Key Technologies 10-Q 6-30-2005
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549-1004
_____________________________________________

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
for the quarterly period ended June 30, 2005

or

 o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
for the transition period from ____ to ____

Commission File No. 0-21820
____________________________________________

KEY TECHNOLOGY, INC.
(Exact name of Registrant as specified in its charter)

Oregon
(State or jurisdiction of
incorporation or organization)
93-0822509
(I.R.S. Employer
Identification No.)

150 Avery Street
Walla Walla, Washington 99362
(Address of principal executive offices and zip code)

(509) 529-2161
(Registrant's telephone number, including area code)
_____________________________________________


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
 
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

The number of shares outstanding of the Registrant's common stock, no par value, on July 29, 2005 was 5,085,824 shares.
 

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
FORM 10-Q FOR THE THREE MONTHS ENDED JUNE 30, 2005
TABLE OF CONTENTS
 
PART I.  
     
Item 1.
  
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
Item 2.
13
     
Item 3.
20
     
Item 4.
20
     
PART II.
 
     
Item 2.
21
     
Item 6.
22

23

24
 
2

PART I.
FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
CONDENSED UNAUDITED CONSOLIDATED BALANCE SHEETS
JUNE 30, 2005 AND SEPTEMBER 30, 2004
 
   
June 30,
      
September 30,
  
   
2005
      
2004
  
       
(in thousands) 
    
Assets
              
Current assets:
                    
Cash and cash equivalents
  
$
13,158
        
$
8,817
  
Trade accounts receivable, net
    
10,720
         
9,336
 
Inventories:
                    
Raw materials
    
6,574
         
6,460
 
Work-in-process and sub-assemblies
    
4,880
         
4,749
 
Finished goods
    
3,695
         
2,424
 
Total inventories
    
15,149
         
13,633
 
Deferred income taxes
    
2,217
         
2,119
 
Other current assets
    
1,616
         
1,097
 
Total current assets
    
42,860
         
35,002
 
Property, plant and equipment, net
    
4,387
         
5,046
 
Deferred income taxes
    
10
         
6
 
Investment in joint venture
    
1,420
         
1,914
 
Goodwill, net
    
2,524
         
2,524
 
Intangibles and other assets, net
    
7,080
         
8,022
 
Total
  
$
58,281
        
$
52,514
  
                     
Liabilities and Shareholders' Equity
                    
Current liabilities:
                    
Accounts payable
  
$
2,621
        
$
1,599
  
Accrued payroll liabilities and commissions
    
3,860
         
3,781
 
Accrued customer support and warranty costs
    
1,388
         
1,283
 
Other accrued liabilities
    
2,837
         
2,007
 
Customers' deposits
    
3,784
         
2,536
 
Current portion of long-term debt and capital lease obligations
    
1,148
         
1,210
 
Current portion of mandatorily redeemable preferred stock
    
1,124
         
1,279
 
Current portion of warrants
    
255
         
316
 
Total current liabilities
    
17,017
         
14,011
 
Long-term debt and capital lease obligations
    
1,439
         
2,323
 
Deferred income taxes
    
840
         
136
 
Total shareholders' equity
    
38,985
         
36,044
 
Total
  
$
58,281
        
$
52,514
  
 
See notes to condensed unaudited consolidated financial statements.
 
3

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
CONDENSED UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED JUNE 30, 2005 AND 2004

   
2005
      
2004
  
   
  (in thousands, except per share data)  
  
               
Net sales
  
$
25,917
        
$
22,170
  
Cost of sales
    
14,732
         
11,954
 
Gross profit
    
11,185
         
10,216
 
Operating expenses:
                    
Sales and marketing
    
3,395
         
3,458
 
Research and development
    
1,186
         
1,545
 
General and administrative
    
2,052
         
2,026
 
Amortization of intangibles
    
334
         
331
 
Total operating expenses
    
6,967
         
7,360
 
Gain on sale of assets
    
15
         
-
 
Earnings from operations
    
4,233
         
2,856
 
Other expense
    
(140
)
        
(3
)
Earnings before income taxes
    
4,093
         
2,853
 
Income tax expense
    
1,384
         
845
 
Net earnings
    
2,709
         
2,008
 
Assumed dividends on mandatorily redeemable preferred stock
    
(40
)
        
(37
)
Net earnings available to common shareholders
  
$
2,669
        
$
1,971
  
                     
                     
Earnings per share
                    
- basic
  
$
0.53
        
$
0.40
  
- diluted
  
$
0.52
        
$
0.38
  
                     
Shares used in per share calculations - basic
    
5,037
         
4,947
 
                     
Shares used in per share calculations - diluted
    
5,218
         
5,269
 
 
See notes to condensed unaudited consolidated financial statements.
 
4

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
CONDENSED UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE NINE MONTHS ENDED JUNE 30, 2005 AND 2004

   
2005
      
2004
  
   
  (in thousands, except per share data)  
  
               
Net sales
  
$
58,757
        
$
61,674
  
Cost of sales
    
35,239
         
35,511
 
Gross profit
    
23,518
         
26,163
 
Operating expenses:
                    
Sales and marketing
    
9,532
         
10,112
 
Research and development
    
3,702
         
4,180
 
General and administrative
    
5,821
         
5,639
 
Amortization of intangibles
    
998
         
992
 
Total operating expenses
    
20,053
         
20,923
 
Gain on sale of assets
    
28
         
6
 
Earnings from operations
    
3,493
         
5,246
 
Other income
    
86
         
34
 
Earnings before income taxes
    
3,579
         
5,280
 
Income tax expense
    
1,145
         
1,630
 
Net earnings
    
2,434
         
3,650
 
Assumed dividends on mandatorily redeemable preferred stock
    
(39
)
        
(70
)
Net earnings available to common shareholders
  
$
2,395
        
$
3,580
  
                     
                     
Earnings per share
                    
- basic
  
$
0.48
        
$
0.73
  
- diluted
  
$
0.47
        
$
0.70
  
                     
Shares used in per share calculations - basic
    
5,013
         
4,886
 
                     
Shares used in per share calculations - diluted
    
5,201
         
5,223
 

See notes to condensed unaudited consolidated financial statements.

5

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
CONDENSED UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED JUNE 30, 2005 AND 2004

   
2005
      
2004
  
       
(in thousands) 
    
Net cash provided by operating activities
  
$
6,639
        
$
3,746
  
                     
Cash flows from investing activities:
                    
Proceeds from sale of property
    
26
         
190
 
Additions to property, plant and equipment
    
(644
)
        
(894
)
Cash paid for acquired company, net of cash acquired
    
(1,059
)
        
-
 
Net cash used in investing activities
    
(1,677
)
        
(704
)
                     
Cash flows from financing activities:
                    
Repayment of long-term debt
    
(935
)
        
(815
)
Redemption of preferred stock
    
(155
)
        
(88
)
Redemption of warrants
    
(61
)
        
(39
)
Proceeds from issuance of common stock
    
521
         
1,457
 
Net cash provided by (used in) financing activities
    
(630
)
        
515
 
                     
Effect of exchange rates on cash
    
9
         
372
 
Net increase in cash and cash equivalents
    
4,341
         
3,929
 
Cash and cash equivalents, beginning of the period
    
8,817
         
6,442
 
Cash and cash equivalents, end of the period
  
$
13,158
        
$
10,371
  
                     
Supplemental information:
                    
Cash paid during the period for interest
  
$
139
        
$
154
  
Cash paid during the period for income taxes
  
$
27
        
$
993
  
Equipment obtained through lease financing
  
$
-
        
$
245
  
Depreciation and amortization
  
$
2,369
        
$
2,370
  
 
See notes to condensed unaudited consolidated financial statements.
 
6

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.
Condensed unaudited consolidated financial statements

Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been omitted from these condensed unaudited consolidated financial statements. These condensed unaudited consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2004. The results of operations for the three and nine-month periods ended June 30, 2005 are not necessarily indicative of the operating results for the full year.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

In the opinion of management, all adjustments, consisting only of normal recurring accruals, have been made to present fairly the Company's financial position at June 30, 2005 and the results of its operations and its cash flows for the three and nine-month periods ended June 30, 2005 and 2004.

In 2004, the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Force (“EITF”) reached consensus on issue No. 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128. Issue No. 03-6 determined that for participating securities, the two-class method of computing basic earnings per share is required. Dividends must be calculated for the participating security on undistributed earnings and are a reduction in the net income available to common shareholders. The Company’s Series B mandatorily redeemable preferred stock is a participating security as it has the right to dividends should dividends be declared on common stock. Assumed dividends on undistributed earnings are allocated as if the entire net income were distributed and based on the relationship of the weighted average number of common shares outstanding and the weighted average number of common shares outstanding if the preferred stock were converted into common. As required by the consensus, prior periods have been restated.

2.
Acquisitions

Effective February 10, 2005, the Company acquired all the outstanding stock of Freshline Machines Pty. Ltd. (“Freshline”). The purchase price, including acquisition costs, was approximately $1,477,000. The purchase agreement also provides for contingent payments if Freshline’s gross revenues in the twelve month period subsequent to acquisition exceed specific targets. The maximum contingent purchase price under these contingencies is $700,000. The Company paid the cash purchase price from cash on hand.

The acquisition was accounted for as a purchase and Freshline’s results of operation for the period subsequent to the acquisition have been included in the Company’s Consolidated Statements of Operations for the periods ending June 30, 2005. The purchase price has been allocated to the assets and liabilities of Freshline based on their estimated fair values. Based on the estimates, the Company recorded approximately $152,000 of Patents / developed technologies, which is being amortized on a straight-line basis over 10 years, as the product lines associated with these assets are expected to continue to generate revenues for an extended period of time. Assets and liabilities acquired were as follows (in thousands):

Fair value of assets acquired
        
Tangible assets
  
$
1,041
  
Note receivable from previous owner
    
672
 
Patents / developed technologies
    
152
 
Liabilities assumed
    
(806
)
Cash paid for common stock, less cash acquired of $418
  
$
1,059
  

The note receivable from Freshline’s previous owner was re-paid in March 2005. In addition, the Company entered into the following two agreements with the previous owner: (1) A one year rental, with a one-year
 
7

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

renewal option, of the building where Freshline is currently operating. The building is approximately 14,500 square feet of combined manufacturing and office space; (2) A two-year consulting agreement.

3.
Stock Compensation

The Company has elected to account for its stock-based compensation plans under Accounting Principles Board Opinion No. 25 (“APB 25”). If the Company had accounted for its stock-based compensation plans under Statement of Financial Accounting Standards (“SFAS”) No. 123, the Company’s net earnings and earnings per share would approximate the pro forma disclosures below (in thousands, except per share amounts):

   
Three months ended March 31,
  
Six months ended March 31,
  
   
2005
  
2004
  
2005
  
2004
  
                   
Net earnings (loss), as reported
  
$
2,709
  
$
2,008
  
$
(2,434
)
$
3,650
  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    
(72
)
$
(180
)
  
(226
)
$
(477
)
Pro forma net earnings (loss)
  
$
2,637
  
$
975
  
$
2,208
 
$
3,173
  
                           
Earnings (loss) per share:
                          
Basic - as reported
  
$
0.53
  
$
0.40
  
$
(0.48
)
$
0.73
  
Basic - pro forma
  
$
0.52
  
$
0.37
  
$
(0.43
)
$
0.64
  
 
                          
Diluted - as reported
  
$
0.52
  
$
0.38
  
$
(0.47
)
$
0.70
  
Diluted - pro forma
  
$
0.51
  
$
0.35
  
$
(0.43
)
$
0.61
  

During the nine-month period ended June 30, 2005, the Company granted options to purchase 25,000 shares of common stock. The weighted average fair value of the options granted, using the Black-Scholes methodology, was $5.43 per share. The total value of these options was $136,000, which will be amortized over the one-year vesting period. These options expire in February 2015.

4.
Earnings per share

The calculation of the basic and diluted earnings per share (“EPS”) is as follows (in thousands except per share data):

8

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

   
For the three months ended
June 30, 2005
  
For the three months ended
June 30, 2004
  
   
Earnings
  
Shares
  
Per-Share Amount
  
Earnings
  
Shares
  
Per-Share Amount
  
                           
Net earnings from continuing operations
  
$
2,709
              
$
2,008
              
Less: Assumed dividends on mandatorily redeemable preferred stock
    
(40
)
              
(37
)
            
Basic EPS:
                                      
Net earnings available to common shareholders
    
2,669
    
5,037
  
$
0.53
    
1,971
   
4,947
  
$
0.40
  
Effect of dilutive securities:
                                      
Common stock options
          
105
                
231
        
Mandatorily redeemable preferred stock
    
40
    
76
          
37
    
91
        
Diluted EPS:
                                      
Earnings available to common shareholders plus assumed conversions
  
$
2,709
    
5,218
  
$
0.52
  
$
2,008
    
5,269
  
$
0.38
  

   
For the nine months ended
June 30, 2005
  
For the nine months ended
June 30, 2004
  
   
Earnings
  
Shares
  
Per-Share Amount
  
Earnings
  
Shares
  
Per-Share Amount
  
                           
Net earnings from continuing operations
  
$
2,434
              
$
3,650
              
Less: Assumed dividends on mandatorily redeemable preferred stock
    
(39
)
              
(70
)
            
Basic EPS:
                                      
Net earnings available to common shareholders
    
2,395
    
5,013
  
$
0.48
    
3,580
   
4,886
  
$
0.73
  
Effect of dilutive securities:
                                      
Common stock options
          
107
          
-
    
241
        
Mandatorily redeemable preferred stock
    
39
    
81
          
70
    
96
        
Diluted EPS:
                                      
Earnings available to common shareholders plus assumed conversions
  
$
2,434
    
5,201
  
$
0.47
  
$
3,650
    
5,223
  
$
0.70
  
 
9

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The weighted average number of diluted shares includes only potential common shares that are not anti-dilutive to reported EPS. The following potential common shares were not included in the EPS calculations as they were anti-dilutive:
 
   
Three months ended June 30,
  
Nine months ended June 30,
  
   
2005
  
2004
  
2005
  
2004
  
                   
Common shares from:
                          
Assumed exercise of stock options
    
259,000
   
183,600
   
279,000
   
183,600
 
Assumed conversion of warrants
    
25,466
   
31,671
   
25,466
   
31,671
 


5.
Income taxes

The provision (benefit) for income taxes is based on the estimated effective income tax rate for the year.

6.
Comprehensive income

The calculation of comprehensive income is as follows (in thousands):

   
Three months ended
  
   
June 30, 2005
  
June 30, 2004
  
Components of comprehensive income:
              
Net earnings
  
$
2,709
  
$
2,008
  
Other comprehensive income -
              
foreign currency translation adjustment, net of tax
    
(240
)
  
(56
)
Total comprehensive income
  
$
2,469
  
$
1,952
  

   
Nine months ended
  
   
June 30, 2005
  
June 30, 2004
  
Components of comprehensive income:
              
Net earnings
  
$
2,434
  
$
3,650
  
Other comprehensive income -
              
foreign currency translation adjustment, net of tax
    
(43
)
  
139
 
Total comprehensive income
  
$
2,391
  
$
3,789
  

7.
Contractual guarantees and indemnities

Product warranties

The Company provides a warranty on its products ranging from ninety days to two years following the date of shipment. The warranty is typically limited to repair or replacement of the defective product. The Company establishes allowances for warranties for specifically identified, as well as anticipated, warranty claims based on contractual terms, product conditions and actual warranty experience by product line. The provision for warranty costs is charged to cost of sales at the time such costs are known or estimable.

A reconciliation of the changes in the Company’s allowances for warranties for the nine months ended June 30, 2005 and 2004 (in thousands) is as follows:

10

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

   
Nine months ended
  
   
June 30, 2005
  
June 30, 2004
  
Beginning balance
  
$
889
  
$
837
  
Warranty costs incurred
    
(1,321
)
  
(1,243
)
Warranty expense accrued
    
1,283
   
1,156
 
Translation adjustments
    
(1
)
  
10
 
Ending balance
  
$
850
  
$
760
  

Intellectual property and general contractual indemnities

The Company, in the normal course of business, provides specific, limited indemnification to its customers for liability and damages related to intellectual property rights. In addition, the Company may enter into contracts with customers where it has agreed to indemnify the customer for personal injury or property damage caused by the Company’s products and services. Indemnification is typically limited to replacement of the items or the actual price of the products and services. The Company maintains product liability insurance as well as errors and omissions insurance, which may provide a source of recovery in the event of an indemnification claim, but does not maintain insurance coverage for claims related to intellectual property rights.

Historically, any amounts payable under these indemnifications have not had a material effect on the Company’s business, financial condition, results of operations, or cash flows. The Company has not recorded any provision for future obligations under these indemnifications. If the Company determines it is probable that a loss has occurred under these indemnifications, then any such reasonably estimable loss would be recognized.

Director and officer indemnities

The Company has entered into indemnification agreements with its directors and certain executive officers which require the Company to indemnify such individuals against certain expenses, judgments and fines in third-party and derivative proceedings. The Company may recover some of the expenses and liabilities that arise in connection with such indemnifications under the terms of its directors’ and officers’ insurance policies. The Company has not recorded any provision for future obligations under these indemnification agreements.

Bank guarantees and letters of credit

At June 30, 2005, the Company’s European subsidiary had approximately $1.2 million of outstanding performance guarantees secured by bank guarantees under the Company’s credit facility in Europe. Bank guarantees arise when the European subsidiary collects customer deposits prior to order fulfillment. The customer deposits received are recorded as liabilities on the Company’s balance sheet. The bank guarantees repayment of the customer deposit in the event an order is not completed. The bank guarantee is canceled upon shipment and transfer of title. These bank guarantees arise in the normal course of the Company’s European business and are not deemed to expose the Company to any significant risks since they are satisfied as part of the design and manufacturing process. In addition, at June 30, 2005, the Company had a standby letter of credit for $300,000 securing certain self-insurance contracts related to workers compensation and a standby letter of credit for $275,000 securing payments under a lease contract for a domestic production facility. If the Company fails to meet its contractual obligations, these bank guarantees and letters of credit may become liabilities of the Company.
 
11

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

8.
Future accounting changes

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is effective for the Company on October 1, 2005. This Statement requires the Company to measure and expense the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award and amends the disclosure requirements related to awards of equity instruments. Beginning October 1, 2005, the Company will begin expensing the cost of equity instruments awarded as part of the Employees’ Stock Incentive Plan and Employee Stock Purchase Plan over the requisite service period related to such awards. The Company has elected to implement this new standard under the modified prospective application. Under the modified prospective application, the Company will expense the cost of new or modified awards over the requisite service period and the cost of previous awards for the requisite service period remaining after October 1, 2005. Until October 1, 2005, the Company will continue to account for share-based payments under APB No. 25 and continue to include the applicable disclosures. (See Note 3.)

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). This statement is effective October 1, 2005. The Company does not believe SFAS No. 151 will have a material effect on its financial position or results of operations. 
 
12
 
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 
Certain statements set forth below may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to differ from those expressed or implied by the forward-looking statements. With respect to the Company, the following factors, among others, could cause actual results or outcomes to differ materially from current expectations:
·
adverse economic conditions, particularly in the food processing industry, may adversely affect the Company's revenues;
·
competition and advances in technology may adversely affect sales and prices;
·
the Company's new products may not compete successfully in either existing or new markets;
·
the limited availability and possible cost fluctuations of materials used in the Company's products could adversely affect the Company's gross profits;
·
the Company's inability to protect its intellectual property may adversely affect the Company's competitive advantage;
·
intellectual property-related litigation expenses and other costs resulting from infringement claims asserted against the Company or its customers by third parties may adversely affect the Company’s results of operations and its customer relations; and
·
the other factors discussed in Exhibit 99.1 to the Company’s Annual Report on Form 10-K filed with the SEC on December 17, 2004, which exhibit is hereby incorporated by reference.

Given these uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements. The Company disclaims any obligation subsequently to revise or update forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

Overview

General

The Company and its operating subsidiaries design, manufacture, sell and service process automation systems that process product streams of discrete pieces to improve safety and quality. These systems integrate electro-optical automated inspection and sorting systems with process systems that include specialized conveying and preparation systems. The Company provides parts and service for each of its product lines to customers throughout the world. Industries served include food processing and industrial applications such as tobacco, plastics, and pharmaceuticals. The Company maintains three domestic manufacturing facilities, a European manufacturing facility located in The Netherlands, and an Australian manufacturing facility. The Company markets its products directly and through independent sales representatives.

In the past several years, 40% or more of the Company’s sales have been made to customers located outside the United States. In its export and international sales, the Company is subject to the risks of conducting business internationally, including unexpected changes in regulatory requirements; fluctuations in the value of the U.S. dollar, which could increase or decrease the sales prices in local currencies of the Company’s products; tariffs and other barriers and restrictions; and the burdens of complying with a variety of international laws.

Current Period

The Company’s third quarter results benefited from the high backlog coming into the quarter and the Company’s solid performance throughout the quarter. Continued good order volume, coupled with good shipping performance, allowed the Company to deliver record sales for the quarter of $25.9 million compared to $22.2 million for the corresponding period last year. Operating expenses were in line with management’s expectations as the Company continues to align overall spending levels, as well as spending by category, with its growth initiatives.
 
New orders received during the third quarter were $19.7 million, compared to $15.9 million in the corresponding quarter last year, an increase of 23.6%. New orders were up significantly at 78% over last year in the process systems product family, while orders for automated inspection systems were up almost 17%. Parts and service orders were down less than 1.6% from last year. From an orders standpoint, the third quarter of 2005 was the

13

second highest third quarter in Company history, exceeded only by orders in the third quarter of fiscal 2002, which were $21.2 million.

The Company enters the fourth quarter of fiscal 2005 with total backlog at $15.4 million as compared to a backlog of $12.7 million entering the fourth quarter of fiscal 2004. The distribution of the backlog across the product lines is 33.7% for automated inspection systems, 38.9% for process systems, and 27.4% for parts and service. The parts and service backlog includes a number of upgrade projects that will be installed in the fourth quarter of fiscal 2005.

The Company is encouraged by customer reaction to the Raptor Laser Technology which was introduced during the Company’s second quarter. The Company believes the Freshline Machines product line, acquired during the second quarter, remains an attractive market opportunity, although the ramp up of orders is at a slower pace than initially expected.

Operating expenses for the third quarter of fiscal 2005 of $7.0 million were a 5.3% reduction from the $7.4 million spending level in the third quarter of fiscal 2004. The lower spending level for the quarter was due primarily to planned decreases in research and development project costs as recently developed products transition to commercialization.

During the third quarter of fiscal 2005, the Company’s cash position increased by $2.3 million. The Company’s cash position is quite strong at $13.2 million and its debt level remains low at $2.6 million.

Application of Critical Accounting Policies

The Company has identified its critical accounting policies, the application of which may materially affect the financial statements, either because of the significance of the financial statement item to which they relate, or because they require management judgment to make estimates and assumptions in measuring, at a specific point in time, events which will be settled in the future. The critical accounting policies, judgments and estimates which management believes have the most significant effect on the financial statements are set forth below:
 
·
Revenue recognition
 
·
Allowances for doubtful accounts
 
·
Valuation of inventories
 
·
Long-lived assets
 
·
Allowances for warranties
 
·
Accounting for income taxes

Management has discussed the development, selection and related disclosures of these critical accounting estimates with the audit committee of the Company’s board of directors.

Revenue Recognition. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the sale price is fixed or determinable, and collectibility is reasonably assured. Additionally, the Company sells its goods on terms which transfer title and risk of loss at a specified location, typically shipping point, port of loading or port of discharge, depending on the final destination of the goods. Accordingly, revenue recognition from product sales occurs when all factors are met, including transfer of title and risk of loss, which occurs either upon shipment by the Company or upon receipt by customers at the location specified in the terms of sale. Revenue earned from services is recognized ratably over the contractual period or as the services are performed. If any contract provides for both equipment and services (multiple deliverables), the sales price is allocated to the various elements based on objective evidence of fair value. Each element is then evaluated for revenue recognition based on the previously described criteria. The Company’s sales arrangements provide for no other, or insignificant, post shipment obligations. If all conditions of revenue recognition are not met, the Company defers revenue recognition. In the event of revenue deferral, the sale value is not recorded as revenue to the Company, accounts receivable are reduced by any amounts owed by the customer, and the cost of the goods or services deferred is carried in inventory. In addition, the Company periodically evaluates whether an allowance for sales returns is necessary. Historically, the Company has experienced few sales returns. If the Company believes there are potential sales returns, the Company would provide any necessary provision against sales. The Company believes that revenue recognition is a “critical accounting estimate” because the Company’s terms of sale vary significantly, and management exercises judgment in determining whether to recognize or defer
 
14

revenue based on those terms. Such judgments may materially affect net sales for any period. Management exercises judgment within the parameters of accounting principles generally accepted in the United States of America (GAAP) in determining when contractual obligations are met, title and risk of loss are transferred, the sales price is fixed or determinable and collectibility is reasonably assured. At June 30, 2005, the Company had deferred $2.5 million of revenue compared to $0.7 million deferred at September 30, 2004.

Allowances for doubtful accounts. The Company establishes allowances for doubtful accounts for specifically identified, as well as anticipated, doubtful accounts based on credit profiles of customers, current economic trends, contractual terms and conditions, and customers’ historical payment patterns. Factors that affect collectibility of receivables include customer satisfaction and general economic or political factors in certain countries that affect the ability of customers to meet current obligations. The Company actively manages its credit risk by utilizing an independent credit rating and reporting service, by requiring certain percentages of down payments, and by requiring secured forms of payment for customers with uncertain credit profiles or located in certain countries. Forms of secured payment could include irrevocable letters of credit, bank guarantees, third-party leasing arrangements or EX-IM Bank guarantees, each utilizing Uniform Commercial Code filings, or the like, with governmental entities where possible. The Company believes that the accounting estimate related to allowances for doubtful accounts is a “critical accounting estimate” because it requires management judgment in making assumptions relative to customer or general economic factors that are outside the Company’s control. As of June 30, 2005, the balance sheet included allowances for doubtful accounts of $490,000. Actual charges to the allowance for doubtful accounts for the nine-month periods ended June 30, 2005 and 2004 were $30,000 and $85,000, respectively. Accruals for bad debt expense for the nine-month periods ended June 30, 2005 and 2004 were ($108,000) and $96,000, respectively. If the Company experiences actual bad debt expense in excess of estimates, or if estimates are adversely adjusted in future periods, the carrying value of accounts receivable would decrease and charges for bad debts would increase, resulting in decreased net earnings.

Valuation of inventories. Inventories are stated at the lower of cost or market. The Company’s inventory includes purchased raw materials, manufactured components, purchased components, work in process, finished goods and demonstration equipment. Provisions for excess and obsolete inventories are made after periodic evaluation of historical sales, current economic trends, forecasted sales, estimated product lifecycles and estimated inventory levels. The factors that contribute to inventory valuation risks are the Company’s purchasing practices, electronic component obsolescence, accuracy of sales and production forecasts, introduction of new products, product lifecycles and the associated product support. The Company actively manages its exposure to inventory valuation risks by maintaining low safety stocks and minimum purchase lots, utilizing just in time purchasing practices, managing product end-of-life issues brought on by aging components or new product introductions, and by utilizing inventory minimization strategies such as vendor-managed inventories. The Company believes that the accounting estimate related to valuation of inventories is a “critical accounting estimate” because it is susceptible to changes from period to period due to the requirement for management to make estimates relative to each of the underlying factors ranging from purchasing to sales to production to after-sale support. At June 30, 2005, cumulative inventory adjustments to lower of cost or market totaled $2.9 million compared to $3.0 million as of September 30, 2004. If actual demand, market conditions or product lifecycles are adversely different from those estimated by management, inventory adjustments to lower market values would result in a reduction to the carrying value of inventory, an increase in inventory write-offs, and a decrease to gross margins.

Long-lived assets. The Company regularly reviews all of its long-lived assets, including property, plant and equipment, investments in joint ventures, and amortizable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If the total of projected future undiscounted cash flows is less than the carrying amount of these assets, an impairment loss based on the excess of the carrying amount over the fair value of the assets is recorded. In addition, goodwill is reviewed based on its fair value at least annually. As of June 30, 2005, the Company held $14.9 million of property, plant and equipment, investments in joint ventures, goodwill and other intangible assets, net of depreciation and amortization. There were no changes in the Company’s long-lived assets that would result in an adjustment of the carrying value for these assets. Estimates of future cash flows arising from the utilization of these long-lived assets and estimated useful lives associated with the assets are critical to the assessment of fair values. The Company believes that the accounting estimate related to long-lived assets is a “critical accounting estimate” because: (1) it is susceptible to change from period to period due to the requirement for management to make assumptions about future sales and cost of sales generated throughout the lives of several product lines over extended periods of time; and (2) the potential effect that recognizing an impairment could have on the assets reported on the Company’s balance sheet and the potential material adverse effect on reported earnings or loss. Changes in these estimates could result in a determination of

15

asset impairment, which would result in a reduction to the carrying value and a reduction to net earnings in the affected period.

Allowances for warranties. The Company’s products are covered by warranty plans that extend between 90 days and 2 years, depending upon the product and contractual terms of sale. The Company establishes allowances for warranties for specifically identified, as well as anticipated, warranty claims based on contractual terms, product conditions and actual warranty experience by product line. Company products include both manufactured and purchased components, and therefore, warranty plans include third-party sourced parts which may not be covered by the third-party manufacturer’s warranty. Ultimately, the warranty experience of the Company is directly attributable to the quality of its products. The Company actively manages its quality program by using a structured product introduction plan, process monitoring techniques utilizing statistical process controls, vendor quality metrics, a quality training curriculum for every employee and feedback loops to communicate warranty claims to designers and engineers for remediation in future production. Warranty expense has varied widely in the past due to such factors as significant new product introductions containing defects and design errors on individual projects. The Company believes that the accounting estimate related to allowances for warranties is a “critical accounting estimate” because: (1) it is susceptible to significant fluctuation period to period due to the requirement for management to make assumptions about future warranty claims relative to potential unknown issues arising in both existing and new products, which assumptions are derived from historical trends of known or resolved issues; and (2) risks associated with third-party supplied components being manufactured using processes that the Company does not control. As of June 30, 2005, the balance sheet included warranty reserves of $850,000, while $1.3 million of warranty charges were incurred during the nine-month period then ended, compared to warranty reserves of $760,000 as of June 30, 2004 and warranty charges of $1.2 million for the nine-month period then ended. If the Company’s actual warranty costs are higher than estimates, warranty plan coverages are adversely varied, or estimates are adversely adjusted in future periods, reserves for warranty would need to increase, warranty expense would increase and gross margins would decrease.

Accounting for income taxes. The Company’s provision for income taxes and the determination of the resulting deferred tax assets and liabilities involves a significant amount of management judgment. The quarterly provision for income taxes is based partially upon estimates of pre-tax financial accounting income for the full year and is affected by various differences between financial accounting income and taxable income. Judgment is also applied in determining whether the deferred tax assets will be realized in full or in part. In management’s judgment, when it is more likely than not that all or some portion of specific deferred tax assets, such as foreign tax credit carryovers, will not be realized, a valuation allowance must be established for the amount of the deferred tax assets that are determined not to be realizable. There was no valuation allowance at June 30, 2005 due to anticipated utilization of all the deferred tax assets as the Company believes it will have sufficient taxable income combined with the lengthy expiration periods on carryforward items to utilize these assets. The Company maintains reserves for estimated tax exposures in jurisdictions of operation. These tax jurisdictions include federal, state and various international tax jurisdictions. Potential income tax exposures include potential challenges of various tax credits, export-related tax benefits, and issues specific to state and local tax jurisdictions. Exposures are typically settled primarily through audits within these tax jurisdictions, but can also be affected by changes in applicable tax law or other factors, which could cause management of the Company to believe a revision of past estimates is appropriate. During fiscal 2005, 2004, and 2003, there have been no significant changes in these estimates. Management believes that an appropriate liability has been established for estimated exposures; however, actual results may differ materially from these estimates. The Company believes that the accounting estimate related to income taxes is a “critical accounting estimate” because it relies on significant management judgment in making assumptions relative to temporary and permanent timing differences of tax effects, estimates of future earnings, prospective application of changing tax laws in multiple jurisdictions, and the resulting ability to utilize tax assets at those future dates. If the Company’s operating results were to fall short of expectations, thereby affecting the likelihood of realizing the deferred tax assets, judgment would have to be applied to determine the amount of the valuation allowance required to be included in the financial statements established in any given period. Establishing or increasing a valuation allowance would reduce the carrying value of the deferred tax asset, increase tax expense and reduce net earnings.

In October 2004, the American Jobs Creation Act of 2004 was enacted. This legislation phases out the Extra Territorial Income Exclusion (“ETI”) beginning January 1, 2005 through December 31, 2006. The ETI exclusion reduced the Company’s effective tax rate by 2.8% in 2004. The legislation also provides for a new deduction for manufacturing income, which phases in beginning in the Company’s 2006 fiscal year through 2010. Although final regulations have not been written for the new manufacturing income deduction, the Company anticipates that this deduction will largely, if not completely, offset the loss of the ETI exclusion. However, the effects in individual

16

fiscal years during the phase-in periods may vary and increase the Company’s effective tax rate during these periods. The Company does not believe that other provisions of the new legislation will have a material effect on the Company’s income taxes.

Results of Operations 

For the three months ended June 30, 2005 and 2004

Net sales increased 16.9% to $25.9 million for the three-month period ended June 30, 2005 from $22.2 million in the corresponding quarter last year. International net sales in the third quarter were $11.0 million compared to $9.9 million for the corresponding quarter in 2004.

New orders received during the third quarter of fiscal 2005 totaled $19.7 million, an increase of 23.6% from $15.9 million for the corresponding period in fiscal 2004. New international orders were $10.4 million compared to $8.9 million for the corresponding quarter of 2004. Orders for the third quarter of 2005 compared to the 2004 third quarter increased for both automated inspection systems and process systems, while parts and service orders were down slightly. Within the automated inspection systems product line, Tegra orders were down from last year, while orders for Optyx, Prism and tobacco sorters all showed significant increases. All major product areas in the process systems product line showed increases over last year. In addition, the Freshline acquisition contributed modestly to process systems orders for the quarter.

The Company’s backlog at the close of the June 30, 2005 quarter totaled $15.4 million, a 21.9% increase from a backlog of $12.7 million at the same time last year. Backlog for automated inspection systems was down 13.3% from last year and represented 33.7% of total backlog. Processing systems and parts and service backlog increased 52.5% and 54.8%, respectively, over last year and represented 38.9% and 27.4%, respectively, of total backlog.

Gross profit for the third quarter of fiscal 2005 was $11.2 million compared to $10.2 million in the corresponding quarter last year, or 43.2% and 46.1% of net sales, respectively. The dollar increase in gross profit was driven by the overall increase in sales volume and the associated greater utilization of the Company’s manufacturing resources. The reduction in gross profit as a percent of sales was due to the lower margin process systems products representing a larger percentage of total sales.

Operating expenses decreased by $0.4 million, or 5.3%, in the third quarter of 2005 to $7.0 million from $7.4 million in the 2004 third quarter. Decreases in the third quarter operating expenses compared to the same period last year were due primarily to planned decreases in research and development project costs.

Other expense for the third quarter of 2005 was $140,000 compared to $3,000 for the same period in 2004. The third quarter of 2005 included a charge of $124,000, which represents the Company’s share in the loss of the InspX joint venture.

The Company reported net earnings of $2,709,000, or $0.52 per diluted share, for the third quarter of fiscal 2005 compared to net earnings of $2,008,000, or $0.38 per diluted share, in the corresponding quarter last year. The increase in net earnings was primarily due to increased sales and decreased operating expenses.

For the nine months ended June 30, 2005 and 2004

Net sales reported were $58.8 million for the nine months ended June 30, 2005, a decrease of 4.7% from the sales reported for the corresponding period in 2004 of $61.7 million. International net sales in the first nine months of fiscal 2005 were $29.0 million compared to $23.7 million for the first nine months of 2004. Because of the slow start in 2005, automated inspection systems nine-month sales remain lower than the prior year. Both process systems sales and parts and service sales increased over the prior year period.

New orders received during the first nine months of 2005 totaled $60.7 million, an increase of 12.9% over $53.8 million received in the first nine months of 2004. International orders were $29.8 million compared to $25.4 million for the first nine months of 2004. Within the automated inspection systems product line, orders for Tegra Sorters were down significantly while Prism orders showed a significant increase. Orders for process systems and for parts and service were up, with process systems showing increases in every category.
 
17

Gross profit for the first nine months of 2005 was $23.5 million compared to $26.2 million for the corresponding period in 2004, or 40.0% and 42.4% of net sales, respectively. The lower sales volume in the first nine months of 2005, the resulting underutilization of manufacturing resources and a less favorable product mix account for the lower gross profit in both dollar and percentage terms.

Operating expenses for the first nine months of 2005 decreased by $0.9 million, or 4.2%, to $20.1 million from $20.9 million in the corresponding period for 2004. The decrease was due to the effect of the reduction in workforce taken in the fourth quarter of 2004, the planned reduction in R&D spending, and lower commission costs. The general administrative component of operating expenses was $5.8 million compared to $5.6 million for the first nine months of 2004. The increase was due to costs incurred in connection with an abandoned acquisition as well as an increase in recruiting and relocation costs.

Other income increased by $52,000 to $86,000 in the first nine months of 2005 compared to $34,000 in the corresponding period of 2004. During the 2005 period, the Company received $500,000 related to the resolution of a dispute with a licensee over a breach of the license agreement. Also during the 2005 period, the Company recorded a loss of $493,000 related to its InspX joint venture.

The Company reported net earnings of $2,434,000, or $0.47 per diluted share, for the most recent nine-month period compared to net earnings of $3,650,000, or $0.70 per diluted share, for the corresponding period in 2004.

Liquidity and Capital Resources

For the nine months ended June 30, 2005, net cash provided by operating activities totaled $6.6 million. Cash flow from operating activities was derived from net earnings before non-cash expenses, such as depreciation and amortization, of $5.6 million plus changes in non-cash working capital of $1.0 million. The primary sources of cash from the other components of working capital were a $0.9 million increase in cash received for customer deposits as backlog increased during the period and a $1.6 million increase in accounts payable and other accrued liabilities associated primarily with inventory purchases and a $0.4 million increase in income taxes payable. These increases were offset by $1.2 million of cash used to purchase inventory and a $0.9 million increase in accounts receivable due to increased quarterly sales.

Cash flow from operating activities in the first nine months of fiscal 2005 was $2.9 million higher than in the same period of fiscal 2004. During the first nine months of 2005, non-cash working capital increased by $1.0 million, while for the same period in 2004, non-cash working capital decreased $2.7 million, a swing of $3.7 million. This increase was offset in part by the effect of net earnings in the first nine months of 2005 of $2.4 million compared to net earnings in the corresponding period of 2004 of $3.7 million.

Net cash used in investing activities was $1.7 million in the nine-month period ended June 30, 2005 and $0.7 million in the comparable period a year ago. Expenditures during the first nine months of 2005 were for capital equipment as well as the Company’s investment in Freshline Machines. During the first nine months of 2004, expenditures were for capital equipment net of proceeds received on disposals.

Net cash used in financing activities during the nine-month period ended June 30, 2005 totaled $0.6 million, reflecting repayments of long-term debt plus redemption of preferred stock and warrants totaling $1.2 million offset by proceeds from issuance of common stock of $0.5 million. This compares to net cash flows provided by financing activities of $0.5 million for the same period in the prior year, consisting of proceeds from issuance of common stock of $1.5 million offset by repayments of long term debt plus redemption of preferred stock and warrants totaling $0.9 million.

The Company’s domestic credit facility provides a credit accommodation totaling $11.8 million in the United States consisting of a term loan of $1.8 million and a revolving credit facility of up to $10.0 million. The revolving credit facility matures in April 2006. The term loan requires quarterly payments of principal of $200,000 and matures on July 31, 2007. The term loan bears interest at The Wall Street Journal prime rate, which was 6.0% at June 30, 2005. The revolving credit facility bears interest, at the Company’s option, of either The Wall Street Journal prime rate less 1.5% or a LIBOR based rate. The rate was 4.50% at June 30, 2005. The credit facility is secured by all of the U.S. personal property, including patents and other intangibles of the Company and its subsidiaries, and contains covenants that require the maintenance of a defined debt ratio, a fixed charge coverage ratio, and minimum profitability. The credit facility also restricts the payment of dividends. At June 30, 2005, the

18

Company was in compliance with all loan covenants. At June 30, 2005, borrowings under the term loan were $1.8 million and there were no borrowings outstanding under the revolving credit facility. At June 30, 2004, borrowings under the term loan were $2.6 million. There were no borrowings outstanding under the revolving credit facility at June 30, 2004.

Additionally, the Company’s credit accommodation with a commercial bank in The Netherlands provides a credit facility for its European subsidiary. This credit accommodation totals $3.6 million and includes term loans of $585,000, an operating line of the lesser of $1.8 million or the available borrowing base, which is based on varying percentages of eligible accounts receivable and inventories, and a bank guarantee facility of $1.2 million. The term loans require quarterly principal payments of $37,000 and mature in October 2006 and August 2012. The term loans are secured by real property of the Company’s European subsidiary, while the operating line and bank guarantee facility are secured by all of the subsidiary’s personal property. The credit facility bears interest at the bank’s prime rate, with a minimum of 3.00%, plus 1.75%. At June 30, 2005, the interest rate was 4.75%. Interest rates on the term loans are subject to annual renegotiation. At June 30, 2005, the Company had borrowings under this facility of approximately $585,000 in term loans, and had received bank guarantees of $1.2 million under this agreement.

Outstanding Series B Convertible Preferred stock totaled 112,419 shares as of June 30, 2005, and outstanding warrants totaled 25,466. Subsequent to the end of the third quarter, the Company has redeemed over 85% of these outstanding Series B preferred stock and warrants and paid the security holders from available cash.

The Company’s continuing contractual obligations and commercial commitments existing on June 30, 2005 are as follows:

   
Payments due by period (in Thousands)
  
Contractual Obligations
    
Total
    
Less than 1 year
    
1 - 3 years
    
4 - 5 years
    
After 5 years
  
                                 
Long-term debt *
  
$
2,385
  
$
948
  
$
1,165
  
$
121
  
$
151
  
Capital lease obligations
    
202
    
200
    
2
    
-
    
-
  
Operating leases
    
15,028
    
1,494
    
2,489
    
1,696
    
9,349
  
Warrant redemption obligations
    
255
    
255
    
-
    
-
    
-
  
Series B redemption obligations
    
1,124
    
1,124
    
-
    
-
    
-
  
Total contractual cash obligations
  
$
18,994
  
$
4,021
  
$
3,656
  
$
1,817
  
$
9,500
  

*
Includes the revolving credit line, term loan and mortgage payments on the Company’s owned facility in Europe.

The Company anticipates that ongoing cash flows from operations along with currently available operating credit lines will be sufficient to fund the Company’s operating needs. At June 30, 2005, the Company had standby letters of credit totaling $1.8 million, which includes secured bank guarantees under the Company’s credit facility in Europe and letters of credit securing certain self-insurance contracts and lease commitments. If the Company fails to meet its contractual obligations, these bank guarantees and letters of credit may become liabilities of the Company. The Company has no off-balance sheet arrangements or transactions, arrangements or relationships with “special purpose entities.”
 
19

ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

The Company has assessed its exposure to market risks for its financial instruments and has determined that its exposures to such risks are generally limited to those affected by the value of the U.S. Dollar compared to the Euro and to a lesser extent the Australian dollar.

The terms of sales to European customers are typically denominated in either Euros or U.S. Dollars. The terms of sales to customers in Australia are typically denominated in their local currency. The Company expects that its standard terms of sale to international customers, other than those in Europe and Australia, will continue to be denominated in U.S. dollars. For sales transactions between international customers, including European customers, and the Company’s domestic operations, which are denominated in currencies other than U.S. dollars, the Company assesses its currency exchange risk and may enter into forward contracts to minimize such risk. At June 30, 2005, the Company was not a party to any currency hedging transaction. As of June 30, 2005, management estimates that a 10% change in foreign exchange rates would affect net earnings before taxes by approximately $129,000 on an annual basis as a result of converted cash, accounts receivable and sales or other contracts denominated in foreign currencies.

During the nine-month period ended June 30, 2005, the Euro lost a net of 3% in value, ranging between a 3% loss and an 8% gain for the period, against the U.S. dollar. The effect of these fluctuations on the operations and financial results of the Company were:

·
Translation adjustments of ($43,000), net of income tax, were recognized as a component of comprehensive income as a result of converting the Euro denominated balance sheet of Key Technology B.V. into U.S. dollars, and to a lesser extent, the Australian dollar balance sheets of Key Technology Australia Pty. Ltd. and Freshline Machines Pty. Ltd., and the Peso balance sheet of Productos Key Mexicana.

·
Foreign exchange losses of $80,000 were recognized in the other income and expense section of the consolidated statement of operations as a result of conversion of Euro and other foreign currency denominated receivables and cash carried on the balance sheet of the U.S. operations, as well as the result of the conversion of other non-functional currency receivables, payables and cash carried on the balance sheet of the European, Australian and Mexican operations.

A relatively weaker U.S. dollar on the world markets makes the Company’s U.S.-manufactured goods relatively less expensive to international customers when denominated in U.S. dollars or potentially more profitable to the Company when denominated in a foreign currency. A relatively weaker U.S. dollar on the world markets, especially as measured against the Euro, may favorably affect the Company’s market and economic outlook for international sales. The Company’s Netherlands-based subsidiary transacts business primarily in Euros and does not have significant exports to the U.S.

Under the Company’s current credit facilities, the Company may borrow at the lender’s prime rate between minus 150 and plus 175 basis points. At June 30, 2005, the Company had $1.8 million of borrowings which had variable interest rates. During the quarter then ended, interest on its various variable rate credit facilities varied from 4.50% and 6.00%. At June 30, 2005, the rate was 6.00% on its term loan, 4.50% on its domestic credit facility and 4.75% on its European credit facility. As of June 30, 2005, management estimates that a 100 basis point change in these interest rates would affect net income before taxes by approximately $18,000 on an annual basis.


ITEM 4.
CONTROLS AND PROCEDURES

The Company's President and Chief Executive Officer and the Senior Vice President and Chief Financial Officer have evaluated the disclosure controls and procedures relating to the Company at June 30, 2005 and concluded that such controls and procedures were effective to provide reasonable assurance that information required to be disclosed by the Company in reports filed or submitted by the Company under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There were no changes in the Company's internal control over financial reporting during the quarter ended June 30, 2005 that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

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PART II.
OTHER INFORMATION

ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following table provides information about purchases made by or on behalf of the Company during the quarter ended June 30, 2005 of equity securities registered by the Company under Section 12 of the Securities Exchange Act of 1934. Subsequent to the end of the third quarter, the Company has redeemed over 85% of these outstanding Series B preferred stock and warrants and paid the security holders from available cash.

Issuer Purchases of Equity Securities
 
Mandatorily Redeemable Series B Convertible Preferred Stock (1)
  
                   
Period
  
Total Number of Shares Purchased
  
Average Price Paid per Share
  
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
  
Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
  
April 1 - 30, 2005
    
580
  
$
10
    
-
        
May 1 - 31, 2005
    
1,003
  
$
10
    
-
        
June 1 - 30, 2005
    
1,335
  
$
10
    
-
        
Total
    
2,918
                
112,419
  

Warrants (2)
  
                   
Period
  
Total Number of Warrants Purchased
  
Average Price Paid per Warrant
  
Total Number of Warrants Purchased as Part of Publicly Announced Plans or Programs
  
Maximum Number of Warrants that May Yet Be Purchased Under the Plans or Programs
  
April 1 - 30, 2005
    
4,466
  
$
10
    
-
        
May 1 - 31, 2005
    
12
  
$
10
    
-
        
June 1 - 30, 2005
    
407
  
$
10
    
-
        
Total
    
4,885
                
25,466
  

(1)
The Company issued 1,340,366 shares of Series B convertible preferred stock (“Series B”) at a price of $8.60 per share in conjunction with the acquisition of Advanced Machine Vision Corporation on July 12, 2000. Each share of Series B, par value of $0.01 per share, was able to be converted into 2/3 of a share of common stock. The Series B was convertible at the option of the holder at any time, unless previously redeemed, or by the Company upon a merger, consolidation, share exchange or sale of substantially all of its assets. The holders of Series B were able to require the Company to repurchase any or all of their shares at any time after July 12, 2002 at the redemption price of $10.00. If not converted to common stock or redeemed at the option of the Series B holder after July 12, 2002, the Company was required to redeem the Series B for $10.00 per share on July 11, 2005.

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(2)
The Company issued 365,222 warrants at a fair market value of $10.00 per warrant in conjunction with the issuance of the Series B. Each warrant entitled its holder to purchase at any time for a period of five years from July 12, 2000 one share of common stock at $15.00 per share, subject to certain adjustments. The warrants permitted the holder to engage in a net exercise of the warrants if the fair market value of one share of common stock was greater than $15.00 per share on the date of exercise. Prior to the expiration date of the warrant, July 11, 2005, the holder may have required the Company to redeem the warrant for cash at a price equal to $10.00 for each whole share of common stock that may be purchased under the warrant.


ITEM 6.
EXHIBITS

 
31.1
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 
31.2
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 
32.1
Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
32.2
Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
22

KEY TECHNOLOGY, INC. AND SUBSIDIARIES
SIGNATURES


 
SIGNATURES
   
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
   
 
KEY TECHNOLOGY, INC.
 
(Registrant)
   
Date: August 12, 2005
By
/s/ Kirk W. Morton
    Kirk W. Morton
    President and Chief Executive Officer
    (Principal Executive Officer)
     
     
Date: August 12, 2005
By
/s/ Ronald W. Burgess
    Ronald W. Burgess
     Senior Vice President and Chief Financial Officer
    (Principal Financial and Accounting Officer)
 
23

EXHIBIT INDEX

Exhibit

 
31.1
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 
31.2
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 
32.1
Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
32.2
Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
24