Edgar Filing: KEY TECHNOLOGY INC

body.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_____________________________________________

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

for the fiscal year ended September 30, 2007

x 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

(Address of Principal Executive Offices)

99362

(Zip Code)

Registrant’s telephone number, including area code: (509) 529-2161

_____________________________________________

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Common Stock, no par value

Name of each exchange on which registered

Nasdaq Global Market

Securities registered pursuant to Section 12(g) of the Act:

None

Indicated by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act Yes o No x

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 ý No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

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

Large accelerated filer o Accelerated filer x Non-accelerated filer o

Indicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

The aggregate market value of the Registrant's common stock held by non-affiliates on March 31, 2007 (based on the last sale price of such shares) was approximately $77,689,216.

There were 5,552,697 shares of the Registrant's common stock outstanding on December 7, 2007.

DOCUMENTS INCORPORATED BY REFERENCE

Parts of Registrant's Proxy Statement dated on or about January 4, 2008 prepared in connection with the Annual Meeting of Shareholders to be held on February 6, 2008 are incorporated by reference into Part III of this Report.

Table of Contents

KEY TECHNOLOGY, INC.

2007 FORM 10-K

TABLE OF CONTENTS

PART I		PAGE
Item 1.	BUSINESS	1
Item 1A.	RISK FACTORS	9
Item 2.	PROPERTIES	11
Item 3.	LEGAL PROCEEDINGS	11
Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	11
PART II
Item 5.	MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES	12
Item 6.	SELECTED FINANCIAL DATA	15
Item 7.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	16
Item 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	27
Item 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	29
Item 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	56
Item 9A.	CONTROLS AND PROCEDURES	56
PART III
Item 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE	57
Item 11.	EXECUTIVE COMPENSATION	57
Item 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS	57
Item 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE	58
Item 14.	PRINCIPAL ACCOUNTANT FEES AND SERVICES	58
PART IV
Item 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES	58
SIGNATURES		61
EXHIBIT INDEX		62

Table of Contents

PART I

From time to time, Key Technology, Inc. (“Key” or the “Company”), through its management, may make forward-looking public statements with respect to the Company regarding, among other things, expected future revenues or earnings, projections, plans, future performance, product development and commercialization, and other estimates relating to the Company’s future operations. Forward-looking statements may be included in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), in press releases or in oral statements made with the approval of an authorized executive officer of Key. The words or phrases “will likely result,” “are expected to,” “intends,” “is anticipated,” “estimates,” “believes,” “projects” or similar expressions are intended to identify “forward-looking statements” within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act of 1933, as amended, as enacted by the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are subject to a number of risks and uncertainties. The Company cautions investors not to place undue reliance on its forward-looking statements, which speak only as to the date on which they are made. Key’s actual results may differ materially from those described in the forward-looking statements as a result of various factors, including those listed below:

·	adverse economic conditions, particularly in the food processing industry, either globally or regionally, may adversely affect the Company's revenues;

·	competition and advances in technology may adversely affect sales and prices;

·	failure of the Company’s new products to 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 inability of the Company to protect its intellectual property, especially as the Company expands geographically, may adversely affect the Company’s competitive advantage; and

·	intellectual property-related litigation expenses and other costs resulting from infringement claims asserted against the Company by third parties may adversely affect the Company’s results of operations and its customer relations.

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.

ITEM 1. BUSINESS.

General

The Company was founded in 1948 as a local producer of vegetable processing equipment. The Company has evolved into a worldwide supplier of process automation solutions to the food processing industry and other industries such as tobacco and pharmaceuticals. The present Company was incorporated in 1982 as a result of a management buyout of the predecessor organization.

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 equipment. The Company provides parts and service for each of its product lines to customers throughout the world.

Table of Contents

Industry Background

Food Processing Industry

The Company’s primary market is the food processing industry. Food processors must process large quantities of raw product through different stages, including sorting to remove foreign material and defective pieces, and inspection for product quality and safety. The frequency and severity of defects in the raw product is highly variable depending upon local factors affecting crops. Historically, defect removal and quality control in the food processing industry have been labor intensive and dependent upon and limited by the variability of the work force. The industry has sought to replace manual methods with automated systems that achieve higher yield, improve product quality and safety, and reduce costs.

The Company’s strategy is to solve processing industry problems of high labor costs, inadequate yields and inconsistent quality and safety by providing automated inspection systems and process systems. The Company’s process automation systems use advanced optical inspection technology to improve product yield (more of the good product recovered) and quality (higher percentage of defective product and foreign material removed) over the manual sorting and defect removal methods historically used by food processors. In more developed markets, such as those in North America and Western Europe, the substitution of automated inspection for manual inspection is well underway. However, processors in these areas remain keenly interested in process yield and product quality and safety improvements.

The largest markets for the Company’s products have been processors of potatoes, vegetables, fruit and snack foods. The Company believes many additional applications for its systems exist in both food and non-food markets.

The principal potato market served by the Company’s systems is french fries. French fries comprise approximately 90% of the over eight billion pounds of frozen potato products processed annually in the United States. The expansion of American-style fast food chains in other countries is beginning to result in development of the frozen french fry market overseas. Current domestic investment in new french fry processing facilities has flattened relative to historical levels, largely in response to changing consumer preferences. However, investments in process yield enhancement and in greater process throughputs from existing plants remain significant items for the Company and its customers in the potato market. The Company’s recent diversification strategies have resulted in less dependence on this industry although it continues to be a strategically important market.

The Company’s products are used in the fruit and vegetable processing market where field-harvested products are cleaned, graded, automatically sorted, blanched and processed prior to freezing, canning or packaging for sale to institutional and retail markets. Principal fruit and vegetable markets for the Company are green beans, corn, carrots, peas, onions, apples, pears, cranberries, peaches, pre-prepared, ready-to-eat salads and vegetables, dehydrated fruits and vegetables, and fresh-cut fruit products.

The global food processing industry has been in a consolidation period and market conditions suggest further consolidation in the future. The Company believes the resulting food processing companies are financially stronger, yet are faced with the need to improve profitability while satisfying external pressures to hold constant or reduce prices for their own products and provide safer products to the consuming public. Since the Company’s equipment results in higher process yields, improved product quality and safety, as well as reduced processing costs, the Company believes these surviving companies will have increased interest in the Company’s products to satisfy these needs, allowing for expanded sales into the food processing industry in future years. Due to the seasonal nature of the food processing industry, the Company does experience some seasonality of orders and shipments. Orders and shipments to this industry in the Company’s first fiscal quarter of the year tend to be lower than during the Company’s other fiscal quarters. Demand for the Company’s products remained strong during fiscal 2007 due to positive market conditions and new product introductions by the Company.

Table of Contents

Non-food Industries – Tobacco, Pharmaceuticals and Nutraceuticals

Processors in non-food industries also implement systems solutions to reduce costs, increase yields, and produce higher quality products. The Company’s primary non-food markets are the tobacco industry and the pharmaceutical/nutraceutical industry.

In fiscal 2007, the tobacco industry represented a small share of the Company’s sales. The Company’s products provide tobacco companies sorting capability to remove foreign matter from a stream of stripped tobacco.

In fiscal 2007, the pharmaceutical and nutraceutical industries represented a small share of the Company’s sales. However, to further its growth strategy, the Company continued to expand its line of automation solutions, introducing three new product lines to provide more comprehensive solutions to its customers.

Products

The following table sets forth sales by product category for the periods indicated:

	Fiscal Year Ended September 30,
	2007				2006				2005
	(in thousands)
Automated inspection systems	$	46,858	44	%	$	30,264	36	%	$	27,284	34	%
Process systems		40,947	38	%		34,925	41	%		31,853	40	%
Parts and service/contracts		19,735	18	%		19,651	23	%		21,185	26	%
Net sales	$	107,540	100	%	$	84,840	100	%	$	80,322	100	%

Service and maintenance contracts are less than 10% of total net sales and are therefore summarized with parts and service/contracts.

The following table sets forth the percent of the total gross margin contributed by each product category for the periods indicated:

	Fiscal Year Ended September 30,
	2007			2006			2005
Automated inspection systems		51	%		44	%		41	%
Process systems		30	%		30	%		28	%
Parts and service/contracts		19	%		26	%		31	%
Total gross margin		100	%		100	%		100	%

Upgrades of automated inspection systems are included with automated inspection systems.

Automated Inspection Systems

Automated inspection systems are used in various applications to detect and eliminate defects and foreign materials, most often during processing of raw and semi-finished products. The Company’s product families within this group include the following: ADR^® automatic defect removal systems used in the french fry industry; Tobacco Sorter™3 tobacco sorting systems used in tobacco threshing and primary processing; and the Tegra^® and Optyx^® sorter families which are used in a wide variety of applications in many industries and markets. All of the Company’s automated inspection systems operate on Key’s advanced G6 electro-optical platform, which features a controller, modular vision engine and high-resolution cameras. The modular design and use of industry-wide connectivity standards ease future upgrades to keep the systems up to date and performing optimally as technology advances.

Table of Contents

Nearly all systems in this group use proprietary linear array, charged coupled device ("CCD") monochromatic, color or multi-spectral cameras. Each of the cameras scan the product-streams, which move at 5 to 20 feet per second, at the rate of 1,500 to 8,000 times per second and can identify defects as small as 1/128 of an inch (0.17 mm) in diameter. Systems with monochromatic cameras generally are sold at lower price levels and are most effective for product that has a marked disparity in shade between the defective and the good product. Systems with color cameras are required when a variety of defect and product colors occur simultaneously, when the difference in shading between the defective and the good product is more subtle, and where shape sorting is required. Multi-spectral systems can utilize infrared or ultraviolet technologies, individually or in combination with visible light, to identify defects that may not be detectable by using solely visible light spectra.

Tegra System. Tegra is the Company’s highest capacity optical sorter and provides accurate in-air defect removal. Tegra incorporates object-based sorting technology that recognizes not only color and size, but also shape characteristics. This capability provides a solution to previously difficult sorting problems, such as differentiation between green beans and green bean stems. Tegra, as with all sorters, incorporates KeyWare^® software that substantially reduces operational complexity. KeyWare consists of application packs, each specifically designed for a single product category that, together with the system’s computer hardware capability and networking software, support all standard factory control and automation interfaces. These features allow Tegra to establish data connectivity and communication with a processing plant's computer network system. Certain present and potential applications for Tegra systems include potato products, green beans, dried beans, corn, carrots, peas, spinach and other leafy vegetables, pears, nuts, grains, coffee, recycled commodities such as paper and plastic, and tobacco.

Optyx System. The Optyx family of sorters provides a unique combination of on-belt and in-air sorting and offers multiple sensor capabilities with cameras, lasers, or a combination of cameras and lasers. The lower cost Optyx 3000 series has the power and sorting capabilities of a larger sorter in an economical and compact machine. It is ideal for smaller processors and lower volume processing lines which are unable to justify the expense of a larger sorter.

In 2005, Key added laser-sensing technology to its optical inspection capabilities, enabling improved foreign material detection and removal based on differences in the optical properties of materials, regardless of color. Raptor Laser Technology was first available in the Optyx 3000 Series Sorter, which combines Key’s proprietary state-of-the-art G6 color cameras and powerful G6 sorting platform with laser technology. In fiscal 2006, the Company introduced Raptor Laser Technology in the high-volume Optyx 6000 Series Sorter. The larger Optyx 6000 series sorter provides customers with a mid-size sorting option with greater throughput. Featuring a doublewide platform that uses Key’s G6 engine, Optyx 6000 Raptor detects the smallest defects and foreign material to optimize product quality and maximize food safety at double the throughput of an Optyx 3000. As the first wide-belt laser sorter to maintain the high resolution of the finest narrow-belt laser sorters, it can sort fresh, frozen and dried fruits and vegetables, including frozen potato products, tree nuts, raisins and other food products at production rates of up to 40,000 pounds (approximately 18 metric tons) per hour, depending on the application.

In 2007, FluoRaptor™ was added to the Optyx product family. FluoRaptor, a fluorescence-sensing laser, is designed to maximize the detection and removal of defects, extraneous vegetable matter, and foreign material (FM) based on differing levels of chlorophyll, and is ideal for the fresh-cut and vegetable industries.

Optyx series sorters employ a novel broad-band illumination system and are designed to require minimal maintenance. The Optyx line of sorters has gained strong acceptance in segments of the fruit, vegetable, processed potato, dried fruit and nut, and snack food markets. Additionally, Optyx has been placed in applications inspecting pharmaceuticals, nutraceuticals, plastics, tobacco, and paper.

Tobacco Sorter 3. The tobacco industry has special requirements in the handling and sorting of its tobacco products, which vary in size and moisture content and other properties depending upon the type of product being produced and the point of handling and inspection. Key’s Tobacco Sorter 3 (TS3), utilizes a specially constructed frame, enclosure, and material handling arrangement to meet the specific product inspection requirements of this industry. TS3 has been installed in North America, Latin America, Europe and Asia.

Table of Contents

ADR System. The Company’s ADR systems are used to transport, inspect and remove defects from French fries. The Company believes its ADR system is the principal optical inspection and defect removal system used in the French fry processing industry. The Company’s full-capacity ADR systems can process up to 27,000 pounds of product per hour. The most recent version, introduced in fiscal 2006, is ADR^®5, a combination of the well-proven conveying and fry alignment system of ADR^® III with the G6 engine, improved cutting subsystem and LED lighting including infrared. LED lighting provides a high level of output stability, both spectral and intensity, with extremely low maintenance cost. The improved cutting subsystem enables the system to cut excessively long fries to control product length, a function especially valuable for fast-food products. The ADR 5 system is available both as a new system as well as an upgrade to existing ADR^® II and ADR III installations.

Pharmaceutical and Nutraceutical Inspection Systems. In fiscal 2007, the Company introduced the OptyxSG/P and OptyxSG/N inspection systems, the Impulse™ size grading system, and the PulseScrubber™ softgel polishing system.

Introduction of the OptyxSG/P enables the Company to offer a fully 21CFR11-compliant, high-volume inspection solution to solid dose pharmaceutical manufacturing. Applicable to OTC (over the counter) and prescription drugs, the OptyxSG/P meets validation requirements pharmaceutical customers face when selecting automation for their FDA-regulated production lines. The Company shipped the first OptyxSG/P in the third fiscal quarter. Also introduced in 2007 was the OptyxSG/N, a replacement for the original OptyxSG, targeted at the nutraceutical market. The /N version includes many of the features of the /P without the specific enhancements required for the regulated pharmaceutical market. The Company shipped the first OptyxSG/N in the fourth quarter of fiscal 2007.

With the introduction of the Impulse/P solid dose size grading product line, the Company continued to build toward a more comprehensive “full line” solution. The Impulse/P, derived from the Company’s Impulse vibratory conveyor technology, provides high-volume vibratory size grading that complements other automation solutions like the OptyxSG-series. First shipments of the Impulse/P began in the third quarter of fiscal 2007.

The PulseScrubber product, introduced in the fourth quarter of fiscal 2007, is targeted at the softgel manufacturing segment and provides a fully-automated, high-volume continuous-flow alternative to traditional batch-oriented softgel polishing. The Company expects first shipments in early calendar 2008. Like the Impulse/P, the PulseScrubber complements other systems to provide customers the economic benefits of highly-integrated continuous automation.

The Company’s Vantyx^® inspection system is a product developed for inspection of blister-packed solid dose pharmaceuticals. Using patented spatial color analysis technology, this product line inspects solid-dose pharmaceuticals for broken or missing pieces, foreign products, discoloration or coating defects, as well as the integrity of capsules. The pharmaceutical inspection system also verifies and detects color, size, location and shape defects at processing rates of over one million pieces per hour.

Upgrades. The Company has a large installed base of inspection and processing systems. This installed base generates potential business for the Company’s upgrade products. In contrast to the acquisition of new inspection and processing systems products, upgrades can provide the customer with a less capital intensive alternative.

The Company believes that there is an opportunity for the sale of upgrade product offerings to its customers so that newer technology with advanced features, lower cost, greater reliability, and performance enhancements can benefit owners of Key systems. The Company has increased its investment in development of specific upgrade products, particularly the G6 vision engine which creates upgrade opportunities for many customers in its installed base of sorting systems.

Process Systems

Conveying and process systems are utilized worldwide throughout processing industries to move and process product within a production plant. The Company’s conveying and process systems include the SmartShaker^® vibratory solutions of Iso-Flo^® and Impulse™ branded conveyor systems, Farmco rotary grading systems, Turbo-

Table of Contents

Flo^® steam blanchers, Forté™ Process Control systems, Freshline product family for fresh-cut, and additional conveying and processing equipment. The functions of these product lines include conveying, transferring, distributing, aligning, feeding, metering, separating and grading, as well as blanching, cooking, pasteurizing, cooling, cleaning, washing and drying. The process systems group includes standard products as well as custom designed equipment.

Iso-Flo Vibratory Conveying Systems. The Company’s principal specialized conveying system is its Iso-Flo vibratory conveyor system. The Iso-Flo conveyor is a type of pan conveyor. Pan conveyors are common throughout industries that process product streams of discrete pieces, including the food processing industry. Pan conveyors move product pieces by vibrating the pan at high frequency along a diagonal axis, upward and forward. This action propels the product ahead in small increments and distributes it evenly for close control of movement and presentation.

Iso-Flo systems are used in a variety of processing applications, including potato products, vegetables and fruits (green beans, peas, carrots, corn, peaches, pears, cranberries and apples), snack foods, cereals, fresh salads, cheese, poultry, and seafood. Non-food processing applications include nutraceuticals, tobacco, pet food and plastics.

Impulse is a line of nearly silent electromagnetic vibratory conveyors which combine the advantage of quick start/stop with precise metering control. Additionally, the Impulse conveyor drive systems are oil-free, which limits the potential for contamination and improves the safety of food products. This conveyor system was developed for packaging applications in snack food, dry ingredient, chemical and pharmaceutical processing, but is seeing increased application in a wide variety of food and industrial processes.

Rotary grading systems. The mechanical sizing, sorting, separating, and grading products sold under the Farmco brand name are used in many food processing and fresh vegetable packing operations. These rotary sizing and grading technologies optimize yield, increase packaging efficiency, and improve product quality by either removing oversized, undersized and small irregular-shaped pieces of product from the line or separating product into predetermined size categories. In combination with other Company-provided equipment, these products increase overall line efficiency and systems capability.

Turbo-Flo and Preparation Systems. The Company designs and manufactures preparation systems to prepare products prior to cooking, freezing, canning or other processing. Products in this group include the Turbo-Flo Blancher/Cooker/Pasteurizer, air cleaners, air coolers, vegetable metering and blending systems, and bulk handling equipment. These products represent the Company’s most mature product line. Sales of these products over the years have formed a customer base for sales of other Company products and are also establishing a customer base in developing geographic markets.

Preparation system revenues may also include a variety of third-party supplied equipment and installation services which are sold as components of larger processing lines, for which the Company has assumed turn-key sales responsibility. In addition, the process systems group includes other custom designed conveying and raw food sizing, grading, and preparation equipment.

Forté Control Systems. The Company’s primary offering in the area of process control for processing systems, Forté, provides a foundation for a wide range of control options for processing lines, from simple on/off commands to data logging and recipe entry. This product is complementary to the Company’s primary equipment lines.

Freshline products. The Company’s product line addresses the fresh-cut food industry and includes high volume automatic dryers, as well as a range of processing solutions from individual machines to large-scale production lines with automated control systems.

Parts and Service/Contracts

The Company has a large installed base of inspection and processing systems. This installed base generates potential business for the Company’s parts and service products. The Company has made parts and service an area

Table of Contents

of strategic focus, and realigned its organization to leverage the large installed base and its strong customer support organization.

The Company provides spare parts and post-sale field and telephone-based repair services to support its customers’ routine maintenance requirements and seasonal equipment startup and winterization processes. The Company considers its parts and maintenance service sales to be important potential sources of future revenue growth. The Company continues to realign its service organization so that field service personnel are now geographically located closer to its customers throughout the world. This strategy has contributed to revenue growth and improved gross margins in parts and service. The Company also typically provides system installation support services which are included in the sales price of certain of its products, principally automated inspection systems, and customer training.

Engineering, Research and Development

At September 30, 2007, the Company’s research and development department had 33 employees who conduct new product research and development and sustaining engineering for released products. The Company’s technical staff includes electronic, optical, mechanical and software engineers, mathematicians and technical support personnel.

The Company’s project engineering department had 46 employees engaged in project engineering for custom systems. The project engineering teams are responsible for engineering and designing the details of each custom order. A document control team maintains and controls product documentation and the product modeling database for the development engineering and project engineering teams as well as the manufacturing department.

In fiscal 2007, the Company’s research and development expenses, together with engineering expenses not applied to the manufacturing costs of products, were approximately $5.5 million, compared to $6.4 million and $5.1 million in 2006 and 2005, respectively.

Manufacturing

The Company maintains two domestic manufacturing facilities, one located in Walla Walla, Washington and one in Redmond, Oregon. The Company also has a European manufacturing facility located in The Netherlands. The Company’s current manufacturing facilities and its product design and manufacturing processes integrate Computer Aided Engineering (CAE), Finite Element Analysis (FEA), Computer Aided Design (CAD), Computer Aided Manufacturing (CAM) and Computer Integrated Manufacturing (CIM) technologies. Manufacturing activities include process engineering; fabrication, welding, finishing, and assembly of custom designed stainless steel systems; camera and electronics assembly; subsystem assembly; and system test and integration. The Company manufactures specific products in the following locations:

Location	Size in Square Feet	Products/Services Produced
Walla Walla, Washington	173,000	Automated Inspection Process Systems Parts and Service
Redmond, Oregon	19,000	Process Systems Parts and Service
Beusichem, The Netherlands	45,000	Process Systems Parts and Service
Beusichem, The Netherlands	18,000	Parts Warehouse Future Manufacturing Expansion

The Company manufactures certain of its products to Underwriters Laboratories and United States Department of Agriculture standards. Certain of the Company’s products also comply with the Canadian Standards Association

Table of Contents

(CSA), European CE (Conformité Européene) and Electronic Testing Laboratory (ETL) safety standards. The Company’s domestic facilities were recertified to the ISO 9001:2000 standard in 2006.

Certain components and subassemblies included in the Company’s products are obtained from limited-source or sole-source suppliers. The Company attempts to ensure that adequate supplies are available to maintain manufacturing schedules. Although the Company seeks to reduce its dependence on limited- and sole-source suppliers, the partial or complete loss of certain sources of supply could have an adverse effect on the Company’s results of operations and relations with customers. During fiscal 2007 and 2006, the Company experienced higher component costs and reduced margins on certain product lines due to the worldwide shortage of stainless steel.

Environmental

The Company has not received notice of any material violations of environmental laws or regulations in on-going operations at any of its manufacturing locations.

Sales and Marketing

The Company markets its products directly and through independent sales representatives. In North America, the Company operates sales offices in Walla Walla, Washington; Medford, Oregon; Redmond, Oregon; and Santiago de Querétaro, Mexico. The Company’s subsidiary, Key Technology B.V., provides sales and service to European and Middle Eastern and South African customers. The Company’s subsidiary, Key Technology Australia Pty Ltd., provides sales and service to customers primarily in Australia and New Zealand. The Company’s subsidiary Productos Key Mexicana S. de R.L. de C.V. provides sales and service to customers in Mexico, Central and South America. The Company’s subsidiary, Key Technology (Shanghai) Trading Company Ltd., provides sales and service to customers in greater China. The Company supplies products from both product groups - automated inspection systems and process systems - to customers in its primary markets through common sales and distribution channels. In addition, the Company supplies parts and service through its worldwide service organization.

Most exports of products manufactured in the United States for shipment into international markets other than Europe and Australia have been denominated in U.S. dollars. Sales into Europe of systems, spare parts and service, as well as products manufactured in Europe, are generally denominated in European currencies, most commonly Euros. Sales into Australia are typically denominated in its local currency. 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 in international markets; tariffs and other barriers and restrictions; and the requirements of complying with a variety of international laws. Additional information regarding export and international sales is set forth in Note 15 to the Company’s Consolidated Financial Statements for the fiscal year ended September 30, 2007.

During fiscal 2007, 2006 and 2005, sales to our largest customer, McCain Foods, represented approximately 9%, 17% and 16% of total net sales, respectively. While the Company believes that its relationship with McCain is satisfactory, the loss of this customer could have a material adverse effect on the Company’s revenues and results of operations.

Backlog

The Company’s backlog as of September 30, 2007 and September 30, 2006 was approximately $30.9 million and $22.8 million, respectively. The Company schedules production based on firm customer commitments and forecasted requirements. The Company includes in backlog only those customer orders for which it has accepted purchase orders.

Competition

The markets for automated inspection systems and process systems are highly competitive. Important competitive factors include price, performance, reliability, and customer support and service. The Company believes

Table of Contents

that it currently competes effectively with respect to these factors, although there can be no assurance that existing or future competitors will not introduce comparable or superior products at lower prices. Certain of the Company’s competitors may have substantially greater financial, technical, marketing and other resources. The Company’s principal competitors are believed to be FMC Technologies, Inc., Heat & Control, Inc. and its subsidiaries, BEST N.V., Sortex Ltd. and Kiremko B.V. The Company has encountered additional small competitors entering its markets, including the introduction of potentially competing tobacco sorters into the Chinese market manufactured by Chinese companies. As the Company enters new markets, it expects to encounter additional new competitors.

Patents and Trademarks

The Company currently holds forty-eight United States patents issued from 1989 through 2007, and eleven other national patents issued by other countries. The first of these patents expires in calendar 2008, and the Company believes that expiration will not have a significant effect on the Company. As of December 7, 2007, nineteen other national patent applications have been filed and are pending in the United States and other countries and two international or regional applications have been filed that are awaiting the national phase. The Company has thirty-three registered trademarks and eight pending applications for trademarks.

The Company also attempts to protect its trade secrets and other proprietary information through proprietary information agreements and security measures with employees, consultants and others. The laws of certain countries in which the Company’s products are or may be manufactured or sold may not protect the Company’s products and intellectual property rights to the same extent as the laws of the United States.

Employees

At September 30, 2007, the Company had 532 full-time employees, including 263 in manufacturing, 79 in engineering, research and development, 135 in marketing, sales and service, and 55 in general administration and finance. A total of 143 employees are located outside the United States. The Company utilizes temporary contract employees, which improves the Company’s ability to adjust manpower in response to changing demand for Company products. Of the total employees at September 30, 2007, twenty-six were contract employees. None of the Company’s employees in the United States are represented by a labor union. The manufacturing employees located at the Company’s facility in Beusichem, The Netherlands are represented by the Small Metal Union. The Company has never experienced a work stoppage, slowdown or strike.

Available Information

The Company’s annual and quarterly reports and other filings with the United States Securities and Exchange Commission (“SEC”) are made available free of charge through the Investor Relations section of the Company’s website at www.key.net as soon as reasonably practicable after the Company files such material with the SEC. The information on or that can be accessed through the Company’s website is not a part of this Annual Report on Form 10-K.

ITEM 1A. RISK FACTORS.

In addition to the other information in this Annual Report on Form 10-K, the following risk factors should be considered carefully in evaluating the Company and its business because such factors may have a significant effect on its operating results and financial condition. As a result of the risk factors set forth below and the information presented elsewhere in this Annual Report on Form 10-K, actual results could differ materially from those included in any forward-looking statements.

Adverse economic conditions in the food processing industry, either globally or regionally, may adversely affect the Company's revenues.

The markets the Company serves, particularly the food processing industry, are experiencing variable economic conditions. The U.S. and European markets in the food processing industry are not growing and are experiencing

Table of Contents

consolidation. Additionally, varying consumer demand, product supply, and plant capacity, most notably in the potato market, could result in reduced or deferred capital equipment purchases for the Company’s product lines. While the Company has reacted to these developments with applications directed to the growing fresh vegetable and fruit industries as well as the pharmaceutical and nutraceutical industries, loss of business, particularly in the potato industry, would have a negative effect on the Company’s sales and net earnings.

Competition and advances in technology may adversely affect sales and prices.

The markets for the Company’s products are highly competitive. Advances in technology may remove some barriers to market entry, enabling additional competitors to enter the Company’s markets. Such additional competition could force the Company to reduce prices to remain competitive, and decrease the Company’s profits, having a material adverse affect on the Company’s business and financial condition. There can be no assurance that the Company will be able to continue to compete effectively in the future.

The Company’s new products may not compete successfully in either existing or new markets.

The future success and growth of the Company is dependent upon its ability to develop, market, and sell products and services in certain food processing markets as well as to introduce new products into other existing and potential markets. There can be no assurance the Company can successfully penetrate these potential markets or expand into new international markets with its current or new products.

The limited availability and possible cost fluctuations of materials used in the Company's products could adversely affect the Company's business.

Certain of the components, subassemblies and materials for the Company’s products are obtained from single sources or a limited group of suppliers. Although the Company seeks to reduce dependence on sole or limited source suppliers, the partial or complete loss of certain of these sources could have an adverse effect on the Company’s results of operations and customer relationships. In addition, certain basic materials, such as stainless steel, are used extensively in the Company’s product fabrication processes. Such basic materials may also be subject to worldwide shortages or price fluctuations related to the supply of or demand for raw materials, such as nickel, which are used in their production by the Company’s suppliers. A significant increase in the price or decrease in the availability of one or more of these components, subassemblies or basic materials could also adversely affect the Company’s results of operations. The high price of stainless steel worldwide in fiscal 2006 and 2007 resulted in higher component costs and reduced margins on certain product lines.

The inability to protect its intellectual property, especially as the Company expands geographically, may adversely affect the Company's competitive advantage.

The Company’s competitive position may be affected by its ability to protect its proprietary technology. The Company has obtained certain patents and has filed a number of patent applications. The Company also anticipates filing applications for protection of its future products and technology. There can be no assurance that any such patents will provide meaningful protection for the Company’s product innovations, or that the issuance of a patent will give the Company any material advantage over its competition in connection with any of its products. The Company may experience additional intellectual property risks in international markets where it may lack patent protection. The patent laws of other countries, such as China, may differ from those of the U.S. as to the patentability of the Company’s products and processes. Moreover, the degree of protection afforded by foreign patents may be different from that of U.S. patents.

Intellectual property-related litigation expenses and other costs resulting from infringement claims asserted against the Company by third parties may adversely affect the Company’s results of operations and its customer relations.

The technologies used by the Company may infringe the patents or proprietary technology of others. In the past, the Company has been required to initiate litigation to protect its patents. The cost of enforcing the Company’s patent rights in lawsuits that it may bring against infringers or of defending itself against infringement charges by

Table of Contents

other patent holders or other third parties, including customers, may be high and could have an adverse effect on the Company’s results of operations and its customer relations.

ITEM 2. PROPERTIES.

The Company owns or leases the following properties:

Location	Purpose	Square Feet	Owned or Leased	Lease Expires	Renewal Period
Walla Walla, Washington	Corporate office, manufacturing, research and development, sales and marketing, administration	173,000	Leased with option to purchase within the lease term	2020	None
Redmond, Oregon	Manufacturing, research and development, sales, administration	19,000	Leased	2012	2017
Beusichem, The Netherlands	Manufacturing, sales and marketing, administration	45,000	Leased	2008	2013
Beusichem, The Netherlands	Parts warehouse, future manufacturing expansion	18,000	Owned	n/a	n/a

The Company also has leased office space for sales and service and other activities in Medford, Oregon, Dingley, Australia, Shanghai, China, Santiago de Querétaro, Mexico and Rotselaar, Belgium.

The Company considers all of its properties suitable for the purposes for which they are used.

ITEM 3. LEGAL PROCEEDINGS.

From time-to-time, the Company is named as a defendant in legal proceedings arising out of the normal course of its business. As of December 7, 2007, the Company was not a party to any material legal proceedings.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

Table of Contents

PART II

ITEM 5.

MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Common Stock

Shares of the Company’s common stock are quoted on the Nasdaq Global Market under the symbol “KTEC”. The following table shows the high and low bid prices per share of the Company’s common stock by quarter for the two most recent fiscal years ending with the month of July 2006 and shows the high and low sales prices per share of the Company’s common stock for August 2006 - September 30, 2007:

Stock price by quarter	High		Low
Fiscal year ended September 30, 2007
First Quarter	$	15.230	$	11.311
Second Quarter		16.870		13.500
Third Quarter		23.100		15.190
Fourth Quarter		30.950		21.170
Fiscal year ended September 30, 2006
First Quarter	$	15.000	$	12.250
Second Quarter		13.175		11.180
Third Quarter		12.860		11.500
Fourth Quarter (July)		13.400		12.050
Fourth Quarter (August – September)		13.330		10.700

The source of these quotations for the Company’s common stock was the Nasdaq Online^SMInternet site.

The Company had approximately 1,570 beneficial owners of its common stock, of which 201 are of record, as of December 7, 2007.

The Company has not historically paid dividends on its common or preferred stock. The Board of Directors presently intends to continue its policy of retaining earnings for reinvestment in the operations of the Company. The current credit facility with the Company’s principal domestic bank restricts the payment of dividends.

Issuer Purchases of Equity Securities

The following table provides information about purchases made by or on behalf of the Company during the quarter ended September 30, 2007 of equity securities registered by the Company under Section 12 of the Securities Exchange Act of 1934.

Stock Repurchase Program (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
July 1 - 31, 2007		0			0
August 1 - 31, 2007		0			0
September 1 - 30, 2007		0			0
Total		0			0	411,748

Table of Contents

(1) The Company initiated a stock repurchase program effective November 27, 2006. The Company may purchase up to 500,000 shares of its own common stock under the program.

Table of Contents

STOCK PERFORMANCE GRAPH

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN

AMONG KEY TECHNOLOGY, INC., A PEER GROUP, AND THE RUSSELL MICROCAP INDEX

TOTAL RETURN ANALYSIS
	9/30/2002	9/30/2003	9/30/2004	9/30/2005	9/30/2006	9/30/2007
Key Technology	$ 100.00	$ 236.91	$ 224.55	$ 283.43	$ 255.09	$ 600.80
Peer Group	$ 100.00	$ 148.70	$ 228.49	$ 262.75	$ 286.21	$ 512.40
Russell Microcap	$ 100.00	$ 154.27	$ 177.18	$ 207.28	$ 221.83	$ 243.31

PEER GROUP: Cognex Corp., Perceptron, Inc., Flir Systems, Inc., Flow International Corp., Elbit Vision Systems Ltd., PPT Vision, Inc., Robotic Vision Systems, Inc., FMC Technologies, Inc.

Table of Contents

ITEM 6.

SELECTED FINANCIAL DATA.

The selected consolidated financial information set forth below for each of the five years in the period ended September 30, 2007 has been derived from the audited consolidated financial statements of the Company. The information below should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Company’s Consolidated Financial Statements and Notes thereto as provided in Item 7 and Item 8 of this Annual Report on Form 10-K, respectively.

	Fiscal Year Ended September 30,
	2007		2006			2005			2004			2003
	(in thousands, except per share data)
Statement of Operations Data:
Net sales	$	107,540	$	84,840		$	80,322		$	80,610		$	82,622
Cost of sales		66,099		53,041			49,145			46,887			48,626
Gross profit		41,441		31,799			31,177			33,723			33,996
Operating expenses		32,839		31,743			27,193			28,295			25,221
Gain on sale of assets		23		109			28			5			4
Income from operations		8,625		165			4,012			5,433			8,779
Other income (expense)		1,961		(980	)		(419	)		(132	)		(327	)
Earnings (loss) from continuing operations before income taxes		10,586		(815	)		3,593			5,301			8,452
Income tax (benefit) expense		3,176		(22	)		902			1,617			2,693
Net earnings		7,410		(793	)		2,691			3,684			5,759
Assumed dividends on mandatorily redeemable preferred stock		--		--			(33	)		(69	)		(132	)
Accretion of mandatorily redeemable preferred stock		--		--			--			--			--
Net earnings (loss) available to common shareholders	$	7,410	$	(793	)	$	2,658		$	3,615		$	5,627
Earnings (loss) per share – basic	$	1.41	$	(0.15	)	$	0.53		$	0.74		$	1.18
– diluted	$	1.37	$	(0.15	)	$	0.52		$	0.71		$	1.15
Cash dividends per share	$	--	$	--		$	--		$	--		$	--
Shares used in per share calculation – basic		5,265		5,205			5,041			4,909			4,774
– diluted		5,407		5,205			5,219			5,222			4,989

Balance Sheet Data:
Cash and cash equivalents and short-term investments	$	27,880	$	15,246		$	13,181		$	8,817		$	6,442
Working capital		40,946		30,057			28,164			20,991			17,226
Property, plant and equipment, net.		4,671		4,275			4,264			5,046			5,503
Total assets		75,497		57,938			57,527			52,514			51,215
Current portion of long-term debt		--		1			1,121			1,210			1,066
Long-term debt, less current portion		--		--			1,199			2,323			3,249
Mandatorily redeemable preferred stock and warrants, including current portion		--		--			--			1,595			1,882
Shareholders' equity		50,393		41,252			40,471			36,044			30,219

Certain reclassifications have been made to prior year amounts to conform to the current year presentation.

Table of Contents

ITEM 7.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Introduction

The Company and its wholly-owned subsidiaries design, manufacture and sell process automation systems, integrating electro-optical inspection, sorting and process systems.

The Company consists of Key Technology, Inc. which directly owns five subsidiaries: Key Holdings USA LLC; Key Technology Australia Pty Ltd.; Productos Key Mexicana S. de R. L. de C.V.; Key Technology (Shanghai) Trading Co., Ltd.; and Key Technology AMVC LLC (inactive). Key Holdings USA LLC owns Suplusco Holdings B.V., its European subsidiary, which owns Key Technology B.V. Key Technology Australia Pty Ltd. owns Freshline Machines Pty Ltd. (inactive). The Company manufactures products in Walla Walla, Washington; Redmond, Oregon; and Beusichem, The Netherlands.

Overview

Sales for the year ended September 30, 2007 were $107.5 million compared with $84.8 million for fiscal 2006. The Company reported net earnings for fiscal 2007 of $7.4 million, or $1.37 per diluted share, compared with a net loss of $793,000, or $0.15 per diluted share, for fiscal 2006. The principal reasons for the increase in net earnings for fiscal 2007 compared to fiscal 2006 were the 26.8% increase in sales volume, reflecting the 27.4% increase in orders for fiscal 2007, and the improvement of gross margins to 38.5% in fiscal 2007 from 37.5% in fiscal 2006. Automated inspection systems sales were up 55%, process systems sales were up 17%, and parts and service sales remained on par with the prior fiscal year. The primary market forces driving demand for our products are: the increased concerns about food safety and security, the inability of food and pharmaceutical processors to obtain cost effective labor, and the Company’s expansion into international markets. Export and international sales for the fiscal years ended September 30, 2007, 2006 and 2005 accounted for 46%, 51% and 52% of net sales in each year, respectively.

In 2007, the Company again focused efforts on three major initiatives to achieve its long-term revenue growth plan:

Expand and grow its participation in the pharmaceutical and nutraceutical market;

Strengthen and grow the level of business in China; and

Continue to grow the Company’s aftermarket product lines.

Although the results from 2007 reflected some revenue progress from these initiatives, sales in our core businesses including upgrades accounted for the majority of the increased revenues. The pharmaceutical initiative began in the fourth quarter of 2005 with the formation of the SYMETIX™ business unit. This business unit was formed to dedicate a team of employees to develop and grow Key’s business in the pharmaceutical and nutraceutical market. Anticipated penetration into this market will extend and advance the Company’s existing patented, high-resolution inspection technology and material handling platforms. Revenue increased $1.4 million in fiscal 2007 to $2.1 million as efforts on the pharmaceutical initiative began to make progress.

The Company has historically been successful in selling tobacco sorters in China. Larger opportunities exist there in the food processing business as well, and the Company invested in China during fiscal 2006 to enhance sales, service and applications support to build upon its established base. In 2006, the Company opened offices and located personnel in-country. In 2007, the Company experienced similar sales volumes into the Chinese market as in 2006, but with new traction in the food processing equipment market which was offset by lower fiscal 2007 tobacco volume. Increased order volume in the last two quarters of fiscal 2007 indicates that the Company’s expansion efforts into the Chinese food processing market is gaining traction.

The Company also focused on its aftermarket product lines (which include parts/service and upgrades) during 2007. With the introduction of the G6 family of products in 2005, this enhanced vision engine technology provided additional product upgrade opportunities. Upgrades are an important aspect of the aftermarket product lines, and the

Table of Contents

new modular G6 product family, which provides advanced image processing capability, has been well received by the Company’s current customers. Aftermarket sales (including upgrades which are classified in automated inspection systems) increased in fiscal 2007 from fiscal 2006 by 24% to $32.7 million. The Company believes a 42% increase in upgrade orders in fiscal 2007 over fiscal 2006 and the strong backlog at the end of fiscal 2007 bode well for the fiscal 2008 performance of the aftermarket business.

Other accomplishments during fiscal 2007 included completing the initial audit of the Company’s internal controls pursuant to Sarbanes-Oxley Section 404, completing the closure of the Company’s manufacturing facilities in Australia, reducing staff in the Medford, Oregon sales and engineering office, and selling the Company’s interest in the InspX joint venture.

The Company’s strategic initiatives for 2008 are to continue to build upon the direction and solid revenue base the Company developed during 2007. The focus for the coming year is to continue to grow sales in the Company’s core markets and invest in a market driven technology road map that provides the new products required by our customers. In addition, the Company will focus on four primary industries: potatoes, fresh cut produce, processed fruit and vegetables, and pharmaceutical/nutraceutical, and focus on four developing regions: China, Latin America, Eastern Europe and the Middle East.

The Company also plans to increase research and development expenditures and develop a global Enterprise Resource Planning, or ERP, system. Efforts in research and development will continue to focus on customer solutions, providing new products that meet current needs as well as anticipated future functionality requirements. The Company began preliminary work on developing a global ERP system in the third and fourth quarters of fiscal 2007. The Company has selected an ERP system and a business partner. Implementation will be spread over a three-year period, with total costs of $5.5 million expected over the 2008-2010 period. A significant portion of these ERP implementation costs will be capitalized.

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 criteria 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 (maintenance, installation support, and repairs) 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

Table of Contents

criteria. The Company’s sales arrangements provide for no other significant 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 will provide any necessary provision against sales. In accordance with the Financial Accounting Standard Board’s Emerging Issues Task Force Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Product,” the Company accounts for cash consideration (such as sales incentives) that are given to customers or resellers as a reduction of revenue rather than as an operating expense unless an identified benefit is received for which fair value can be reasonably estimated. 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 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 September 30, 2007, the Company had invoiced $2.3 million compared to $1.5 million at September 30, 2006 for which the Company has not recognized revenue.

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 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 September 30, 2007, the balance sheet included allowances for doubtful accounts of $414,000. Amounts charged to bad debt expense for fiscal 2007 and 2006 were $16,000 and $29,000, respectively. Actual charges to the allowance for doubtful accounts for fiscal 2007 and 2006 were $98,000 and $83,000, 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. Write downs 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 September 30, 2007, cumulative inventory adjustments to lower of cost or market totaled $1.8 million compared to $2.2 million as of September 30, 2006. Amounts charged to expense to record inventory at lower of cost or market for fiscal 2007 and 2006 were $386,000 and $1.6 million, respectively. Actual charges to the cumulative inventory adjustments upon disposition or sale of inventory were $903,000 and $2.3 million for fiscal 2007 and 2006, respectively. If actual demand, market conditions or product lifecycles are adversely different from those estimated by management,

Table of Contents

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, 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 September 30, 2007, the Company held $10.8 million of property, plant and equipment, 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 recoverability and 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 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 standard warranty plans included in the price of the products ranging from 90 days to five years, depending upon the product and contractual terms of sale. The majority of product warranties are for periods between one and two years. 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. 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 September 30, 2007, the balance sheet included warranty reserves of $1.4 million, while $2.1 million of warranty charges were incurred during the fiscal year then ended, compared to warranty reserves of $1.0 million as of September 30, 2006 and warranty charges of $2.0 million for the fiscal year then ended. If the Company’s actual warranty costs are higher than estimates, future warranty plan coverages are different, or estimates are adversely adjusted in future periods, reserves for warranty expense 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. At September 30, 2007, the Company had valuation reserves of approximately $510,000 consisting of $450,000 for deferred tax assets related to the sale of the investment in the InspX joint venture and the valuation reserve for notes receivable and contingent payments; and a net $60,000 for combined U.S., Australian and Chinese deferred tax assets and liabilities, primarily related to net operating loss carryforwards in those foreign jurisdictions. There were no other valuation allowances at September 30, 2007 due to anticipated utilization of all the deferred tax assets as the Company believes it will have sufficient taxable income to utilize these

Table of Contents

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 2007 and 2006, 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 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 0.2%, 14.3% and 5.4% in 2007, 2006 and 2005, respectively. The legislation also provides for a new deduction for manufacturing income, which phases in beginning in the Company’s 2006 fiscal year through 2010. The Company anticipates that this deduction will largely, if not completely, offset the loss of the ETI exclusion. However, the effects in individual fiscal years during the phase-in periods may vary and increase the Company’s effective tax rate during these periods. For fiscal 2007 and 2006, the deduction for manufacturing income reduced the Company’s effective tax rate by 0.8% and 0%, respectively.

Table of Contents

Summary of Financial Information
	Fiscal Year Ended September 30,
	2007		2006			Change $			Change %
	(in thousands)
Statement of Operations Data

Net sales	$	107,540	$	84,840		$	22,700			26.8
Gross profit		41,441		31,799			9,642			30.3

Research and development		5,520		6,444			(924	)		-14.3
Sales and marketing		17,191		14,784			2,407			16.3
General and administrative		8,821		9,185			(364	)		-4.0
Amortization		1,307		1,330			(23	)		-1.7
Total operating expense		32,839		31,743			1,096			3.5

Gain on sale of assets		23		109			(86	)	N/M*
Income from operations		8,625		165			8,460		N/M*
Other income and expense		1,961		(980	)		2,941		N/M*
Income tax expense (benefit)		3,176		(22	)		3,198		N/M*
Net income (loss)		7,410		(793	)		8,203		N/M*

Balance Sheet Data
Cash and cash equivalents		27,880		15,246			12,634			82.9
Accounts receivable		14,020		10,381			3,639			35.1
Inventories		18,753		16,035			2,718			17.0

Other Data (unaudited)
Orders		115,276		90,500			24,776			27.4
Backlog		30,931		22,756			8,175			35.9

* Not meaningful

Table of Contents

Results of Operations

Fiscal 2007 compared to Fiscal 2006

Net sales for the year ended September 30, 2007 were $107.5 million, a 27% increase over the $84.8 million reported for fiscal 2006. The Company ended the year strongly with a record fourth quarter of $31.7 million in sales, a 31% increase over the corresponding period in fiscal 2006.

Sales in the Company’s automated inspection systems product line increased by 55% to $46.9 million in fiscal 2007, accounting for 44% of total revenues, compared to $30.3 million in fiscal 2006 and 36% of total revenues. The most significant increase was in upgrade sales which increased $5.7 million or 81% to $12.7 million. Sales increased in all automated inspection product lines except tobacco, which dropped $2.5 million to $0.7 million in fiscal 2007 as a result of a significant tobacco order from China that shipped in fiscal 2006. Process systems sales in fiscal 2007 were $40.9 million, a 17.2% increase over the $34.9 million reported for fiscal 2006. Sales of process systems accounted for 38% of total revenues in fiscal 2007 compared to 41% in fiscal 2006. Shipments of process systems in fiscal 2007 from United States operating locations increased nearly 27% and from the Netherlands increased by nearly 12%. Parts and service sales remained on par with the prior year at $19.7 million and represented 18% of sales this year, down from 23% of sales in fiscal 2006.

New orders increased 27%, or $24.8 million, to $115.3 million in fiscal 2007 over the $90.5 million in orders received in fiscal 2006. Backlog at September 30, 2007 increased to $30.9 million compared to the $22.8 million reported at the end of fiscal 2006. The order mix for the more recent year improved over fiscal 2006. The Company’s higher margin automated inspection systems orders increased to almost 42% of order volume in fiscal 2007 compared to 40% in the prior year due in large part to an almost 42% increase in upgrade orders and a $3.0 million increase in SYMETIX orders.

Gross profits increased to $41.4 million for fiscal 2007 compared to $31.8 million in fiscal 2006, or 38.5% and 37.5% of sales, respectively. The principle driver for the $9.6 million increase in gross profit relates to the nearly 27% increase is sales volume. The improvement in gross profit percentage relates to the increased mix of automated inspection systems sales as well as lower other cost of sales relating to improved manufacturing and overhead variances. Gross profits were negatively affected by higher raw material cost increases driven by stainless steel pricing, as well as lower labor efficiencies relating to hiring and training over 40 new production employees in 2007.

Research and development spending decreased $924,000 to $5.5 million, or 5.1% of sales, in fiscal 2007 from $6.4 million and 7.6% of sales in fiscal 2006. The decrease was driven largely by focusing on fewer research and development projects, as well as the closure and the reduction in staffing of the Company’s Medford, Oregon facility.

Sales and marketing spending in fiscal 2007 was $17.2 million, a significant increase from the $14.8 million spent in fiscal 2006. As a percent of sales, costs dropped 1.4% from the 17.4% of sales reported in fiscal 2006 to 16.0% of sales reported in fiscal 2007. The primary drivers for the increase were the significantly higher sales volume, as well as continued investment in the Company’s China sales office and its SYMETIX initiative in the pharmaceutical and nutraceutical industry.

General and administrative spending in fiscal 2007 was $8.8 million and 8.2% of sales for the year, compared to $9.2 million and 10.8% of sales for fiscal 2006. The decrease in fiscal 2007 was due to the closure of the Company’s operations in Australia and reduced management consulting costs. General and administrative costs incurred in 2006 included non-recurring costs related to information system upgrades. General and administrative costs decreased in fiscal 2007 despite the $500,000 of external costs incurred to comply with Section 404 of the Sarbanes-Oxley Act.

Other income and expense was $2 million of income for fiscal 2007 compared to $1 million of expense for fiscal 2006. During fiscal 2007, the Company recognized a gain of $750,000 from the sale of the investment in the InspX joint venture. In fiscal 2006, the Company booked a charge of $865,000 related to the write-off of it’s investment in InspX. During fiscal 2006, the Company’s equity in the earnings of InspX was an additional loss of $389,000.

Table of Contents

Interest income increased to $726,000 in fiscal 2007 from the $391,000 reported for fiscal 2006 due to increased investment of cash generated by operations. The Company also recognized exchange gains of $570,000 in fiscal 2007 compared with $86,000 in the prior year.

The effective tax rate for the Company was 30.2% in fiscal 2007 compared to 2.7% in fiscal 2006. The effective tax rate for fiscal 2007 was primarily affected by the reversal of valuation reserves recorded in fiscal 2006 related to the Company’s valuation of its investment in the InspX joint venture. Other items, such as permanent differences arising from extra-territorial income exclusions, domestic production deductions, research and development tax credits, tax exempt interest, and other permanent differences, caused the effective tax rate to vary from the 34% statutory rate in fiscal 2007.

Net earnings in fiscal 2007 were $7.4 million, or $1.37 per diluted share, compared to a net loss of $793,000, or $0.15 per diluted share, in fiscal 2006. The principal reasons for the increase in earnings for fiscal 2007 compared to fiscal 2006 were increased sales volumes and improved gross profit margins. In addition, earnings improved due to the effect of the InspX transactions in both years.

Fiscal 2006 compared to Fiscal 2005

Net sales for the year ended September 30, 2006 were $84.8 million, a 5.6% increase over the $80.3 million reported for fiscal 2005. The Company ended the year strongly with a record fourth quarter of $24.2 million in sales, a 12.1% increase over the corresponding period in fiscal 2005.

Sales in the Company’s automated inspection systems product line increased by 8.6% to $30.3 million in fiscal 2006, accounting for 36% of total revenues, compared to $27.9 million in fiscal 2005, and 34% of revenues. The most significant increase was in tobacco sorters due to a shipment to China which was delayed from fiscal 2005 into the first quarter of fiscal 2006. Process systems sales in fiscal 2006 were $34.9 million, a 9.6% increase over the $31.9 million reported for fiscal 2005, and increased to 41% of total revenue in fiscal 2006 compared to 40% in fiscal 2005. Parts and service sales decreased by 7.2% to $19.7 million in fiscal 2006, compared to the $21.2 million reported for fiscal 2005, representing 23% and 26% respectively of total revenues.

Orders increased by $6.8 million to $90.5 million in fiscal 2006, an 8.1% increase over the $83.7 million in new orders received in fiscal 2005. Backlog at September 30, 2006 increased to $22.8 million, compared to the $16.6 million reported at the end of fiscal 2005. The order mix for the year improved over fiscal 2005, with the Company’s higher margin automated inspection systems orders increasing to almost 40% of order volume compared to 35% in the prior period due in large part to an almost 57% increase in upgrade orders and a 39% increase in Tegra orders.

Gross profits increased to $31.8 million for fiscal 2006 compared to $31.2 million in fiscal 2005, or 37.5% and 38.8% of sales, respectively. The principle drivers for the reduction in gross profit percentage were increased inventory reserves, including reserves related to the Freshline facility closure, raw material cost increases driven by stainless steel pricing, and costs associated with the consolidation of the Company’s Walla Walla facilities early in fiscal 2006.

Research and development spending increased to $6.4 million and 7.6% of sales in fiscal 2006 from $5.1 million and 6.4% of sales in fiscal 2005. The increase was driven largely by increased spending for development of the Raptor 6000 upgrade and products for the nutraceutical market. In addition, $273,000 was charged to research and development during the fourth quarter related to the reduction in staffing in the Company’s Medford, Oregon facility.

Sales and marketing spending in fiscal 2006 was $14.8 million and 17.4% of sales, a significant increase from $12.6 million and 15.7% of sales for 2005. The primary drivers for the increase were the investment in the Company’s China office and related sales initiative, as well as the investment in SYMETIX, the Company’s initiative in the pharmaceutical and nutraceutical industry.

Table of Contents

General and administrative spending in fiscal 2006 was $9.2 million and 10.8% of sales for the year, compared to $8.1 million and 10.1% of sales for fiscal 2005. This increase was due to FAS 123R costs, contract and professional service costs, and recruiting and relocation costs.

Other income and expense was $980,000 of expense for fiscal 2006 compared to $419,000 of expense for fiscal 2005. During fiscal 2006, the Company booked a charge of $865,000 related to the write-off of it’s investment in InspX, its joint venture with Peco LLC. During the year, the Company’s share of InspX performance was a loss of $389,000 compared to a loss in fiscal 2005 of $659,000. Interest income increased to $391,000 in fiscal 2006 from the $229,000 reported for fiscal 2005.

The effective tax rate for the Company was 2.7% in fiscal 2006 compared to 25.1% in fiscal 2005. The most significant factor affecting the rate in fiscal 2006 was the reduction in the value of deferred tax assets related to InpsX and Freshline. Other items, such as permanent differences arising from extra-territorial income exclusions, research and development tax credits and other permanent differences, caused the effective tax rate to vary from the 34% statutory rate.

The net loss from continuing operations in fiscal 2006 was $793,000, or $0.15 per diluted share, compared to net earnings of $2.7 million, or $0.52 per diluted share in fiscal 2005. The principal reasons for the decrease in earnings for fiscal 2006 compared to fiscal 2005 were increased spending related to the investment in strategic initiatives in the pharmaceutical and nutraceutical market and in China, as well as the increased costs associated with the closure of the Freshline facility, the reduction in staffing in Medford, Oregon, and the charges related to the write-off of the InspX investment.

Liquidity and Capital Resources

Fiscal 2007

For fiscal year 2007, net cash increased by $12.6 million, or nearly 83%, to $27.9 million on September 30, 2007. The Company generated $12.4 million in cash from operating activities and generated $575,000 from financing activities and consumed $749,000 in investing activities.

The net cash provided by operating activities during fiscal 2007 of $12.4 million included net earnings for the year of $7.4 million, non-cash expenses for depreciation and amortization of $2.6 million and non-cash share based payments and deferred income taxes of $987,000 and $721,000, respectively. Net earnings also included the $750,000 gain on the sale of InspX. This gain is not included in the cash provided by operations. Non-cash working capital at September 30, 2007 declined from the same time last year, contributing $1.7 million to the cash provided by operating activities. Increased business activity at the end of and during the fourth quarter of fiscal 2007 versus 2006, reflected by the record year-end backlog and the record fourth quarter revenues, resulted in increased inventory and receivables. These increases were more than offset by increases in accounts payable, customer deposits, customer support and warranty accruals, as well as higher yearly incentive accruals.

Cash used in investing activities totaled $749,000 during fiscal 2007. Capital expenditures during fiscal 2007 were approximately $1.6 million for the fiscal year, including $706,000 for software purchased for the global ERP implementation project. These expenditures were partially offset by $750,000 of proceeds from the sale of InspX and $64,000 in proceeds from the sale of property. Cash used for investing activities in fiscal 2006 was $1.4 million.

Cash generated from financing activities totaled $575,000 in fiscal 2007. The Company initiated a stock repurchase program in fiscal 2007 and repurchased 88,252 shares of stock during the fiscal year using $1.3 million of cash. These applications of cash were more than offset by the $1.6 million generated from the issuance of common stock related to option exercises. Financing activities also benefited by the $320,000 excess tax benefit from share based payments. During the prior fiscal year, the Company used cash to payoff both the current and long term portion of long term debt in the amount of $2.3 million. At the end of fiscal 2006 and 2007, the Company had no long term debt outstanding.

Table of Contents

The Company’s domestic credit facility provides for a revolving credit line of up to $10 million and credit sub-facilities of $3.0 million each for sight commercial letters of credit and standby letters of credit. The credit facility matures on June 30, 2008. The credit facility bears interest, at the Company’s option, of either the bank prime rate minus 1.75% or LIBOR plus 1.0% per annum. At September 30, 2007, the interest rate would have been 6.0%. The credit facility is secured by all U.S. accounts receivable, inventory and fixed assets. The credit facility contains covenants which require the maintenance of a defined net worth ratio, a liquidity ratio and minimum profitability. The credit facility also restricts the payment of dividends, mergers and acquisitions, incurrence of additional indebtedness, transactions, including purchases and retirements, in the Company’s own common stock, and places limitations on capital expenditures and lease expenditures, without the prior consent of the Lender. At September 30, 2007, the Company had no borrowings outstanding under the credit facility and $530,000 in standby letters of credit. At September 30, 2007, the Company was in compliance with its loan covenants, and had received the consent of the lender for its stock repurchase program.

The Company’s credit accommodation with a commercial bank in The Netherlands provides a credit facility for its European subsidiary. This credit accommodation totals $3.5 million and includes an operating line of the lesser of $2.1 million or the available borrowing base, which is based on varying percentages of eligible accounts receivable and inventories, and a bank guarantee facility of $1.4 million. 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 September 30, 2007, the interest rate was 6.8%. At September 30, 2007, the Company had no borrowings under this facility and had received bank guarantees of $668,000 under the bank guarantee facility. The credit facility allows overages on the bank guarantee facility. Any overages reduce the available borrowings from the operating line.

The Company anticipates that the ongoing cash flows from operations and borrowing capacity under currently available operating credit lines will be sufficient to fund the Company’s operating needs for the foreseeable future. Cash provided by operating activities was $12.4 million, $5.5 million and $7.6 million in each of the last three years, respectively. This operating cash flow has allowed the Company to fund capital asset purchases and eliminate the long-term debt outstanding. The Company anticipates that its cash needs will continued to be met from cash from operations as it embarks on its initiatives to grow the pharmaceutical, nutraceutical and aftermarket businesses, and expand its operation in China and other world-wide locations. The Company also anticipates cash expenditures of $5.5 million over the 2008-2010 fiscal years for development of a global ERP system, a significant portion of which will be capitalized. In addition, due to the rate of growth, the Company is investigating opportunities for increased office and plant space, primarily through leased facilities in the Walla Walla area. The Company had no material commitments for capital expenditures at September 30, 2007.

Prior Years - Fiscal 2006 and 2005

For fiscal year 2006, net cash increased by $2.1 million to $15.2 million on September 30, 2006. The Company generated $5.5 million in cash from operating activities and consumed $1.4 million in investing activities and $2.0 million in financing activities.

The net cash provided by operating activities during fiscal 2006 of $5.5 million included a net loss for the year which reduced cash by $0.8 million. This net loss included the non-cash loss of $1.3 million from the Company’s joint venture equity interest in InspX and non-cash expenses for depreciation and amortization of $3.0 million. Higher business levels at the end of 2006 versus 2005 reflected by the increased order backlog resulted in increased payables and liabilities, as well as higher inventory levels. These increases included higher accounts payable, $1.7 million, higher customer deposits on orders in process, $2.2 million, and higher inventories, $1.0 million. All other operating activities resulted in a use of cash in fiscal 2006 of $0.8 million.

Cash used in investing activities was for machinery and equipment purchases during fiscal 2006 and amounted to $1.4 million for the fiscal year. Cash used in investing activities in fiscal 2005 of $2.0 million was slightly higher than fiscal 2006 and included the Freshline acquisition in early fiscal 2005 of $1.1 million.

Cash used in financing activities totaled $2.0 million in fiscal 2006. During the fiscal year, the Company used cash to payoff both the current and long term portion of debt in the amount of $2.3 million. Borrowings at

Table of Contents

September 30, 2005 consisted of a term loan with a balance of $1.6 million, notes payable totaling $0.5 million and capital leases totaling $0.2 million. At the end of fiscal 2006, the Company had no long term debt outstanding. These applications of cash were partially offset by the receipt of $0.3 million due to the issuance of common stock pursuant to the exercise of stock options.

For fiscal year 2005, net cash increased $4.4 million, increasing from $8.8 million on September 30, 2004 to $13.2 million on September 30, 2005. Net cash provided by operating activities during fiscal 2005 was $7.6 million. Net income generated $2.7 million and non-cash expenses for depreciation and amortization provided $3.2 million. Net income also included the non-cash loss impact of the Company’s equity interest in InspX’s of $659,000. Other changes in cash provided by operating activities were primarily due to changes in working capital relating to increased business activity at the end of fiscal 2005 over fiscal 2004 year-end.

Cash used in investing activities was $2.0 million during fiscal 2005. The acquisition of Freshline Machines Pty Ltd. used $1.1 million in cash and the purchase of machinery and equipment used $1.0 million. The Company acquired $1.8 million in assets related to the Freshline purchase and assumed $0.8 million in liabilities.

Cash used in financing activities totaled $1.1 million in fiscal 2005. Cash used for the redemption of Series B Preferred Stock and the redemption of warrants was $1.3 million and $0.2 million, respectively. The Company also made debt payments which reduced the Company’s long-term debt by $1.2 million. These applications of cash were partially offset by the receipt of $1.5 million due to the issuance of common stock pursuant to the exercise of stock options.

Contractual Obligations

The Company’s continuing contractual obligations and commercial commitments existing on September 30, 2007 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
Operating leases		12,646		1,268		1,991		2,045		7,342
Purchase obligations		251		251		-		-		-
Total contractual cash obligations	$	12,897	$	1,519	$	1,991	$	2,045	$	7,342

At September 30, 2007, the Company had standby letters of credit totaling $1.2 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.”

Future Accounting Changes

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an interpretation of FASB Statement No. 109. FIN 48 provides guidance for the recognition, derecognition and measurement in financial statements of tax positions taken in previously filed tax returns or tax positions expected to be taken in tax returns. FIN 48 requires an entity to recognize the financial statement impact of a tax position when it is more likely than not that the position will be sustained upon examination. If the tax position meets the more likely than not recognition threshold, the tax effect is recognized at the largest amount of the benefit that is greater than fifty percent likely of being realized upon ultimate settlement. FIN 48 also provides guidance on classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company was required to adopt FIN 48 as of October 1, 2007. The Company has not fully completed its evaluation of the impact Interpretation 48 will have on its financial position and results of operations after adoption; however, the Company currently estimates that upon adoption the Company will record an

Table of Contents

estimated $250,000 increase in retained earnings. The Company believes that the adoption of FIN 48 will not have a material ongoing effect on its financial position, results of operations, and cash flow.

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements,” which establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather it eliminates inconsistencies in the guidance found in various prior accounting pronouncements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is evaluating the potential effects of this standard, although we do not expect the adoption of SFAS No. 157 to have a material effect on our financial position, results of operation, or cash flows.

In February 2007, the FASB issued Statement 159, “The Fair Value Option for Financial Assets and Financial Liabilities”. This Statement permits entities to elect to measure certain financial instruments and other items at fair value through earnings. The fair value option may be applied on an instrument by instrument basis, is irrevocable and is applied only to entire instruments. SFAS 159 requires additional financial statement presentation and disclosure requirements for those entities that elect to adopt the standard and is effective for fiscal years beginning after November 15, 2007. We do not anticipate any material impact on our financial condition or results of operations as a result of the adoption of SFAS 159.

In September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. In some situations, companies will be required to record errors that occurred in prior years even though those errors were immaterial for each year in which they arose. Companies may choose to either restate all previously presented financial statements or record the cumulative effect of such errors as an adjustment to retained earnings at the beginning of the period in which SAB 108 is applied. SAB 108 is effective for fiscal years ending after November 15, 2006, and was adopted by the Company on October 1, 2006. The adoption of SAB 108 had no effect on the Company's financial statements.

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES 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, Mexican Peso and Chinese Renminbi.

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, although as the Company expands its operations in Latin America and China, transactions denominated in these currencies may increase. 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 September 30, 2007, the Company was not a party to any currency hedging transaction. As of September 30, 2007, management estimates that a 10% change in foreign exchange rates would affect net earnings before taxes by approximately $519,000 on an annual basis as a result of converted cash, accounts receivable, loans to foreign subsidiaries, and sales or other contracts denominated in foreign currencies.

As of September 30, 2007, the Euro gained a net of 11% in value against the U.S. dollar compared to its value at September 30, 2006. During the twelve-month period ended September 30, 2007, changes in the value of the Euro against the U.S. dollar ranged between a 1% gain and a 11% gain. Other foreign currencies also gained in value against the U.S. Dollar. The effect of these fluctuations on the operations and financial results of the Company were:

·	Translation adjustments of $443,000, net of income tax, were recognized as a component of comprehensive income as a result of converting the Euro denominated balance sheets of Key Technology B.V. and Suplusco

Table of Contents

Holding 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., the RMB balance sheet of Key Technology (Shanghai) Trading Co., Ltd., and the Peso balance sheet of Productos Key Mexicana.

Foreign exchange gains of $570,000 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, intercompany loans, 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 sheets of the European, Australian, Chinese, and Mexican operations.

The U.S. dollar weakened during the fiscal year and the U.S. dollar is still in a relatively weak position on the world markets. 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. On the other hand, materials or components imported into the U.S. may be more expensive. 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 September 30, 2007, the Company had no borrowings which had variable interest rates. During the year then ended, interest rates applicable to its variable rate credit facilities ranged from 5.75% to 6.8%. At September 30, 2007, the rate was 6.0% on its domestic credit facility and 6.8% on its European credit facility. As of September 30, 2007, management estimates that a 100 basis point change in these interest rates would not affect net income before taxes because the Company had no borrowings outstanding under its variable interest rate facilities.

Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

Title	Page
Report of Independent Registered Public Accounting Firm	30
Report of Independent Registered Public Accounting Firm	31
Consolidated Balance Sheets at September 30, 2007 and 2006	32
Consolidated Statements of Operations for the three years ended September 30, 2007	34
Consolidated Statements of Shareholders' Equity for the three years ended September 30, 2007	35
Consolidated Statements of Cash Flows for the three years ended September 30, 2007	36
Notes to Consolidated Financial Statements	38
Supplementary Data	55

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders of Key Technology, Inc.

We have audited the accompanying consolidated balance sheets of Key Technology, Inc. (an Oregon corporation) as of September 30, 2007 and 2006, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended September 30, 2007. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Key Technology, Inc. as of September 30, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 2007 in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Key Technology Inc.’s internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated December 7, 2007 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ GRANT THORNTON LLP

Seattle, Washington

December 7, 2007

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders of Key Technology, Inc.

We have audited the internal control over financial reporting of Key Technology, Inc. (the Company) as of September 30, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Key Technology, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control—Integrated Framework issued by COSO.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets of Key Technology, Inc. as of September 30, 2007 and 2006, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended September 30, 2007 and our report dated December 7, 2007 expressed an unqualified opinion on those financial statements.

/s/ GRANT THORNTON LLP

Seattle, Washington

December 7, 2007

Table of Contents

KEY TECHNOLOGY, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2007 AND 2006
(In thousands)

	2007		2006
ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	27,880	$	15,246
Trade accounts receivable, net		14,020		10,381
Inventories		18,753		16,035
Deferred income taxes		2,120		2,145
Prepaid expenses and other assets		1,954		2,294

Total current assets		64,727		46,101

PROPERTY, PLANT, AND EQUIPMENT, Net		4,671		4,275

DEFERRED INCOME TAXES		-		160

INTANGIBLES, Net		3,573		4,876

GOODWILL, Net		2,524		2,524

OTHER ASSETS		2		2

TOTAL	$	75,497	$	57,938


See notes to consolidated financial statements.			(Continued)

Table of Contents

KEY TECHNOLOGY, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2007 AND 2006
(In thousands, except shares)

	2007		2006
LIABILITIES AND SHAREHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$	5,692	$	3,983
Accrued payroll liabilities and commissions		6,663		4,400
Accrued customer support and warranty costs		1,946		1,137
Income tax payable		181		4
Customer purchase plans		651		393
Other accrued liabilities		798		866
Customers’ deposits		7,850		5,260
Current portion of long-term debt		-		1

Total current liabilities		23,781		16,044

DEFERRED INCOME TAXES		722		46

LONG-TERM DEFERRED RENT		601		596

COMMITMENTS AND CONTINGENCIES		-		-

SHAREHOLDERS’ EQUITY:
Preferred stock—no par value; 5,000,000 shares authorized;
none issued and outstanding		-		-
Common stock—no par value; 15,000,000 shares authorized; 5,508,658 and
5,385,688 issued and outstanding at September 30, 2007 and 2006, respectively		17,105		14,698
Retained earnings		32,659		26,311
Accumulated other comprehensive income		629		243

Total shareholders’ equity		50,393		41,252

TOTAL	$	75,497	$	57,938

See notes to consolidated financial statements.			(Concluded)

Table of Contents

KEY TECHNOLOGY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
THREE YEARS ENDED SEPTEMBER 30, 2007
(In thousands, except per share data)

	2007			2006			2005
NET SALES	$	107,540		$	84,840		$	80,322

COST OF SALES		66,099			53,041			49,145

Gross profit		41,441			31,799			31,177

OPERATING EXPENSES:
Selling		17,191			14,784			12,639
Research and development		5,520			6,444			5,134
General and administrative		8,821			9,185			8,087
Amortization of intangibles		1,307			1,330			1,333

Total operating expenses		32,839			31,743			27,193

GAIN ON SALE OF ASSETS		23			109			28

INCOME FROM OPERATIONS		8,625			165			4,012

OTHER INCOME (EXPENSE):
Royalty income		31			17			-
Interest income		726			391			229
Interest expense		(12	)		(36	)		(179	)
Equity in earnings (loss) of joint venture		-			(389	)		(659	)
Gain on sale of joint venture		750			-			-
Impairment charge on investment in joint venture		-			(865	)		-
Other, net		466			(98	)		190

Total other income (expense)—net		1,961			(980	)		(419	)

Earnings (loss) before income taxes		10,586			(815	)		3,593
Income tax expense (benefit)		3,176			(22	)		902
Net earnings (loss)		7,410			(793	)		2,691
Assumed dividends on mandatorily redeemable preferred stock		-			-			(33	)
Net earnings (loss) available to common shareholders	$	7,410		$	(793	)	$	2,658
EARNINGS (LOSS) PER SHARE—Basic	$	1.41		$	(0.15	)	$	0.53
EARNINGS (LOSS) PER SHARE—Diluted	$	1.37		$	(0.15	)	$	0.52
SHARES USED IN PER SHARE CALCULATION—Basic		5,265			5,205			5,041
SHARES USED IN PER SHARE CALCULATION—Diluted		5,407			5,205			5,219

See notes to consolidated financial statements.

Table of Contents

KEY TECHNOLOGY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
THREE YEARS ENDED SEPTEMBER 30, 2007
(Dollars in thousands)

							Deferred						Accumulated
	Common Stock						Stock-						Other
							Based			Retained			Comprehensive
	Shares			Amount			Compensation			Earnings			Income (Loss)			Total
Balance at September 30, 2004		4,982,500		$	11,493		$	0		$	24,413		$	138		$	36,044
Components of comprehensive income:
Net earnings											2,691						2,691
Comprehensive income—foreign currency translation adjustment, net of tax of $8														(15	)		(15	)
Total comprehensive income																	2,676
Tax benefits from share-based payments					30												30
Shares converted from mandatorily redeemable preferred stock		52
Shares converted from warrants		230			6												6
Reclass expired warrants to equity					127												127
Issuance of stock upon exercise of stock options		191,858			1,481												1,481
Issuance of stock for Employee Stock Purchase Plan		3,644			34												34
Stock grants - employment-based		54,500			751			(751	)
Stock grants - performance-based		115,000			1,379			(1,379	)
Amortization of deferred stock-based compensation								73									73
Balance at September 30, 2005		5,347,784			15,301			(2,057	)		27,104			123			40,471
Components of comprehensive income:
Net loss											(793	)					(793	)
Comprehensive income—foreign currency translation adjustment, net of tax of $62														120			120
Total comprehensive income																	(673	)
Tax benefits from share-based payments					262												262
Share based payments					910												910
Issuance of stock upon exercise of stock options		40,412			220												220
Issuance of stock for Employee Stock Purchase Plan		5,765			62												62
Stock grants - employment-based		25,926
Stock grants - performance-based		(34,199	)
Reversal of deferred stock compensation on adoption of FASB 123(R)					(2,057	)		2,057
Balance at September 30, 2006		5,385,688			14,698			0			26,311			243			41,252
Components of comprehensive income:
Net earnings											7,410						7,410
Comprehensive income—foreign currency translation adjustment, net of tax of $228														443			443
Less: Reclassification to net earnings (net of tax benefit of $29)														(57	)		(57	)
Total comprehensive income																	7,796
Tax benefits from share-based payments					58												58
Share based payments					1,031												1,031
Issuance of stock upon exercise of stock options		174,184			1,495												1,495
Issuance of stock for Employee Stock Purchase Plan		4,176			64												64
Stock buyback		(88,252	)		(241	)					(1,062	)					(1,303	)
Stock grants - employment-based		70,736
Stock forfeitures and retirements		(37,874	)
Balance at September 30, 2007		5,508,658		$	17,105		$	0		$	32,659		$	629		$	50,393