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 new customer growth in the coming quarters by securing new programs, increasing our worldwide manufacturing capacity and continuing to improve our manufacturing processes. Ongoing challenges that we face 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 second quarter of fiscal year 2009 was $106,000 compared to $1.6 million for the second quarter of fiscal year 2008. The decrease was related to the goodwill impairment charge of $765,000 during the second quarter of fiscal year 2009 and the gain realized on the sale of real estate of $951,000 during the second quarter of fiscal year 2008. Net income was $514,000 and $1.8 million for the first six months of fiscal year 2009 and 2008, respectively. The decrease for the first six months of fiscal year 2009 compared to the first six months of fiscal year 2008 was related to the goodwill impairment charge of $765,000 during the second quarter of fiscal year 2009 and the gain realized on the sale of real estate of $951,000 during the second quarter of fiscal year 2008.

Sales for the second quarter of fiscal year 2009 decreased 7.5% to $47.0 million compared to $50.8 million for the same period of fiscal year 2008. This decrease in sales reflects the expected lower demand from established customers due to the unfavorable global economic situation. New customers, as of the beginning of fiscal year 2008, contributed sales of approximately $11.7 million for the quarter ended December 27, 2008, compared to $5.8 million for the quarter ended December 29, 2007. Sales for the first six months of fiscal 2009 were $95.2 million or a decrease of 0.2% from $95.4 million during the same period of the prior year. 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 third quarter of fiscal year 2009 are expected to be in the range of $42 million to $46 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 our established customers. While our new programs continue to move into production and ramp up, some customers have reduced their forecasts for coming periods. New programs' sales 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. Future 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 second quarter of fiscal year 2009 was 8.1% compared to 6.9% for the second quarter of fiscal year 2008. Gross profit was 7.6% for the first six months of fiscal 2009 compared to 6.9% for the first six months of fiscal 2008. The increase in gross profit as a percentage of sales for the second quarter of fiscal year 2009 and the first six months of fiscal 2009 as compared to the same periods of fiscal 2008 was due to reduced labor related costs, improving production efficiencies and lower operating expenses as the result of favorable exchange rates. Additionally, 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 1.90 and a long-term debt to equity of 0.01. 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 the revolving loan or enter into a new revolving loan agreement by the maturity date. Total cash provided by operations was $854,000 for the quarter ended December 27, 2008. We maintain sufficient liquidity for our expected future operations and had approximately $10.1 million available from our revolving line of credit based on eligible collateral at December 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 AND ESTIMATES

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 surplus inventory against earnings.

Allowance for Doubtful Accounts

We value our accounts receivable net of an allowance for doubtful accounts of $185,000 and $110,000 at December 27, 2008 and June 28, 2008, respectively. This allowance is based on estimates of the portion of accounts receivable that may not be collected in the future. 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 $11.0 million on the total deferred tax asset is appropriate as of December 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 increase or decrease will result in an additional income tax expense or benefit.

Goodwill

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, the Company recorded goodwill in the amount of $765,000, which related to the acquisition of Honeywell's manufacturing facilities in Juarez, Mexico in fiscal year 1994. Per SFAS No. 142, goodwill is not amortized, but must be analyzed for impairment at least annually. The Company's goodwill impairment analysis is performed at the end of the second quarter each year using the two-step method. This analysis is also performed during the year whenever a "triggering event" would indicate that goodwill had been impaired.

As of December 27, 2008, the Company completed its annual impairment test. The Company performed the first step of its goodwill impairment test and determined that the book value of the Company exceeded its fair value based on the quoted market price of the Company's stock as of December 26, 2008. The result of the first step indicated that goodwill was impaired and therefore, the Company performed the second step of the goodwill analysis in accordance with SFAS No. 142. The second step

analyzes any excess or implied fair value of goodwill upon allocating the fair value of the Company to all its assets and liabilities other than goodwill and then comparing the residual amount, if any, to the book value of the goodwill. There was no residual amount of goodwill to allocate upon completing this step. As the deteriorating global economy adversely affected the Company's common stock price, the Company concluded that goodwill was impaired due to the significant and sustained decline in the Company's market capitalization to below the book value. The Company recorded an impairment charge of approximately $765,000 for the quarter ended December 27, 2008.

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. As of December 27, 2008, we had forward contracts to lock in known future cash outflows for payroll and utility expenses denominated in the Mexican peso. As of December 27, 2008, the fair value of these contracts was a liability of approximately $113,000, which was included in other current liabilities and recorded as an unrealized loss in accumulated other comprehensive loss.

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.



                                            Second Quarter Ended                                  Six Months Ended
                                 December 27, 2008         December 29, 2007         December 27, 2008         December 29, 2007
Net sales                                    100.0 %                   100.0 %                   100.0 %                   100.0 %
Cost of sales                                 91.9                      93.1                      92.4                      93.1

Gross profit                                   8.1                       6.9                       7.6                       6.9
Operating expenses
Research, development and
engineering                                    1.3                       1.3                       1.3                       1.4
Selling, general and
administrative                                 4.4                       3.7                       4.4                       4.0
Goodwill impairment                            1.6                       0.0                       0.8                       0.0
Gain on sale of real
estate                                         0.0                      (1.9 )                     0.0                      (1.0 )

Operating income                               0.8                       3.8                       1.1                       2.5
Interest expense                               0.4                       0.5                       0.4                       0.5

Income before income taxes                     0.4                       3.3                       0.7                       2.0
Income tax provision                           0.2                       0.1                       0.2                       0.1

Net income                                     0.2 %                     3.2 %                     0.5 %                     1.9 %

Sales

Sales for the second quarter of fiscal year 2009 decreased 7.5% to $47.0 million compared to $50.8 million for the same period of fiscal year 2008. This decrease in sales reflects the expected lower demand from established customers due to the unfavorable global economic situation. However, sales to new customers contributed approximately $11.7 million for the quarter ended December 27, 2008, compared to $5.8 million for the quarter ended December 29, 2007. Sales for the first six months of fiscal 2009 were $95.2 million or a decrease of 0.2% from $95.4 million during the same period of the prior year. 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 third quarter of fiscal year 2009 are expected to be in the range of $42 million to $46 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 our established customers. While our new programs continue to move into production and ramp up, some customers have reduced their forecasts for coming periods. New programs' sales 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. Future 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 six months ended December 27, 2008 and December 29, 2007, respectively:
International Gaming Technology, Inc. (18.2%, 15.9%), Lexmark International, Inc. (16.3%, 17.6%), and Zebra Technologies Corporation (less than 10% for December 27, 2008, 19.0%). It is anticipated that new customer program wins will dilute the 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 with customers 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 second quarter of fiscal year 2009 was 8.1% compared to 6.9% for the second quarter of fiscal year 2008. Gross profit was 7.6% for the first six months of fiscal 2009 compared to 6.9% for the first six months of fiscal 2008. The increase in gross profit as a percentage of sales for the second quarter of fiscal year 2009 and the first six months of fiscal 2009 as compared to the same periods of fiscal 2008 was due to reduced labor related costs, improved production efficiencies and lower operating expenses as the result of favorable exchange rates. Additionally, 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 $200,000 and $14,000 for the first six months of fiscal year 2009 and 2008, respectively. 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 $3.4 million in the second quarter of fiscal year 2009 and $1.6 million in the second quarter of fiscal year 2008. The difference was mainly attributable to the goodwill impairment charge of $765,000 during the second quarter of fiscal year 2009 and the gain realized on the sale of real estate of $951,000 during the second quarter of fiscal year 2008. Operating expenses as a percentage of sales increased to 7.3% in the second quarter of fiscal year 2009 from 3.1% in the second quarter of fiscal year 2008. Operating expenses for the first six months of fiscal year 2009 were $6.2 million compared to $4.1 million in the first six months of fiscal year 2008. Operating expenses as a percentage of sales increased to 6.5% in the first six months of fiscal year 2009 from 4.3% in the first six months of fiscal year 2008. The increase in total operating expenses during the first six months of fiscal year 2009 when compared to the same period of fiscal year 2008, was mainly due to increases in selling, general and administrative (SG&A) expenses, the goodwill impairment charge and the gain realized on the sale of real estate realized in the prior year.

Total SG&A expenses were $2.1 million and $1.9 million during the second quarters of fiscal years 2009 and 2008, respectively. SG&A expenses for the first six months of fiscal year 2009 were $4.2 million compared to $3.8 million in the first six months of fiscal year 2008. Higher SG&A expenses in the second quarter and first six months of fiscal 2009 compared to the same periods of fiscal 2008 were attributable to foreign exchange losses on Mexican peso denominated financial assets and the addition of a sales representative. Additionally, for the first six months of fiscal year 2009 compared to fiscal year 2008 there was a charge of $75,000 and $11,000, respectively, to provide for doubtful collection of receivables.

Total research, development, and engineering (RD&E) expenses were $592,000 and $641,000 during the second quarters of fiscal years 2009 and 2008, respectively. RD&E expenses were $1.2 million and $1.3 million in the first six months of fiscal 2009 and 2008, respectively. Lower RD&E expenses in the second quarter and first six months of fiscal year 2009 compared to the same periods of fiscal year 2008 were the result of cost reduction efforts to keep RD&E expenses below the prior fiscal year periods.

Interest

Interest expense decreased to $180,000 in the second quarter of fiscal year 2009 from $241,000 in the second quarter of fiscal year 2008. For the first six months of fiscal years 2009 and 2008, interest expense amounted to $362,000 and $510,000, respectively. The decreases in interest expense in the second quarter and first six months of fiscal year 2009 compared to the same periods of fiscal year 2008 are 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 $11.0 million on the total deferred tax asset is appropriate as of December 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 second 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 . . .