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

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

FOR THE PERIOD ENDED OCTOBER 1, 2005

OR

FOR THE PERIOD FROM                      TO                     .

Commission File Number 0-11559

KEY TRONIC CORPORATION

(Exact name of registrant as specified in its charter)

N. 4424 Sullivan Road

Spokane Valley, 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 during the past 90 days. Yes þ No¨

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

Indicate by check mark whether the registrant is a shell company. Yes ¨ No þ.

At October 31, 2005, 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 INCOME

(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)

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 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 ended October 1, 2005 and October 2, 2004 were 13 week periods.

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 prime rate or LIBOR rate. The agreement specifies four alternative levels of margin to be added to each of these base rates depending on the Company’s compliance with certain financial covenants. Interest rates on outstanding balances ranged from 6.16% to 7.00% on October 1, 2005. The increase in rates from fiscal year end 2005 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 revolving loan matures August 22, 2009. As of October 1, 2005, approximately $4.4 million was available to draw from the revolving line of credit.

The income tax provision for the first quarter of fiscal year 2006 was $7,000 compared to $117,000 for the first quarter of the prior fiscal year. The income tax provisions are attributable primarily to taxable earnings of foreign subsidiaries. The reduction in the provision in the first quarter of fiscal 2006 compared with same period of fiscal 2005 is related to a reduction in tax rates 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. SFAS 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.

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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 is as follows (in thousands, except per share information):

There were approximately 860,000 and 932,000 antidilutive stock options not included in the diluted shares outstanding for the quarters ended October 1, 2005 and October 2, 2004, 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 first quarter of 2006 included approximately $20,000 of compensation expense. Net income for the first quarter of fiscal year 2005 did not include any compensation expense related to options. The Company did not grant any stock options in the first quarter of 2006 and does not anticipate future grants. As of October 1, 2005, there was $25,000 of total unrecognized compensation costs related to remaining unvested stock options. These costs will be recognized over the next five quarters.

For purposes of disclosure under SFAS No. 148, the following is the pro forma effect of the then unvested options had they been recorded under the fair value based method during the first quarter of fiscal year 2005 (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 the options granted during the quarter ended October 2, 2004.

Purchase Commitments: The amount of firm commitments to contractors and suppliers for future capital expenditures was approximately $92,000 at October 1, 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 five 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:

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 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 was greater, until the total payment of $7.0 million had been made, provided the total payment was completed by December 15, 2005. The Company made its last quarterly payment to F&G on September 1, 2005 in the amount of $812,000 thereby completing payment of the entire $7.0 million settlement amount.

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

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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

The electronic manufacturing services (EMS) industry has experienced growth over the years and is expected to continue to grow as more original equipment manufacturers (OEMs) shift to outsourced manufacturing. OEM outsourcing trends continue to be very positive for the EMS industry. The Company believes that it is positioned in the EMS industry to expand its customer base and achieve long term growth.

Key Tronic Corporation is an independent provider of EMS for OEMs. The Company’s 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 on a global basis. 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 has made 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.

During the first quarter of fiscal 2006, the Company had an anticipated decline in end-market demand for several existing programs and new programs did not ramp up rapidly enough to offset the 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 increased its year-over-year operating income and earnings through its improved production efficiencies and continued to pursue new customer prospects during the quarter. The Company’s 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 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 those programs that may be initially too small for larger contract manufacturers. 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 first quarter of fiscal 2006 was $702,000 as compared to $266,000 for the first quarter of fiscal 2005. The increase was directly related to increased production efficiencies and favorable product mix. Operating expenses remained flat for the quarter ended October 1, 2005 as compared to the quarter ended October 2, 2004.

Sales for the first quarter of fiscal year 2006 decreased 9.3% to $44.3 million compared to $48.8 million for the same period of fiscal year 2005. The decrease in sales reflects a decline in revenue from existing programs. Sales in the second quarter of fiscal year 2006 are expected to be comparable to the first quarter and in the range of $42 million to $46 million.

Gross profit as a percentage of sales for the first quarter of 2006 was 8.7% compared to 7.3% for the first quarter of fiscal 2005. The increase resulted from improved production efficiencies and favorable product mix. The level of gross margin is impacted by 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 2.01 and a long-term debt to equity ratio of 0.43. 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 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 period of the adjustment.

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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 of certain items in the Consolidated Statements of Income for the periods indicated.

Sales

Sales for the first quarter of fiscal year 2006 decreased 9.3% to $44.3 million compared to $48.8 million for the same period of fiscal year 2005. The decrease in sales reflects a decline in unit sales on several existing customer’s programs. Sales in the second quarter of fiscal year 2006 are estimated to be comparable to the first quarter and in the range of $42 million to $46 million.

Sales to our 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 purchases by its significant customers and most contracts with customers 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 assemblies, precision molding, tool making, assembly, and engineering can be applied to a wide variety of products.

Gross Profit

Our gross profit as a percentage of sales for the first quarter of fiscal 2006 was 8.7% compared to 7.3% during the first quarter of fiscal 2005. The increase is due to improved production efficiencies and favorable changes in product mix. The level of gross margin is impacted by facility utilization, product mix, timing of the start-up of new programs, pricing within the electronics industry and material costs.

The gross profit in the first quarters of fiscal 2006 and 2005 included charges (credits) related to changes in the allowance for obsolete inventory. 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 demand and market conditions. The reserves are established on inventory which the Company has determined customers are not contractually responsible for, or on inventory that the Company believes that the customers will be unable to purchase. The credit in first quarter fiscal 2005 related to the sale of previously reserved inventory.

Operating Expenses

Total operating expenses were $2.9 million in the first quarter of fiscal years 2006 and 2005. Operating expenses as a percentage of sales increased to 6.5% in the first quarter of fiscal 2006 from 5.9% in the first quarter of fiscal 2005. The Company’s operating expenses remained flat for the quarter while sales revenue decreased by 9.1% when compared to the first quarter of fiscal 2005.

Total research, development, and engineering expenses were $662,000 and $705,000 during the first quarters of fiscal 2006 and 2005, respectively. Savings were achieved by a reduction in expenditures for outside services. Selling expenses increased to $568,000 from $493,000 due to increasing internal sales staff and additional one-time expenses relating to closing the Company’s Ireland sales office. General and administrative expenses were $1.7 million in each of the first quarters of fiscal 2006 and 2005.

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Interest

Interest expense decreased to $261,000 in the first quarter of fiscal year 2006 compared to $299,000 in fiscal year 2005 due to a decrease in the average outstanding revolving credit facility balance offset by an increase in the variable interest rates charged on the balance.

Income Taxes

The income tax provision for the first quarter of fiscal year 2006 was $7,000 compared to $117,000 for the first quarter of the prior fiscal year. The income tax provisions are primarily attributable to taxable earnings of foreign subsidiaries. The reduction in the provision in the first quarter of fiscal year 2006 is related to a reduction in effective tax rates applicable to the Company’s Mexican operations. The Company has domestic tax loss carryforwards of approximately $60 million. In accordance with SFAS 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

Quarter Ended

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 used in operating activities was $1.2 million during the first quarter of fiscal year 2006 compared to $595,000 during the same period of the prior fiscal year. The increase in cash used in operating activities was due to a decrease in accounts payable, accrued compensation, other liabilities, and litigation settlement payable. These were offset by a decrease in accounts receivable and inventory. The decrease in accounts payable and inventory for the first quarter of fiscal 2005 was due primarily to a decrease in revenue and the Company taking advantage of early-pay discounts. The decrease in accrued compensation was the result of the payment of incentive compensation that was previously accrued at the 2005 fiscal year end. The Company also made the final $812,000 payment on a litigation settlement referred to previously.

Investing Cash Flow

During the first quarter of fiscal year 2006, the Company spent $897,000 for capital additions compared to $179,000 in the same period in the previous fiscal year. The Company’s capital expenditures are primarily purchases of manufacturing equipment to support its production facilities. The Company also uses leases in acquiring equipment. Leases are often utilized when technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. During the current quarter, the Company entered into a $950,000 operating lease for production equipment and a $90,000 operating lease for computer hardware upgrades. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds.

Restricted cash includes amounts in the Company’s bank account that must be used to pay down the Company’s long-term revolving line of credit. These amounts will fluctuate daily based on collections.

Financing Cash Flow

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 range of interest on outstanding balances was 6.10% to 7.00% on October 1, 2005. The credit facility matures August 22, 2009. As of October 1, 2005, the Company was in compliance will all loan covenants and based on eligible collateral, approximately $4.4 million was available for the Company to draw from the revolving line of credit. Cash requirements of the Company are affected by the level of current operations and new EMS programs. The Company believes that projected cash from operations, funds available under the revolving credit facility, and leasing capabilities will be sufficient to meet our working and fixed capital requirements for the foreseeable future.

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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 can change significantly on a quarterly basis. 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 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

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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 domestic and foreign environmental regulations relating to the use, storage, and disposal of materials used in our manufacturing processes. If we fail to comply with any present or future regulations, we could be subject to future liabilities or the suspension of current manufactured products. In addition, such regulations could restrict our ability to expand our operations or could require us to acquire costly equipment, substitute materials, or incur other significant expenses to comply with government regulations.

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.

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 October 1, 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 1,896,000 shares were vested and exercisable. Of the outstanding options, approximately 860,000 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:

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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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