KTCC

Business Context and Reporting Period

Company: Key Tronic Corporation (KeyTronicEMS Co.)
Filing Type: Form 10-K (Annual Report)
Period Ended: June 30, 2007
Industry: Electronic Manufacturing Services (EMS) and consumer product manufacturing.
Operations: The Company provides product realization services for OEMs, including design, surface mount technologies (SMT), molding, and assembly. Operations are conducted in the United States, Mexico, and China. The Company shifted its strategic focus from keyboard manufacturing to EMS approximately eight years prior to this filing.

Key Financial Metrics

Liquidity: The Company maintained a current ratio of 2.31. As of June 30, 2007, approximately $11.1 million was available under its $25 million revolving line of credit.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 7.5% to $201.7 million, driven by increased demand from major customers and new customer programs.
• Margin Compression: Gross margin decreased to 8.8% from 9.2% in 2006. This was attributed to customer price decreases exceeding cost savings, a $404,000 write-off of inventory/tooling for a bankrupt customer, and start-up costs for a new SMT line in Spokane.
• Net Income Decline: Net income fell to $5.2 million from $9.8 million. While 2007 included a $1.5 million gain on the sale of real estate, it was offset by $460,000 in acquisition due diligence costs and bad debt write-offs. Conversely, 2006 net income was bolstered by a $5.0 million non-cash tax benefit from releasing a valuation allowance.
• Operating Cash Flow: Operating cash flow turned negative at ($1.9) million, primarily due to a $7.1 million decrease in accounts payable and a reduction in inventory levels.
• Debt Levels: The revolving loan balance increased to $13.1 million from $10.1 million to support working capital needs.

Guidance, Outlook, and Risks

Outlook: Management expects sales for the first quarter of fiscal 2008 to range between $42 million and $45 million due to decreased current customer demand. However, the Company anticipates significant revenue contributions from new customer programs in the latter part of fiscal 2008.

Key Risks and Contingencies:

• Customer Concentration: The top five customers accounted for 73% of total sales in 2007. The largest single customer (Zebra Technologies) represented 22% of sales. Loss of a major customer could materially impact results.
• Supplier Dependence: Reliance on sole-source suppliers for key components poses a risk of production delays.
• Foreign Operations: Significant operations in Mexico and China expose the Company to foreign currency fluctuations, import/export regulations, and political risks.
• Real Estate Contingency: A potential $951,000 gain from the sale of adjacent land in New Mexico is deferred pending the removal of a flood plain designation; payment is not assured.
• Inventory and Bad Debt: The Company recorded significant provisions for obsolete inventory and bad debt related to a customer bankruptcy in 2007.

Investor Verification Checklist

• Customer Concentration: Verify the stability of contracts with the top three customers (Zebra, Lexmark, IGT), which collectively represent 57% of revenue.
• Cash Flow Sustainability: Assess the ability to generate positive operating cash flow given the negative $1.9 million outflow in 2007 and reliance on the revolving credit facility.
• Real Estate Gain Realization: Monitor the status of the flood plain designation for the New Mexico land sale to determine if the deferred $951,000 gain will be recognized.
• Inventory Valuation: Review the adequacy of the reserve for obsolete inventory, particularly given the $404,000 write-off related to a bankrupt customer.
• Debt Covenants: Confirm continued compliance with the fixed charge ratio covenant required by the CIT Group financing agreement.