Summary of KEY TRONIC CORP

Item 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

KeyTronicEMS is a leader in electronic manufacturing services and solutions to original equipment manufacturers of a broad range of products. We provide engineering services, worldwide procurement and distribution, materials management, world-class manufacturing and assembly services, in-house testing, and unparalleled customer service. Our international production capability provides our customers with benefits of improved supply-chain management, reduced inventories, lower transportation costs, and reduced product fulfillment time. We continue to make investments in all of our operating 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.

Our mission is to provide our customers with superior manufacturing and engineering services at the lowest total cost for the highest quality products, and create long-term mutually beneficial business relationships by employing our "Trust, Commitment, Results" philosophy.

Executive Summary

During fiscal year 2012 we set a new record for annual revenue of $346.5 million, a 36.5 percent growth as compared to sales of $253.8 million in fiscal year 2011. The increase in net sales was primarily driven by an increase in revenues related to new programs for both new and longstanding customers and a net increase in demand related to current customer programs, partially offset by the negative impact of the uncertain macroeconomic environment. Net sales for the first quarter of fiscal year 2013 are expected to be within the range of $94 million to $99 million. Future results will depend on actual levels of customers' orders, the timing of the start up of production of new product programs and the potential impact of the macroeconomic uncertainty. We believe that we are well positioned in the EMS industry to continue expansion of our customer base and continue long-term growth.

The concentration of our largest customers increased during fiscal year 2012 with the top five customers' sales increasing to 73 percent of total sales in 2012 from 62 percent in 2011, and 57 percent in 2010. Our current customer relationships involve a variety of products, including consumer electronics, electronic storage devices, plastics, household products, gaming devices, specialty printers, telecommunications, industrial equipment, military supplies, computer accessories, electronic whiteboards, medical, educational, irrigations, automotive, transportation management and robotics. The growth during fiscal year 2012 was powered by an increasingly diverse mix of new customer programs. At the end of fiscal year 2012, we were generating revenue from 165 separate programs and 48 distinct customers as compared to 119 programs and 33 customers at the end of fiscal year 2011. 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 8.6 percent in fiscal year 2012 compared to 8.1 percent for the prior fiscal year. This 0.5 percentage point increase in gross profit as a percentage of net sales during fiscal year 2012 as compared to fiscal year 2011 is primarily related to a 2.3 percentage point improvement in leveraging of certain overhead costs, as a percent of sales, partially offset by a 1.8 percentage point increase in material costs, as a percent of sales, resulting from higher material content in certain new customer programs. The level of gross margin is impacted by product mix, timing of the start up of new programs, facility utilization, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.

Operating income as a percentage of sales for fiscal year 2012 was 4.1 percent compared to 2.7 percent for fiscal year 2011. The increase in operating income as a percentage of sales was due to an increase in gross margin, leveraging of certain operating expenses and by improving efficiencies during fiscal year 2012.

Net income for fiscal year 2012 was $11.6 million or $1.10 per diluted share, as compared to net income of $5.7 million or $0.55 per diluted share for fiscal year 2011. The increase in net income for fiscal year 2012 as compared to fiscal year 2011 was primarily due to the increase in net sales coupled with an improvement in our gross margin and operating income partially offset by an increase in income tax expense.

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We maintain a strong balance sheet with a current ratio of 2.4 and a long-term debt to equity ratio of 0.19. Total cash used in operating activities as defined on our cash flow statement was $5.1 million during fiscal year 2012. However, we maintain sufficient liquidity for our expected future operations and had $15.0 million in outstanding borrowings on our revolving line of credit with Wells Fargo, N.A. and $15.0 million remained available at June 30, 2012. We believe cash flow from operations, our borrowing capacity, and equipment lease financing should provide adequate capital for planned growth over the long term.

RESULTS OF OPERATIONS

Comparison of the Fiscal Year Ended June 30, 2012 with the Fiscal Year Ended
July 2, 2011

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.



                                                                           Fiscal Year Ended
                                        June 30,          % of           July 2,          % of                         %  point
                                          2012          net sales         2011          net sales       $ change        change
Net sales                               $ 346,475            100.0 %    $ 253,846            100.0 %    $  92,629             -  %
Cost of sales                             316,639             91.4        233,198             91.9         83,441           (0.5 )

Gross profit                               29,836              8.6         20,648              8.1          9,188            0.5
Operating expenses:
Research, development and engineering       4,444              1.3          3,782              1.5            662           (0.2 )
Selling, general and administrative        11,041              3.2          9,927              3.9          1,114           (0.7 )

Total operating expenses                   15,485              4.5         13,709              5.4          1,776           (0.9 )

Operating income                           14,351              4.1          6,939              2.7          7,412            1.4
Interest expense, net                         510              0.1            457              0.2             53           (0.1 )

Income before income taxes                 13,841              4.0          6,482              2.6          7,359            1.4
Income tax provision                        2,215              0.6            746              0.3          1,469            0.3

Net income                              $  11,626              3.4 %    $   5,736              2.3 %    $   5,890            1.1 %

Effective income tax rate                    16.0 %                          11.5 %

Net Sales

Net sales were $346.5 million and $253.8 million in fiscal years 2012 and 2011, respectively.

Net sales increased $92.6 million during fiscal year 2012 as compared with fiscal year 2011. This increase in net sales was primarily driven by an approximate $90.6 million increase in revenues related to new programs for both new and longstanding customers and to a lesser extent a $2.9 million increase related to increased demand from certain current customer programs. These increases were partially offset by $0.9 million related to customer program losses. The negative impact resulting from the uncertain macroeconomic environment is reflected in the analysis of our new and longstanding customers programs as discussed above.

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The following table shows the revenue by industry sectors as a percentage of revenue for fiscal years 2012 and 2011:

                                                 Years Ended
                                       June 30, 2012       July 2, 2011
            Communication                          36 %               22 %
            Consumer                               20                 20
            Gaming                                 18                 16
            Transaction Printer                    12                 18
            Computer and Peripheral                 7                 13
            Industrial                              6                  6
            Commercial Printer                      1                  5

            Total                                 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 continue to see a change in the industry concentrations of our revenue.

Sales to foreign locations represented 40.6 percent, and 31.9 percent of our total net sales in fiscal years 2012, and 2011, respectively.

Cost of Sales

Total cost of sales as a percentage of net sales was 91.4 percent, and 91.9 percent in fiscal years 2012, and 2011, respectively.

Total cost of materials as a percentage of net sales was approximately 70.4 percent, and 68.6 percent in fiscal years 2012, and 2011, respectively. The change from year-to-year is primarily the result of higher material content in certain new customer programs and changes in product mix.

Production and support costs as a percentage of net sales were 21.0 percent, and 23.3 percent in fiscal years 2012, and 2011, respectively. The decrease in fiscal year 2012 is primarily related to the leveraging of our fixed costs as a percentage of sales during the fiscal year.

We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. Warranty expense is related to workmanship claims on keyboards and EMS products. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense was approximately $65,000 and $158,000 in fiscal years 2012, and 2011, respectively.

Gross Profit

Gross profit as a percentage of net sales was 8.6 percent, and 8.1 percent in fiscal years 2012, and 2011, respectively.

The 0.5 percentage point increase in gross profit as a percentage of net sales during fiscal year 2012 as compared to fiscal year 2011 is primarily related to a 2.3 percentage point improvement in leveraging of certain overhead costs, as a percent of sales, partially offset by a 1.8 percentage point increase in material costs, as a percent of sales, resulting from higher material content in certain new customer programs and changes in product mix.

We took early pay discounts to suppliers that totaled approximately $932,000 and $678,000, in fiscal years 2012, and 2011, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.

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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 expense was $4.4 million and $3.8 million in fiscal years 2012, and 2011, respectively. This $0.6 million increase is primarily the result of increased headcount and to a lesser extent higher incentive compensation.

Total RD&E expenses as a percent of net sales were 1.3 percent and 1.5 percent in fiscal years 2012, and 2011, respectively. This 0.2 percentage point improvement in RD&E is primarily related to our continued success in leveraging operating expenses as a percent of net sales.

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 $11.0 million and $9.9 million in fiscal years 2012, and 2011, respectively. This $1.1 million increase is primarily related to an increase in headcount.

Total SG&A expenses as a percent of net sales were 3.2 percent, and 3.9 percent in fiscal years 2012, and 2011, respectively. This 0.7 percentage point improvement in SG&A is primarily related to our continued success in leveraging operating expenses as a percent of net sales.

Interest Expense

We had net interest expense of $0.5 million, and $0.5 million in fiscal years 2012, and 2011, respectively. Interest expense for fiscal year 2012 remained relatively flat as compared to fiscal year 2011.

Income Tax Provision

We had an income tax expense of $2.2 million during fiscal year 2012 as compared to an income tax expense of $746,000 in fiscal year 2011. The income tax expense recognized during fiscal 2012 was primarily a function of U.S. and foreign taxes recognized at the statutory rates offset by the net benefit associated with federal research and development tax credits and changes in potential foreign tax credits. The income tax expense recognized during fiscal 2011 was primarily a function of U.S. and foreign taxes recognized at the statutory rates offset by the net benefit associated with federal research and development tax credits, the release of the valuation allowance in China, and changes in potential foreign tax credits.

Due to increased profitability, revenue growth, and new customer programs, we utilized all remaining domestic net operating loss carryforwards (NOLs) during fiscal year 2012. Furthermore, all previous NOL carryforwards in China have been fully utilized as well. As a result, there is no remaining deferred tax asset as of June 30, 2012 related to NOLs. In addition, we reviewed our requirements for liquidity domestically to fund our revenue growth and to look for potential future acquisitions. We continue to anticipate repatriating a portion of our unremitted foreign earnings. The associated taxes and potential foreign tax credits were first included in the income tax benefit that was realized during fiscal year 2010 and certain changes in the estimates of foreign earnings and profits and tax pools resulted in the recognition of additional tax benefits during fiscal years 2011 and 2012. For further information on taxes please review footnote 5 of the "Notes to Consolidated Financial Statements".

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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 five assembly and storage facilities in Juarez, Mexico. This subsidiary is primarily used to support our U.S. operations.

� Key Tronic Computer Peripherals (Shanghai) Co., Ltd. leases two facilities with SMT, assembly and warehouse 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 shipping instructions) from our worldwide operations, including domestic exports, were $140.8 million and $81.1 million in fiscal years 2012, and 2011, respectively. Products and manufacturing services provided by our subsidiary operations are primarily sold to customers directly by the parent company. Key Tronic Computer Peripherals (Shanghai) Co., Ltd., our subsidiary in Shanghai, China, had only minimal direct sales to customers in China during the past two fiscal years.

Comparison of the Fiscal Year Ended July 2, 2011 with the Fiscal Year Ended
July 3, 2010

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.



                                                                            Fiscal Year Ended
                                         July 2,          % of           July 3,           % of                          %  point
                                          2011          net sales         2010           net sales       $ change         change
Net sales                               $ 253,846            100.0 %    $ 199,620             100.0 %    $  54,226              -  %
Cost of sales                             233,198             91.9        180,370              90.4         52,828             1.5

Gross profit                               20,648              8.1         19,250               9.6          1,398            (1.5 )
Operating expenses:
Research, development and engineering       3,782              1.5          2,783               1.4            999             0.1
Selling, general and administrative         9,927              3.9          9,079               4.5            848            (0.6 )

Total operating expenses                   13,709              5.4         11,862               5.9          1,847            (0.5 )

Operating income                            6,939              2.7          7,388               3.7           (449 )          (1.0 )
Interest expense, net                         457              0.2            102               0.1            355             0.1

Income before income taxes                  6,482              2.6          7,286               3.6           (804 )          (1.0 )
Income tax provision (benefit)                746              0.3         (1,404 )             0.7         (2,150 )          (0.4 )

Net income                              $   5,736             2.3  %    $   8,690              4.4  %    $  (2,954 )          (2.1 )%

Effective income tax rate                    11.5 %                         (19.3 )%

Net Sales

Net sales were $253.8 million, and $199.6 million in fiscal years 2011 and 2010, respectively.

Net sales increased $54.2 million during fiscal year 2011 as compared with fiscal year 2010. This increase in net sales was primarily driven by an approximate $77.9 million increase in revenues related to new programs for both new and longstanding customers. This was partially offset by a $18.5 million decline related to decreased demand from certain current customer programs. In addition, during fiscal year 2011 we experienced an approximately $5.2 million decline related to the negative impact of end-of-life customer programs and to a lesser extent customer program losses. The negative impact resulting from industry-wide shortages in the global supply chain that occurred throughout most of the year and the uncertain macroeconomic environment are reflected in the analysis of our new and longstanding customers programs as discussed above.

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The following table shows the revenue by industry sectors as a percentage of revenue for fiscal years 2011 and 2010:

                                                 Years Ended
                                       July 2, 2011       July 3, 2010
             Communication                        22 %               11 %
             Consumer                             20                 26
             Gaming                               16                 13
             Transaction Printer                  18                 22
             Computer and Peripheral              13                 15
             Industrial                            6                  4
             Commercial Printer                    5                  9

             Total                               100 %              100 %

Sales to foreign locations represented 31.9 percent, and 17.9 percent of our total net sales in fiscal years 2011, and 2010, respectively.

Cost of Sales

Total cost of sales as a percentage of net sales was 91.9 percent, and 90.4 percent in fiscal years 2011, and 2010, respectively.

Total cost of materials as a percentage of net sales was approximately 68.6 percent, and 62.2 percent in fiscal years 2011, and 2010, respectively. The change from year-to-year is primarily the result of higher material content in certain new customer programs and changes in product mix.

Production and support costs as a percentage of net sales were 23.3 percent, and 28.2 percent in fiscal years 2011, and 2010, respectively. The decrease in fiscal year 2011 is primarily related to the leveraging of our fixed costs as a percentage of sales during the fiscal year.

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 approximately $0.3 million, and $2.2 million in fiscal years 2011, and 2010, respectively. The large provision in fiscal year 2010 was primarily due to a discontinuance of manufacturing for certain customers that became no longer viable.

We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. Warranty expense is related to workmanship claims on keyboards and EMS products. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense was approximately $158,000 and $45,000 in fiscal years 2011, and 2010, respectively.

Gross Profit

Gross profit as a percentage of net sales was 8.1 percent, and 9.6 percent in fiscal years 2011, and 2010, respectively.

The 1.5 percentage point decrease in gross profit as a percentage of net sales during fiscal year 2011 as compared to fiscal year 2010 is primarily related to a 6.4 percentage point increase in material costs, as a percent of sales, resulting from higher material content in certain new customer programs, partially offset by a 4.9 percentage point improvement in leveraging of certain overhead costs.

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We took early pay discounts to suppliers that totaled approximately $678,000, and $364,000, in fiscal years 2011, and 2010, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.

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 $3.8 million, and $2.8 million in fiscal years 2011, and 2010, respectively. As a percentage of net sales, RD&E was 1.5 percent and 1.4 percent in fiscal years 2011, and 2010, respectively. The increase in RD&E in fiscal year 2011 is primarily the result of increased headcount and to a lesser extent higher incentive compensation.

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 $9.9 million, and $9.1 million in fiscal years 2011, and 2010, respectively. As a percentage of net sales SG&A was 3.9 percent, and 4.5 percent in fiscal years 2011, and 2010, respectively. Approximately half of our SG&A expenses relates to salary costs of our employees.

The $0.8 million increase in SG&A expenses in fiscal year 2011 as compared to fiscal year 2010 is primarily due to a $0.5 million increase in outside services and professional fees, a $0.4 million increase in salary related costs, and a $0.3 million increase related to other overhead costs. This was partially offset by an approximate $0.4 million decrease in incentive compensation expense.

Interest Expense

We had net interest expense of $0.5 million, and $0.1 million in fiscal years 2011, and 2010, respectively. Interest expense increased in fiscal year 2011 when compared to fiscal year 2010 as the average balance of the revolving line of credit was higher in addition to interest expense incurred as a result of our capital lease obligations. We often utilize short-term fixed LIBOR rates on portions of our revolving line of credit to limit the affect of interest rate volatilities.

Income Tax Provision

We had an income tax expense of $746,000 during fiscal year 2011 as compared to an income tax benefit of $1.4 million in fiscal year 2010. The income tax expense recognized during fiscal 2011 was primarily a function of U.S. and . . .