KEY TRONIC CORP - Quarter Report: 2005 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 31, 2005

OR

For the transition period from                      to                     

Commission File Number 0-11559

KEY TRONIC CORPORATION

(Exact name of registrant as specified in its charter)

(509) 928-8000

Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changed since last report)

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 during the past 90 days. Yes  þ    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

                        Large accelerated filer  ¨                         Accelerated filer  ¨                         Non-accelerated filer  þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

At February 1, 2006, 9,703,413 shares of common stock, no par value (the only class of common stock), were outstanding.

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KEY TRONIC CORPORATION

Index

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PART I: FINANCIAL INFORMATION

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 EARNINGS

(Unaudited)

See accompanying notes to consolidated financial statements.

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KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

(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 CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The condensed consolidated financial statements included herein have been prepared by Key Tronic Corporation and subsidiaries (the Company) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). The financial statements reflect all normal and recurring adjustments which in the opinion of management are necessary for a fair presentation of the financial position, results of operations and cash flows for the interim 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 periods presented are not necessarily indicative of the results to be expected for the full fiscal year. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 2, 2005.

The Company’s reporting period is a 52/53 week fiscal year ending on the Saturday closest to June 30. The quarters and six months ended December 31, 2005 and January 1, 2005 were 13 and 26 week periods, respectively.

The components of inventories consist of the following:

The Company has entered into a financing agreement with CIT Group/Business Credit, Inc. (CIT) which provides a revolving credit facility up to $25 million. The revolving loan is secured by the assets of the Company. The interest rate provisions allow for a variable rate based on either the JP Morgan Chase prime rate or LIBOR rate. The agreement specifies four alternative levels of margin to be added to each of these base rates depending on compliance with certain financial covenants. The range of interest on outstanding balances was 6.16% to 6.52% as of December 31, 2005. The increase in rates from fiscal year end is related to increases in published prime and LIBOR rates.

The agreement and subsequent amendments contain financial covenants that relate to total equity, earnings before interest, taxes, depreciation and amortization, and a minimum fixed charge ratio. The Company is in compliance with all loan covenants. The credit facility matures August 22, 2009. As of December 31, 2005, approximately $7.4 million was available to draw from the revolving line of credit.

The Company has no income tax provision for the first six months of fiscal year 2006 compared to a provision of $238,000 for the first six months of the prior fiscal year. The income tax provisions are attributable to taxable earnings of foreign subsidiaries. The reduction in the provision in fiscal 2006 compared with same period of fiscal 2005 is related to a reduction in tax rates and temporary tax credits applicable to income of the Company’s Mexican operations. The Company has domestic tax loss carryforwards of approximately $60 million. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 109, Accounting for Income Taxes, a valuation allowance is required if it is more likely than not that some or all of the deferred tax assets will not be realized in the future. Accordingly, management has determined that a valuation allowance equal to the net deferred tax asset is appropriate at this time.

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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. Basic and diluted EPS are as follows (in thousands, except per share information):

There were approximately 905,000 and 900,000 antidilutive stock options not included in the diluted shares outstanding for the quarter and six months ended December 31, 2005, respectively.

Effective July 3, 2005, the Company adopted SFAS No. 123(R), Share-Based Payment, using the fair value method to account for all remaining unvested stock options. Because the Company does not have a significant number of non-vested options outstanding, the adoption of SFAS No. 123(R) did not have a material impact on operating results. Net income for the second quarter and first six months of fiscal 2006 included approximately $11,000 and $31,000 of related stock-based compensation expense, respectively. Net income for the first six months of fiscal year 2005 did not include any compensation expense related to options. The Company did not grant any stock options in fiscal 2006 and does not anticipate future grants. As of January 1, 2006, there was $16,000 of total unrecognized compensation costs related to remaining unvested stock options. These costs will be recognized over the next four quarters.

The following is the pro forma effect of the options had they been recorded under the fair value based method during each of the following periods (in thousands, except per share info):

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The fair value of each option grant is estimated on the date of grant using the following assumptions: 0% dividend yield, 5-year life, stock price volatility of 111.8% and risk free interest rate of 3.46% for options granted during the six months ending January 1, 2005. No options have been granted during fiscal year 2006.

Purchase Commitments: The Company had no firm commitments to contractors and suppliers for capital expenditures at December 31, 2005.

Leases: The Company leases some of its facilities, certain equipment, and automobiles under non-cancelable lease agreements. These agreements expire on various dates during the next six years.

Warranty: 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 the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. The Company currently establishes 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.

Components of the reserve for warranty costs consist of the following (in thousands):

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 year end reports on Form 10-K, Quarterly Reports on Form 10-Q and current reports on Form 8-K.

OVERVIEW

Key Tronic Corporation, dba “KeyTronicEMS, Co.” (the Company), is an independent provider of electronic manufacturing services (EMS) for original equipment manufacturers (OEMs). The EMS industry has experienced growth and is expected to

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continue its growth as more OEMs shift to outsourced manufacturing. OEM outsourcing trends continue to be very positive for the EMS industry.

The Company believes that it is well positioned in the EMS industry to expand its customer base and achieve long term growth. Its core strengths include innovative design and engineering expertise in electronics, mechanical engineering, and precision molding and tooling combined with high-quality, low-cost production and assembly from key global locations. This global production capability provides customers with the benefits of improved supply-chain management, reduced inventories, lower transportation costs, and reduced product fulfillment time. The Company continues to make investments in its Mexico and China facilities which give it the production capacity and logistical advantages which will enable it to continue to win new business.

The Company saw a slight increase in sales revenue during the second quarter of fiscal 2006 when compared to the first quarter of the year. However, the first six months of fiscal 2006 when compared to fiscal 2005, the Company has seen a decline in end-market demand for existing programs, and new programs have not ramped up rapidly enough to offset this decline. The decline was similar to a number of other EMS companies which have also reported recent softness in end-market demand. However, the Company continued to increase its year-over-year operating income and earnings through reduced material costs and production efficiencies. The Company has also developed a number of new customer prospects. The Company’s current customer relationships involve a variety of products, including consumer electronics and plastics, gaming devices, household products, medical devices, educational toys, specialty printers and printer components, and computer accessories.

The EMS industry is intensely competitive, and Key Tronic, at this time, has less than 1% of the potential market. The Company is planning for growth in its coming quarters by expanding its worldwide manufacturing capacity and continuing to improve its manufacturing processes. The Company believes that it can win new business, particularly programs that may be initially too small for larger contract manufacturers and EMS providers. Current challenges facing the Company include the following: continuing to win new programs, improving operating efficiencies, controlling costs and developing competitive pricing strategies.

Net income for the second quarter of fiscal 2006 was $1.0 million as compared to $490,000 for the second quarter of fiscal 2005. Net income was $1.7 million compared to $756,000 for the first six months of fiscal 2006 and 2005, respectively. The increase was directly related to reduced material costs and improved production efficiencies. Operating expenses decreased slightly for the quarters and six months ended December 31, 2005 as compared to the quarter and six months ended January 1, 2005.

Sales for the second quarter of fiscal year 2006 decreased 11.5% to $45.4 million compared to $51.2 million for the same period of fiscal year 2005. Sales for the first six months of fiscal 2006 were $89.6 million or a decrease of 10.4% from $100.0 million during the same period of the prior year. The decrease in sales reflects a decline in end-market demand of existing programs. Sales in the third quarter of fiscal year 2006 are expected to be comparable to the second quarter and in the range of $42 million to $46 million.

Gross profit as a percentage of sales for the second quarter of 2006 was 1.2% better when compared to the second quarter of fiscal 2005 or 1.4% better for the first six months of fiscal 2006 compared to fiscal 2005. The increase in gross profit resulted from reduced material costs and improved production efficiencies. The level of gross margin is impacted by a number of items which may include facility utilization, product mix, timing of the start-up of new programs, pricing within the electronics industry and material costs.

The Company maintains a strong balance sheet with a current ratio of 1.93 and a long-term debt to equity ratio of 0.38. The Company maintains a good working relationship with its asset-based lender, and believes that internally generated funds and the Company’s revolving line of credit will provide adequate capital for current operations and long-term growth.

CRITICAL ACCOUNTING POLICIES

Revenue Recognition: The Company recognizes revenue primarily when products are shipped. SEC Staff Accounting Bulletin 104 states that revenue generally is realized or realizable and earned when all of the following criteria are met:

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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 surplus inventory in excess of its reserves, and it would be necessary to charge the excess against future earnings. When the Company has purchased materials based upon a customer’s forecast, the materials are usually covered by lead-time assurance agreements. These agreements provide that the financial liability for materials purchased within lead-time based upon the customer’s forecasts, lies with the customer. If the Company purchases materials outside the lead-time assurance agreement and the customer’s forecasts do not materialize, the Company generally has 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 identification of specific 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 EMS, its exposure to potential warranty claims has declined significantly. The Company’s warranty period for keyboards is significantly longer than that for EMS products. Also the Company does not warrant design defects in products manufactured for EMS customers.

Income Taxes: The Company has domestic tax loss carry-forwards of approximately $60 million. In accordance with Financial Accounting Standard No. 109, Accounting for Income Taxes, management assesses 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. Historical net losses and the litigation judgment of fiscal year 2002 were considered evidence of the Company’s possible inability to utilize the balance of the deferred tax assets; therefore, the valuation allowance was increased to the amount of the net deferred tax asset. Management continues to assess the need for a valuation allowance and has determined that a full valuation allowance is still appropriate at this time. The Company’s tax loss carry-forwards begin to expire this fiscal year.

Although the Company has a history of operating losses, it is possible that future earnings may require the reinstatement of all or a portion of the deferred tax assets. If this should occur, an income tax benefit would be recorded which would have a favorable effect on reported earnings per share in the periods of any adjustment.

RESULTS OF OPERATIONS

The financial information and discussion below should be read in conjunction with the Consolidated Financial Statements and Notes. The following table presents the percentage relationship to net sales that certain items in our Consolidated Statements of Income for the periods indicated.

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Sales

Sales for the second quarter of fiscal 2006 were $45.4 million, down 11.5% from $51.2 million for the second quarter of fiscal 2005, and up 2.5% from $44.3 million in the previous quarter of the current year. The decrease in sales during the quarter as compared to the second quarter of fiscal 2005 is attributed to a decrease in specialty printers and printer components, and educational toys partially offset by an increase in sales of SMT printed circuit board assemblies.

Sales for the first six months of fiscal 2006 were $89.6 million, a decrease of 10.4% from $100.0 million in the same period of fiscal 2005. The decrease in sales in fiscal year 2006 when compared to the same period of fiscal 2005 is due to a significant decrease in consumer electronics and printer accessories offset partially by an increase in sales of SMT printed circuit board assemblies.

Sales for third quarter of fiscal 2006 are anticipated to be similar to second quarter. However, a new consumer product program is starting production in the third quarter while a number of other prospective customer programs could begin as early as the fourth quarter. Sales in the third quarter of fiscal 2006 are estimated to be in the range of $42 to $46 million.

Sales to the Company’s largest customers may vary significantly from quarter to quarter depending on the size and timing of customer program commencement, forecasts, delays, modifications, and transitions. The Company remains dependent on continued sales from its significant customers and most contracts are not firm long-term purchase commitments. The Company seeks to maintain flexibility in production capacity by employing skilled temporary and short-term labor and by utilizing short term leases on equipment and manufacturing facilities. In addition, our capacity and core competencies of SMT for printed circuit board assemblies, precision molding, tool making, assembly, and engineering services can be utilized for a wide variety of products.

Gross Profit

Gross profit as a percentage of sales for the second quarter of fiscal 2006 was 9.0% compared to 7.8% during the second quarter of fiscal 2005. The increase is due to reduced material costs and improved production efficiencies.

The gross profit percentage for the first six months of fiscal 2006 was 8.9% as compared to 7.5% for the same period of fiscal 2005. The increase resulted from favorable product mix and improved production efficiencies. The level of gross margin is impacted by a number of items which may include facility utilization, product mix, timing of the start-up of new programs, competitive pricing within the electronics industry and material costs.

The gross profit includes charges related to changes in the allowance for obsolete inventory and estimated warranty costs. The Company adjusts the allowance for estimated obsolescence as necessary in an amount equal to the difference between the cost of inventory and estimated market value based on assumptions of future demands and market conditions. The reserves are established on excess or obsolete inventory which the Company has determined that customers are not contractually responsible for, or on inventory that will not be ultimately used or purchased by customers under contractual obligations. The Company establishes its warranty reserve based on historical warranty costs for each product line combined with liability estimates based on sales activities. If actual return rates or repair/replacement costs differ significantly from estimates, adjustments to costs of sales may be required.

Operating Expenses

Total operating expenses were $2.8 million and $5.7 million in the second quarter and first six months of fiscal 2006 compared to $3.1 million and $6.0 million in the second quarter and first six months of 2005, respectively. The decrease in operating expenses is directly related to a decrease in general and administrative expenses. However, operating expenses as a percent of sales was

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6.2% and 6.4% for the second quarter and the first six months of 2006, respectively, compared to 6.0% for the second quarter and first six months of fiscal 2005. The percentage increase is the result of decreased sales in fiscal 2006.

Total research, development and engineering (RD&E) expenses were $607,000 and $708,000 during the second quarters of fiscal 2006 and 2005, respectively. RD&E was $1.3 million and $1.4 million in the first six months of fiscal 2006 and 2005, respectively. The decrease in RD&E in both the second quarter and six months of 2006 was from the fact that the Company was able to bill its customers more for design and engineering services for product development—the majority of costs of which are fixed salary expense. When reimbursable services are performed the associated RD&E cost is reclassified to costs of sales and the amount billed is included in revenue.

Selling expense in the second quarter of 2006 was $490,000 compared to $528,000 in second quarter of 2005 and $1.1 million and $1.0 million in the first six months of fiscal years 2006 and 2005, respectively. The decrease during the quarter is related to a severance accrual for employees in Ireland that occurred in second quarter of 2005 offset partially by additional sales staff hired domestically in fiscal 2006. The slight increase for the first six months of fiscal 2006 relates to the additional sales staff.

General and administrative expenses (G&A) amounted to $1.7 million and $1.8 million during the second quarters of fiscal 2006 and 2005, respectively. Included in G&A is a charge of $140,000 to provide for doubtful accounts in the second quarter of fiscal 2005, whereas there was no such provision in 2006. G&A was $3.3 and $3.5 million in the first six months of both fiscal 2006 and 2005. The reduction for the first six months of fiscal 2006 is due to the provision for doubtful accounts, the shutdown of the sales office in Ireland, and no longer paying life insurance premiums due to the death of a former officer of the Company.

Interest

Interest expense decreased to $275,000 in the second quarter of 2006 compared to $308,000 in the second quarter of fiscal year 2005. For the first six months of fiscal 2006 and 2005, interest expense amounted to $536,000 and $607,000, respectively. The decrease in interest expense is directly related to the average revolver balance offset partially by an increase in the variable interest rates charged on the balance. The weighted average interest rate on the Company’s revolver at December 31, 2005 was 6.46% while at January 1, 2005 the weighted average rate was 5.32%.

Income Taxes

The income tax benefit for the second quarter of fiscal year 2006 was $(7,000) compared to $120,000 tax provision for the second quarter of the prior fiscal year. The Company did not have any provision for income tax for the first six months of 2006 as compared to $238,000 for the same period of fiscal 2005. The income tax provisions are attributable primarily to taxable earnings of foreign subsidiaries. The reduction in the provision in the first six months of fiscal year 2006 is related to a reduction in effective tax rates and temporary tax credits applicable to the Company’s Mexican operations. The Company has domestic federal and state tax loss carryforwards of approximately $60 million thus eliminating federal and state liability against current period income. In accordance with SFAS No. 109, a valuation allowance is required if it is more likely than not that some or all of the deferred tax assets will not be realized in the future. Accordingly, management has determined that a valuation allowance equal to the net deferred tax asset is appropriate at this time.

Backlog

Order backlog consists of purchase orders received for products expected to be shipped within the next 12 months although shipment dates are subject to change due to design modifications or other customer requirements. Order backlog should not be considered an accurate measure of future sales.

CAPITAL RESOURCES AND LIQUIDITY

Operating Cash Flow

Cash provided by operating activities was $240,000 during the six months ended December 31, 2005 compared to $2.5 million of cash used in operating activities during the same period of the prior fiscal year. Cash provided by operating activities in fiscal 2006 was due primarily to net income, decreases in receivables and inventory offset in part by an decrease in accounts payable, accrued compensation, and the final payment towards the litigation settlement. The large decrease in receivables is related to the decrease in revenues year-over-year. Accounts payable decreased by $5.1 million or $4.5 million more than the decrease inventory due to the Company taking early pay discounts on certain inventory purchases in fiscal 2006.

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Investing Cash Flow

During the first six months of fiscal year 2006, the Company spent $1.4 million for capital additions compared to $470,000 in the same period of the previous fiscal year. The increase is related to establishing an additional SMT line in China during fiscal 2006. The Company’s capital expenditures are primarily purchases of manufacturing equipment to support its operations in Mexico and China. The Company also uses leases in acquiring equipment. Leases are often utilized when the potential cost of technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds.

Financing Cash Flow

Cash provided by financing activities was $1.7 million for the first six months of fiscal 2006 compared to $3.8 million in fiscal 2005. Cash requirements of the Company are affected by the level of current operations and new EMS programs. The Company utilizes the revolving line of credit to temporarily fund its cash requirements and believes it currently has sufficient availability to grow and expand the business. The financing agreement with CIT Group/Business Credit, Inc. (CIT) provides a revolving credit facility up to $25 million. The range of interest on outstanding balances was 6.16% to 6.52% as of December 31, 2005. The credit facility matures August 22, 2009. As of December 31, 2005, the Company was in compliance with all loan covenants and based on eligible collateral, approximately $7.4 million was available to draw from the revolving line of credit. Restricted cash includes float amounts in the Company’s bank account that must be used to pay down the Company’s revolving line of credit balance. These amounts fluctuate daily based on collections.

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 may 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 The concentration of the Company’s customers and product mix can change significantly. At present, the Company’s customer base is highly concentrated and could become even more concentrated. The Company’s largest EMS customer accounted for 19% of net sales in fiscal year 2005. This same customer accounted for 14% of sales in 2004 and 8% in 2003. For the fiscal years ended 2005, 2004, and 2003, the five largest customers accounted for 68%, 58% and 64% of total 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.

Dependence on Suppliers The Company is dependent on many suppliers, including certain sole source suppliers, to provide key components and raw materials used in manufacturing customers’ products. Delays in deliveries from suppliers or the inability to

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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.

Interest Rate Risk The Company is exposed to interest rate risk under its revolving credit facility with interest rates based on various levels of margin added to published prime rate and LIBOR rates depending on the calculation of certain financial covenants.

Compliance with Current and Future Environmental Regulation The Company is subject to a variety of federal, state, local and foreign environmental regulations relating to the use, storage, discharge and disposal of hazardous chemicals used during the manufacturing process or potentially requiring design changes or recycling of products manufactured. Over the years, environmental laws have become, and in the future may become, more stringent, imposing greater compliance costs and increasing risks and penalties associated with violations. If the Company fails to comply with any present and future regulations, it could be subject to future liabilities, fines, penalties, the loss of customer programs, or the suspension or prohibition of products manufactured. In addition, such regulations could restrict our ability to expand our facilities or could require us to acquire costly equipment, or to incur other significant expenses to comply with environmental regulations, including expenses associated with the recall of any non-compliant product.

For example, the European Union enacted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive (RoHS) and the Waste Electrical and Electronic Equipment Directive (WEEE), for implementation in European Union member states. RoHS and WEEE regulate the use of certain hazardous substances in, and require the collection, reuse and recycling of waste from certain products we manufacture. Similar legislation is currently in force or is being considered in the United States, as well as other countries, such as Japan and China. In general, the Company is not directly responsible for the compliance of our manufactured products with laws like RoHS and WEEE. These laws generally apply to the Company’s OEM customers. However, the Company may provide compliance-related services to our customers upon request. Failing to have the capability of delivering the products which comply with these present and future environmental laws and regulations could restrict our ability to expand facilities, or could require us to acquire costly equipment or to incur other significant expenses to comply with environmental regulations, and could impair our relations with our customers.

Foreign Currency Fluctuations A significant portion of the Company’s operations and customers are in foreign locations. As a result, transactions may occur in currencies other than the U.S. dollar. Exchange rate fluctuations among other currencies used by the Company could directly or indirectly affect our financial results. Future currency fluctuations are dependent upon a number of factors and cannot be easily predicted. The Company currently does not use financial instruments to hedge foreign currency fluctuation and unexpected expenses could occur from future fluctuations in exchange rates.

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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.

Stock Price and Dilution Volatility The common 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 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. As of December 31, 2005, there were outstanding options for the purchase of approximately 1,976,000 shares of common stock of the Company, of which options for approximately 1,961,000 shares were vested and exercisable. Of the outstanding options, approximately 905,000 have exercise prices higher than the average closing price for the quarter. Holders of the common stock will suffer immediate and substantial dilution to the extent outstanding options to purchase the common stock are exercised.

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

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PART II. OTHER INFORMATION:

The Annual Meeting of Shareholders was held on October 27, 2005 at which shareholders voted on proposals as follows:

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Table of Contents

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.

KEY TRONIC CORPORATION

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