Overview

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

The EMS industry experienced growth over the past several years as more original equipment manufacturers (OEMs) chose to outsource manufacturing. This expansion of the EMS industry allowed us to continue to expand our customer base and the industries that we serve. However, the challenging global economic environment has had a negative impact on our results of operations as the demand from our customers has declined. We successfully confronted the challenging global economic environment in fiscal year 2009 by reducing our costs while ramping up new customer programs, which allowed us to maintain profitability and strengthen our balance sheet. The ramp up for our new programs was slowed by the recession, but these new programs continue to represent a growing portion of our revenue and a promising foundation for our future. In keeping with our long-term strategic objectives, we have been successfully building a more diversified customer portfolio and a less concentrated revenue base, spanning a wider range of industries.

Our sales of $184.9 million in fiscal year 2009 decreased by 9.4% over sales of $204.1 million in fiscal year 2008. This decrease in sales reflects the lower demand from established customers due to the unfavorable global economic environment. The decline in demand from our established customers was partially offset by revenue from new customers. In fiscal year 2008 new customers contributed approximately 9% of revenue. These same customers plus new customers in 2009 contributed approximately 29% of revenue. Sales for the first quarter of fiscal year 2010 are expected to be within the range of $41 million to $44 million. 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 win new business in coming periods and profitably grow our revenue as the economy recovers.

The concentration of our largest customers decreased during fiscal year 2009 with the top five customers' sales decreasing to 52% of total sales in 2009 from 68% in 2008, and 73% in 2007. Our current customer relationships involve a variety of products, including consumer electronics, electronic storage devices, plastics, household products, gaming devices, specialty printers, exercise equipment, telecommunications, industrial equipment, fuel cell technology and computer accessories. The total number of our customers continued to increase during fiscal year 2009. Some of these new customers have programs that represent small annual sales while others have multi-million-dollar potential.

Gross profit as a percent of sales was 7.1% in fiscal year 2009 compared to 8.2% for the prior fiscal year. The decrease in gross profit as a percentage of net sales was the result of lower fixed cost absorption due to sales decreasing. Additionally we incurred charges of approximately $1.3 million for severance charges related to cost reduction efforts.

Net income for fiscal year 2009 was $1.1 million or $0.11 per diluted share, down from $5.6 million net income or $0.54 per diluted share for fiscal year 2008. The results of both years were affected by unusual events. In fiscal year 2009 we incurred charges of $765,000 for goodwill impairment, approximately $533,000 for the write-off of a foreign receivable and approximately $1.3 million for severance charges related to cost reduction efforts. In fiscal year 2008 we realized a gain on the sale of real estate of $951,000.

We maintain a strong balance sheet with a current ratio of 2.59 and a long-term debt to equity ratio of 0.05. Total cash provided by operations was $10.0 million during fiscal year 2009. We maintain sufficient liquidity for our expected future operations and had approximately $15.3 million available from our revolving line of credit based on eligible collateral at June 27, 2009. We believe that internally generated funds, our revolving line of credit, and leases on equipment should provide adequate capital for planned growth over the long term.

The revolving credit facility with CIT was set to mature on August 22, 2009. On August 19, 2009, we entered into a credit agreement with Wells Fargo Bank, N.A. providing for a revolving line of credit facility for up to $20 million and paid off the CIT revolving loan. The agreement specifies that we, and our subsidiaries, use the proceeds of the revolving line of credit primarily for working capital and general corporate purposes. We may elect to borrow under this revolving line of credit at an interest rate of either a "Base Rate" or a "Fixed Rate". The base rate is the higher of the prime rate, daily one month LIBOR plus 1.5%, or the Federal Funds rate plus 1.5% and the fixed rate is LIBOR plus 2.1% or LIBOR plus 2.5% depending on the level of trailing four quarters EBITDA. Based on the trailing four quarters EBITDA as of June 27, 2009, we could borrow up to $14.4 million under the new line of credit.

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

Results of Operations

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

                                                                    Years Ended
                                              June 27, 2009        June 28, 2008        June 30, 2007
Net sales                                             100.0 %              100.0 %              100.0 %
Cost of sales                                          92.9                 91.8                 91.2

Gross profit                                            7.1                  8.2                  8.8

Operating expenses (income)
Research, development and engineering                   1.2                  1.3                  1.6
Selling, general and administrative                     4.5                  4.0                  4.5
Goodwill impairment                                     0.4                   -                    -
Gain on sale of real estate held for sale                -                  (0.4 )               (0.7 )

Total operating expenses                                6.1                  4.9                  5.4


Operating income                                        1.0                  3.3                  3.4

Interest expense                                        0.3                  0.5                  0.7

Income before income taxes                              0.7                  2.8                  2.7

Income tax provision (benefit)                          0.1                  0.1                  0.1

Net income                                              0.6 %                2.7 %                2.6 %

Net Sales

Net sales were $184.9 million, $204.1 million, and $201.7 million in fiscal years 2009, 2008, and 2007, respectively.

This decrease in net sales during fiscal year 2009 reflects the expected lower demand from established customers due to the unfavorable global economic environment. However, new customer programs from 2008 and 2009 partially offset this decline in demand, contributing approximately 29% of our total revenue in fiscal year 2009. We anticipate that several more new customer programs will enter production in fiscal year 2010 and begin contributing to revenue.

The increase in net sales during fiscal year 2008 compared to fiscal year 2007 resulted from an increase in sales revenue from new customer programs offset by a moderate decrease in the demand from some of our existing customers. New customer programs contributed approximately 9% of our total revenue in fiscal year 2008. Customer demand will fluctuate based on changes in the sell-through of customers' products.

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

                                                  Years Ended
                              June 27, 2009      June 28, 2008      June 30, 2007
    Commercial Printer                   15 %               16 %               19 %
    Communication                        10 %                9 %                9 %
    Computer and Peripheral              17 %                8 %                3 %
    Consumer                             19 %                9 %               14 %
    Gaming                               13 %               19 %               17 %
    Industrial                            4 %                3 %                2 %
    Transaction Printer                  22 %               36 %               36 %

    Total                               100 %              100 %              100 %

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

Sales to foreign customers represented 11.3%, 5.6%, and 9.0% of our total net sales in fiscal years 2009, 2008, and 2007, respectively. The increase in sales to foreign customers from fiscal year 2009 compared to fiscal year 2008 is the result of new customers in foreign locations. The decrease in sales to foreign customers from fiscal year 2008 compared to fiscal year 2007 was due to exiting production of a consumer product for a customer in Asia.

Cost of Sales

Total cost of sales as a percentage of net sales was 92.9%, 91.8%, and 91.2% in fiscal years 2009, 2008, and 2007, respectively.

Total cost of materials as a percentage of sales was approximately 61.0%, 61.2%, and 61.8% in fiscal years 2009, 2008, and 2007, respectively. The change from year-to-year is directly related to changes in product mix.

Production costs as a percentage of net sales were 31.9%, 30.6%, and 29.4% in fiscal years 2009, 2008, and 2007, respectively. The increase in fiscal year 2009 compared to fiscal year 2008 is related to lower fixed cost abortion due to sales decreasing and $1.3 million for severance charges related to cost reduction efforts. The increase in fiscal year 2008 compared to fiscal year 2007 is related to start-up cost we incurred throughout the year in association with new customer programs, inefficiencies of overtime and expedite costs associated with accelerated customer demand, and increased freight costs.

We provide for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage. The amounts charged to expense for these inventories were $303,000, $159,000, and $544,000 in fiscal years 2009, 2008, and 2007, respectively. Approximately $240,000 of the provision in fiscal year 2007 was related to a specific customer filing bankruptcy during the year. The majority of the remaining provision in each year related to stocked computer keyboards and other computer peripherals, and various inventory items that were deemed obsolete during the period.

We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense (recovery) was approximately $(93,000), $196,000, and $31,000 in fiscal years 2009, 2008, and 2007, respectively. The recovery in fiscal year 2009 related to the release of a warranty claim for a specific product that was identified in fiscal year 2008. Warranty expense for fiscal years 2008 and 2007 is related to workmanship claims on keyboards and certain EMS products.

Gross Profit

Gross profit as a percentage of net sales was 7.1%, 8.2%, and 8.8% in fiscal years 2009, 2008, and 2007, respectively.

The decrease in gross profit from fiscal year 2008 to 2009 was the result of lower fixed cost absorption due to sales decreasing. Additionally we incurred charges of approximately $1.3 million for severance charges related to cost reduction efforts.

The decrease in gross profit from fiscal year 2007 to 2008 is related mainly to start-up costs we incurred throughout the year in association with new customer programs, inefficiencies of overtime and expedite costs associated with accelerated customer demand, increased freight costs, and increasing costs of raw materials. In fiscal year 2007 there were certain customer sales price decreases in the aggregate in excess of achieved cost savings, a write off of $240,000 in inventory and $164,000 tooling related to a customer that filed for bankruptcy, and the additional costs incurred with the installation and start up of a new SMT line in Spokane Valley. We took early pay discounts to suppliers that totaled $142,000, $51,000, and $211,000 in fiscal years 2009, 2008, and 2007, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.

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

Research, Development and Engineering

Research, development and engineering expenses (RD&E) consists principally of employee related costs, third party development costs, program materials, depreciation and allocated information technology, and facilities costs. Total RD&E was $2.3 million, $2.7 million, and $3.2 million in fiscal years 2009, 2008, and 2007, respectively. As a percentage of net sales, RD&E was 1.2%, 1.3%, and 1.6% in fiscal years 2009, 2008, and 2007, respectively.

The decrease in RD&E in fiscal year 2009 compared to fiscal year 2008 is the result of cost reduction efforts and lower incentive and bonus expenses. The decrease in RD&E in fiscal year 2008 compared to fiscal year 2007 is related to transferring engineers and support personnel from RD&E to manufacturing costs of sales as their job roles changed to support the new SMT line in Spokane Valley, Washington.

Selling, General and Administrative

Selling, general and administrative expenses (SG&A) consist principally of salaries and benefits, advertising and marketing programs, sales commissions, travel expenses, provision for doubtful accounts, facilities costs, and professional services. Total SG&A expenses were $8.4 million, $8.3 million, and $9.2 million in fiscal years 2009, 2008, and 2007, respectively. As a percentage of sales SG&A was 4.5%, 4.0%, and 4.5% in fiscal years 2009, 2008, and 2007, respectively. Approximately half of our SG&A expenses relates to salary costs of our employees.

The increase in SG&A expenses in fiscal year 2009 compared to fiscal year 2008 is mainly attributable to foreign exchange losses on Mexican peso denominated financial assets and the addition of a sales representative which were partially offset by cost reduction efforts. Additionally, in fiscal year 2009 there was a charge of $604,000 to provide for doubtful collection of receivables, of which $533,000 was related to the write off of a foreign receivable. The decrease in SG&A expenses in fiscal year 2008 compared to fiscal year 2007 was due to $122,000, and $550,000, respectively, in bad debt expense, of which $536,000 was related to a customer filing bankruptcy during fiscal year 2007. In addition $460,000 of due diligence expenses, attorneys' fees, and bank fees were expensed in fiscal year 2007 as we decided not to proceed with a potential acquisition.

Goodwill Impairment

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we 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. In accordance with SFAS No. 142, goodwill is not amortized, but must be analyzed for impairment at least annually. Our goodwill impairment analysis was performed at the end of the second quarter each year using the two-step method.

As of December 27, 2008, we completed our annual impairment test. We performed the first step of our goodwill impairment test and determined that our book value exceeded our fair value based on the quoted market price of our stock as of December 26, 2008. The result of the first step indicated that goodwill was impaired and therefore, we 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 our fair value to all our 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 our common stock price, we concluded that 100% of the goodwill was impaired due to the significant and sustained decline in our market capitalization to below the book value. We recorded an impairment charge of $765,000 for the quarter ended December 27, 2008. As of June 27, 2009 there was no goodwill recorded in our Consolidated Balance Sheet.

Gain on Real Estate Held for Sale

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

Interest Expense

We had net interest expense of $590,000, $1.0 million, and $1.4 million in fiscal years 2009, 2008, and 2007, respectively. Interest expense decreased in fiscal year 2009 when compared to fiscal years 2008 and 2007 as the average balance of the revolving line of credit was lower along with a decrease in variable interest rates. We do not currently use derivatives to hedge interest rate risk. We do utilize short-term fixed LIBOR rates on portions of our revolving line of credit for short-term interest savings in anticipation of rate increases. We successfully negotiated a variable rate decrease on interest charged by our lender on our revolving line of credit and term debt during fiscal year 2007.

Income Tax Provision

We had an income tax provision of $130,000, $261,000, and $206,000 in fiscal years 2009, 2008, and 2007. The tax provision in fiscal years 2009 and 2008 is primarily related to income taxes paid in China and Mexico. The income tax expense of fiscal year 2007 primarily related to income taxes in the United States, which was primarily caused by a one-time repatriation of earnings from our Mexico subsidiaries. We applied certain tax credits to offset tax liabilities of our Mexican subsidiaries during calendar year 2007. We expect to pay income taxes in calendar year 2009 due to recently enacted tax laws in Mexico. We recognized a United States income tax benefit in fiscal year 2009 of $104,000 related to reducing the valuation allowance on our net deferred tax asset in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. We have domestic tax net operating loss carryforwards (NOLs) of approximately $33.2 million as of June 27, 2009. In accordance with SFAS No. 109, we assessed our recent operating levels and the sources of future taxable income to estimate a deferred tax asset. A valuation allowance against deferred tax assets is required if it is more likely than not that some of the deferred tax assets will not be realized. We have determined that the $8.3 million valuation allowance is appropriate at this time.

International Subsidiaries

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

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

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

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

Foreign sales (based on location of customer) from our worldwide operations, including domestic exports, were $20.9 million, $11.4 million, and $18.5 million in fiscal years 2009, 2008, and 2007, respectively. The decrease in fiscal year 2009 foreign sales is mainly related to a specific foreign customer program. Products and manufacturing services provided by our subsidiary operations are sold to customers directly by the parent company. Key Tronic Computer Peripherals (Shanghai) Co., Ltd., our subsidiary in Shanghai, China, had only minimal sales to customers in China during the past three fiscal years.

Capital Resources and Liquidity

Cash flows provided by operating activities were $10.0 million in fiscal year 2009 compared to $(718,000) used in operating activities in fiscal year 2008 and $(1.9) million used in fiscal year 2007.

The increase in cash provided by operating activities in fiscal year 2009 from 2008 was primarily due to a decrease in trade receivables and inventory. Trade receivables and inventory decreased by $10.5 million and $5.3 million, respectively, during fiscal year 2009. These decreases were partially offset by a decrease of accounts payable of $10.8 million. These decreases are the result of lower sales in the fourth quarter of fiscal year 2009 as compared to 2008 and a concerted effort to reduce our inventory and align it with our current level of business.

The decrease in cash used in operating activities in fiscal year 2008 from 2007 was primarily due to an increase in cash provided by net income of $5.6 million and increases in accounts payable and accrued compensation and vacation totaling $6.1 million. These sources of cash were partially offset by $5.7 million increase in inventory and $5.8 million increase in accounts receivable. The increases in accounts payable and inventory at the end of fiscal year 2008 were related to our increasing inventory for new customers. In addition, trade receivables increased $5.6 million as the result of higher sales during our fourth quarter.

Cash used in investing activities includes capital expenditures and proceeds from the sale of property and equipment. Capital expenditures were $1.9 million, $1.2 million, and $3.1 million in fiscal years 2009, 2008, and 2007, respectively. Our capital expenditures are primarily for purchases of manufacturing assets to support our operations in Spokane Valley, Washington, Mexico and China. Capital expenditures increased for fiscal year 2009 as compared to 2008 as we invested in manufacturing equipment to support the requirements of new customers. Capital expenditures were higher in fiscal year 2007 as compared to fiscal year 2008 as the result of purchasing a facility in Juarez to replace a leased manufacturing location. We have also continued to use a variety of operating leases to fund the purchase of manufacturing equipment.

Our primary financing activity in fiscal years 2009, 2008, and 2007 was borrowing and repayment under our financing agreement with CIT Group/Business Credit, Inc. (CIT). Our financing agreement with CIT provided a revolving credit facility of up to $25 million. The revolving loan was secured by our assets. The interest rate provisions allow for a variable rate based on either the prime rate or LIBOR rate. The agreement specified four alternative levels of margin to be added to these base rates depending on compliance with certain financial covenants. The range of interest being paid to CIT on outstanding balances was 1.82%-3.25% as of June 27, 2009. The financing agreement contained financial covenants that relate to total equity, earnings before interest, taxes, depreciation and amortization, and a minimum fixed charge ratio. All but one of the financial covenants, the fixed charge ratio, had been removed by subsequent amendments to the financing agreement. As of June 27, 2009, we were in compliance with our remaining loan covenant. At June 27, 2009, the outstanding revolving loan balance was $2.4 million compared to $12.3 million at fiscal year . . .