In Thousands of Dollars except for per share information. Introduction and Overview
This Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to provide investors with an understanding of the operating performance and financial condition of Keithley Instruments, Inc. A discussion of our business, including our strategy for growth, products and competition, is included in Part I of this Form 10-K. Business Overview
Our business is to design, develop, manufacture and market complex electronic instruments and systems geared to the specialized needs of electronics manufacturers for high-performance production testing, process monitoring, product development and research. Our primary products are integrated systems used to source, measure, connect, control or communicate electrical direct current (DC), radio frequency (RF) or optical signals. Our customers are engineers, technicians and scientists in manufacturing, product development and research functions. During fiscal 2008, semiconductor orders comprised approximately 30 percent of our total orders; wireless communications orders were about 15 percent; precision electronic components/subassembly manufacturers were approximately 25 percent, which includes customers in automotive, computers and peripherals, medical equipment, aerospace and defense, and manufacturers of components; and research and education orders were about 25 percent. The remainder of orders came from customers in a variety of other industries. Although our products vary in capability, sophistication, use, size and price, they generally test, measure and analyze electrical, RF, optical or physical properties. As such, we consider our business to be in a single industry segment.
The most important factors influencing our ability to grow revenue are (i) our customers' spending patterns as they invest in new capacity or upgrade manufacturing lines for new product offerings, (ii) our ability to offer interrelated products with differentiated value that solve our customers' most compelling test challenges, and (iii) our success in penetrating key accounts with our globally deployed sales and service team. We continue to believe that our strategy of pursuing a focused set of applications will allow us to grow faster than the overall test and measurement industry.
Many of the industries we serve, including but not limited to the semiconductor industry, the wireless communications industry, and precision electronic components/subassembly manufacturers, have historically been very cyclical and have experienced periodic downturns. Although our sales were up in fiscal 2008 from fiscal 2007 levels, our results for fiscal 2008 reflected reduced capital equipment spending among our customers in manufacturing, especially in the semiconductor industry. Additionally, our customers across all industries and geographies demonstrated reduced order patterns during the later part of our fourth quarter of fiscal 2008 which could also impact our fiscal 2009 results. In response to the sequential order contraction we experienced, we took action during the fourth quarter of fiscal 2008 to reduce our future operating expenses and expect a resulting benefit during fiscal 2009. Additionally, during November we announced further cost reduction measures including a suspension of salary increases, a hiring freeze with the exception of a few critical replacements, and a reduction in our capital expenditures as well as travel and other discretionary spending. Our new product development spending for the year was down slightly from the prior year. We believe that new product development is important, and we remain committed to maintain the necessary resources to implement our strategy in the short-term to successfully introduce our new product launches that we have in development.
Our focus during the past several years has been on building long-term relationships and strong collaborative partnerships with our global customers to serve their measurement needs. Toward that end, we rely primarily upon employing our own sales personnel to sell our products, and use sales representatives, to whom we pay a commission, in areas where we believe it is not cost-beneficial to employ our own people. This sales channel strategy allows us to build a sales network of focused, highly trained sales engineers who specialize in measurement expertise and problem-solving for customers and enhances our ability to sell our products to customers with worldwide operations. We believe our ability to serve our customers has been strongly enhanced by deploying our own employees throughout the United States, Europe and Asia. We expect that selling through our own sales force will be favorable to earnings during times of strong sales and unfavorable during times of depressed sales as a substantial portion of our selling costs are fixed.
We continue to believe that both the semiconductor and wireless areas drive change within the electronics industry. These technology changes create many opportunities for us. In fiscal 2004, we opened a West Coast development center, the sole focus of which is to develop our new RF product family. RF measuring is increasingly becoming an important part of our customers' requirements, as they are incorporating RF technology into their products. During fiscal 2008, we received important design wins for our RF products and our expanded offering has greatly increased our exposure to new customers and opportunities. Additionally, advances in technology require us to enhance our parametric test platforms to respond to our customers' changing needs. While we focus on these important initiatives, we cannot stop investing in our precision DC and current-voltage
(I-V) product lines, as they serve the same core set of customers. Critical Accounting Policies and Estimates Management has identified the Company's "critical accounting policies." These policies have the potential to have a more significant impact on our financial statements, either because of the significance of the financial statement item to which they relate, or because they require judgment and estimation due to the uncertainty involved in measuring, at a specific point in time, events which will be settled in the future.
Use of estimates:
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the reported financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

Revenue recognition:
Keithley Instruments, Inc. recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. Delivery is considered to have been met when title and risk of loss have transferred to the customer. Upon shipment, a provision is made for estimated costs that may be incurred for product warranties and sales returns. Revenue earned from service contracts is recognized ratably over the contractual service periods, and is not material to the Company's consolidated results. Shipping and handling costs are recorded as Cost of goods sold on the Consolidated Statements of Operations. Inventories:
Inventories are stated at the lower of cost or market. Cost is determined based on a currently-adjusted standard, which approximates actual cost on a first-in, first-out basis. We periodically review our recorded inventory and estimate a reserve for obsolete or slow-moving items. If actual demand and market conditions are less favorable than those projected by management, additional reserves may be required. If actual market conditions are more favorable than anticipated, our cost of sales will be lower than expected in that period. Income taxes:
Keithley is subject to taxation from federal, state and international jurisdictions. The annual provision for income taxes and the determination of the resulting deferred tax assets and liabilities involves a significant amount of judgment by management. Judgment also is applied in determining whether the deferred tax assets will be realized in full or in part. In evaluating our ability to recover our deferred tax assets, which totaled $31,515 at September 30, 2008, we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent fiscal years, and our forecast of future taxable income. In determining future taxable income, we are responsible for assumptions utilized including the amount of pretax operating income in each tax jurisdiction, the reversal of book versus tax differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with plans and estimates we are using to manage the underlying business.
We have established a valuation allowance against deferred tax assets related to net operating losses ("NOLs") in foreign, state and local tax jurisdictions which may not be realized due to the uncertainty of future profit levels in the respective jurisdictions. We intend to maintain this valuation allowance until sufficient positive evidence exists to support reversal of the valuation allowance, until such NOLs are utilized or until such NOLs expire. Our income tax expense recorded in the future will be reduced to the extent of offsetting decreases in our valuation allowance. The realization of certain tax credits and the remaining deferred tax asset is dependent upon achieving future forecasted taxable income. If actual results are significantly less than our forecast, an additional valuation allowance may be recorded against the tax credits or the remaining deferred tax assets, which totaled $31,515 at September 30, 2008. An increase in the valuation allowance would result in additional income tax expense in such period and could have a material impact on our future earnings and financial position. In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in various tax jurisdictions. We recognize potential liabilities for anticipated tax issues based upon our estimate of whether additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine that the liabilities are no longer necessary. If our estimate of tax liabilities proves to be less than the ultimate assessment, a further charge of income tax expense would result. Pension plan:
Retirement benefit plans are a significant cost of doing business representing obligations that will be ultimately settled far in the future and therefore are subject to estimation. Pension accounting is intended to reflect the recognition of future benefit costs over the employee's approximate service period based on the terms of the plans and the investment and funding decisions made by us. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine service cost and interest cost to arrive at pension income or expense for the year. As the rate of return on plan assets assumption is a long-term estimate, it can differ materially from the actual return realized on plan assets in any given year, especially when markets are highly volatile. We have analyzed the rates of return on assets used and determined that the rates we use are reasonable based on the plans' historical performance relative to the overall markets in the countries where the plans are effective, as well as the plans' asset mix between equities and fixed income investments. Assumed discount rates are used in measurements of the projected and accumulated benefit obligations, and the service and interest cost components of net periodic pension cost. The discount rate for the United States plan was determined as of the June 30, 2008 measurement date by constructing a portfolio of bonds with cash flows from coupon payments and maturities matching the projected benefit payments under the Plan. Bonds considered in constructing the model portfolio are rated AA- or higher by Standard & Poor's. Callable bonds were excluded from consideration. The longest maturity of any bond included in the data is August 15, 2036. Benefit payments lying beyond 2036 were discounted back to this year using interest rates taken from the Citigroup Pension Discount Curve Comparison to Above Median as of June 30, 2008. The matching bond portfolio produces coupon income in excess of what is needed to meet early period benefit payments. The excess coupon income is accumulated as interest, based on the Citigroup Pension Discount Curve Comparison to Above Median as of June 30, 2008, until such time as it is used to pay benefits.
The discount rate used in determining the recorded liability for our United States pension plan was 7.0% for 2008, compared to 6.375% for 2007 and 6.625% for 2006. The increase in the rate was primarily due to higher interest rates on long-term, highly rated corporate bonds. The discount rate for our German pension plan was 6.25% for 2008, compared to 5.5% for 2007 and 4.5% for 2006. The increase in the rate was primarily due to higher interest rates on long-term, highly rated corporate bonds.
Actual rate of (loss) return on United States plan assets was (4.2%) for 2008 compared to an expected rate of return of 8.25%. A 0.25% increase (decrease) in the expected rate of return would have produced a $107 decrease (increase) in 2008 expense.

The pension plan assets in Germany are invested through an insurance company. The insurance company directs the investments for this insurance contract. Because of the type of investments in the insurance contract, an expected rate of return of 5.0% was assumed.
Management will continue to assess the expected long-term rate of return on plan assets and discount rate assumptions for both the United States plan and non-U.S. plans based on relevant market conditions as prescribed by accounting principles generally accepted in the United States and will make adjustments to the assumptions as appropriate. Pension income or expense is allocated to Cost of goods sold, Selling, general and administrative expenses, and Product development expenses in the Consolidated Statements of Operations. The United States pension plan has experienced adverse asset returns from the June 30, 2008 measurement date through the end of the fiscal year. If pension plan returns on assets continue at the September 30, 2008 level, the Company would experience a non-cash impact to its Consolidated Balance Sheet and shareholders' equity at the end of the next fiscal year as well as increased pension expense for fiscal 2010. See Note G for additional information. Stock compensation plans:
With the adoption of SFAS No. 123(R) on October 1, 2005, the Company is required to record the fair value of stock-based compensation awards as an expense. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a greater level of judgment which makes them critical accounting estimates. We use an expected stock-price volatility assumption that is primarily based upon observed historical volatility of Keithley's stock price, as there is not a substantial enough market for exchange-traded options. During fiscal year 2008, we used a stock-price volatility assumption of 38%. With regard to the weighted-average expected option life assumption, we consider several factors, including the historical option exercise behavior of our employees, historical cancellation rates of past options, and the current life of options outstanding and vested. During fiscal year 2008, we used an expected life assumption of 4.75 years. We also are required to estimate an expected forfeiture rate when recognizing compensation cost. We review this rate every reporting period and adjust it when necessary based upon our past history of actual forfeitures.
We currently grant non-cash compensation in the form of non-qualified stock options, performance share units and restricted share units. The final number of common shares to be issued pursuant to the performance share unit awards will be determined at the end of each three-year performance period. The awards granted in fiscal year 2007 and 2008 can be adjusted in 25 percent increments and may range from a maximum of twice the initial award, as specified in the agreement, to a minimum of no units depending upon the level of attainment of performance thresholds. We currently are accruing expense for performance share unit awards based upon our estimate that the number of shares to be issued will be equal to 50 percent of the initial award amount for those granted in fiscal 2007 and 100 percent of the initial award amount for those granted in 2008. We recorded the expense for the awards granted in 2006 which vested in 2008 equal to 50 percent of the initial award amount. Our future earnings can fluctuate throughout the performance period specified in the agreements depending upon our estimate of the number of awards we expect will be issued upon the completion of the performance period.
Results of Operations
The following discussion should be read in conjunction with the Financial Statements and Supplementary Data included in Item 8 of this Annual Report. Percent of net sales for the years ended September 30:

                                                        2008        2007        2006

      Net sales                                        100.0       100.0       100.0
      Cost of goods sold                                41.1        40.2        38.7

      Gross profit                                      58.9        59.8        61.3
      Selling, general and administrative expenses      43.6        44.5        40.9
      Product development expenses                      16.7        18.0        15.3
      Severance and related charges                      0.9         0.0         0.0

      Operating (loss) income                           (2.3 )      (2.7 )       5.1
      Investment income                                  1.0         1.5         1.3
      Interest expense                                  (0.0 )      (0.0 )      (0.0 )
      Impairment of long-term investments               (1.7 )      (0.0 )      (0.0 )

      (Loss) income before income taxes                 (3.0 )      (1.2 )       6.4
      (Benefit) provision for income taxes              (1.3 )      (1.0 )       1.0

      Net (loss) income                                 (1.7 )      (0.2 )       5.4

We recorded a net loss of $2,593, or $0.16 per diluted share for fiscal 2008 and $349, or $0.02 per diluted share for fiscal 2007. We recorded net income of $8,361, or $0.50 per diluted share, for 2006.
Net sales were $152,468 in 2008 compared with $143,658 in 2007, and $155,212 in 2006. The 6% increase in sales in 2008 was primarily the result of increased orders for our instrumentation products which more than offset a decrease in sales for our parametric testers, while the 7% sales decrease in 2007 was primarily due to lower sales to our semiconductor production test customers for our parametric testers. The effect of a

weaker U.S. dollar positively impacted sales growth by four percentage points in 2008 and one percent in 2007, while the effect of a stronger U.S. dollar negatively impacted sales growth by two percentage points in 2006. During fiscal 2008 and 2007, we experienced a softening in conditions in the electronics industry that intensified during the later part of fiscal 2008, particularly amongst our production semiconductor customers. During the later part of fiscal 2008 and into fiscal 2009, the broader electronics industry continued to slowdown. Throughout 2006 we had noted improving conditions in the strength of our customers and the electronics industry as a whole. Geographically, sales were up 1% in the Americas, 8% in Asia, and 9% in Europe during 2008. During 2007, sales were down 22% in the Americas, up 4% in Asia, and down 5% in Europe. Cost of goods sold as a percentage of net sales was 41.1%, 40.2% and 38.7% in 2008, 2007 and 2006, respectively. The increase in cost as a percentage of sales in 2008 was primarily the result of an increase in excess and obsolete inventory reserves and increased freight costs. The increase in cost as a percentage of sales in 2007 over 2006 was primarily the result of lower volumes and unfavorable product mix. Foreign exchange hedging had a minimal effect on cost of goods sold in 2008, 2007, and 2006.
Selling, general and administrative expenses of $66,413 increased 4% in 2008 from $64,008 in 2007, and increased less than 1% in 2007 from $63,554 in 2006. The increase in 2008 over 2007 was primarily the result of increased foreign exchange costs due to the 10% weaker U.S. dollar, higher commissions and sales incentives, higher salary costs, and increased consultant costs. These costs were partially offset by the absence of costs associated with the stock option investigation and shareholder litigation that were included in 2007. The slight increase in 2007 over 2006 was the result of higher salaries due to increased headcount, higher costs associated with the stock option investigation and shareholder litigation, higher costs in our Asian sales and support operations, and higher translation costs outside the U.S. due to a 5% weaker dollar. These costs were offset by lower employee benefit costs, lower costs associated with stock-based compensation as a result of adjusting the estimated expense for certain performance share award units to 50% of target, and lower costs for bonuses and other incentives tied to financial performance. During the second half of fiscal 2007, we also reduced our discretionary spending for items such as consultants, temporary help and training.
Product development expenses of $25,504 decreased 1% from $25,863 in 2007 and increased 9% in 2007 from $23,671 in 2006. The increase in 2007 was primarily a result of our increased investment in product development activities to expand our product offerings, including our RF product line.
During 2008, we recorded $1,377 for costs associated with our announced reduction in global workforce. We did not incur such costs during 2007 and 2006. See Note J.
Interest income was $1,603 in 2008, $2,307 in 2007 and $1,972 in 2006. The decrease in 2008 was the result of lower average cash and investment balances, a change in investment types, and lower average interest rates. Higher interest rates accounted for the increase in 2007. Interest expense was $70 in 2008, $55 in 2007 and $9 in 2006.
During 2008, we recorded an impairment loss on our long-term investments totaling $2,620. The impairment loss included $1,500 representing a valuation allowance against a note receivable from a company, as well as a $1,100 write-down of our investment in that company that is carried at cost. See Note D.
The effective tax rate for fiscal 2008, including discrete items, was a benefit of 42.8%, compared to a benefit of 79.3% for 2007 and an expense of 15.7% in 2006. The effective benefit in 2008 was greater than the U.S. statutory rate due to the recognition of current year research tax credits, state and local tax benefits and the recognition of benefits associated with prior year adjustments. These benefits were partially offset by the net impact of losses in foreign jurisdiction which are not available for a tax benefit and the U.S. tax on foreign remittances.
The effective benefit for 2007 was greater than the U.S. statutory rate due to the current year utilization of research tax credits, and an $882 benefit for the retroactive application of research tax credits for fiscal 2006. These benefits were partially offset by the net U.S. tax on foreign remittances, effective tax rates in foreign jurisdictions that are higher than the U.S. statutory tax rate, and the net impact of other permanent differences. The effective tax rate for 2006 was less than the U.S. statutory rate due to the utilization of a foreign tax credit carryforward that previously had a valuation allowance against it, the release of the valuation allowance on the remainder of the foreign tax credit carryforward and tax benefits from extraterritorial income exclusion on U.S. exports. These benefits were partially mitigated by state and local income taxes and effective tax rates in foreign jurisdictions that are higher than the U.S. statutory tax rate. See Note I. Our financial results are affected by foreign exchange rate fluctuations. Generally, a weakening U.S. dollar versus foreign currency favorably impacts our foreign currency denominated sales. A strengthening U.S. dollar has an unfavorable effect. This foreign exchange effect cannot be precisely isolated since many other factors affect our foreign sales and earnings. These factors include product offerings and pricing policies of Keithley and our competition, whether competition is foreign or U.S. based, changes in technology, product and customer mix, and local and worldwide economic conditions.
We utilize hedging techniques designed to mitigate the short-term effect of exchange rate fluctuations on operations and balance sheet positions by entering into foreign exchange forward contracts. We do not speculate in foreign currencies or derivative financial instruments, and hedging techniques do not increase our exposure to foreign exchange rate fluctuations.

Financial Condition, Liquidity and Capital Resources

Working Capital
The following table summarizes working capital as of September 30:

                                                        2008         2007

             Current assets:
             Cash and cash equivalents              $ 22,073     $ 12,888
             Short-term investments                    5,700       32,340
             Refundable income taxes                     230          136
             Accounts receivable and other, net       17,035       19,510
             Total inventories                        19,823       14,675
             Deferred income taxes                     5,483        3,961
             Other current assets                      2,079        2,026

             Total current assets                     72,423       85,536

             Current liabilities:
             Short-term debt                              23          799
             Accounts payable                          7,325        8,018
             Accrued payroll and related expenses      7,073        4,799
             Other accrued expenses                    6,142        4,753
             Income taxes payable                      1,174        3,911

             Total current liabilities                21,737       22,280

             Working capital                        $ 50,686     $ 63,256

Working capital decreased during fiscal year 2008 by $12,570, partially due to the reclassification of $6,120 of investments in auction rate securities from . . .