Introduction

The Company and its wholly-owned subsidiaries design, manufacture and sell process automation systems integrating electro-optical inspection, sorting and process systems.

The Company consists of Key Technology, Inc. which directly owns six subsidiaries: Key Holdings USA LLC; Key Technology Australia Pty Ltd.; Productos Key Mexicana S. de R. L. de C.V.; Key Technology (Shanghai) Trading Co., Ltd.; Key Technology Asia-Pacific Pte. Ltd.; and Key Technology AMVC LLC (inactive). Key Holdings USA LLC owns Suplusco Holdings B.V., its European subsidiary, which owns Key Technology B.V. The Company manufactures products in Walla Walla, Washington; Redmond, Oregon; and Beusichem, The Netherlands.

Overview

Sales for the year ended September 30, 2008 were $134.1 million compared with $107.5 million for fiscal 2007. The Company reported net earnings for fiscal 2008 of $7.5 million, or $1.35 per diluted share, compared with net earnings of $7.4 million, or $1.37 per diluted share, for fiscal 2007. Fiscal year 2007 included a $750,000 gain, or $0.14 per share, of non-operating income associated with the sale of the Company's 50% interest in its InspX joint venture. Net earnings increased in fiscal 2008 compared to fiscal 2007 as a result of a 24.7% increase in sales volume, reflecting the 18.7% increase in orders for fiscal 2008, as well as the improvement of gross margins to 39.7% in fiscal 2008 from 38.5% in fiscal 2007. These increases were partially offset by increased operating expenses of $43.0 million, or 32% of net sales, compared to $32.8 million, or 30.5% of net sales, for fiscal 2007 and unfavorable changes in foreign currency exchange rates, particularly in the fourth quarter of fiscal 2008. Automated inspection systems sales were up 19%, process systems sales were up 38%, and parts and service sales increased 9% over the prior fiscal year. The primary market forces driving demand for our products are: the increased concerns about food safety and security, the inability of food and pharmaceutical processors to obtain cost effective labor, and the Company's expansion into international markets. Export and international sales for the fiscal years ended September 30, 2008, 2007 and 2006 accounted for 50%, 46% and 51% of net sales in each year, respectively.

In 2008, the Company focused efforts on four major initiatives to achieve its long-term revenue growth plan:

· Continue to grow the Company's core food processing markets including potatoes, fresh-cut, and processed fruit and vegetables;

· Expand and grow its participation in the pharmaceutical and nutraceutical market;

· Strengthen and grow the level of international business, including the Asia Pacific and Latin America regions; and

· Continue to grow the Company's aftermarket product lines.

In 2008, sales in our core food processing businesses, including upgrades, accounted for a significant portion of the company's increased revenues. Sales in potatoes, fresh-cut, and processed fruit and vegetables all increased significantly in 2008, and orders for the fresh-cut business grew 278% over fiscal 2007. Significant progress, however, was also realized with respect to the other three major initiatives. The pharmaceutical initiative began in the fourth quarter of 2005 with the formation of the SYMETIX® business unit. This business unit was formed to dedicate a team of employees to develop and grow Key's business in the pharmaceutical and nutraceutical market. Anticipated penetration into this market will extend and advance the Company's existing patented, high-resolution inspection technology and material handling platforms. Revenue increased $2.8 million in fiscal 2008 to $4.9 million as efforts on the pharmaceutical initiative began to make progress.

The Company has historically been successful in selling tobacco sorters in China. Larger opportunities exist there in the food processing business, and the Company invested in China during fiscal 2006 to enhance sales, service and applications support to build upon its established base. In 2006, the Company opened an office and located personnel in-country. In 2008, order volume in China increased 166% over fiscal 2007, indicating that the

Company's expansion efforts gained some traction. However, a significant portion of the order volume increase related to tobacco orders, and the Company is still developing its marketing and product strategies to be more successful in the Chinese food processing market. In 2008, the Company was successful in increasing its penetration in the Latin America markets, where orders increased 84% over orders received in fiscal 2007.

The Company also focused on its aftermarket product lines (which include parts/service and upgrades) during fiscal 2008. With the introduction of the G6 family of products in 2005, this enhanced vision engine technology provided additional product upgrade opportunities. Upgrades are an important aspect of the aftermarket product lines, and the modular G6 product family, which provides advanced image processing capability, has been well received by the Company's current customers. Aftermarket sales (including upgrades which are classified in automated inspection systems) increased in fiscal 2008 over fiscal 2007 by 17% to $38.5 million.

The Company's strategic initiatives for 2009 are to continue to build upon the direction and solid revenue base the Company developed during 2008. The focus for the coming year is to continue to grow sales in the Company's core markets and geographical regions, and invest in a market-driven technology road map that provides the new products required by our customers. In addition, the Company will focus on four primary industries: potatoes, fresh cut produce, processed fruit and vegetables, and pharmaceutical/nutraceutical, and focus on four developing regions: China, Latin America, Eastern Europe and the Middle East.

The Company also plans to continue to make significant investments in research and development expenditures and to implement its global Enterprise Resource Planning, or ERP, system. Efforts in research and development will continue to focus on customer solutions, providing new products that meet current needs as well as anticipated future functionality requirements. The Company began preliminary work on developing a global ERP system in the third and fourth quarters of fiscal 2007. Implementation will be spread over a three-year period into fiscal year 2010. A significant portion of the ERP implementation costs will be capitalized. During fiscal 2008, the Company incurred operating expenses of $1.2 million and capital expenditures of approximately $2.3 million associated with the implementation of the ERP system. Cumulative ERP-related operating expenses and capital expenditures are $1.2 million and $3.0 million, respectively.

Application of Critical Accounting Policies

The Company has identified its critical accounting policies, the application of which may materially affect the financial statements, either because of the significance of the financial statement item to which they relate, or because they require management judgment to make estimates and assumptions in measuring, at a specific point in time, events which will be settled in the future. The critical accounting policies, judgments and estimates which management believes have the most significant effect on the financial statements are set forth below:

· Revenue recognition

· Allowances for doubtful accounts

· Valuation of inventories

· Long-lived assets

· Allowances for warranties

· Accounting for income taxes

Management has discussed the development, selection and related disclosures of these critical accounting estimates with the audit committee of the Company's board of directors.

Revenue Recognition. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the sale price is fixed or determinable, and collectability is reasonably assured. Additionally, the Company sells its goods on terms which transfer title and risk of loss at a specified location, typically shipping point, port of loading or port of discharge, depending on the final destination of the goods. Accordingly, revenue recognition from product sales occurs when all criteria are met, including transfer of title and risk of loss, which occurs either upon shipment by the Company or upon receipt by customers at the location specified in the terms of sale. Sales of system upgrades are recognized as revenue upon completion of

the conversion of the customer's existing system when this conversion occurs at the customer site. Revenue earned from services (maintenance, installation support, and repairs) is recognized ratably over the contractual period or as the services are performed. If any contract provides for both equipment and services (multiple deliverables), the sales price is allocated to the various elements based on objective evidence of fair value. Each element is then evaluated for revenue recognition based on the previously described criteria. The Company's sales arrangements provide for no other significant post-shipment obligations. If all conditions of revenue recognition are not met, the Company defers revenue recognition. In the event of revenue deferral, the sale value is not recorded as revenue to the Company, accounts receivable are reduced by any amounts owed by the customer, and the cost of the goods or services deferred is carried in inventory. In addition, the Company periodically evaluates whether an allowance for sales returns is necessary. Historically, the Company has experienced few sales returns. If the Company believes there are potential sales returns, the Company will provide any necessary provision against sales. In accordance with the Financial Accounting Standard Board's Emerging Issues Task Force Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's Product," the Company accounts for cash consideration (such as sales incentives) that are given to customers or resellers as a reduction of revenue rather than as an operating expense unless an identified benefit is received for which fair value can be reasonably estimated. The Company believes that revenue recognition is a "critical accounting estimate" because the Company's terms of sale vary significantly, and management exercises judgment in determining whether to recognize or defer revenue based on those terms. Such judgments may materially affect net sales for any period. Management exercises judgment within the parameters of accounting principles generally accepted in the United States of America (GAAP) in determining when contractual obligations are met, title and risk of loss are transferred, the sales price is fixed or determinable and collectability is reasonably assured. At September 30, 2008, the Company had invoiced $2.9 million compared to $2.3 million at September 30, 2007 for which the Company has not recognized revenue.

Allowances for doubtful accounts. The Company establishes allowances for doubtful accounts for specifically identified, as well as anticipated, doubtful accounts based on credit profiles of customers, current economic trends, contractual terms and conditions, and customers' historical payment patterns. Factors that affect collectability of receivables include general economic or political factors in certain countries that affect the ability of customers to meet current obligations. The Company actively manages its credit risk by utilizing an independent credit rating and reporting service, by requiring certain percentages of down payments, and by requiring secured forms of payment for customers with uncertain credit profiles or located in certain countries. Forms of secured payment could include irrevocable letters of credit, bank guarantees, third-party leasing arrangements or EX-IM Bank guarantees, each utilizing Uniform Commercial Code filings, or the like, with governmental entities where possible. The Company believes that the accounting estimate related to allowances for doubtful accounts is a "critical accounting estimate" because it requires management judgment in making assumptions relative to customer or general economic factors that are outside the Company's control. As of September 30, 2008, the balance sheet included allowances for doubtful accounts of $308,000. Amounts charged to bad debt expense for fiscal 2008 and 2007 were $116,000 and $16,000, respectively. Actual charges to the allowance for doubtful accounts for fiscal 2008 and 2007 were $230,000 and $98,000, respectively. If the Company experiences actual bad debt expense in excess of estimates, or if estimates are adversely adjusted in future periods, the carrying value of accounts receivable would decrease and charges for bad debts would increase, resulting in decreased net earnings.

Valuation of inventories. Inventories are stated at the lower of cost or market. The Company's inventory includes purchased raw materials, manufactured components, purchased components, service and repair parts, work in process, finished goods and demonstration equipment. Write downs for excess and obsolete inventories are made after periodic evaluation of historical sales, current economic trends, forecasted sales, estimated product lifecycles and estimated inventory levels. The factors that contribute to inventory valuation risks are the Company's purchasing practices, electronic component obsolescence, accuracy of sales and production forecasts, introduction of new products, product lifecycles and the associated product support. The Company actively manages its exposure to inventory valuation risks by maintaining low safety stocks and minimum purchase lots, utilizing just in time purchasing practices, managing product end-of-life issues brought on by aging components or new product introductions, and by utilizing inventory minimization strategies such as vendor-managed inventories. The Company believes that the accounting estimate related to valuation of inventories is a "critical accounting estimate" because it is susceptible to changes from period-to-period due to the requirement for management to make estimates relative to each of the underlying factors ranging from purchasing to sales to production to after-sale support. At

September 30, 2008, cumulative inventory adjustments to lower of cost or market totaled $1.7 million compared to $1.8 million as of September 30, 2007. Amounts charged to expense to record inventory at lower of cost or market for fiscal 2008 and 2007 were $708,000 and $386,000, respectively. Actual charges to the cumulative inventory adjustments upon disposition or sale of inventory were $801,000 and $903,000 for fiscal 2008 and 2007, respectively. If actual demand, market conditions or product lifecycles are adversely different from those estimated by management, inventory adjustments to lower market values would result in a reduction to the carrying value of inventory, an increase in inventory write-offs, and a decrease to gross margins.

Long-lived assets. The Company regularly reviews all of its 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 projected future undiscounted cash flows is less than the carrying amount of these assets, an impairment loss based on the excess of the carrying amount over the fair value of the assets is recorded. In addition, goodwill is reviewed based on its fair value at least annually. As of September 30, 2008, the Company held $13.5 million of property, plant and equipment, goodwill and other intangible assets, net of depreciation and amortization. There were no changes in the Company's long-lived assets that would result in an adjustment of the carrying value for these assets. Estimates of future cash flows arising from the utilization of these long-lived assets and estimated useful lives associated with the assets are critical to the assessment of recoverability and fair values. The Company believes that the accounting estimate related to long-lived assets is a "critical accounting estimate" because: (1) it is susceptible to change from period to period due to the requirement for management to make assumptions about future sales and cost of sales generated throughout the lives of several product lines over extended periods of time; and (2) the potential effect that recognizing an impairment could have on the assets reported on the Company's balance sheet and the potential material adverse effect on reported earnings or loss. Changes in these estimates could result in a determination of asset impairment, which would result in a reduction to the carrying value and a reduction to net earnings in the affected period.

Allowances for warranties. The Company's products are covered by standard warranty plans included in the price of the products ranging from 90 days to five years, depending upon the product and contractual terms of sale. The Company establishes allowances for warranties for specifically identified, as well as anticipated, warranty claims based on contractual terms, product conditions and actual warranty experience by product line. Company products include both manufactured and purchased components and, therefore, warranty plans include third-party sourced parts which may not be covered by the third-party manufacturer's warranty. Ultimately, the warranty experience of the Company is directly attributable to the quality of its products. The Company actively manages its quality program by using a structured product introduction plan, process monitoring techniques utilizing statistical process controls, vendor quality metrics, a quality training curriculum for every employee, and feedback loops to communicate warranty claims to designers and engineers for remediation in future production. The Company believes that the accounting estimate related to allowances for warranties is a "critical accounting estimate" because: (1) it is susceptible to significant fluctuation period to period due to the requirement for management to make assumptions about future warranty claims relative to potential unknown issues arising in both existing and new products, which assumptions are derived from historical trends of known or resolved issues; and (2) risks associated with third-party supplied components being manufactured using processes that the Company does not control. As of September 30, 2008, the balance sheet included warranty reserves of $1.7 million, while $2.7 million of warranty charges were incurred during the fiscal year then ended, compared to warranty reserves of $1.4 million as of September 30, 2007 and warranty charges of $2.1 million for the fiscal year then ended. If the Company's actual warranty costs are higher than estimates, future warranty plan coverages are different, or estimates are adversely adjusted in future periods, reserves for warranty expense would need to increase, warranty expense would increase and gross margins would decrease.

Accounting for income taxes. The Company's provision for income taxes and the determination of the resulting deferred tax assets and liabilities involves a significant amount of management judgment. The quarterly provision for income taxes is based partially upon estimates of pre-tax financial accounting income for the full year and is affected by various differences between financial accounting income and taxable income. Judgment is also applied in determining whether the deferred tax assets will be realized in full or in part. In management's judgment, when it is more likely than not that all or some portion of specific deferred tax assets, such as foreign tax credit carryovers, will not be realized, a valuation allowance must be established for the amount of the deferred tax assets that are determined not to be realizable. At September 30, 2008, the Company had valuation reserves of approximately

$450,000 for deferred tax assets related to the sale of the investment in the InspX joint venture and the valuation reserve for notes receivable and contingent payments, and offsetting amounts for U.S. and Chinese deferred tax assets and liabilities, primarily related to net operating loss carry forwards in the foreign jurisdictions that the Company believe will not be utilized during the carryforward period. During fiscal 2008, $60,000 of net valuation reserves for combined U.S. and Australian deferred taxes were eliminated due to the final dissolution of the related Australian entity. There were no other valuation allowances at September 30, 2008 due to anticipated utilization of all the deferred tax assets as the Company believes it will have sufficient taxable income to utilize these assets. The Company maintains reserves for estimated tax exposures in jurisdictions of operation. These tax jurisdictions include federal, state and various international tax jurisdictions. Potential income tax exposures include potential challenges of various tax credits, export-related tax benefits, and issues specific to state and local tax jurisdictions. Exposures are typically settled primarily through audits within these tax jurisdictions, but can also be affected by changes in applicable tax law or other factors, which could cause management of the Company to believe a revision of past estimates is appropriate. During fiscal 2008 and 2007, there have been no significant changes in these estimates. Management believes that an appropriate liability has been established for estimated exposures; however, actual results may differ materially from these estimates. The Company believes that the accounting estimate related to income taxes is a "critical accounting estimate" because it relies on significant management judgment in making assumptions relative to temporary and permanent timing differences of tax effects, estimates of future earnings, prospective application of changing tax laws in multiple jurisdictions, and the resulting ability to utilize tax assets at those future dates. If the Company's operating results were to fall short of expectations, thereby affecting the likelihood of realizing the deferred tax assets, judgment would have to be applied to determine the amount of the valuation allowance required to be included in the financial statements in any given period. Establishing or increasing a valuation allowance would reduce the carrying value of the deferred tax asset, increase tax expense and reduce net earnings.

The federal Research and Development Credit ("R&D credit") expired on December 31, 2007. Subsequent to the end of the Company's fiscal year, the Emergency Economic Stabilization Act of 2008 was enacted. As part of the legislation, the existing R&D credit was retroactively renewed and extended to December 31, 2009. Due to this subsequent change in tax law, the Company expects to record approximately $160,000 of additional R&D tax credits in the first quarter of fiscal 2009 related to R&D expenditures incurred during fiscal 2008.

The Company adopted the provisions of FASB Interpretation 48, Accounting for Uncertainty in Income Taxes, on October 1, 2007. Previously, the Company had accounted for tax contingencies in accordance with Statement of Financial Accounting Standards 5, Accounting for Contingencies. As required by Interpretation 48, which clarifies Statement 109, Accounting for Income Taxes, the Company recognizes the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. At the adoption date, the Company applied Interpretation 48 to all tax positions for which the statute of limitations remained open. As a result of the implementation of Interpretation 48, the Company recognized a decrease of approximately $250,000 in the liability for unrecognized tax benefits, which was accounted for as an increase to the October 1, 2007 balance of retained earnings.

Comparison of Fiscal 2008 to Fiscal 2007
                                                      Fiscal Year Ended September 30,
                                             2008          2007         Change $       Change %
                                                              (in thousands)
Statement of Operations Data
Net sales                                  $ 134,086     $ 107,540     $   26,546           24.7
Gross profit                                  53,193        41,441         11,752           28.4

Research and development                       8,744         5,520          3,224           58.4
Sales and marketing                           21,373        17,191          4,182           24.3
General and administrative                    11,528         8,821          2,707           30.7
Amortization                                   1,307         1,307              -            0.0
Total operating expense                       42,952        32,839         10,113           30.8

Gain on sale of assets                            81            23             58            n/m *
Income from operations                        10,322         8,625          1,697           19.7
Other income and expense                         666         1,961         (1,295 )        -66.0
Income tax expense                             3,515         3,176            339           10.7
Net income                                     7,473         7,410             63            0.9

Balance Sheet Data
Cash and cash equivalents                     36,322        27,880          8,442           30.3
Accounts receivable                           13,577        14,020           (443 )         -3.2
Inventories                                   21,915        18,753          3,162           16.9

Other Data (unaudited)
Orders for year ended September 30           136,874       115,276         21,598           18.7
Backlog at fiscal year end                    33,804        30,931          2,873            9.3

Results of Operations

Fiscal 2008 compared to Fiscal 2007

Net sales for the year ended September 30, 2008 were $134.1 million, a 25% increase over the $107.5 million reported for fiscal 2007. The Company ended the year strongly with a record fourth quarter of $40.2 million in sales, a 27% increase over the corresponding period in fiscal 2007.

Sales in the Company's automated inspection systems product line increased by 19% to $56.0 million in fiscal 2008, accounting for 42% of total revenues, compared to $46.9 million in fiscal 2007 and 44% of total revenues. The most significant increase was in upgrade sales which increased $4.3 million or 34% to $16.9 million. Sales increased over the prior year in almost all automated inspection product lines including the new Manta automated inspection product which was introduced in fiscal 2008. Process systems sales in fiscal 2008 were $56.6 million, a 38% increase over the $40.9 million reported for fiscal 2007. Sales of process systems accounted for 42% of total revenues in fiscal 2008 compared to 38% in fiscal 2007. Shipments of process systems in fiscal 2008 . . .