KEY TRONIC CORP - Quarter Report: 2003 March (Form 10-Q)

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarter Ended March 29, 2003

Commission File Number

Number 0-11559

KEY TRONIC CORPORATION

North 4424 Sullivan

Spokane, Washington 99216

(509) 928-8000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No  ¨.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨  No  x.

At May 8, 2003, 9,672,580 shares of Common Stock, no par value (the only class of common stock), were outstanding.

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KEY TRONIC CORPORATION

Index

* Items are not applicable

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PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to consolidated financial statements.

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KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to consolidated financial statements.

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KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

See accompanying notes to consolidated financial statements.

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KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to consolidated financial statements.

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KEY TRONIC CORPORATION AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

BASIS OF PRESENTATION

In the opinion of management, the accompanying unaudited consolidated interim financial statements reflect all adjustments of a normal and recurring nature necessary for a fair presentation, in all material respects, of the financial position, results of operations, and cash flows for the periods presented. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The results of operations for the interim periods are not necessarily indicative of the results for the entire year. These financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s 10-K report for the fiscal year ended June 29, 2002. Certain reclassifications have been made for consistent presentation.

On October 24, 2002, the Company announced the settlement of the litigation with F&G Scrolling Mouse LLC as explained in greater detail in Note 7 to these financial statements. Readers should be aware that the reported earnings for the nine months ended March 29, 2003, include a one-time benefit for reversal of previously recorded litigation expense.

1. 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 will initially record 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 using the income approach during the second quarter ended December 28, 2002. The test did not indicate the necessity to write-down the Company’s stated goodwill of $765,000. Therefore, the goodwill transitional impairment test did not have a material impact on the Company’s consolidated financial statements.

The net effect of adopting this accounting standard was to increase net income by $32,000 or $0.00 per basic and diluted share for the quarter ended March 30, 2002 and $96,000 or $0.01 per basic and diluted share for the nine months ended March 30, 2002. 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 year 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 of 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)”. 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. This Statement improves the prominence and clarity of the pro forma disclosures required by Statement 123 by prescribing a specific tabular format and by requiring disclosure in the interim 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 the Company’s 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.

2. INVENTORIES

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3. LONG-TERM OBLIGATIONS

On August 22, 2001, the Company obtained a new revolving credit facility with CIT Group/Business Credit, Inc. for up to $25 million. The new revolving loan is secured by certain assets of the Company. The agreement specifies four different levels of margin to be added to the prime rate between 0.25% and 1.00% depending on certain financial covenants calculated by the Company. 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 March 29, 2003 was 0.50%. The full rate of interest as of March 29, 2003 was 4.75%. 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 was effective on August 24, 2001, (the closing date of the agreement) and will now terminate on August 23, 2005. As of March 29, 2003, the Company was in compliance with all loan covenants. At March 29, 2003, the outstanding revolving credit balance was $7,528,000 compared to $6,475,000 at fiscal year end June 29, 2002.

4. SUPPLEMENTAL CASH FLOW INFORMATION

As of March 29, 2003, and June 29, 2002, the Company’s cash balances included restricted cash of $580,463 and $279,827, respectively. The $580,463 includes two amounts; $460,055 is a deposit required by the state of Washington for self-insurers that would cover the Company’s maximum calculated workers’ compensation liability in the event of default by the Company. This calculated liability was previously covered by a bond, which was secured through an insurance company; however, when the bond matured during the second quarter of fiscal 2003, insurance companies were no longer willing to write workers’ compensation bonds. The remaining $120,408 is the amount of uncollected funds in the Company’s depository account as of March 29, 2003. Such funds are considered restricted, because they cannot be used for any other purpose than to decrease the Company’s revolving debt.

5. INCOME TAXES

The income tax provision for the third quarter of fiscal year 2003 was $14,000 versus an income tax provision of $82,000 for the third fiscal quarter of the prior year. The provision for the nine months of fiscal years 2003 and 2002 were $368,000 and $5,315,000, respectively. The provisions for the third quarter of fiscal 2003 is the result of provisions on the earnings of foreign subsidiaries less a tax refund of $37,000 for recovery of domestic taxes in a prior year. In addition, the foreign provisions were less than normal due also to tax refunds for previous overpayments of tax. The provision for the nine months of fiscal year 2003 is the result of provisions on the earnings of foreign subsidiaries less the $37,000 refund discussed above. The provision for the 2002 periods was the result of provisions on the earnings of foreign subsidiaries and the elimination of the Company’s net deferred tax assets in the amount of $4,951,000. A valuation allowance was recorded equal to the deferred tax assets as a result of the large financial loss during 2002, which increased the Company’s net operating 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. The valuation allowance was increased to the full value of the deferred tax assets. The Company’s tax loss carry-forwards begin expiring in 2006.

6. EARNINGS PER SHARE

Basic EPS is computed by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Diluted EPS is computed by dividing net income by the weighted-average number of common shares and common share equivalents outstanding during the period. Total weighted average shares outstanding for the quarters ended March 29, 2003 and March 30, 2002 were 9,672,580 respectively. The number of stock options outstanding for the fiscal 2003 and 2002 periods were 2,154,000 and 2,083,000 respectively.

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7. STOCK OPTIONS

The Company accounts for its employee stock option plan in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (FIN No. 44). Accordingly, no compensation is recognized for employee or director stock options granted with exercise prices greater than or equal to the fair value of the underlying common stock at date of grant. If the exercise price is less than the market value at the date of grant, the difference is recognized as deferred compensation expense, which is amortized over the vesting period of the options. The Company accounts for stock options issued to non-employees in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” under the fair value based method.

For purposes of disclosure under SFAS No. 123 and 148, the following is the pro forma effect of the options had they been recorded under the fair value based method (in thousands, except per share info):

8. COMMITMENTS AND CONTINGENCIES

The amount of firm commitments to contractors and suppliers for capital expenditures was approximately $73,000 at March 29, 2003.

The Company leases its facilities, certain equipment, and automobiles under noncancelable operating lease agreements. These agreements expire at various dates during the next nine years.

The Company provides warranties on certain product sales and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or to replace the products under warranty. We currently establish warranty reserves based on historical warranty costs for each product line combined with liability estimates based on the prior twelve months’ sales activities. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods.

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Components of the reserve for warranty costs during the three months and nine months ended March 29, 2003 and the year ended June 29, 2002 were as follows (in thousands):

Litigation Settlement: 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 the first nine months of fiscal year 2003, the Company made payments to F&G totaling approximately $3.0 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 nine months ended March 29, 2003, include a one-time benefit of $12.2 million ($1.26 per share) for reversal of previously recorded litigation expense.

FORWARD-LOOKING STATEMENTS

This Quarterly Report contains forward-looking statements in addition to historical information. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Risks and uncertainties that might cause such differences include, but are not limited to those outlined in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risks and Uncertainties That May Affect Future Results.” Readers are cautioned not to place undue reliance on forward-looking statements, which reflect management’s opinions only as of the date hereof. The Company undertakes no obligation to 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.

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

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, the Company would have inventory in excess of their reserves and it would be necessary to charge the excess against future earnings. When the Company has purchased material based upon a customer’s forecast, it is usually covered by lead-time assurance agreements. 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.

Bad Debt Provision: 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 goods 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. As the Company has made the transition from primarily manufacturing keyboards to electronic manufacturing services (“EMS”), its exposure to potential warranty claims has declined significantly. The Company’s warranty period for keyboards is generally three times longer than that for EMS products. Also the Company does not warrant design defects for EMS customers.

CAPITAL RESOURCES AND LIQUIDITY

Operating activities provided $0.1 million of cash during the first nine months of fiscal year 2003 versus $0.7 million used in operating activities during the same period of the prior year. The $0.1 million in cash provided by operating activities in the first nine months of fiscal year 2003 was primarily due to two term loans extended to the Company by CIT for the purchase of equipment. Other significant changes affecting cash from operations for the first nine months of fiscal 2003 were a reduction in accounts payable to vendors, and an increase in inventory offset by a decrease in accounts receivable due to slower sales during the current fiscal year. Also contributing to the use of cash in operating activities was the $3.0 million paid to F&G Scrolling Mouse through the first nine months of fiscal year 2003.

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During the first nine months of fiscal year 2003, the Company spent $1.4 million versus $1.0 million in capital additions in the same period in the previous fiscal year. The increase was due primarily to the purchase of new production equipment in the Las Cruces, New Mexico facility. The Company anticipates capital expenditures of approximately $0.6 million through the remainder of the current fiscal year ending June 28, 2003. Actual capital expenditures may vary from anticipated expenditures depending upon future results of operations. See RISKS AND UNCERTAINTIES THAT MAY AFFECT FUTURE RESULTS, pages 14-15. Capital expenditures are expected to be financed with internally generated funds.

On August 22, 2001, the Company obtained a new revolving credit facility with CIT Group/Business Credit, Inc. for up to $25 million. The new revolving loan is secured by certain assets of the Company. The agreement specifies four different levels of margin to be added to the prime rate between 0.25% and 1.00% depending on certain financial covenants calculated by the Company. 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 March 29, 2003 was 0.50%. The full rate of interest as of March 29, 2003 was 4.75%. 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 was effective on August 24, 2001, (the closing date of the agreement) and will now terminate on August 23, 2005. As of March 29, 2003, the Company was in compliance with all loan covenants. At March 29, 2003, the outstanding revolving credit balance was $7,528,000 compared to $6,475,000 at fiscal year end June 29, 2002.

Other than its revolving credit facility and normal operating accounts payable, at March 29, 2003, the Company has a $4.2 million litigation settlement obligation, and operating lease commitments of approximately $360,000 per month for the remainder of the 2003 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.

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 debt. The term and revolving debt is secured by substantially 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.

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.

RESULTS OF OPERATIONS

Net income for the third quarter ended March 29, 2003 was $0.3 million or $.03 per share compared with a net income of $0.4 million or $.04 per share for the third quarter of the previous year. For the nine months ended March 29, 2003, net income was $12.9 million or $1.33 per share compared with a net loss of $22.1 million or ($2.29) per share for the same period of the prior year. Both of the nine month ended periods were significantly affected by litigation (see Note 7). During the nine months ended March 30, 2002, the Company recorded a $17.0 million loss on this litigation judgment. During the nine months ended March 29, 2003, the Company recorded a $12.2 million reversal of this loss as the case was settled.

NET SALES

Net sales for the third quarter ended March 29, 2003 were $30.6 million compared to $46.5 million for the third quarter of the previous year. For the nine months ended March 29, 2003, sales were $95.2 million compared to $131.7 million for the same period of the previous year. The decrease in revenue for the second quarter and nine months ended March 29, 2003 was due to decreased shipments to some of the Company’s larger customers for a variety of reasons. In the previous fiscal year, the Company’s largest customer began marketing a new product that required a ramp-up to fill sales channels. In the current fiscal year, sales to this customer matches their sell-through to the end user versus the ramp-up for market penetration in fiscal year 2002. Other contributing factors during the third quarter of fiscal year 2003 were some end-of-life customer programs and poor economic conditions in general. The F&G lawsuit, which was settled during the second quarter of fiscal 2003, also affected the Company’s sales during the first nine months of the year, because the Company was unable to secure new business while the judgment was pending.

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EMS revenue accounted for 87.2% of total revenue in the third quarter of fiscal year 2003 versus 89.8% of total revenue in the third quarter of fiscal year 2002. For the nine months ended March 29, 2003, EMS revenue accounted for 87.1% of total revenue versus 89.0% of total revenue for the same time period of the prior fiscal year.

As a percentage of sales, keyboard revenue was 12.5% for the third quarter of fiscal year 2003 compared to 10.2% in the third quarter of fiscal year 2002. For the nine months ended March 29, 2003, keyboard revenue was 12.6% and 11.0% for the same period of the prior year.

COST OF SALES

Cost of sales was 87.7% of revenue in the third quarter of fiscal year 2003, compared to 90.8% for the third quarter of fiscal year 2002. Cost of sales was 88.7% of revenue for the nine months ended March 29, 2003 compared to 91.4% for the same period of the prior year. As a percentage of sales, cost of sales for the third quarter and nine months ended March 29, 2003 declined primarily due to improvements in operating efficiencies and lower material costs.

RESEARCH, DEVELOPMENT AND ENGINEERING

Research, development and engineering (RD&E) expenses were $0.7 million in the third quarter of fiscal year 2003 and $0.6 million for the same period of fiscal year 2002. As a percentage of sales, RD&E expenditures were 2.4% in the third quarter of fiscal year 2003, compared to 1.3% for the same period of the prior year. RD&E expenses were $2.2 million for the nine months ended March 29, 2003, compared to $1.9 million for the same period of the prior year. As a percentage of sales, RD&E expenditures were 2.3% of the current nine month period versus 1.4% for the same period of the prior fiscal year. The increase in RD&E expenses was 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.

SELLING EXPENSES

Selling expenses were $0.6 million in the third quarter of fiscal year 2003 compared to $0.7 million in the third quarter of fiscal year 2002. Selling expenses as a percentage of revenue for the third quarter of 2003 were 2.1% compared to 1.5% for the third quarter of fiscal year 2002. For the nine months ended March 29, 2003, selling expenses were $1.6 million compared to $2.2 million for the same period of the prior year. As a percentage of revenue for the current nine month period, selling expenses were 1.6% for both fiscal year 2003 and fiscal year 2002. The decrease in selling expenses for the nine months ended March 29, 2003 was due to a reduction in promotional programs and marketing expenses related to keyboard sales.

GENERAL AND ADMINISTRATIVE

General and administrative (G&A) expenses for the third quarter of fiscal year 2003 were $1.8 million and $2.2 million in the third quarter of fiscal 2002. As a percentage of revenue, G&A expenses were 5.9% in the third quarter of fiscal year 2003 and 4.8% in the third quarter of fiscal year 2002. For the nine months ended March 29, 2003, G&A expenses were $5.4 million compared to $6.4 million for the same period of the prior year. As a percentage of revenue G&A expenses for the first nine months of fiscal 2003 were 5.7% versus 4.9% for the same period of the prior year. The lower G&A expenses were due to a year over year decline in legal costs and the adoption of FASB No. 142 which ceases further amortization of goodwill. Also contributing to the reduction of G&A expenses was a staffing reduction in the Company’s Ireland facility.

INTEREST

Interest expense was $262,000 in the third quarter of fiscal 2003 compared to $400,000 for the third quarter of fiscal year 2002 and $759,000 in the first nine months of fiscal 2003 compared to $1,094,000 in fiscal 2002. This decrease resulted from overall lower debt outstanding and reduced interest rates during the 2003 periods.

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INCOME TAXES

The income tax provision for the third quarter of fiscal year 2003 was $14,000 versus an income tax provision of $82,000 for the third fiscal quarter of the prior year. The provision for the nine months of fiscal years 2003 and 2002 were $368,000 and $5,315,000, respectively. The provisions for the third quarter of fiscal 2003 is the result of provisions on the earnings of foreign subsidiaries less a tax refund of $37,000 for recovery payment of domestic taxes in a prior year. In addition, the foreign provisions were less than normal due also to tax refunds for previous overpayments of tax. The provision for the nine months of fiscal year 2003 is the result of provisions on the earnings of foreign subsidiaries less the $37,000 refund discussed above. The provision for the 2002 periods was the result of provisions on the earnings of foreign subsidiaries and the elimination of the Company’s net deferred tax assets in the amount of $4,951,000. A valuation allowance was recorded equal to the deferred tax assets as a result of the large financial loss during 2002, which increased the Company’s net operating 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. The valuation allowance was increased to the full value of the deferred tax assets. The Company’s tax loss carry-forwards begin expiring in 2006.

BACKLOG

The Company’s backlog at the end of third quarter of fiscal year 2003 was $30.4 million compared to $27.0 million at June 29, 2002 and $36.7 million at the end of the third quarter of fiscal year 2002. Order backlog consists of purchase orders received for products expected to be shipped within the next fiscal year although shipment dates are subject to change due to design modifications or other customer requirements. Order backlog should not be considered an accurate measure of future sales.

RISKS AND UNCERTAINTIES THAT MAY 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 there can be no assurance that its customer base will not become more concentrated. Four of the Company’s EMS customers accounted for 39%, 10%, 13%, and 10% of net sales, respectively during fiscal 2002. In 2001, these same customers accounted for 0%, 39%, 27% and 5%, of the Company’s net sales, respectively. 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.

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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.

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 March 29, 2003, there were outstanding options for the purchase of approximately 2,154,000 shares of common stock of the Company (Common Stock), of which options for approximately 1,801,000 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.

Item 3. 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 debt. The term and revolving 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 April 25, 2003, the JP Morgan Chase Bank prime rate was 4.25%.

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.

Item 4. Controls and Procedures

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PART II. OTHER INFORMATION:

Item 1. Legal Proceedings

None

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

(1) 99.1 certifications

(b) Reports on Form 8-K

None

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

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CERTIFICATION

I, Jack W. Oehlke, President and Chief Executive Officer of Key Tronic Corporation, certify that:

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CERTIFICATION

I, Ronald F. Klawitter, Chief Financial Officer of Key Tronic Corporation, certify that:

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