KEY TRONIC CORP - Annual Report: 2003 (Form 10-K)

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UNITED STATES

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

For the Fiscal Year Ended June 28, 2003

Commission File Number 0-11559

KEY TRONIC CORPORATION

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨  No  x.

The aggregate market value of the voting stock held by non-affiliates of the Registrant was $10,470,911 as of December 28, 2002.

The number of shares of Common Stock of the Registrant outstanding as of August 29, 2003 was 9,672,580 shares.

The Exhibit Index is located at pages 38 - 39.

DOCUMENTS INCORPORATED BY REFERENCE

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

Document Description

Table of Contents

KEY TRONIC CORPORATION

2003 FORM 10-K

TABLE OF CONTENTS

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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

Key Tronic Corporation (dba KeyTronicEMS), a Washington corporation organized in 1969, and its subsidiaries (hereinafter collectively called the “Company” or “Key Tronic” unless the context otherwise requires) are principally engaged in electronic manufacturing services (EMS) for original equipment manufacturers (OEMs). The Company also manufactures keyboards for personal computers, terminals, and workstations primarily in standard layouts that can be sold directly from inventory on hand.

BACKGROUND

Historically, Key Tronic was a manufacturer of only electronic keyboards, but about five years ago, after assessing its strengths and capabilities, the Company’s focus was shifted 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 tool making, precision molding, prototype design, liquid plastic injection molding, printed circuit board assembly (both through-hole and surface-mount), and full box build.

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 OEMs shift to external manufacturing, and it is expected to continue in this growth pattern for several years.

CUSTOMERS AND MARKETING

OEM MARKETS

The Company provides manufacturing services for outsourced OEM products. Key Tronic is capable of providing a mix of EMS services including product design, tool making, precision molding, prototype design, liquid plastic injection molding, printed circuit board assembly, full box builds, and printing screened silver flexible circuit membranes. The percentage of revenues from EMS services for the fiscal years ended June 28, 2003, June 29, 2002, and June 30, 2001 were 88.6%, 89.4%, and 76.2%, respectively. Sales of such products are generally not seasonal in nature.

Clorox accounted for 31% of consolidated revenue in fiscal year 2003 compared to 39% in fiscal year 2002. Hewlett Packard accounted for approximately 8%, 10%, and 39% of the Company’s consolidated revenues in fiscal years 2003, 2002, and 2001, respectively. Lexmark accounted for 8%, 13%, and 27% of consolidated revenues in fiscal years 2003, 2002, and 2001, respectively. No other customers accounted for 10% or more of consolidated revenues in the three fiscal years presented. In the fiscal years ended June 28, 2003, June 29, 2002, and June 30, 2001, the five largest customers, including Clorox, Hewlett Packard, and Lexmark, accounted for 63%, 76%, and 81% of total sales, respectively.

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Although keyboard manufacturing is still included in the Company’s product offerings, annual sales continue to decline. During the fiscal years ended June 28, 2003, June 29, 2002, and June 30, 2001, the Company realized revenues of approximately $14.6 million, $18.3 million, and $38.6 million, respectively, from the sale of keyboards representing approximately 11.1%, 10.4%, and 23.3% of consolidated revenues. 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 keyboards. Keyboard sales can increase somewhat during the last half of each calendar year in conjunction with the holiday season, but generally sales of these products are not seasonal in nature.

The Company markets its products and services primarily through its direct sales organization aided by strategically located field sales people and distributors. Although the Company established relationships with several independent sales organizations to assist in marketing the Company’s EMS product lines in the U.S., commissions earned and paid during fiscal year 2003 were insignificant.

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 printed screened silver flexible circuit membranes.

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 marketplace. Key Tronic uses computer-aided design techniques and unique software to assist in preparation of the tool design layout and tool fabrications, to reduce tooling costs, improve component and product quality and enhance turnaround time during product development.

Key Tronic uses a variety of manual and 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 and components for its products from many different suppliers both domestic and international. Key Tronic develops close working relationships with its suppliers, many of whom have been supplying products to the Company for several years.

FOREIGN MARKETS

Information concerning geographic areas for the years ended June 28, 2003, June 29, 2002, and June 30, 2001 is summarized in the following table.

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Foreign sales from worldwide operations, including domestic exports, were $16.2 million in fiscal year 2003 compared to $32.3 million and $88.9 million in fiscal years 2002 and 2001, respectively. Foreign sales were 12.4% of net sales in fiscal 2003 compared to 18.4% and 53.6% in fiscal years 2002 and 2001, respectively. The decrease in foreign sales for fiscal year 2003 is primarily the result of declining sales to the foreign subsidiaries of one EMS customer. Sales from Key Tronic Europe, Ltd. represented approximately 3.3% of consolidated sales to external customers in fiscal year 2003 compared to 3.0% and 5.8% in fiscal years 2002 and 2001, respectively. Although the Company hopes to expand its EMS business to include the European market, sales within Europe at the present time are primarily for electronic keyboards. Key Tronic Computer Peripheral Co., Ltd., the Company’s subsidiary in Shanghai, China, did not have any local sales in fiscal year 2003. In fiscal years 2002 and 2001, local sales from this subsidiary were $88,000 and $1.5 million, respectively. The decrease in sales to local Chinese customers is also the result of lower purchases from the same EMS customer as previously discussed.

For additional financial information about foreign operations, see Note 9 to the Consolidated Financial Statements.

BACKLOG

At August 2, 2003, the Company had an order backlog of approximately $34.9 million. This compares with a backlog of approximately $24.6 million at August 3, 2002. 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.

RESEARCH, DEVELOPMENT, AND ENGINEERING

The Company’s research, development, and engineering expenses (RD&E) were $2.9 million, $2.6 million, and $2.7 million in fiscal years 2003, 2002, and 2001, respectively. Research, development and engineering expenses as a percentage of sales were 2.2%, 1.5%, and 1.6% in fiscal years 2003, 2002, and 2001, respectively. The slight increase in RD&E expenses in fiscal year 2003 was due primarily to reinstated employee wages and merit increases that were under a 10% pay reduction in fiscal year 2002, and a reduction in rebillable engineering services.

COMPETITION

The Company believes that its principal competitors in the EMS market are divided into three tiers, the first tier includes such companies as Solectron, Celestica and Flextronics. The second tier has several companies with smaller market capitalization such as Plexus, Pemstar and Suntron. The Company believes they are positioned in the third tier, which includes SMTC, Nortech, and IEC Electronics. The principal methods of competition are price, quality, and the range of services offered.

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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 year 2001, Key Tronic began operating under the trade name “KeyTronicEMS” to better represent its primary business concentration.

EMPLOYEES

As of June 28, 2003, the Company had approximately 2,687 employees compared to 1,995 on June 29, 2002. The increase in employees is due primarily to additional production workers hired in the Company’s Juarez facility to ramp-up for more labor intensive customer programs. 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 bonus programs involving periodic payments to all employees based on quarterly or fiscal year before-tax income. The Company maintains a 401(k) plan for U.S. employees, 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 maintains stock option plans for certain employees and outside directors.

The Company has manufacturing and sales operations located in the United States, Mexico, China, and Ireland. The table below lists the locations and square feet for the Company’s operations as of June 28, 2003:

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On February 21, 2002, the Company sold real estate, which it owned in Cheney, Washington for $1,705,628 and recorded a gain of $84,000.

The Company considers the productive capacity of its current facilities sufficient to carry on the Company’s business.

On December 20, 2001, a jury in Seattle federal court rendered a verdict in the case of F&G Scrolling Mouse, LLC, Fernando Falcon and Federico Gilligan v. Microsoft Corporation, Honeywell, Inc., and Key Tronic Corporation, United States District Court for the Western District of Washington, Case No. C99-995C (the “litigation”) finding that Key Tronic misappropriated trade secrets and breached a confidentiality agreement with Plaintiffs. The jury awarded damages to the Plaintiffs in the amount of $16.5 million. The judgment against the Company was subsequently increased to approximately $19.2 million through an award of pre-judgment interest. On October 24, 2002, the Company reached a settlement of the litigation with the Plaintiffs (hereafter called “F&G”). Under the terms of the settlement, the Company has agreed to pay F&G a total of $7.0 million. The Company was required to make an initial payment to F&G of $2.5 million, as well as make quarterly payments to F&G of $200,000 or 50% of Key Tronic’s operating income, whichever is greater, until the total payment of $7.0 million has been made, provided the total payment is completed by December 15, 2005. During fiscal year 2003, the Company made payments to F&G totaling approximately $3.3 million.

If the total of $7.0 million is not paid by 12/15/2005, the total settlement amount increases on 12/15/2005 to $7.6 million. If payment of $7.6 million is not completed by 12/15/2006 the total settlement amount increases to $8.2 million. If payment of $8.2 million is not completed by 12/15/2007 the total settlement amount increases to $8.8 million. If payment of $8.8 million is not completed by 12/15/2008 the total settlement amount increases to $9.7 million. If payment of $9.7 million is not completed by 12/15/2009 the total settlement amount increases to $10.6 million. If payment of $10.6 million is not made by 12/15/2010 the total settlement amount increases to $11.5 million. Any unpaid balance remaining at 12/15/2011 will accrue interest thereafter at prime plus 1½% per annum until paid. If the Company fails to make any minimum quarterly payment when due, Plaintiffs have the right to accelerate all remaining payments in the amount of $11.5 million less any amounts previously paid.

Reported earnings for the year ended June 28, 2003, include a one-time benefit of $12.2 million ($1.26 per share) for reversal of previously recorded litigation accrual.

Also see Note 8 to the Consolidated Financial Statements.

None

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PART II

MARKET INFORMATION

Key Tronic Corporation’s common stock is traded on the NASDAQ National Market System under the symbol KTCC. Quarterly high and low closing sales prices for Key Tronic common stock for fiscal years 2003 and 2002 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 28, 2003, the Company had 1,405 shareholders of record. The Company’s current financing agreement contains a covenant that prohibits the declaration or payment of dividends (see Note 4 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.

KEY TRONIC TEN-YEAR FINANCIAL HIGHLIGHTS

(Dollars in millions, except share amounts)

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CRITICAL ACCOUNTING POLICIES

Revenue Recognition: The Company recognizes revenue primarily when products are shipped. Staff Accounting Bulletin 101 states that revenue generally is realized or realizable and earned when all of the following criteria are met:

The Company believes that it meets the above criteria for the following reasons:

Inactive, Obsolete and Surplus Inventory Reserve: The Company reserves for inventories that it deems inactive, obsolete or surplus. This reserve is calculated based upon the demand for the products that the Company produces. Demand is determined by expected sales or customer forecasts. If expected sales do not materialize, then the Company would have inventory in excess of their reserves and would have to charge the excess against future earnings. In the case where the Company has purchased material based upon a customer’s forecast, the Company is usually covered by lead-time assurance agreements with each customer. These contracts state that the financial liability for material purchased within lead-time and based upon the customer’s forecasts, lies with the customer. If the Company purchases material outside the lead-time assurance agreement and the customer’s forecasts do not materialize, the Company would have the financial liability and would have to charge the excess against future earnings.

Allowance for Doubtful Accounts: The Company values its accounts receivable net of an allowance for doubtful accounts. This allowance is based on estimates of the portion of accounts receivable that may not be collected in the future, and the amount of this allowance is disclosed in the Company’s Consolidated Balance Sheet. 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 the Company’s customers were to develop unexpected and immediate financial problems that would prevent payment of open invoices, the Company 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 good sold. Management reviews the adequacy of this accrual quarterly based on historical analysis and anticipated product returns. Over the course of the past three years, the Company’s warranty expense has decreased. The declines in warranty expense and the related accrual account are directly related to the change in the composition of the Company’s revenue from keyboards to EMS. As the Company has made the transition from manufacturing only keyboards to EMS, its exposure to warranty issues has declined significantly. The Company’s warranty period for keyboards is generally longer than that for EMS products. Also the Company does not warrant design defects for EMS customers.

RESULTS OF OPERATIONS

Fiscal year 2003: Fiscal year 2003 sales decreased 25% from fiscal year 2002. The decrease is due primarily to a slowdown in shipments to some of the Company’s larger EMS customers for a variety of reasons. Keyboard sales decreased approximately $3.7 million or 19.9%. EMS sales also decreased by $41.0 million or 26%. During fiscal years 2003 and 2002, the Company was involved in litigation that resulted in a judgment in 2002 which negatively affected the ability to acquire new business. The Company has seen an increase in new business upon the elimination of this uncertainty in 2003 and expects this trend to continue. The Company’s gross profit percentage on sales for fiscal year 2003 was 11.4%, which is an increase of 2.9% from the previous year. The increase is a result of improvements in overall operating efficiencies and lower material costs.

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Fiscal year 2002: Fiscal year 2002 sales increased approximately 6% from fiscal year 2001. This increase is due primarily to sales of new EMS products offset by declines in keyboard sales. Revenue from keyboard sales decreased $20.3 million or 52.6% from fiscal 2001 while revenue from EMS sales increased $30.7 million or 24.3%. Even though keyboard sales continue to decline, the margins on these sales usually exceed those that can be realized on EMS sales, so the Company will continue to service this industry until such time that it is no longer feasible or profitable to do so. The Company’s gross profit percentage on total sales for fiscal year 2002 was 8.5%, which is an increase of 3.9% from fiscal year 2001. This increase is primarily the result of a new product line in full production during fiscal year 2002 that utilized excess operating capacity.

NET SALES

Net sales in fiscal year 2003 were $130.9 million compared to $175.6 million and $165.9 million in fiscal years 2002 and 2001, respectively. This represents an approximate decrease of 25% in fiscal year 2003. This decrease was due to decreased shipments to some of the Company’s larger customers for a variety of reasons. A key factor was a slowing of newly acquired customers until the legal judgment was settled in the second quarter of fiscal year 2003. Other main factors included end of life programs and poor economic conditions in general. EMS sales were 88.6% of total revenue in fiscal 2003 compared to 89.4% and 76.2% in fiscal years 2002 and 2001, respectively. Keyboard sales were 11.1% of sales in fiscal 2003 compared to 10.4% and 23.3% of total sales in fiscal years 2002 and 2001, respectively.

COST OF SALES

In fiscal year 2003, cost of sales was 88.6% of revenues compared to 91.5% in fiscal year 2002 and 95.4% in fiscal year 2001. The decrease in 2003 was due primarily to improvements in operating efficiencies and lower material costs. The decrease in fiscal year 2002 compared to fiscal year 2001 was due primarily to an EMS customer acquired during fiscal year 2002 that helped utilize excess capacity in the Company’s main manufacturing facility. The Company provides for warranty costs based on historical experience and anticipated product returns. The amounts charged to expense were approximately $150,000, $215,000, and $220,000 in fiscal years 2003, 2002, and 2001, respectively. The decline in warranty expense is attributable primarily to the decline in keyboard sales. The Company’s warranty period for keyboards is generally longer than that for EMS products. Also the Company does not warrant design defects for EMS customers. Cost of sales also includes shipping and handling costs of $2.0 million in fiscal year 2003 compared to $2.4 million in fiscal year 2002, and $2.0 million in fiscal year 2001. The Company’s freight costs for inbound shipments of production materials fluctuate from year to year depending on negotiated freight rates and the necessity for expedited shipping methods. The Company provides for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage. The amounts charged to expense were $.2 million, $2.2 million, and $.4 million in fiscal years 2003, 2002, and 2001, respectively.

RESEARCH, DEVELOPMENT AND ENGINEERING

The Company’s research, development and engineering (RD&E) expenses were $2.9 million, $2.6 million, and $2.7 million, in fiscal years 2003, 2002, and 2001, respectively. As a percentage of sales, these expenses were 2.2%, 1.5%, and 1.6%, respectively. In fiscal years 2003, 2002, and 2001, the Company focused most of its RD&E efforts on EMS programs. The slight increase in fiscal year 2003 compared to fiscal year 2002 and 2001 is due primarily to reinstated employee wages and merit increases that were previously under a 10% pay reduction and merit freeze in the prior fiscal year, and a reduction in rebillable engineering services in fiscal year 2003.

SELLING

Selling expenses were $2.3 million, $2.8 million, and $4.7 million in fiscal years 2003, 2002, and 2001, respectively. Selling expenses as a percentage of revenues were 1.7%, 1.6%, and 2.9%, respectively. The decreases in fiscal year 2003 compared to fiscal year 2002 were due primarily to a reduction in promotional programs and marketing expenses related to keyboard sales. The significant decrease in selling expenses for fiscal year 2002 compared to fiscal year 2001 was due to a large drop in keyboard sales. Sales of keyboards through distribution require greater promotional and marketing programs than sales of EMS products. In addition, the Company did not employ outside sales representatives for its keyboard products in fiscal year 2002, so commission expense was significantly decreased.

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GENERAL AND ADMINISTRATIVE

General and administrative expenses were $7.2 million, $8.4 million and $9.6 million in fiscal years 2003, 2002, and 2001, respectively. As a percentage of sales, these expenses were 5.5% in fiscal year 2003, 4.8% in fiscal year 2002, and 5.8% in fiscal year 2001. The decrease in fiscal year 2003 was primarily due to a year over year decline in legal expenses as a result of the termination of the F&G litigation. Other contributing factors were a decreased provision for doubtful accounts, lower telephone expenses, decreased staffing in Ireland, and the adoption of SFAS 142, which ceased the amortization of goodwill. The decrease between fiscal years 2002 and 2001 was due primarily to a significant decrease in the provision for doubtful accounts and decreased compensation and fringe benefits as a result of attrition and a 10% reduction in salaries.

INTEREST EXPENSE

The Company had interest expenses of $1.0 million, $1.3 million, and $2.1 million in fiscal years 2003, 2002, and 2001, respectively. The decrease in fiscal year 2003 was due to a significant decrease in the Company’s interest rates applied to its revolving debt. The major factor in the interest rates was the decrease in bank prime rates. The decrease in interest expense for fiscal year 2002 was attributable to lower rates and lower outstanding debt.

OTHER INCOME, NET

The Company had net other income of $237,000, $358,000, and $879,000 in fiscal years 2003, 2002, and 2001, respectively. Other income in fiscal year 2003 is primarily proceeds from the sale of an equity security. The net other income for fiscal year 2002 is primarily the result of recognizing gains on the sale of two of the Company’s buildings. In February of 2002, the Company sold its real estate located in Cheney, Washington, recognizing a gain of $84,000 (Note 3). In December of 2000, the Company sold its headquarters building in Spokane, Washington, under a sale lease-back transaction. The Company did not recognize the gain on the sale of the headquarters building during the time period that it had guaranteed the rent on the second floor of the building. At the end of December 2001, the one-year of guaranteed rent payments was fulfilled, and the Company recognized a gain of $479,000 (Note 3) from the sale of this building. The difference between these gains and the reported amount of $358,000 is due to miscellaneous non-operating expenses. The other income in 2001 was primarily due to gains from the sale of fixed assets.

INCOME TAXES

The Company had income tax expense of $600,000 in fiscal year 2003 compared to $5.4 million in fiscal year 2002 and $643,000 in fiscal year 2001. The current year’s expense is primarily the result of tax provisions on the earnings of foreign subsidiaries. The large increase in income tax expense in fiscal year 2002 was due primarily to establishing a 100% valuation allowance against the Company’s net deferred tax assets after a litigation judgment was awarded to F&G Scrolling Mouse. These assets totaled $4.5 million. Prior to the award of this judgment, Key Tronic had almost $45.9 million in tax loss carry-forwards. Financial Accounting Standard No. 109 requires that management assess the sources of future taxable income, which may be available to recognize the deductible differences that comprise deferred tax assets. A valuation allowance against deferred tax assets is required if it is more likely than not that some or all of the deferred tax assets will not be realized. Because the litigation judgment was considered evidence of the Company’s possible inability to utilize the balance of the deferred tax assets, the valuation allowance was increased to the full value. The Company’s tax loss carry-forwards begin expiring in 2006. The remaining $900,000 of the Company’s income tax provision was due to income taxes on the earnings of foreign subsidiaries. The income tax expense in fiscal year 2001 was also due to income taxes on the earnings of foreign subsidiaries.

INTERNATIONAL (MEXICO, EUROPE, ASIA)

One of the Company’s Mexican subsidiaries, 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 U.S. operations. The Company’s Mexican subsidiary, Key Tronic Reynosa SA de CV, leases a manufacturing facility in Reynosa, Mexico. This subsidiary is used exclusively to manufacture products for one EMS customer.

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Key Tronic Europe, Ltd. (KTEL), the Company’s operation in Dundalk, Ireland, is primarily used to solicit sales and support customers within Europe. The keyboards previously manufactured in Dundalk, Ireland to support the European market are now assembled at the Shanghai, China facility.

Key Tronic Computer Peripheral Co., Ltd., located in Shanghai, China, began operations in 1999. Its primary function is manufacturing electronic keyboards for export; however, it is also capable of providing EMS services for local customers.

Foreign sales from worldwide operations, including domestic exports, were $16.2 million in fiscal year 2003 compared to $32.3 million and $88.9 million in fiscal years 2002 and 2001, respectively. Foreign sales were 12.4% of net sales in fiscal 2003 compared to 18.4% and 53.6% in fiscal years 2002 and 2001, respectively. Sales from Key Tronic Europe, Ltd. represented approximately 3.3% of consolidated sales to external customers in fiscal year 2003 compared to 3.0% and 5.8% in fiscal years 2002 and 2001, respectively. The decrease in foreign sales for fiscal year 2003 is primarily the result of declining sales to the foreign subsidiaries of one EMS customer and the continuing decline of keyboard sales from the Company’s subsidiary in Ireland. Although the Company hopes to expand its EMS business to include the European market, sales within Europe currently are primarily for electronic keyboards. Key Tronic Computer Peripheral Co., Ltd., the Company’s subsidiary in Shanghai, China, did not have any sales to local customers during fiscal year 2003. In fiscal years 2002 and 2001, sales to local customers were $88,000 and $1.5 million, respectively. The decrease in sales to local Chinese customers is also the result of lower purchases from the same EMS customer as previously discussed.

CAPITAL RESOURCES AND LIQUIDITY

The Company used $.5 million of cash from operating activities in fiscal year 2003 versus $.9 million and $7.5 million of cash provided by operating activities in fiscal years 2002 and 2001, respectively. The cash used in fiscal year 2003 was due primarily to a significant increase in inventory levels. The increase in inventories was from a ramp-up for new EMS programs, and from an increase in the Company’s printed circuit board business. Printed circuit board production requires higher material content than most other EMS programs currently in production. Also contributing to the use of cash was the amount paid to F&G under the settlement agreement signed during fiscal year 2003. Offsetting the uses in cash was a reduction in accounts receivable due to reduced sales in fiscal year 2003. The decrease in cash provided by operating activities in fiscal year 2002 compared to fiscal year 2001 was due primarily to the reduction of accounts payable. The significant increase in cash provided by operating activities in fiscal year 2001 was due primarily to the collection of trade receivables. Capital expenditures were $2.1 million, $1.1 million, and $.7 million in fiscal years 2003, 2002, and 2001, respectively. The increase in capital expenditures for fiscal year 2003 was primarily due to the purchase of new production equipment in the Las Cruces, New Mexico facility. The Company’s cash position decreased by $.2 million from fiscal year 2002 to fiscal year 2003. The Company had working capital of $21.8 million at June 28, 2003 and $22.3 million at June 29, 2002.

The Company’s primary financing activity in fiscal years 2003, 2002, and 2001 was the borrowing and repayment under the Company’s debt agreements.

On August 22, 2001, the Company entered into a financing agreement with CIT Group/Business Credit, Inc. which provides a revolving credit facility up to $25 million. The new revolving loan is secured by the assets of the Company. The interest rate provisions of the agreement specify four alternative levels of margin to be added to the prime rate ranging from 0.25% to 1.00% depending on compliance with certain financial covenants. For the first year of the financing agreement with CIT, a margin of 0.75% was added to the prime rate. The prime rate is based on the JP Morgan Chase prime rate. The margin applicable at June 28, 2003 was 0.50%. The full rate of interest as of June 28, 2003 was 4.50%. On November 19, 2002 a third amendment to the financing agreement was signed. The amendment contains financial covenants that relate to total equity, earnings before interest, taxes, depreciation and amortization, and a minimum fixed charge ratio. The amendment also extended the term of the agreement by one year. The agreement became effective on August 24, 2001, and will now terminate on August 23, 2005. As of June 28, 2003, the Company was in compliance with all loan covenants. At June 28, 2003, the outstanding revolving loan balance was $9,864,000 compared to $6,475,000 at fiscal year end June 29, 2002. The increase in the loan balance was due primarily to required payments to F&G in compliance with the settlement of the legal judgment in the second quarter of fiscal 2003.

In addition to the Company’s revolving credit facility payment obligations and normal operating expenses, at June 28, 2003, the Company had a $1.1 million litigation settlement payment obligation, and operating lease commitments of approximately $270,000 per month for the remainder of the 2004 fiscal year. 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.

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Contractual Obligations

In the normal course of business, the Company enters into contracts, which obligate the Company to make payments in the future. The table below sets forth the Company’s significant future obligations by time period.

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 herein, the words “expects”, “believes”, “anticipates” and similar expressions are intended to identify forward-looking statements.

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 customers’ 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, its customers, its suppliers and its competitors. 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. The products which the Company manufactures for its customers have relatively short product lifecycles, therefore the Company’s business, operating results and financial condition are dependent in significant part on the Company’s ability to obtain orders from new customers and new product programs from existing customers.

Competition The EMS industry is intensely competitive. Competitors may 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. The Company’s inability to provide comparable or better manufacturing services at a lower cost than its competitors could cause sales to decline. In addition, competitors can copy the Company’s non-proprietary designs after the Company has invested in development of products for customers, thereby enabling such 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. The Company’s largest EMS customer accounted for 31% of net sales in fiscal year 2003. This same customer accounted for 39% of sales in 2002. Three other of the Company’s EMS customers accounted for 9%, 8%, and 8% of net sales during fiscal year 2003. These same customers accounted for 10%, 13%, and 10% of net sales in fiscal year 2002 and 0%, 27%, and 39% in fiscal year 2001. 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 Suppliers The Company is dependent on many suppliers, including sole source suppliers, to provide key components and raw materials used in manufacturing customers’ products. Delays in deliveries from suppliers or the inability to obtain sufficient quantities of components and raw materials could cause delays or reductions in shipment of products to our customers which could adversely affect the Company’s operating results and damage customer relationships.

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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.

Foreign Manufacturing Operations Virtually all products manufactured by the Company are produced at the Company’s facilities located in Mexico and China. Accordingly the Company’s operations are subject to a variety of risks unique to international operations including import and export duties and value added taxes, import and export regulation changes, the burden and cost of compliance with foreign laws and foreign economic and political risk.

Technological Change and New Product Risk The markets for the Company’s customers’ 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 customers’ ability to enhance existing products and to develop and introduce, on a timely and cost-effective basis, new products that keep pace with technological developments and emerging industry standards and address evolving and increasingly sophisticated customer requirements. Failure of the Company’s customers to do so could substantially harm the Company’s customers’ competitive positions. There can be no assurance that the Company’s customers will be successful in identifying, developing and marketing products that respond to technological change, emerging industry standards or evolving customer requirements.

Dilution and Stock Price Volatility As of June 28, 2003, there were outstanding options for the purchase of approximately 2,086,000 shares of common stock of the Company (Common Stock), of which options for approximately 1,849,000 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 declines 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 EMS and computer industries or to the 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.

NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Under the statement, the Company records intangible assets that are acquired individually or with a group of other assets in the financial statements at acquisition. Goodwill in each reporting unit shall be tested for impairment annually. An entity has six months from the date it initially applies Statement 142 to complete the first step of that transitional goodwill impairment test. The Company adopted SFAS No. 142 on June 30, 2002, and completed its impairment test during the second quarter ended December 28, 2002. The test did not indicate an impairment of the Company’s stated goodwill of $765,000.

The net effect of adopting this accounting standard was to eliminate amortization expense of $128,000 annually and increase net income by $0.01 per basic and diluted share for the fiscal year ended June 28, 2003. In accordance with SFAS No. 142, the effect of this accounting change is reflected prospectively. Comparative disclosure as if the change had been retroactively applied to the prior years is as follows (in thousands, except per share data):

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In April 2002, the Financial Accounting Standards Board issued SFAS No. 145. The purpose of this statement is to rescind previously issued SFAS No. 4, 44, and 64, and to amend SFAS No. 13. Statement No. 4 and 64 relate to reporting gains and losses from extinguishment of debt. Statement No. 44 concerned accounting for intangible assets of motor carriers, and Statement No. 13, “Accounting for Leases” was amended to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. The provisions related to Statement 13 are effective for transactions occurring after May 15, 2002, and the remaining provisions of the statement are effective for fiscal years beginning after May 15, 2002. The Company adopted this new statement after issuance in April 2002; however, there were no lease transactions during the period between May 15, 2002 and June 29, 2002 that would be covered under the provisions of the statement. This new statement, in its entirety, is in effect for the Company’s fiscal year beginning June 30, 2002. Adoption of this statement did not have a material impact on the Company’s consolidated financial statements.

Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated With Exit or Disposal Activities”, was issued in June 2002. This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” by requiring that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Company adopted SFAS No. 146 on June 30, 2002 for exit or disposal activities initiated after December 31, 2002. Adoption of this statement did not have a material impact on the Company’s consolidated financial statements.

In December 2002, the FASB issued SFAS No. 148 “Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123.” SFAS No. 148 provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects of reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Finally, this Statement amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. The amendments to SFAS No. 123, which provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation is effective for financial statements for fiscal years ending after December 15, 2002. The amendment to SFAS No. 123 relating to disclosures and the amendment to Opinion 28 is effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. The Company has adopted the disclosure provisions of SFAS No. 148 on its 2003 financial statements. As the Company does not intend to adopt the fair value provisions of FAS No. 123, the Company does not believe that implementing SFAS No. 148 will have a material impact on its consolidated financial statements.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS No. 149 is effective for all contracts created or modified after June 30, 2003. The Company does not believe that the adoption of this standard will have a material effect on its consolidated financial statements.

In November 2002, the FASB issued Interpretation (FIN) No. 45, which requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantees. It also requires disclosure in interim and annual financial statements of its obligations under certain guarantees it has issued. The initial recognition and measurement provisions of FIN No. 45 are to be applied prospectively to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements for periods ending after December 15, 2002. Adoption of FIN No. 45 did not have a material effect on the Company’s consolidated financial statements.

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities”. FIN No. 46 clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A variable interest entity is required to be consolidated by the Company that has a majority of the exposure to expected losses of the variable interest entity. The Interpretation is effective immediately for variable interest entities created after January 31, 2003. For variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003, the Interpretation applies in the first fiscal year or interim period beginning after June 15, 2003. The Company does not believe the issuance of this Interpretation will have a material impact on its consolidated financial statements.

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In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The Standard requires that certain freestanding financial instruments be classified as liabilities, including mandatorily redeemable financial instruments, obligations to repurchase the issuer’s equity shares by transferring assets and certain obligations to issue a variable number of shares. SFAS No. 150 is effective for financial instruments entered into or modified subsequent to May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. The Company does not anticipate that the implementation of this Standard will have a material impact on its consolidated financial statements.

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 debt. The Company’s debt is secured substantially by all of the Company’s assets. The interest rates applicable to the Company’s revolving loan fluctuate with the JP Morgan Chase Bank prime rate. As of July 22, 2003, the JP Morgan Chase Bank prime rate was 4.00%.

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

Although the Company has international operations, the functional currency for all active subsidiaries is the U.S. dollar. The Company imports for its own use raw materials that are used in its manufacturing operations. Substantially all of the Company’s purchases are denominated in U.S. dollars and are paid 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 2004 through 2006 are estimated based on implied forward rates in the yield curve as of June 28, 2003. These forward rates have been increased by .50% based on the financing agreement with CIT. The Company’s revolving debt could increase or decrease depending upon cash needs over the period of time that the financing agreement remains in place with CIT. The JP Morgan Chase Bank prime rate will fluctuate with the market and could go up or down depending on market conditions. The Company’s applicable margin is estimated to remain at .50% based on expected performance over the course of the next two fiscal years.

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Reports of Independent Certified Public Accountants

The Board of Directors and Shareholders

Key Tronic Corporation

Spokane, Washington

We have audited the accompanying consolidated balance sheet of Key Tronic Corporation and subsidiaries (the Company) as of June 28, 2003, and the related consolidated statements of operations, shareholders’ equity and cash flows for the year then ended. We have also audited the schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit.

We conducted our audit 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 and schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Key Tronic Corporation and subsidiaries at June 28, 2003, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

Also, in our opinion, the schedule presents fairly, in all material respects, the information set forth therein.

As discussed in Note 1 to the consolidated financial statements, the Company changed its method for accounting for goodwill in fiscal 2003.

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

We have audited the accompanying consolidated balance sheet of Key Tronic Corporation and subsidiaries (the Company) as of June 29, 2002, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended June 29, 2002, and June 30, 2001. 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 29, 2002, and the results of their operations and their cash flows for the years ended June 29, 2002, and June 30, 2001, in conformity with accounting principles generally accepted in the United States of America.

August 16, 2002

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CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY