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

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

OR

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.

At May 1, 2005, 9,690,913 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 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 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 3, 2004.

The Company’s reporting period is a 52/53 week fiscal year ending on the Saturday closest to June 30. The quarters and nine months ended April 2, 2005 and April 3, 2004 were 13 and 39 week periods, respectively.

In December 2004, the Financial Accounting Standards Board (FASB) revised and retitled Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation as SFAS No. 123R, Share Based Payment. This revised statement requires stock options to be recorded using the fair value method, superseding Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. Under APB Opinion 25, issuing stock options to employees could have resulted in recognition of no compensation cost. SFAS 123R eliminates this alternative and requires entities to expense the cost of employee services received in exchange for stock options based on the grant date fair value of those awards. The Company currently accounts for its employee stock options in accordance with APB Opinion No. 25 while disclosing the pro forma effect of the options had they been recorded under the fair value method. As required by the statement, the Company plans to adopt the revised statement in its fiscal year 2006 beginning on July 3, 2005. As a result, the Company estimates that compensation expense for previously granted options will approximate $50,000 in fiscal year 2006 and $9,000 in fiscal year 2007. (See footnote 7 for further discussion.)

In November 2004, the FASB issued SFAS No. 151, Inventory Costs an amendment of ARB No. 43, Chapter 4. The statement amends ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current period charges. In addition it requires that allocation of fixed production overhead to the cost of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred in the Company’s fiscal year 2006 and thereafter. The Company does not anticipate that the provisions of SFAS 151 will have a material effect on the consolidated financial statements.

The components of inventories consist of the following:

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During the current quarter, the Company entered into a new amendment to its financing agreement with CIT Group/Business Credit, Inc. (CIT) that increases the revolving credit facility up to $25 million. The revolving loan is secured by substantially all of 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 three alternative levels of margin to be added to each of these base rates depending on achieving certain financial profitability levels. Each level of margin was reduced 0.25% with the new amendment. The range of interest on outstanding balances was 5.27% to 6.00% as of April 2, 2005. The agreement contains financial covenants that relate to total equity, earnings before interest, taxes, depreciation and amortization, and a minimum fixed charge ratio. The credit facility matures August 22, 2009. As of April 2, 2005, based on eligible collateral and amounts temporarily held in restricted cash, approximately $7.9 million was available to draw from the revolving line of credit.

In addition to increasing the revolving credit facility and extending the term three years, the amendment provides for a $1.5 million real estate term loan and a $500,000 capital expenditure line of credit. As of April 2, 2005, no amount had yet been drawn on either of these new borrowing facilities. The Company intends to use the term loan to finance the purchase of a 62,000 square foot manufacturing facility in Juarez, Mexico that is adjacent to the Company’s main facility. The capital expenditure line of credit will be used for anticipated equipment purchases.

The income tax provisions are attributable primarily to taxable earnings of foreign subsidiaries. The benefit for the third quarter of fiscal 2005 relates to one of the Company’s Mexican subsidiaries changing its estimated tax for statutory year 2004 by applying certain tax credits when filing its tax return. The Company has domestic tax loss carryforwards of approximately $59 million. In accordance with FASB 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.

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):

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There were approximately 932,000 antidilutive stock options not included in the diluted shares outstanding for the quarter and nine months ended April 2, 2005.

As allowed by SFAS No. 123, Accounting for Stock-Based Compensation, the Company accounts for its employee stock option plans in accordance with the provisions of APB Opinion No. 25 and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation. Accordingly, no compensation is currently 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 will adopt FASB No. 123R beginning on July 3, 2005 at which point compensation expense will be recorded for options that have not yet vested or any new grants.

For purposes of disclosure under SFAS No. 123 and SFAS No. 148, Accounting for Stock-Based Compensation, 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):

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: 0% dividend yield, 5-year life, stock price volatility of 104.1% and 81.2%, and risk free interest rates of 3.37% and 4.6% for the nine months ending April 2, 2005 and April 3, 2004, respectively.

Purchase Commitments: The Company had no firm commitments for future capital expenditures at April 2, 2005. However, on February 14, 2005, the Company signed a letter of intent to purchase a manufacturing facility in Juarez, Mexico for approximately $1.4 million.

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

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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):

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. As of April 2, 2005, the Company has made payments to F&G totaling approximately $5.7 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.

On April 22, 2005, the Company entered into an agreement to purchase a 62,000 square foot manufacturing facility in Juarez, Mexico for approximately $1.4 million. The facility is adjacent to the Company’s main manufacturing facility. The facility was acquired to replace a 38,000 square foot building that is coming off lease in June 2005 and to increase capacity.

On April 30, 2005, a former executive of the Company, on whom the Company carried a life insurance policy, passed away. As a result of the related coverage, the Company estimates a gain on the benefit proceeds when received in the amount of approximately $1.1 million. This amount was not included in the forecasted results of the fourth quarter of fiscal 2005 in the Company’s press release dated April 28, 2005.

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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 and Quarterly Reports on Form 10-Q.

OVERVIEW

Key Tronic Corporation is an independent provider of electronic manufacturing services (EMS) for original equipment manufacturers (OEMs). The EMS industry has experienced significant growth recently and is expected to continue to grow as more OEMs shift to outsourced manufacturing. 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 gives it the production capacity and logistical advantages to continue to win new business. The Company believes that it is positioned in the EMS industry to expand its customer base and continue business growth.

The Company has continued to acquire new customers and increase production on programs for existing customers. During fiscal 2005, the Company has made substantial commitments to expand and enhance its EMS business development efforts and those efforts are in part responsible for the recent growth in sales revenue. The Company’s new customer programs involve a variety of products, including consumer electronics and plastics, gaming devices, household products, specialty printers, hospital products 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 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 price strategies.

Net income for the third quarter of fiscal 2005 was $852,000, up from $112,000 for the third quarter of fiscal 2004, and up from net income of $490,000 for the previous quarter. For the first nine months of fiscal 2005, net income was $1.6 million, up from a net loss of $155,000 for the same period of fiscal 2004. The increase in net income is directly related to the increase in sales during fiscal 2005.

Sales for the third quarter of fiscal 2005 were $49.7 million, up 33.2% from $37.3 million for the third quarter of fiscal 2004, and down 3.0% from $51.2 million in the previous quarter. The increase in sales during the quarter as compared to the third quarter of fiscal 2004 is attributed to an increase in unit sales of printed circuit board assemblies (PCBAs) and printer accessories.

Sales for the first nine months of fiscal 2005 were $149.7 million, up 43.3% from $104.5 million in the same period of fiscal 2004. The increase in sales in fiscal year 2005 when compared to the same period of fiscal 2004 is due to a significant increase in unit sales of printer and printer accessories, PCBAs and consumer electronics offset by a decrease in sales of household products.

The increase in revenue base represents stronger growth with existing programs and new programs from new and existing customers as vertically integrated OEMs continue to convert to an outsourcing model. Further growth in sales volume of PCBAs and printer related programs is anticipated throughout the remainder of fiscal 2005. The Company expects revenue to increase the next quarter 5% to 10% from the third quarter of fiscal 2005.

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The Company maintains a strong balance sheet with a current ratio of 1.7 and a long-term debt to equity ratio of 0.5. The Company maintains a good working relationship with its asset-based lender, and believes that internally generated funds and the Company’s borrowing facilities will provide adequate working capital and sufficient funds for planned growth.

CRITICAL ACCOUNTING POLICIES

The Company’s financial statements and related disclosures are prepared in accordance with accounting principles generally accepted in the Unites States of America (GAAP). GAAP requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, these estimates and judgments are evaluated based upon historical experience and various other factors and circumstances. Management of the Company believes that these estimates and judgments are reasonable under the current circumstances; however, actual results may vary from these estimates and judgments under different future circumstances. The Company has identified the following critical accounting policies that affect the more significant estimates and judgments used in the preparation of the consolidated financial statements. For further discussion of our significant accounting policies, refer to Note 1- “Significant Accounting Policies” to the consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended July 3, 2004.

Revenue Recognition: The Company recognizes revenue primarily when products are shipped. SEC 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 revenue that has been recognized for the following reasons:

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.

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 material based upon a customer’s forecast, it is usually covered by lead-time assurance agreements. These agreements 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 if the material could not effectively be used for alternative purposes.

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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. The Company does not currently warrant design defects in products manufactured for EMS customers. 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.

Income Taxes: The Company is required to estimate income taxes in each of the jurisdictions in which it operates. This process involves estimating the actual current tax liability together with evaluating temporary differences in recognition of income (loss) for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Company’s balance sheets. A valuation allowance against deferred tax assets is required whenever the recovery of the assets from future earnings is considered doubtful. In fiscal 2002, the Company wrote off its net deferred tax assets totaling approximately $5 million by recording additional income tax expense and increasing the valuation allowance for the deferred tax assets. The Company’s management made this decision as a result of the large financial loss recorded in that fiscal year and uncertainty due to a verdict rendered in the F&G Scrolling Mouse LLC litigation (see Note 8 of the condensed consolidated financial statements). As of April 2, 2005, the Company had approximately $59 million in tax loss carryforwards, which will expire in 2006 through 2024.

Although the Company has a history of operating losses, it is possible that future earnings may indicate the need to reinstate all or a portion of the deferred tax assets. If this should occur, an income tax benefit would be recorded, and this 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 that certain items in our Consolidated Statements of Income for the periods indicated.

Sales

Sales for the third quarter of fiscal 2005 were $49.7 million, up 33.2% from $37.3 million for the third quarter of fiscal 2004, and down 3.0% from $51.2 million in the previous quarter. The increase in sales during the quarter as compared to the third quarter of fiscal 2004 is attributed to sales of PCBAs and an increase in printer accessories.

Sales for the first nine months of fiscal 2005 were $149.7 million, up 43.3% from $104.5 million in the same period of fiscal 2004. The increase in revenue reflects new manufacturing program revenue from new and existing customers. The increase in sales in fiscal year 2005 when compared to the same period of fiscal 2004 is due to a significant increase in PCBAs, printer and printer accessories, and consumer electronics offset by a decrease in sales of household products.

The Company continues to achieve its revenue growth without acquisitions. During the third quarter of 2005, the Company continued to lower its dependence on its largest customers as the customer base continues to increase. Future growth in PCBAs and printer related programs is anticipated throughout the remainder of fiscal 2005. The Company expects revenue to increase the next quarter 5% to 10% from the third quarter of fiscal 2005.

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 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 for PCBAs, precision molding, tool making, assembly, and engineering can be applied to a wide variety of products.

Gross Profit

Gross profit as a percentage of sales for the third quarter of fiscal 2005 was 8.1% compared to 9.8% during the third quarter of fiscal 2004. The decrease is due to the changes in product mix offset in part by better manufacturing efficiencies. Gross profit margins in the future will continue to depend on facility utilization, product mix, start-up of new programs, pricing within the electronics industry, and material costs.

The gross profit percentage for the first nine months of fiscal 2005 was 7.7% as compared to 9.3% for the same period of fiscal 2004. The decrease is attributable to changes in product mix, inventory obsolescence, and sales price reductions offset in part by better manufacturing efficiencies. The gross profit includes 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 demands and market conditions. The reserves are established on inventory which the Company has determined that customers are not contractually responsible for, or on inventory that will not be

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ultimately used or purchased by customers under contractual obligations. The credit to costs of sales in the first nine months of fiscal 2004 related to the sale of previously reserved inventory.

Operating Expenses

Total operating expenses were $3.0 million and $8.9 million in the third quarter and first nine months of fiscal 2005 compared to $3.0 million and $8.5 million in the third quarter and first nine months of 2004, respectively. The increase in operating expenses for the nine months is directly related to the increase in sales and the related increase in selling expense and engineering support. However, as a percent of sales total operating expenses were 6.0% for the third quarter and the first nine months of 2005 compared to 8.1% and 8.2% for the third quarter and first nine months of fiscal 2004, respectively. The percentage decrease is the result of maintaining consistent operating expense levels even while increasing sales significantly during the quarter and first nine months of fiscal 2005.

Total research, development and engineering (RD&E) expenses were $713,000 and $638,000 during the third quarters of fiscal 2005 and 2004, respectively. RD&E was $2.1 million and $1.9 million in the first nine months of fiscal 2005 and 2004, respectively. The Company had additional electrical engineering and program management costs during the first nine months of fiscal 2005 based on the sales product mix and current product development while reducing mechanical engineering costs.

Selling expense in the third quarter of 2005 was $556,000 compared to $621,000 in third quarter of 2004 and $1.6 million and $1.3 million in the first nine months of fiscal years 2005 and 2004, respectively. The decrease in selling expenses in the third quarter relates partly to a reduction in expenses of Ireland. The increase for the first nine months is related to an increase in commission expense and outside service fees due to the increased volume of sales, which was partially offset by a reduction in advertising expense.

General and administrative expenses amounted to $1.7 million and $1.8 million during the third quarters of fiscal 2005 and 2004, respectively. General and administrative expenses were $5.2 million and $5.3 million in the first nine months of fiscal 2005 and 2004, respectively. Offsetting increases in salary costs were premium expense reductions resulting from renegotiation of the Company’s liability insurance and reductions in other operating expenses and administrative expenses at the Ireland facility during fiscal year 2005. In October of 2004, the administrative functions for the Ireland facility were transferred to the Company’s corporate offices. As a result, the Company’s staff in Ireland was decreased and the remaining employees were moved to a smaller leased facility. The Company’s business in Ireland remains sales, marketing, and distribution in support of the European market.

Interest

Interest expense increased to $296,000 in the third quarter of 2005 compared to $273,000 in the third quarter of fiscal year 2004. For the first nine months of fiscal 2005 and 2004, interest expense amounted to $903,000 and $795,000, respectively. The increase in interest expense is directly related to the average revolver balance and the increase in the variable interest rates charged on the balance. The weighted average interest rate on the Company’s revolver at April 2, 2005 was 5.62% while at April 3, 2004 the weighted average rate was 4.50%. The interest rates change with the published prime and LIBOR rates and may increase in the future.

Income Taxes

The income tax provision (benefit) is attributable to the taxable earnings of foreign subsidiaries. The income tax benefit for the third quarter of fiscal 2005 was $(91,000) compared to a provision of $238,000 for the third quarter of the prior fiscal year. The benefit for the third quarter of fiscal 2005 relates to one of the Company’s Mexican subsidiaries changing its estimated tax for statutory year 2004 by applying certain tax credits when filing its tax return. The income tax provision totaled $147,000 for the first nine months of 2005 as compared to $522,000 for the same period of fiscal 2004. The decrease in the first nine months of fiscal 2005 is attributable to the applied tax credits and reductions in effective tax rates applicable to both of the Company’s Mexican operations. Due to the fact that the Company has made tax payments in excess of its calculated liability in Mexico, the Company has recorded a net tax receivable of approximately $900,000 that will be used for reductions of future tax payments or refunded.

The Company has domestic federal and state tax loss carryforwards of approximately $59 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 than 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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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 $3.9 million during the nine months ended April 2, 2005 compared to $1.2 million of cash provided by operating activities during the same period of the prior fiscal year. The increase in cash provided by operating activities was due primarily to an increase in other liabilities and net income, and a decrease in trade receivables offset in part by a decrease in accounts payable and an increase in inventory. Other liabilities increased due to a cash payment made by a customer for future sales. Trade receivables decreased due to better collections particularly in the last two weeks of the quarter and the mix in terms of current customer programs. Inventory has increased as materials and other components have been purchased in order to support future revenues. Accounts payable decreased as the Company continues to increase its early pay discounts on certain inventory purchases.

Investing Cash Flow

During the first nine months of fiscal year 2005, the Company spent $686,000 for capital additions compared to $638,000 in the same period in the previous fiscal year. The Company’s capital expenditures are primarily purchases of manufacturing equipment to support its operations in Mexico and China. The Company also uses operating leases in acquiring equipment. Leases are often utilized when technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. During the first nine months of fiscal 2005, the Company entered into operating leases for equipment valued at approximately $650,000. Subsequent to the end of the quarter on April 22, 2005, the Company entered into an agreement to purchase a facility in Mexico for approximately $1.4 million and plans to invest in additional equipment during the fourth quarter of fiscal 2005. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds and through the use of other debt facilities.

Financing Cash Flow

The Company used $1.6 million for financing activities in the first nine months of fiscal 2005 as compared with $189,000 for the first nine months of fiscal 2004. The increase in cash used was due to an increase in collections held in restricted cash. Restricted cash includes collected 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 and typically clear the next business day.

The Company has entered into an updated 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 5.27% to 6.00% as of April 2, 2005. The credit facility matures August 22, 2009. As of April 2, 2005, the Company was in compliance with all loan covenants and based on eligible collateral and amounts temporarily held in restricted cash, approximately $7.9 million was available 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 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.

In addition to increasing the revolving credit facility, the Company entered into new agreements during the quarter with CIT for a $1.5 million real estate term loan and a $500,000 capital expenditure line of credit. As of April 2, 2005 no amount had yet been drawn on either of these new borrowing facilities. The Company intends to use the term loan to finance the purchase of a manufacturing facility in Mexico. The capital expenditure line of credit will be used for certain anticipated equipment purchases.

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.

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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. Our success will depend largely on the success achieved by our customers in developing and marketing their products. If our customers’ products become obsolete or fail to successfully market to a broad base of buyers, our business could be materially adversely affected. 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 could 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

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 16% of net sales in fiscal year 2004. This same customer accounted for 31% of sales in 2003 and 39% in 2002. For the fiscal years ended 2004, 2003, and 2002, the five largest customers accounted for 58%, 64% and 85% 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 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.

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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 or choose not 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, a portion of our business is conducted 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.

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.

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 April 2, 2005, there were outstanding options for the purchase of approximately 1,991,000 shares of common stock of the Company, of which options for approximately 1,952,000 shares were vested and exercisable. Of the outstanding options, approximately 932,000 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.

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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 and LIBOR rates. 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.

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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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