Summary of KEY TRONIC CORP

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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.), trading on the NASDAQ with the symbol KTCC, was organized in 1969 as a Washington corporation that locally manufactured computer keyboards. 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, allowing us to be 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 for 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 from a wide range of industries.

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. The recent challenging global economic environment has however, 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. 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 continue to focus on controlling operating expenses and leveraging the synergistic capabilities of our world-class 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. Given our competitive advantages and the growing need for some potential customers to move forward with their outsourcing strategies, we are strongly positioned to win new business in coming periods and grow our revenue and profits as the global economic environment improves.

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The EMS industry 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 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.

Sales for the first quarter of fiscal year 2010 decreased 14.4% to $41.3 million compared to $48.2 million for the same period of fiscal year 2009. This decrease in sales reflects the expected lower demand from existing programs with established customers due to the unfavorable global economic environment. The decline in demand from our established customers' programs was partially offset by revenue from new customers and revenue from new programs with existing customers. In the first quarter of fiscal year 2009 new customers contributed 19.4% of revenue. These same customers from 2009 plus new customers in the first quarter of fiscal year 2010 contributed 43.5% of revenue.

In the first quarter of fiscal 2010, we continued to successfully meet the challenges of the global recession by reducing our costs while ramping up our new customer programs and further diversifying our customer portfolio across a wide range of industries. Despite the macro-economic uncertainty, we remain strongly positioned to win new business and currently expect to see growth in the second half of our fiscal year, driven by increased production levels of our new programs for both new and longstanding customers. Sales in the second quarter of fiscal year 2010 are expected to be in the range of $38 million to $43 million. 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.

Net income for the first quarter of fiscal year 2010 was $295,000 compared to $408,000 for the first quarter of fiscal year 2009. The decrease in the net income for the first quarter of fiscal year 2010 as compared to the first quarter of fiscal year 2009 reflects the lower revenue from customers due to the unfavorable global economic environment.

Gross profit as a percentage of sales for the first quarter of fiscal year 2010 was 6.5% compared to 7.1% for the first quarter of fiscal year 2009. The decrease in gross profit as a percentage of net sales was the result of lower fixed cost absorption due to decreased sales. The level of gross margin is impacted by facility utilization, product mix, timing of the start up of new programs, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.

We maintain a strong balance sheet with a current ratio of 2.4 and a long-term debt to equity ratio of 0. Total cash provided by operations was $3.9 million for the first quarter of fiscal year 2010. We maintain sufficient liquidity for our expected future operations and had approximately $13.4 million available under our Wells Fargo Bank, N.A. line of credit as of September 26, 2009. We believe that internally generated funds, our borrowing capacity, and equipment leasing should provide adequate capital for planned growth over the long term.

On August 19, 2009, we entered into a credit agreement with Wells Fargo Bank, N.A. providing for a revolving line of credit facility of up to $20 million and paid off our CIT revolving loan. The agreement with Wells Fargo Bank, N.A. 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%. The fixed rate is LIBOR plus 2.1% or LIBOR plus 2.5% depending on the level of trailing four quarters EBITDA.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Revenue Recognition

We recognize revenue when products are shipped and the sales revenue becomes realizable. FASB ASC Topic 605, 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.

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• 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 $111,000 at September 26, 2009 and June 27, 2009. 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 $33.2 million and other future deductible temporary differences and tax credit carryforwards at June 27, 2009. In accordance with FASB ASC Topic 740, Accounting for Income Taxes, 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 $8.1 million on the total deferred tax asset is appropriate as of September 26, 2009. 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.

Derivatives

We adopted FASB ASC Topic 815, Derivatives and Hedging, as of March 28, 2009. 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 September 26, 2009,

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we had forward contracts to lock in known future cash outflows for payroll, utility, tax, and accounts payable expenses denominated in the Mexican peso. As of September 26, 2009, the fair value of these contracts was an asset of $189,000 which was included in other current assets and recorded as unrealized income in accumulated other comprehensive income.

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 Operations for the periods indicated.



                                                   First Quarter Ended
                                        September 26, 2009      September 27, 2008
Net sales                                            100.0 %                 100.0 %
Cost of sales                                         93.5                    92.9

Gross profit                                           6.5                     7.1

Operating expenses
Research, development and engineering                  1.4                     1.3
Selling, general and administrative                    4.2                     4.5

Total operating expenses                               5.6                     5.8


Operating income                                       0.9                     1.3

Interest expense                                       0.1                     0.4

Income before income taxes                             0.8                     0.9

Income tax provision                                   0.1                     0.1

Net income                                             0.7 %                   0.8 %

Sales

Sales for the first quarter of fiscal year 2010 decreased 14.4% to $41.3 million compared to $48.2 million for the same period of fiscal year 2009. This decrease in sales reflects the expected lower demand from existing programs with established customers due to the unfavorable global economic environment. The decline in demand from our established customers' programs was partially offset by revenue from new customers and revenue from new programs with existing customers. In the first quarter of fiscal year 2009 new customers contributed approximately 19.4% of revenue. These new customers from 2009 plus new customers in 2010 contributed approximately 43.5% of revenue.

Sales to our largest customers may vary significantly from quarter to quarter depending on the size and timing of customer program commencement, forecasts, delays, and design modifications. 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.

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Gross Profit

Included in gross profit are charges related to changes in the allowance for obsolete inventory. We did not record a provision for obsolete inventory for the first three months of fiscal year 2010. We recorded a $138,000 provision for the first three months of fiscal year 2009. 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 as to future demand and market conditions. The reserves are established for inventory that we have determined customers are not contractually responsible for and for inventory that we believe customers will be unable to purchase.

Operating Expenses

Total operating expenses were $2.3 million in the first quarter of fiscal year 2010 and $2.8 million in the first quarter of fiscal year 2009. The difference was mainly attributable to a decrease in selling, general and administrative (SG&A) expenses. Operating expenses as a percentage of sales decreased to 5.6% in the first quarter of fiscal year 2010 from 5.8% in the first quarter of fiscal year 2009.

Total SG&A expenses were $1.7 million and $2.1 million during the first quarters of fiscal years 2010 and 2009, respectively. The difference was mainly attributable to lower charges for doubtful receivables and lower payroll expense due to a workforce reduction. For the first three months of fiscal year 2010 there was no charge to provide for doubtful collection of receivables. A charge of $75,000 for doubtful collection was recorded in the first three months of fiscal year 2009.

Total research, development, and engineering (RD&E) expenses were $562,000 and $626,000 during the first quarters of fiscal years 2010 and 2009, respectively. Lower RD&E expenses in the first quarter of fiscal year 2010 compared to the same period of fiscal year 2009 were the result of lower payroll expense due to a workforce reduction.

Interest

Interest expense decreased to $46,000 in the first quarter of fiscal year 2010 from $182,000 in the first quarter of fiscal year 2009. The decreases in interest expense in the first quarter of fiscal year 2010 compared to the same period of fiscal year 2009 is due to a decrease in the average outstanding revolving credit facility balance and a decrease in variable interest rates.

Income Taxes

We had domestic income tax loss carryforwards of approximately $33.2 million at June 27, 2009. In accordance with FASB ASC Topic 740, Accounting for Income Taxes, a valuation allowance is required if it is more likely than not that some or all of the deferred tax assets will not be realized in the future. Management assessed our recent operating levels and the sources of future taxable income to estimate a valuation allowance. We determined that the valuation allowance of $8.1 million is appropriate as of September 26, 2009. 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 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.

In addition to our domestic operations, we have subsidiaries in Mexico and China. We are currently applying certain tax credits to offset the income tax liabilities of our Mexican subsidiaries. As of January 1, 2008, we became subject to a Mexican business flat tax called Impuesto Empresarial a Tasa Unica (IETU). The effect of IETU and an associated presidential decree on fiscal year 2010 results has been included in the effective tax rate for the three months ended September 26, 2009 and was approximately $26,000. Accordingly, the income tax provisions for the first quarter of fiscal years 2010 and 2009 are primarily attributable to the taxable earnings of our foreign subsidiaries.

Backlog

On September 26, 2009, we had an order backlog of approximately $27.1 million. This compares with a backlog of approximately $35.2 million on September 27, 2008. The change in backlog at September 26, 2009, when compared to September 27, 2008, was due to the decline in demand from our existing customers as the result of the unfavorable global economic environment. Order backlog consists of purchase orders received for products expected to be shipped within the next 12 months, although shipment dates are subject to change due to design modifications or changes in other customer requirements. Order backlog should not be considered an accurate measure of future sales.

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CAPITAL RESOURCES AND LIQUIDITY

Operating Cash Flow

Net cash provided by operating activities for the three months ended September 26, 2009 was $3.9 million, compared to $776,000 provided during the same period of the prior fiscal year. This consisted primarily of a $2.2 million decrease in inventory and a $1.5 million increase in accounts payable. The decrease in inventory was attributable to a reduction of finished goods during the quarter and the increase in accounts payable was primarily driven by the timing of purchases and cash payments during the first three months of fiscal year 2010. Accounts payable fluctuates with changes in inventory levels and negotiated supplier terms. We purchase inventory based on customer forecasts and orders, and when those forecasts and orders change the amount of inventory may also fluctuate.

Investing Cash Flow

During the first three months of fiscal year 2010, we spent $340,000 for capital additions compared to $126,000 in the same period of the previous fiscal year. Our capital expenditures primarily consist of purchases of manufacturing equipment to support our production facilities. We also use leases to acquire equipment. Operating leases are often utilized when potential technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds.

Financing Cash Flow

Our primary financing activity during the first three months of fiscal years 2010 and 2009 was borrowing and repayment under our revolving line of credit facility. Our credit agreement with Wells Fargo Bank N.A. provides a revolving line of credit facility of up to $20 million, subject to availability. The agreement specifies that the proceeds of the revolving line of credit be used primarily for working capital and general corporate purposes of the Company and its subsidiaries. Borrowings under this revolving line of credit bear interest at either a "Base Rate" or a "Fixed Rate", as elected by the Company. The base rate is the higher of the JP Morgan Chase prime rate, daily one month LIBOR plus 1.5%, or the Federal Funds rate plus 1.5%. The fixed rate is LIBOR plus 2.1% or LIBOR plus 2.5% depending on the level of trailing four quarters EBITDA.

As of September 26, 2009, we were in compliance with our loan covenants and approximately $13.4 million was available under the revolving line of credit facility.

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

Restricted cash included amounts in our bank account that must be used to pay down our revolving line of credit.

RISKS AND UNCERTAINTIES THAT MAY AFFECT FUTURE RESULTS

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