KEY TRONIC CORP - Annual Report: 2001 (Form 10-K)

TABLE OF CONTENTS LINK

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of
The Securities Exchange Act of 1934

N. 4424 Sullivan Road
Spokane, Washington 99216
(509) 928-8000

Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock

The registrant has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months, and has been subject to such filing requirements during the past 90 days.

Indicate by checkmark if delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

The aggregate market value of the voting stock held by non affiliates of the Registrant was $19,619,967 as of June 30, 2001.

The number of shares of Common Stock of the Registrant outstanding as of June 30, 2001 was 9,672,580 shares.

The Exhibit Index is located at page 28.

DOCUMENTS INCORPORATED BY REFERENCE

The following documents are incorporated by reference to the extent specified herein:

1

KEY TRONIC CORPORATION
2001 FORM 10-K

TABLE OF CONTENTS

2

FORWARD-LOOKING STATEMENTS

This Annual 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 revise or publicly release the results of any revision to forward-looking statements. Readers should carefully review the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission, including Quarterly Reports on Form 10-Q.

PART I

Item 1.    BUSINESS

Key Tronic Corporation, a Washington corporation organized in 1969, and its subsidiaries (hereinafter collectively called the "Company" or "Key Tronic" unless the context otherwise requires) are engaged in electronic manufacturing services (EMS) for original equipment manufacturers (OEMs) and manufacturing of keyboards for personal computers, terminals, and workstations. The Company operates on a fiscal year that ends on the Saturday closest to June 30. The following discussion relates to three fiscal years of the Company. In previous filings EMS was referred to as contract design and manufacturing (CDM).

BACKGROUND

Historically Key Tronic was a manufacturer of electronic keyboards, but during the course of the past two fiscal years, its focus has changed to electronic manufacturing services (EMS). Presently Key Tronic is known as an independent provider of a mix of EMS services for OEMs. The Company's manufacturing capabilities include circuit board assemblies, tool making, precision molding, proto building, liquid plastic injection molding and printed circuit board assembly (both through-hole and surface mounting).

Operations are currently conducted in facilities in the United States, China, Ireland and Mexico. This global production capability provides customers with benefits of improved supply chain management, reduced inventory, lower transportation costs and reduced product fulfillment time.

The EMS industry is comprised of companies that provide a range of manufacturing services for OEMs. The EMS industry has experienced rapid growth over the past several years as more and more OEMs shift to external manufacturing. Equity Research reports have stated that the EMS market is expected to grow at a rate of 25% over the next three to five years.

KEYBOARD PRODUCTS

During fiscal years 2001, 2000, and 1999, the Company realized revenues of approximately $39.2 million, $70.5 million, and $134.7 million, respectively, from the sale of keyboards representing approximately 24%, 43%, and 76% of total sales. The keyboard market has continued to trend toward standard keyboard layouts. In order to accommodate the demand for standard products, the Company maintains a purchase-from-stock program. The most popular standard layouts are built and stocked for immediate availability. These products serve as enhancements to or replacements for the original system-supplied keyboard.

MANUFACTURING

Since inception, the Company has made substantial investments in developing and expanding its now extensive capital equipment base to achieve selective vertical integration in its manufacturing processes. The Company designs and develops tooling for injection molding machines and manufactures the majority of plastic parts used in the products it manufactures. Additionally, the Company has invested in equipment to produce switch membranes as a means to reduce cost and improve quality.

The OEM keyboard market has increasingly demanded rapid response time and design adaptability from keyboard manufacturers. New computer products are continually being introduced by computer manufacturers, with the timing of product introduction often perceived as having distinct marketing advantages. Developing a keyboard for a new application is a custom process, which requires frequent

contact with the customer while working through changes during design stages. Computer manufacturers place a premium on the ability of the keyboard manufacturer to design and produce keyboards that meet their technical specifications and aesthetic considerations and to deliver in accordance with production schedules. The processes and skills the Company developed and uses in the keyboard market are transferable to and valued in the EMS market. This has resulted in the Company gaining new customers and EMS programs.

The Company's automated manufacturing processes enable it to work closely with its customers during design and prototype stages of production for new custom products and to jointly increase productivity and reduce response time to the market place. Key Tronic uses computer-aided design techniques and unique software to assist in preparation of the tool design layout and tool fabrication, to reduce tooling costs, improve component and product quality and enhance turnaround time during product development.

The Company uses numerous injection molding machines in producing more than 50,000 different keycaps, enclosures and various plastic parts for the products it manufactures. Designs by Key Tronic engineers in both tooling and molding have improved standard processing time and thereby increased productivity. During fiscal 1998, Key Tronic introduced stack molding technology to the manufacturing process. Stacked molds allow the Company to utilize two molds simultaneously thereby producing twice as many parts in nearly the same cycle time used for one part. The molding machines used by the Company employ the latest technology, including the ability to mix plastics and determine the color of finished components as part of the molding process. This automated, pneumatically-fed process, not only allows precise control of color determination, but also results in lower product costs and improved component quality. The Company also produces blank keytops for certain models. The print legends are later added using a laser technology to produce entire key configuration layouts in local languages for the European market.

Key Tronic uses a variety of manual to highly-automated assembly processes in its facilities, depending upon product complexity and degree of customization. Automated processes include component insertion, surface mount technology, flexible robotic assembly, computerized vision system quality inspection, automated switch and keytop installation, and automated functional testing.

The Company purchases materials for its products from a number of different suppliers. Key Tronic believes that it has excellent relationships with its vendors, most of whom have been suppliers for the Company for many years.

CUSTOMERS AND MARKETING

OEM MARKETS

The Company provides manufacturing services for outsourced OEM products. The Company also manufactures and supplies custom keyboards to leading OEMs in the keyboard market.

Hewlett Packard accounted for approximately 39 percent, 38 percent, and 24 percent of net sales in 2001, 2000, and 1999, respectively. Lexmark accounted for 27 percent of net sales in 2001 and 13 percent in 2000. Microsoft accounted for approximately 5 percent, 9 percent, and 11 percent of net sales in 2001, 2000, and 1999, respectively. Gateway accounted for approximately 1 percent, 8 percent, and 13 percent of net sales in fiscal years 2001, 2000, and 1999, respectively. No other customer accounted for more than 10 percent of net sales during any of the last three years. In 2001, 2000, and 1999, the five largest customers accounted for 81 percent, 72 percent, and 60 percent of total sales, respectively.

The Company markets its products and services primarily through its direct sales organization aided by distribution sales in the U.S., Canada and Europe. In fiscal 2001, the Company hired a number of outside sales organizations to help promote its electronic manufacturing services.

All OEM keyboards are accompanied by a manufacturer's three-year warranty that provides for repair or replacement of defective products. Retail products carry a one-year to a limited lifetime warranty. The limited lifetime warranty is product specific.

FOREIGN MARKETS

Information concerning geographic areas for the years ended June 30, 2001, July 1, 2000, and July 3, 1999 is summarized in the following table.

Transfers to affiliates are made at prices which approximate market. Intercompany margins are eliminated upon consolidation.

In 2001, $88.9 million, or 53.6% percent of the Company's revenues were from foreign sales, primarily sales in Europe, the Far East, Canada, Mexico and South America. Foreign sales in 2000 and 1999 were $65.3 million and $75.4 million, respectively. Foreign sales are made primarily through the Company's direct sales force in the U.S. and Ireland. Key Tronic Shanghai (KTS), the Company's facility in Shanghai, China, began operations in the third quarter of 1999 and is used to support customers in that area as well as for export.

For additional financial information about foreign operations, see Note 12 to the Consolidated Financial Statements.

BACKLOG

At August 11, 2001, the Company had an order backlog of approximately $81.5 million. This compares with a backlog of approximately $35 million at August 5, 2000. The increase in backlog is attributable in part to increased customer orders from a new EMS customer for fiscal year 2002. The Company also supports two major OEM customers that have expanded their Just-In-Time (JIT) inventory systems, so that orders are not placed in advance but are pulled from a stock location maintained by Key Tronic. Order backlog is not necessarily indicative of future sales. Order backlog consists of purchase orders received for products expected to be shipped approximately within the next fiscal year, although shipment dates are subject to change due to design modifications or other customer requirements. All orders in backlog are expected to be filled within the current fiscal year.

RESEARCH, DEVELOPMENT, AND ENGINEERING

The Company's research, development, and engineering expenses were $2.7 million, $2.8 million, and $4.9 million in 2001, 2000, and 1999, respectively. Research, development and engineering expenses as a percentage of sales were 1.6 percent, 1.7 percent, and 2.7 percent in 2001, 2000, and 1999, respectively. The slight decrease in fiscal year 2001 is a result of greater recovery of engineering design costs.

COMPETITION

The Company believes that its principal competitors in the EMS market are: Plexus Corp, SCI Systems, ACT Manufacturing, Celestica, Flextronics International, Jabil Circuits, and Solectron. The principal methods of competition are price, quality and capability.

The Company believes that its principal competitors in the keyboard market are: Chicony, NMB and Siletek.

TRADEMARKS AND PATENTS

The Company owns several keyboard patents. However, since the Company's focus is now electronic manufacturing services, management believes that these patents will not have a significant impact on future revenues. The Key Tronic name and logo are federally registered trademarks, and the Company believes they are valuable assets in its business. In fiscal 2001, Key Tronic began operating under the trade name "KeyTronicEMS" to better represent its primary business concentration.

EMPLOYEES

As of July 28, 2001, the Company had approximately 2,151 employees compared to 2,007 on August 5, 2000. Management considers its employee relations to be excellent. The Company's employees in Ireland and Reynosa are represented by local unions. The Company has never experienced any material interruption of production due to labor disputes.

The Company's employee benefit program includes a bonus program involving periodic payments to all employees based on quarterly before-tax income. The Company maintains a tax-qualified profit sharing plan, a 401(k) plan, which provides a matching company contribution on a portion of the employee's contribution, and also provides group health, life, and disability insurance plans. The Company also offers an Executive Stock Option Plan and an Employee Stock Ownership Plan to certain individuals.

Item 2.    PROPERTIES

On December 27, 2000, the Company sold two contiguous parcels of land and its corporate headquarters building in Spokane to Royal Hills Associates L.L.C. (RHA) for approximately $6 million in cash. In connection with the sale, the Company entered into a 10-year lease agreement with RHA for one floor of the two-story building, which the Company will continue to occupy as its headquarters. The initial monthly rent is $30,875 plus allocated expenses. Under the terms of the sale agreement, the Company has guaranteed the rent on the second floor of the building for one year following the closing date of December 27, 2000 (see Capital Resources and Liquidity for further discussion). Proceeds from the sale of these properties was used to pay off the balance of the Company's term loan with General Electrical Capital Corporation (GECC) in the amount of $2,702,000, and to pay down the Company's revolving line of credit (also with GECC) by $2.4 million. The Company also owns a 165,000 sq. ft. assembly and molding facility in Juarez, Mexico in addition to a 45,000 sq. ft. manufacturing and assembly facility in Las Cruces, New Mexico. The Company leases manufacturing facilities in the Spokane Industrial Park which total 156,000 sq. ft. and two warehouses in El Paso, Texas, totaling 52,800 sq. ft. One of the leases at the industrial park expired on July 31, 2001, while the other facility lease was renewed until July 31, 2003. In Dundalk, Ireland, the Company leases 24,200 sq. ft. of office and warehouse space. This lease expires on March 1, 2002. The two leases in El Paso were renewed during fiscal year 2001, and both expire on July 31, 2003. In March 2000, the Company entered into a five-year lease for a 140,000 sq. ft. manufacturing facility in Reynosa, Mexico. In September 1997, the Company signed a five-year operating lease with a local company for property owned by the Company which is located in Cheney, Washington. The lease terms give the lessee an option to buy the property upon notice at any time during the course of the lease. During the fourth fiscal quarter of 1998, the Company leased space of approximately 36,000 sq. ft. in a building in Shanghai, China. The Company began an assembly operation in this facility in the third quarter of fiscal year 1999. The Company considers its properties in good condition, well maintained and suitable for operations. The Company considers the productive capacity of its current facilities sufficient to carry on the Company's business.

Item 3.    LEGAL PROCEEDINGS

The Company currently has fifteen lawsuits by computer keyboard users that are in state or federal courts in New York. These suits allege that specific keyboard products manufactured by the Company were sold with manufacturing, design and warning defects which caused or contributed to their injury. The alleged injuries are not specifically identified but are referred to as repetitive stress injuries (RSI) or cumulative trauma disorders (CTD). These suits seek compensatory damages and some seek punitive damages. It is more likely than not that compensatory damages, if awarded, will be covered by insurance; however, the likelihood that punitive damages, if awarded, will be covered by insurance is remote. A total of 123 suits have been dismissed in California, Connecticut, Florida, Illinois, Kansas, Kentucky, Maryland, Massachusetts, Michigan, New Jersey, New York, Pennsylvania and Texas. Given the inherent uncertainty in litigation, the inherently limited information available with respect to unasserted claims, and the complexity of the circumstances surrounding these matters, management estimates are subject to and will change or be established as facts and circumstances warrant.

The Company is also subject to various legal proceedings that arise in the ordinary course of business. In the opinion of management, the outcome of these matters is not expected to have any material effect on the consolidated financial position or results of operations of the Company.

Also see Note 10 to the June 30, 2001 Consolidated Financial Statements.

Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

PART II

Item 5:     MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

Market Information

Key Tronic Corporation's common stock is traded in the over-the-counter market and is listed on the NASDAQ National Market System under the symbol KTCC. Quarterly high and low sales prices for Key Tronic common stock for fiscal years 2001 and 2000 were as follows:

High and low stock prices are based on the daily closing price reported by the NASDAQ National Market System. These quotations represent prices between dealers without adjustment for markups, markdowns, and commissions, and may not represent actual transactions.

Holders and Dividends

As of June 30, 2001, the Company had 1,400 shareholders of record. The Company's current line of credit agreement contains a covenant that prohibits the declaration or payment of dividends (see Note 5 to Consolidated Financial Statements). The Company has never paid a cash dividend and does not anticipate payment of dividends on its Common Stock in the foreseeable future.

The following selected consolidated financial data of the Company should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the other financial information included elsewhere in this Form 10-K.

Item 6:    SELECTED FINANCIAL DATA

KEY TRONIC TEN-YEAR FINANCIAL HIGHLIGHTS
(Dollars in millions, except share amounts)

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

RESULTS OF OPERATIONS

Fiscal year 2001: Fiscal year 2001 sales increased approximately 1% from the prior year. This slight increase is primarily due to the expansion of the Company's electronic manufacturing services (EMS) operations; the increase was smaller than the company expected due to decreased orders from one major customer. Unit keyboard sales decreased 43% from the prior year, while the average selling price increased 8.2%. The increase in average selling price was primarily due to a higher percentage of keyboard sales to distributors. Distribution sales generally have higher margins than sales to OEM customers. The Company was successful in expanding its EMS business from 56% of total revenue in 2000 to 75% in 2001. The Company continues to emphasize cost control to address price reductions expected by our customers.

If keyboard technology remains the same, price erosion is expected to continue in future years. The Company continues to focus its molding and manufacturing capabilities on increasing production in the EMS market. At the present time, return on investment in this market tends to be more lucrative than for keyboards. The Company's gross profit percentage decreased 4.2% to 4.6% in fiscal year 2001 compared to fiscal year 2000. This decrease is primarily due to the decline of orders by one significant customer resulting in lower sales and increased excess operating capacity. There were also lower sales in the distribution keyboard business which traditionally has much higher margins than the OEM market.

Fiscal year 2000: Fiscal year 2000 sales decreased 8% from the prior year. The decrease was primarily due to a decline in the Company's distribution keyboard sales. Unit keyboard sales decreased 42.4% from the prior year, and the average selling price decreased 13.7%. This impacted the Company's gross profit in 2000 by a decrease of 6.9% to 8.8%. The Company was successful in expanding its EMS business from 21% of total revenue in 1999 to 56% in 2000. The Company continued to emphasize cost control to combat the pressures of ever decreasing unit prices for its keyboards. In 2000, the Company was working with a subcontractor in China for the assembly of keyboards and other input devices, but ended this contract in 2001.

RISKS AND UNCERTAINTIES THAT COULD AFFECT FUTURE RESULTS

The following risks and uncertainties could affect the Company's actual results and could cause results to differ materially from past results or those contemplated by the Company's forward-looking statements. When used in this discussion and analysis and elsewhere in this annual report, the words "expects," "believes," "anticipates" and similar expressions are intended to identify forward-looking statements. Actual future results may differ materially due to uncertainties including risks identified in: Potential Fluctuations In Quarterly Results, Competition, Concentration of Major Customers, Dependence on Key Personnel, Litigation, Technological Change and New Product Risk, Dilution and Stock Price Volatility. Forward-looking statements are based on management's opinions as of the date of this report.

Potential Fluctuations in Quarterly Results: The Company's quarterly operating results have varied in the past and may vary in the future due to a variety of factors, including changes in overall demand for computer products, success of customers' programs, timing of new programs, new product introductions or technological advances by the Company, its customers and its competitors, and changes in pricing policies by the Company. For example, the Company relies on customers' forecasts to plan its business. If those

forecasts are overly optimistic, the Company's revenues and profits may fall short of expectations. Conversely, if those forecasts are too conservative, the Company could have an unexpected increase in revenues and profits.

Competition:   The EMS business and the keyboard industry are intensely competitive. The Company's major competitors in the EMS business are much larger and may be able to offer customers lower prices and less risk particularly on large volume programs. Most of the Company's principal competitors in the keyboard industry are headquartered in Asian countries that have a low-cost labor force. Those competitors may be able to offer customers lower prices on certain high-volume programs. This could result in price reductions, reduced margins and loss of market share, all of which would materially and adversely affect the Company's business, operating results and financial condition. In addition, competitors can copy the Company's non-proprietary designs after the Company has invested in the development of products for customers, thereby enabling competitors to offer lower prices on such products due to savings in development costs.

Concentration of Major Customers:   At present, the Company's customer base is highly concentrated and could become even more concentrated. Three of the Company's OEM customers accounted for 39%, 27%, and 5% of net sales during fiscal year 2001. In 2000, these same customers accounted for 38%, 13%, and 9% of net sales. There can be no assurance that the Company's principal customers will continue to purchase products from the Company at current levels. Moreover, the Company typically does not enter into long-term volume purchase contracts with its customers, and the Company's customers have certain rights to extend or delay the shipment of their orders. The loss of one or more of the Company's major customers, or the reduction, delay or cancellation of orders from such customers, could materially and adversely affect the Company's business, operating results and financial condition.

Dependence on Key Personnel:   The Company's future success depends in large part on the continued service of its key technical, marketing and management personnel and on its ability to continue to attract and retain qualified employees. The competition for such personnel is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. The loss of key employees could have a material adverse effect on the Company's business, operating results and financial condition.

Litigation:   The Company currently has fifteen lawsuits by computer keyboard users which are in state or federal courts in New York. These suits allege that specific keyboard products manufactured by the Company were sold with manufacturing, design and warning defects which caused or contributed to injury. The alleged injuries are not specifically identified but are referred to as repetitive stress injuries (RSI) or cumulative trauma disorders (CTD). These suits seek compensatory damages and some seek punitive damages. It is more likely than not that compensatory damages, if awarded, will be covered by insurance; however, the likelihood that punitive damages, if awarded, will be covered by insurance is remote. A total of 123 lawsuits have been dismissed in California, Connecticut, Florida, Illinois, Kansas, Kentucky, Maryland, Massachusetts, Michigan, New Jersey, New York, Pennsylvania and Texas.

Technological Change and New Product Risk:   The market for the Company's products is characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and relatively short product life cycles. The introduction of products embodying new technologies or the emergence of new industry standards can render existing products obsolete or unmarketable. The Company's success will depend upon its ability to enhance its existing products, to develop and introduce, on a timely and cost-effective basis, new products that keep pace with technological developments and emerging industry standards, and to address evolving and increasingly sophisticated customer requirements. Failure to do so could substantially harm the Company's competitive position. There can be no assurance that the Company will be successful in identifying, developing, manufacturing and marketing products that respond to technological change, emerging industry standards or evolving customer requirements.

Dilution and Stock Price Volatility:   As of June 30, 2001, there were outstanding options for the purchase of approximately 1,966,200 shares of common stock of the Company (Common Stock), of which options for approximately 1,498,033 shares were vested and exercisable. Holders of the Common Stock will suffer immediate and substantial dilution to the extent outstanding options to purchase the Common Stock are exercised. The stock price of the Company may be subject to wide fluctuations and possible rapid increases or decreases over a short time period. These fluctuations may be due to factors specific to the Company, such as variations in quarterly operating results, or changes in analysts' earnings estimates, or to factors relating to the computer industry or securities markets in general, which, in recent years, have experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stocks are traded.

NET SALES

Net sales in 2001 were $165.9 million compared to $164.4 million and $178.3 million in 2000 and 1999, respectively. This represents an approximate increase of 1.0% in 2001. The average unit selling prices of the Company's keyboard products increased by 8.2% in 2001 compared to 13.7% decrease in average unit selling price in 2000. The increase in 2001 is primarily due to the fact that the majority of sales were to distribution customers where margins per keyboard are higher. EMS sales were 75.3% of total revenue in fiscal 2001 compared to 55.5% and 20.8% in fiscal years 2000 and 1999, respectively.

COST OF SALES

In 2001, cost of sales was 95.4% of sales compared to 91.2% in 2000 and 84.3% in 1999. The increase in 2001 was due primarily to lower than expected revenues resulting in excess capacity in operations. The increase in 2000 was due primarily to the decline in distribution keyboard revenues. The Company provides for warranty costs based on historical experience and anticipated product returns. The amounts charged to expense were $220,000, $372,000, and $1,269,000 in 2001, 2000 and 1999, respectively. Also included in cost of sales is the Company's freight costs for shipping and handling to customers. The Company provides for obsolete and nonsaleable inventories based on specific identification of inventory against current demand and recent usage. The amounts charged to expense were $435,000, $(359,000), and $1,674,000 in 2001, 2000, and 1999, respectively.

RESEARCH, DEVELOPMENT AND ENGINEERING

The Company's research, development and engineering (RD&E) expenses were $2.7 million, $2.8 million, and $4.9 million, in 2001, 2000, and 1999, respectively. As a percent of sales, these expenses were 1.6%, 1.7%, and 2.7%, respectively. In 2001, 2000, and 1999, the Company focused most of its RD&E efforts on products for large OEMs. The number of RD&E projects has remained fairly constant over the course of the three years. The decrease in fiscal year 2001 and 2000 was primarily the result of increased cost recovery for services performed on EMS projects.

SELLING

Selling expenses were $4.7 million, $6.3 million, and $9.3 million, in 2001, 2000, and 1999, respectively. Selling expenses as a percentage of revenues were 2.9%, 3.9%, and 5.2%, respectively. The decrease in 2001 and 2000 was due to the decline in distribution keyboard sales, which resulted in lower costs for volume incentive rebates and cooperative advertising.

GENERAL AND ADMINISTRATIVE

General and administrative expenses were $9.6 million, $8.7 million and $8.6 million, in 2001, 2000, and 1999, respectively. General and administrative costs as a percentage of sales were 5.8%, 5.3%, and 4.9%, in 2001, 2000, and 1999, respectively. The increase in 2001 was due primarily to an increase in the Company's provision for doubtful accounts receivable of $714,000. General and administrative expenses for 1999 remained about the same as 1998. The Company recorded $979,000 for its Incentive Compensation Program in 1999 based upon the Company's fiscal year 1999 performance.

INTEREST EXPENSE

The Company had interest expense of $2,125,000, $1,987,000, and $1,887,000 in 2001, 2000, and 1999, respectively. The increase in 2001 and 2000 was due to higher interest rates on the Company's debt.

OTHER INCOME, NET

The Company had other income of $879,000 in 2001, $278,000 in 2000, and $1,480,000 in 1999. The increase in 2001 is primarily due to an increase in the gain from sales of fixed assets. The decrease in 2000 was largely due to the gain due to the sale of real estate in Dundalk, Ireland recorded in 1999 (See Capital Resources and Liquidity).

INCOME TAXES

The Company had income tax expense of $643,000, $164,000, and $1,701,000 in 2001, 2000, and 1999, respectively. Income tax expense on foreign operations represented $643,000, $43,000, and $513,000 of the income tax expense in 2001, 2000, and 1999, respectively. The Company has U.S. tax loss carryforwards of approximately $48.8 million that expire in varying amounts in the years 2006 through 2021.

The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," (See Note 7 to the June 30, 2001 Consolidated Financial Statements). Pursuant to SFAS No. 109, the Company has recorded a deferred tax asset. The balance of the deferred tax asset on June 30, 2001 was $4.5 million, which was net of a valuation allowance of $15.8 million.

INTERNATIONAL (MEXICO, EUROPE, ASIA)

The Company's Mexican subsidiary, Key Tronic Juarez, SA de CV, owns an assembly and molding facility in Juarez, Mexico. This subsidiary is primarily used to support the Company's US and European operations. The Company's Mexican subsidiary, KTC Reynosa, S.A. de C.V., leases manufacturing facilities in Reynosa, Mexico. This subsidiary is used exclusively to manufacture products for an EMS customer.

Key Tronic Europe, Ltd. (KTEL), the Company's operation in Dundalk, Ireland, was restructured in fiscal years 1997 and 1996 to become a sales and distribution operation. The keyboards previously manufactured in Dundalk, Ireland to support the European market are now assembled at the Juarez, Mexico and the Shanghai, China facilities.

Through Key Tronic Shanghai (KTS), the Company operates a facility in Shanghai, China, which began operations in 1999 and is used to support customers in that area as well as for export.

Foreign sales from worldwide operations, including domestic exports, were $88.9 million in 2001 compared to $65.3 million and $75.4 million in 2000 and 1999, respectively. Foreign sales were 53.6% of net sales in 2001 compared to 39.7% and 42.3% in 2000 and 1999, respectively. Sales from KTEL represented 5.8% of consolidated sales to external customers in 2001, compared to 7.1% in 2000 and 9.9% in 1999, respectively. Sales from KTS represented .9% of total sales in 2001 (See Note 12 to the June 30, 2001 Consolidated Financial Statements).

CAPITAL RESOURCES AND LIQUIDITY

The Company generated cash flows from operating activities of $7.5 million, $3.3 million, and $4.2 million in 2001, 2000, and 1999, respectively. Capital expenditures were $.7 million, $1.4 million, and $2.3 million in 2001, 2000, and 1999, respectively. The Company's cash position increased by $1.1 million and $1.6 million in fiscal years 2001 and 1999 respectively, compared to a decrease of $0.9 million in 2000. Cash generated from operating and financing activities allowed the payment of $10.9 million in long-term debt and the purchase of $.7 million in property and equipment in fiscal 2001. The Company had working capital of $22.9 million at June 30, 2001 and $37.1 million at July 1, 2000. The decrease in working capital was due primarily to a decrease in trade receivables. The Company's trade receivables were $21.7 million at June 30, 2001, a decrease of $12.3 million from 2000. The decrease is primarily due to decreased sales in the last two quarters of fiscal year 2001.

On December 31, 1996, the Company entered into a secured credit agreement with General Electric Capital Corporation (GECC). The credit facility provided by this agreement originally included a term loan in the amount of $11 million and a revolving loan for up to $30 million. During the second quarter of fiscal year 1998, the Company entered into an operating lease agreement with GECC, which reduced the borrowing limit on the revolving loan by $4.2 million. The revolving loan and the term note were secured by the assets of the Company. The term note was paid in full on December 27, 2000 with proceeds from the sale of the Spokane headquarters facility. The agreement contained financial covenants that related to maximum capital expenditures, minimum debt service coverage, minimum earnings before interest expense, income tax, depreciation, and amortization, and maximum leverage percentages. In addition to these financial covenants, the credit agreement restricted investments, disposition of assets, and payment of dividends. At June 30, 2001, the Company received a waiver from GECC for non-compliance with certain debt covenants and received a letter of forbearance up to the refinancing that occurred on August 24, 2001.

On August 24, 2001, the Company entered into a financing agreement with CIT Group/Business Credit, Inc. for a revolving credit facility of up to $25 million and paid off the GECC revolving loan. The new revolving loan is secured by the assets of the Company. The financing agreement contains financial covenants that relate to maximum capital expenditures, minimum earnings before interest expense, income tax, depreciation, and amortization, and minimum tangible net worth. The agreement is for a term of three years beginning on August 24, 2001 and ending on August 23, 2004. In addition to the financial covenants, the financing agreement restricts investments, disposition of assets, and the payment of dividends.

The Company anticipates that capital expenditures of approximately $2.7 million will be required during the next fiscal year. Capital expenditures are expected to be financed through cash flow from operating activities.

Real estate held for sale is carried at the lower of cost or net realizable value. In September of 1997, the Company entered into a five-year operating lease with a local firm for property owned by the Company which is located in Cheney, Washington. Monthly lease payments received by the Company are $21,000. The lease terms include an option to buy the property upon notice at any time during the term of the lease.

In June of fiscal year 1999, the Company sold its real estate in Dundalk, Ireland for approximately $2.3 million. Approximately one third of this amount was received in cash at closing. In 2000 the Company collected an additional $1.0 million of the amount due. Substantially all of the remaining amount was received subsequent to year end. Under the terms of the sale agreement, the Company had rent free possession of the premises until March 29, 2000. During March of 2000, the Company's Irish operations were moved from the premises to the Finnabair Industrial Park in Dundalk. In fiscal year 1999, the Company realized a gain of $775,000 net of Irish taxes of $251,000 on this transaction.

The Company believes that funds available under the revolving credit facility and internally generated funds can satisfy cash requirements for a period in excess of 12 months.

New Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 141, all business combinations should be accounted for using the purchase method of accounting; use of the pooling-of-interests method is prohibited. The provisions of the statement will apply to all business combinations initiated after June 30, 2002. SFAS No. 142 includes requirements to test goodwill and indefinite lived intangible assets for impairment rather than amortize them. These standards will be adopted in fiscal 2002. The adoption of SFAS No. 141 and No. 142 are not expected to have a material impact on the Company's financial statements.

SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", was adopted by the Company on July 2, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments and hedging activities. Under this statement, certain derivatives are recognized at fair market value, and changes in fair market value are recognized as gains or losses. The impact of adoption of SFAS133 was not material to the Company's financial statements.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101 ("SAB No. 101"), "Revenue Recognition in Financial Statements", which summarized the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. The Company's adoption of SAB No. 101 on July 2, 2000 did not have a material impact on the Company's operations or financial position.

Item 7A:     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is subject to the risk of fluctuating interest rates in the normal course of business. The Company's major market risk relates to its secured revolving credit facility. A portion of the Company's accounts receivable and inventories are used as collateral for its revolving debt. The interest rates applicable to the Company's revolving loan fluctuate with the JP Morgan Chase Bank prime rate. For the first year of the financing agreement with CIT, a margin of 0.75% will be applicable as an adder to the prime rate. The agreement specifies four different levels of margin between 0.25% and 1.00% depending on the Company's earnings before interest, taxes, depreciation, and amortization. Over the past year under the agreement with GECC, the interest rate on the Company's secured debt was based upon either LIBOR or an Index Rate. The LIBOR rate during the year fluctuated between 4.18% and 6.65%. The weighted average variable interest rates for the Company's secured debt were 9.03% and 7.03% for fiscal years 2001 and 2000, respectively. The weighted average variable interest rates for the revolving debt for fiscal years 2001 and 2000 were 9.48% and 8.37% respectively.

The Company does not enter into derivative transactions or leveraged swap agreements.

Although the Company does have international operations, the functional currency for all active subsidiaries is the US dollar. The Company imports for its own use raw materials that are used in its manufacturing operations. Such purchases are denominated in US dollars and are paid for under normal trade terms.

The table below presents principal (or notional) amounts and related weighted average variable rates by fiscal year of maturity. The weighted average variable interest rates for fiscal years 2002 through 2005 are estimated based on implied forward rates in the yield curve as of June 30, 2001. These forward rates have been increased by .75% based on the financing agreement with CIT.

Item 8:     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEPENDENT AUDITORS' REPORT

To the Shareholders and Board of Directors of Key Tronic Corporation:

We have audited the accompanying consolidated balance sheets of Key Tronic Corporation and subsidiaries (the Company) as of June 30, 2001 and July 1, 2000, and the related consolidated statements of operations, shareholders' equity, and cash flows for the years ended June 30, 2001, July 1, 2000, and July 3, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Key Tronic Corporation and subsidiaries at June 30, 2001 and July 1, 2000, and the results of their operations and their cash flows for the years ended June 30, 2001, July 1, 2000, and July 3, 1999, in conformity with accounting principles generally accepted in the United States of America.

/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Seattle, Washington
August 3, 2001
(August 24, 2001, as to Note 5)

CONSOLIDATED STATEMENTS OF OPERATIONS

See notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME

See notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF CASH FLOWS

See notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    SIGNIFICANT ACCOUNTING POLICIES

Business

Key Tronic Corporation and subsidiaries (the Company) is engaged in electronic manufacturing services (EMS) for original equipment manufacturers (OEMs), and also manufactures keyboards and other input devices.

Principles of Consolidation

The consolidated financial statements include the Company and its wholly owned subsidiaries in Ireland, Mexico, and China. Intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates include the allowance for doubtful receivables, the provision for obsolete and non-saleable inventories, the valuation allowances on deferred tax assets, and the provision for warranty costs. Actual results could differ from those estimates.

Cash Equivalents

The Company considers investments with an original maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost which approximates fair value.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined principally using the first-in, first-out (FIFO) method. The provision to adjust inventory to market value for obsolete and non-saleable inventories was approximately $2,712,000 and $2,349,000 at June 30, 2001 and July 1, 2000, respectively. The Company provides for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage.

Customer Tooling

Customer tooling is the Company's prepaid tooling design and construction costs for customer specified new production tools and molds. Each new project's costs are recorded and tracked against expected costs. These actual costs are invoiced to the Company's customers depending on the terms agreed upon during the quoting process prior to initiation of each new project.

Property, Plant and Equipment

Property, plant and equipment are carried at cost and depreciated using straight-line methods over the expected useful lives. Constructed molds and dies are expensed as incurred if there is no future utility beyond one year. Capitalized molds and dies are depreciated over the expected useful lives of one to three years.

Valuation of Long-lived Assets

The Company, using its best estimates based on reasonable and supportable assumptions and projections, reviews assets for impairment whenever events or changes in circumstances have indicated that the carrying amount of its assets might not be recoverable. Impaired assets are reported at the lower of cost or fair value. No assets were written down during the fiscal year ended June 30, 2001.

Goodwill

Goodwill resulted from the acquisition of substantially all of the assets and liabilities of Honeywell, Inc.'s Keyboard Division on July 30, 1993. Goodwill is amortized on a straight-line basis over a period of 15 years (See New Accounting Pronouncements).

Long-term Liabilities

Short-term obligations that are expected to be refinanced on a long-term basis have been presented as long-term liabilities, see Note 5 for further discussion.

Accrued Warranty

An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. Management reviews the adequacy of this accrual quarterly based on historical analysis and anticipated product returns. Accrued warranty costs at June 30, 2001 and July 1, 2000, were $327,000 and $454,000, respectively.

Net Sales

Sales are generally recognized when products are shipped. Provisions for estimated sales returns are not significant. The Company provides for doubtful accounts receivable primarily based on specific identification.

Cost Of Sales

Cost of sales includes related shipping and handling costs.

Research, Development and Engineering

Research, development and engineering expenses include unreimbursed costs of electronic manufacturing services (EMS) as well as design and engineering costs associated with the production of custom keyboards. Such costs are charged to expense as incurred.

Income Taxes

The Company accounts for income taxes in accordance with provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Under the asset and liability method prescribed by SFAS No. 109, deferred income taxes are provided for temporary differences between the financial reporting and tax bases of assets and liabilities. Deferred taxes are measured using provisions of currently enacted tax laws. Tax credits are accounted for as a reduction of income taxes in the year the credit originates.

Per Share Data

Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing income available to common stockholders by the weighted average number of common and common equivalent shares outstanding during the period using the treasury stock method. The computation assumes the proceeds from the exercise of stock options were used to repurchase common shares at the average market price during the period. The computation of diluted earnings per share does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an antidilutive effect on earnings per share.

Foreign Currency Translation Adjustment

The functional currency of the Company's subsidiaries in Ireland, Mexico and China is the U.S. dollar. Realized foreign currency transaction gains and losses are included in general and administrative expenses. Assets and liabilities of the Company's subsidiary in Ireland had been translated to U.S. dollars at year-end exchange rates. Revenues and expenses had been translated at average exchange rates. Translation gains and losses had been included in a separate component of shareholders' equity. The foreign currency translation adjustment of $245,000 for the year ended June 29, 1996, which was included in the Consolidated Statements of Shareholders' Equity, was a result of changing the functional currency from the Punt to U.S. Dollars and was included in other comprehensive income.

Fair Value of Financial Instruments

The carrying values reflected in the balance sheets at June 30, 2001 and July 1, 2000, reasonably approximate the fair value of cash and cash equivalents. Based on the borrowing rates currently available to the Company for loans with similar terms and average maturities, the fair value of long-term debt is estimated to be $8.1 million and $19.0 million, respectively, as of June 30, 2001 and July 1, 2000, which approximates the carrying values of $8,109,000 as of June 30, 2001 and $19,041,557 as of July 1, 2000.

Stock-based Compensation

The Company accounts for its stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board No. 25, "Accounting for Stock Issued to Employees", and SFAS No. 123 "Accounting for Stock-Based Compensation". Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models. These models require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 73 months in 2001, 73 months in 2000, and 72 months in 1999, respectively; stock volatility, 64.32% in 2001, 64.34% in 2000, and 57.2% in 1999, respectively; risk free interest rates, 6.16% in 2001, 6.16% in 2000, and 6.03% in 1999, respectively and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach and forfeitures are recognized as they occur. If the computed fair values of the 2001, 2000, and 1999 awards had been amortized to expense over the vesting period of the awards, pro forma net income (loss) would have been $(11,734,050) $(1.21) loss per share) in 2001, ($5,747,000) ($.60 loss per share) in 2000, and $2,122,000 ($.22 income per share) in 1999. The weighted average fair values of options granted during fiscal years 2001, 2000, and 1999 were $4.26, $4.38, and $2.88 per share, respectively.

New Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 141, all business combinations should be accounted for using the purchase method of accounting; use of the pooling-of-interests method is prohibited. The provisions of the statement will apply to all business combinations initiated after June 30, 2001. SFAS No. 142 includes requirements to test goodwill and indefinite lived intangible assets for impairment rather than amortize them. These standards will be adopted in fiscal 2002. The adoption of SFAS No. 141 and No. 142 are not expected to have a material impact on the Company's financial statements.

SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" as amended, was adopted by the Company on July 2, 2000. SFAS No. 133 and the related amendments establishes accounting and reporting standards for derivative instruments and hedging activities. Under this statement, certain derivatives are recognized at fair market value, and changes in fair market value are recognized as gains or losses. The impact of adoption was not material to the Company's financial statements.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101 ("SAB No. 101"), "Revenue Recognition in Financial Statements", which summarized the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. The Company's adoption of SAB No. 101 on July 2, 2000 did not have a material impact on the Company's operations or financial position.

Reclassifications

Certain reclassifications of prior year balances have been made for consistent presentation with the current year.

Fiscal Year

The Company operates on a 52/53 week fiscal year. Fiscal years end on the Saturday nearest June 30. As such, fiscal years 2001, 2000, and 1999 ended on June 30, 2001, July 1, 2000, and July 3, 1999, respectively. Fiscal year 2002 will end on June 29, 2002.

2.    INVENTORIES

3.    PROPERTY, PLANT AND EQUIPMENT

4.    RELATED PARTY TRANSACTIONS

The Company has life insurance policies on the life of its founder with net death benefits totaling approximately $3,000,000. Of these, policies with death benefits totaling $750,000 have been designated to fund obligations of the Company to the founder's spouse in the event of his death and, accordingly, such obligations are not recorded in the financial statements. Net cash values of such policies are recorded in the amount of $40,000 and $339,000 in 2001 and 2000, respectively, and are included in other noncurrent assets.

5.    LONG-TERM OBLIGATIONS

The Company maintained a secured credit agreement with General Electric Capital Corporation (GECC). The credit facility provided by this agreement, originally contained a term note of $11 million and a revolving loan for up to $30 million. During the second quarter of fiscal year 1998, the Company entered into an operating lease agreement with GECC, which reduced the borrowing limit on

the revolving loan by $4.2 million. The revolving loan and the term note were secured by the assets of the Company. The term note was paid in full on December 27, 2000 with proceeds from the sale of the Spokane headquarters facility. The revolving loan with GECC bore interest based on the London Interbank Offered Rate (LIBOR). The rate fluctuated between 4.1675% and 6.6500% during fiscal year 2001. The applicable interest rates at June 30, 2001 and July 1, 2000 were 9.25% and 8.43%, respectively. The agreement contained financial covenants that related to maximum capital expenditures, minimum debt service coverage, minimum earnings before interest expense, income tax, depreciation, and amortization, and maximum leverage percentages. In addition to these financial covenants, the credit agreement restricted investments, disposition of assets, and payment of dividends. At June 30, 2001, the Company received a waiver from GECC for non-compliance with certain debt covenants and received a letter of forbearance up to the refinancing that occurred on August 24, 2001.

On August 24, 2001, the Company obtained a new revolving credit facility with CIT Group/Business Credit, Inc. for up to $25 million and paid off the GECC revolving loan. The new revolving loan is secured by the assets of the Company. For the first year of the financing agreement with CIT, a margin of 0.75% will be applicable as an adder to the prime rate. The agreement specifies four different levels of margin between 0.25% and 1.00% depending on the Company's earnings before interest, taxes, depreciation, and amortization. The agreement contains financial covenants that relate to maximum capital expenditures, minimum earnings before interest expense, income tax, depreciation, and amortization, and minimum tangible net worth. The agreement is for a term of three years beginning on August 24, 2001 and ending on August 23, 2004. In addition to the financial covenants, the credit agreement restricts investments, disposition of assets, and the payment of dividends.

Long-term obligations consist of:

The Company accounts for its post-retirement benefits in accordance with the provisions SFAS No. 106 "Employers' Accounting for Post-retirement Benefits Other than Pensions". Under SFAS No. 106, the Company has recorded a liability for certain compensation related agreements for two former employees. The liability was estimated based upon the present value of future cash payments as specified in the agreements. This cost of $296,000 in 2001, $175,000 in 2000, and $181,000 in 1999 was charged against general and administrative expenses. Principal maturities of long-term obligations at June 30, 2001 are:

6.    LEASES

The Company has operating leases for certain equipment and production facilities which expire over periods from one to five years. Future minimum payments under non-cancelable operating leases with initial or remaining terms of one year or more at June 30, 2001, are summarized as follows:

Rental expenses under operating leases were $4,358,000, $2,908,000, and $2,313,000 in 2001, 2000, and 1999, respectively.

7. INCOME TAXES

Income taxes consist of the following: