our new programs are now expected to grow at a slower rate than previously anticipated; however, our flexible business model allows us to take immediate steps to reduce direct labor costs in our manufacturing facilities. 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.

Gross profit as a percentage of sales for the first quarter of fiscal year 2009 was 7.1% compared to 6.9% for the first quarter of fiscal year 2008. The increase was the result of higher sales to customers, which drove higher utilization of our manufacturing facilities. A large part of our overhead and indirect costs do not fluctuate significantly with short-term fluctuations in sales. The level of gross margin is impacted by facility utilization, product mix, timing of the start up of new programs, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.

We maintain a strong balance sheet with a current ratio of 1.76 and a long-term debt to equity of 0.02. Our revolving loan with CIT matures August 22, 2009 and therefore, has been classified as a current liability reducing the current ratio and long-term debt to equity ratio when compared to previous quarters. However, we anticipate that we will renew it or enter into a new revolving loan agreement by its maturity. Total cash provided by operations was $776,000 for the quarter ended September 27, 2008. We maintain sufficient liquidity for our expected future operations and had approximately $8.4 million available from our revolving line of credit based on eligible collateral at September 27, 2008. We believe that internally generated funds, our borrowing capacity, and leases on equipment should provide adequate capital for planned growth over the long term.

CRITICAL ACCOUNTING POLICIES

Revenue Recognition: We recognize revenue when products are shipped and the sales revenue becomes realizable. Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 104, Revenue Recognition, states that revenue generally is realized or realizable and earned when all of the following criteria are met:

• Persuasive evidence of an arrangement exists.

• Delivery has occurred or services have been rendered.

• The seller's price to the buyer is fixed or determinable.

• Collectibility is reasonably assured.

We believe that we meet the above criteria for the following reasons:

• Customer purchase orders confirming the price, shipping terms, and payment terms are required prior to shipment.The terms of our sales are generally FOB shipping point, meaning that the customer takes ownership of the goods and assumes the risk of loss when the goods leave our premises.

• The seller's price to the buyer is fixed or determinable - as noted, we require a customer purchase order, which confirms the price, shipping and payment terms.

• Collectibility is reasonably assured - the credit terms for customers are pre-established based on a review of the customers perceived ability to pay so that collection of the account can be reasonably assured.

Inactive, Obsolete and Surplus Inventory Reserve: We reserve for inventories that we deem inactive, obsolete or surplus. This reserve is calculated based upon the demand for the products that we produce. Demand is determined by expected sales or customer forecasts. If expected sales do not materialize, then we would have inventory in excess of our reserves and would have to charge the excess against future earnings. In the case where we have purchased material based upon a customer's forecast, we are usually covered by lead-time assurance agreements with each customer. These contracts state that the financial liability for material purchased within agreed upon lead-time and based upon the customer's forecasts, lies with the customer. If we purchase material outside the lead-time assurance agreement and the customer's forecasts do not materialize or if we have no lead-time assurance agreement for a specific program, we would have the financial liability and may have to charge inactive, obsolete or suplus inventory against earnings.

Allowance for Doubtful Accounts: We value our accounts receivable net of an allowance for doubtful accounts. This allowance is based on estimates of the portion of accounts receivable that may not be collected in the future and is disclosed in our consolidated balance sheets. The estimates used are based primarily on specific identification of potentially uncollectible accounts. Such accounts are identified using publicly available information in conjunction with evaluations of current payment activity. However, if any of our customers were to develop unexpected and immediate financial problems that would prevent payment of open invoices, we could incur additional and possibly material expenses that would negatively impact earnings.

Accrued Warranty: An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. We review the adequacy of this accrual quarterly based on historical analysis and anticipated product returns and rework costs. As we have made the transition from manufacturing primarily keyboards to primarily EMS products, our exposure to warranty claims has declined significantly. Our warranty period for keyboards is generally longer than that for EMS products. We only warrant materials and workmanship on EMS products, and we do not warrant design defects for EMS customers.

Income Taxes

We had domestic tax loss carryforwards of approximately $42.9 million and other future deductible temporary differences and tax credit carryforwards at June 28, 2008. In accordance with SFAS No. 109, we assess the sources of future taxable income, based on management's estimates, which may be available to recognize the deductible differences that comprise deferred tax assets. A valuation allowance against deferred tax assets is required if it is more likely than not that some or all of the deferred tax assets will not be realized. We have determined that a valuation allowance of $11.1 million on the total deferred tax asset is appropriate at this time. Our judgments regarding future use of deferred tax assets may change due to changes in market conditions, changes in tax laws or other factors. If our assumptions and estimates change in the future, the valuation allowance will be adjusted accordingly and any increase or decrease will result in an additional income tax expense or benefit.

Goodwill

In accordance with SFAS No. 142, Goodwill and Other Intangibles, we recorded intangible assets that are acquired individually or with a group of other assets in the financial statements at acquisition. We test goodwill for impairment annually as required by SFAS No. 142. We adopted SFAS No. 142 on June 30, 2002, and completed our impairment test during the second quarters of each of the subsequent fiscal years. The tests did not indicate an impairment of our stated goodwill of $765,000.

Derivatives

We have adopted SFAS No. 133, Accounting for Derivative Instruments and Certain Hedging Activities, as amended. In accordance with these standards all material derivative instruments are recorded on the balance sheet at their respective fair values. Generally, if a derivative instrument is specifically designated as a cash flow hedge, the change in the fair value of the derivative is recorded in other comprehensive income to the extent the derivative is effective, and recognized in the statement of operations when the hedged item affects earnings. If a derivative instrument is designated as a fair value hedge, the change in fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings in the current period. There were no material derivatives as of September 27, 2008.

RESULTS OF OPERATIONS

The financial information and discussion below should be read in conjunction
with the Consolidated Financial Statements and Notes. The following table
presents the percentage relationship to net sales of certain items in the
Consolidated Statements of Earnings for the periods indicated.



                                                    First Quarter Ended
                                         September 27, 2008     September 29, 2007
 Net sales                                            100.0 %                100.0 %
 Cost of sales                                         92.9                   93.1

 Gross profit                                           7.1                    6.9
 Operating expenses
 Research, development and engineering                  1.3                    1.5
 Selling and administrative                             4.5                    4.3

 Operating income                                       1.3                    1.1
 Interest expense                                       0.4                    0.6

 Income before income taxes                             0.9                    0.5
 Income tax provision                                   0.1                    0.1

 Net income                                             0.8 %                  0.4 %

Sales

Sales for the first quarter of fiscal year 2009 increased 8.3% to $48.2 million compared to $44.6 million for the same period of fiscal year 2008. This increase in sales reflects an overall increase from certain existing customer programs that continue to grow and the continued ramp up of our new customer programs. New customer sales contributed approximately $11.3 million for the quarter ended September 27, 2008, compared to $2.9 million for the quarter ended September 29, 2007. The sales to our existing customer base and these new customers have offset the anticipated decline in demand from some of our existing customers. Sales in the second quarter of fiscal year 2009 are expected to be in the range of $42 million to $45 million. We are expecting lower demand as the global economic situation is creating uncertainty and slowdowns in orders and reductions in forecasts from a number of established customers. While our new programs continue to move into production and ramp up, some customers have reduced their forecasts for coming periods. Sales to our new programs are now expected to grow at a slower rate than previously anticipated; however, our flexible business model allows us to take immediate steps to reduce operating expenses in our manufacturing facilities. 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 following customers represented 10 percent or more of total net sales during the three months ended September 27, 2008 and September 29, 2007: International Gaming Technology, Inc. (21.6%, 13.3%), Lexmark International, Inc. (15.8%, 18.4%), and Zebra Technologies Corporation (9.6%, 20.6%). It is anticipated that new customer program wins will dilute our concentration of revenue of our top customers in the future.

Sales to our largest customers may vary significantly from quarter to quarter depending on the size and timing of customer program commencement, forecasts, delays, design modifications, and transitions. We remain dependent on continued sales to our significant customers and most contracts are not firm long-term purchase commitments. Only a short window of approximately three to six months of total demand information is provided to us by our customers. We seek to maintain flexibility in production capacity by employing skilled temporary and short-term labor and by utilizing short-term leases on equipment and manufacturing facilities. In addition, our capacity and core competencies for printed circuit board assemblies (PCBAs), precision molding, tool making, assembly, and engineering can be applied to a wide variety of products.

Gross Profit

Gross profit as a percentage of sales for the first quarter of fiscal year 2009 was 7.1% compared to 6.9% for the first quarter of fiscal year 2008. The increase was the result of higher sales to customers, which drove higher utilization of our manufacturing facilities. A large part of our overhead and indirect costs do not fluctuate significantly with short-term fluctuations in sales revenue. The level of gross margin is impacted by facility utilization, product mix, timing of the start up of new programs, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.

Included in gross profit are charges related to changes in the allowance for obsolete inventory. Specifically, we had provisions for obsolete inventory of $138,000 for the first three months of fiscal year 2009. We had no provision for inventory for the quarter ended September 29, 2007. We adjust the allowance for estimated obsolescence as necessary in an amount equal to the difference between the cost of inventory and estimated market value based on assumptions of future demand and market conditions. The reserves are established for inventory that we have determined customers are not contractually responsible for and for inventory that we believe customers will be unable to purchase.

Operating Expenses

Total operating expenses were $2.8 million in the first quarter of fiscal year 2009 and $2.6 million in the first quarter of fiscal year 2008. The difference was mainly attributable to an increase in selling and administrative (S&A) expenses. Operating expenses as a percentage of sales were 5.8% for the first quarters of fiscal years 2009 and 2008.

Total S&A expenses were $2.1 million and $1.9 million during the first quarters of fiscal years 2009 and 2008, respectively. There was a charge of $75,000 in the first three months of fiscal year 2009 and $11,000 in the first three months of fiscal year 2008 to provide for doubtful collection of receivables.

Total research, development, and engineering (RD&E) expenses were $626,000 and $677,000 during the first quarters of fiscal years 2009 and 2008, respectively. RD&E expenses were less than the prior year as the result of cost reduction efforts to keep RD&E expenses below the prior fiscal year.

Interest

Interest expense was $182,000 in the first quarter of fiscal year 2009 compared to $269,000 in the first quarter of fiscal year 2008. The decrease in interest expense in the first three months of fiscal 2009 compared to the same period of fiscal 2008 was due to a decrease in the average outstanding revolving credit facility balance and a decrease in variable interest rates.

Income Taxes

We had domestic tax loss carryforwards of approximately $42.9 million and other future deductible temporary differences and tax credit carryforwards at June 28, 2008. In accordance with SFAS No. 109, we assess the sources of future taxable income, which may be available to recognize the deductible differences that comprise deferred tax assets. A valuation allowance against deferred tax assets is required if it is more likely than not that some or all of the deferred tax assets will not be realized. We have determined that a valuation allowance of $11.1 million on the total deferred tax asset is appropriate as of September 27, 2008. Our judgments regarding future use of deferred tax assets may change due to changes in market conditions, changes in tax laws or other factors. If our assumptions and estimates change in the future the valuation allowance will be adjusted accordingly and any resulting increase or decrease will result in an additional income tax expense or benefit.

The income tax provisions for the first quarters of fiscal year 2009 and 2008 are primarily due to foreign income tax payable on behalf of our subsidiaries in China and Mexico. The domestic income tax attributable to current period operations was absorbed by net operating loss carryforwards still covered by deferred tax asset reserves. We applied certain tax credits to offset all of the tax liabilities of our Mexican subsidiaries in previous years. We are expecting to pay income taxes in calendar year 2008 due to recently enacted tax laws in Mexico.

Backlog

On September 27, 2008, we had an order backlog of approximately $35.2 million. This compares with a backlog of approximately $40.4 million on September 29, 2007. Order backlog consists of purchase orders received for products expected to be shipped within the next 12 months, although shipment dates are subject to change due to design modifications or changes in other customer requirements. Order backlog should not be considered an accurate measure of future sales.

CAPITAL RESOURCES AND LIQUIDITY

Operating Cash Flow

Cash provided by operating activities was $776,000 during the three months ended September 27, 2008 compared to $1.6 million provided during the same period of the prior fiscal year. The decrease in cash provided by operating activities during the first three months of fiscal year 2009 when compared to the prior year is due to the decrease in accounts payable of $4.3 million and accrued compensation and vacation of $1.5 million that was more than offset by a decrease in trade receivables of $7.7 million. Trade receivables decreased due to more collections from previous periods during the quarter ended September 27, 2008 as compared to the quarter ended September 29, 2007. The decrease in accounts payable during the first three months of fiscal 2009 was due to a decrease in inventory received compared to inventory received in the quarter ended September 29, 2007, as well as an increase in available cash flow and taking early pay discounts from suppliers. Accounts payable fluctuates with the changes in inventory levels and negotiated supplier terms. We purchase inventory based on customer forecasts and orders, and when those forecasts and orders change the amount of inventory may also fluctuate.

Investing Cash Flow

During the first three months of fiscal year 2009, we spent $126,000 for capital additions compared to $290,000 in the same period of the previous fiscal year. Our capital expenditures primarily consist of purchases of manufacturing equipment to support our production facilities. We also use leases to acquire equipment. Operating leases are often utilized when technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds.

Financing Cash Flow

Our primary financing activity during the first three months of fiscal years 2009 and 2008 was borrowing and repayment under our current revolving loan financing agreement. Our financing agreement provides a revolving credit facility of up to $25 million. The range of interest rates on the balances on outstanding contracts was 4.13% to 5.00% on September 27, 2008. The credit facility matures on August 22, 2009. However, we fully anticipate renewing the revolving loan agreement with CIT or signing a new loan agreement with another lender prior to August 22, 2009. As of September 27, 2008, we were in compliance with our loan covenant, and based on eligible collateral, approximately $8.4 million was available for drawdown from the revolving line of credit.

Our cash requirements are affected by the level of current operations and new EMS programs. We believe that projected cash from operations, funds available under the revolving credit facility, and leasing capabilities will be sufficient to meet our working and fixed capital requirements for the foreseeable future.

Restricted cash includes amounts in our bank account that must be used to pay down our revolving line of credit. These amounts fluctuate daily based on collections.

RISKS AND UNCERTAINTIES THAT MAY AFFECT FUTURE RESULTS

The following risks and uncertainties could affect our actual results and could cause results to differ materially from past results or those contemplated by our forward-looking statements. When used herein, the words "expects", "believes", "anticipates" and similar expressions are intended to identify forward-looking statements.

Potential Fluctuations in Quarterly Results Our quarterly operating results have varied in the past and may vary in the future due to a variety of factors, including changes in overall demand for customers' products, success of customers' programs, timing of new programs, new product introductions or technological advances by us, our customers and our competitors and changes in pricing policies by us, our customers, our suppliers and our competitors.

Component procurement, production schedules, personnel and other resource requirements are based on estimates of customer requirements. Occasionally, our customers may request accelerated production that can stress resources and reduce operating margins. In addition, because many of our operating expenses are relatively fixed, a reduction in customer demand can harm our gross profit . . .