**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.   20549-1004**

 

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**FORM 10-K**

 

**ý**** ANNUAL REPORT PURSUANTTO  SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**for thefiscal year ended September 30, 2003**

 

or

 

**o**** TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from          to        .**

 

**CommissionFile No. 0-21820**

 

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** **

**KEY TECHNOLOGY, INC.**

(Exactname of Registrant as specified in its charter)

 
| **OREGON**                                                 |   | **93-0822509**                        |
|------------------------------------------------------------|--------|---------------------------------------|
| (State of  Incorporation)                                  |   | (I.R.S. Employer  Identification No.) |
|                                                       |   |                                  |
| **150  Avery Street,  Walla Walla, Washington**       |   | **99362**                             |
| (Address of principal  executive offices)                  |   | (Zip Code)                            |
|                                                       |   |                                  |
| **(509)  529-2161**                                   |
| (Registrant’s telephone  number, including area code) |

 

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Securities registeredpursuant to Section 12(b) of the Act:**None**

 

Securities registeredpursuant to Section 12(g) of the Act:**Common Stock, no par value**

### **Series BConvertible Preferred Stock, par value $.01 per shareWarrants to purchase Common Stock, dated July 12, 2000**

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Sections 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. [ý]

 

Indicate by check mark whether the Registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act).

Yes  o  No  ý

 

The aggregate market value of the Registrant’s commonstock held by non-affiliates on March 31, 2003 and December 3, 2003 (based onthe last sale price of such shares) was approximately $21,570,125 and$58,576,022, respectively.

 

There were 4,846,486 shares of the Registrant’s commonstock outstanding on December 3, 2003.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Parts of Registrant’s Proxy Statement dated on orabout January 8, 2004 prepared in connection with the Annual Meeting ofShareholders to be held on February 4, 2004 are incorporated by reference intoPart III of this Report.

 

 

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**KEY TECHNOLOGY, INC.2003 FORM 10-KTABLE OF CONTENTS**

 
| **PART I**    |   |                                                                                             |   |   |
|---------------|--------|--------------------------------------------------------------------------------------------------|--------|--------|
|          |   |                                                                                             |   |   |
| Item 1.       |   | BUSINESS                                                                                         |   |   |
|          |   |                                                                                             |   |   |
| Item 2.       |   | PROPERTIES                                                                                       |   |   |
|          |   |                                                                                             |   |   |
| Item 3.       |   | LEGAL PROCEEDINGS                                                                                |   |   |
|          |   |                                                                                             |   |   |
| Item  4.      |   | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                             |   |   |
|          |   |                                                                                             |   |   |
| **PART II**   |   |                                                                                             |   |   |
|          |   |                                                                                             |   |   |
| Item  5.      |   | MARKET  FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                      |   |   |
|          |   |                                                                                             |   |   |
| Item 6.       |   | SELECTED FINANCIAL  DATA                                                                         |   |   |
|          |   |                                                                                             |   |   |
| Item  7.      |   | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS      |   |   |
|          |   |                                                                                             |   |   |
| Item  7A.     |   | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                      |   |   |
|          |   |                                                                                             |   |   |
| Item  8.      |   | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                     |   |   |
|          |   |                                                                                             |   |   |
| Item  9.      |   | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE            |   |   |
|          |   |                                                                                             |   |   |
| Item 9A.      |   | CONTROLS AND  PROCEDURES                                                                         |   |   |
|          |   |                                                                                             |   |   |
| **PART III**  |   |                                                                                             |   |   |
|          |   |                                                                                             |   |   |
| Item  10.     |   | DIRECTORS  AND EXECUTIVE OFFICERS OF THE REGISTRANT                                              |   |   |
|          |   |                                                                                             |   |   |
| Item 11.      |   | EXECUTIVE COMPENSATION                                                                           |   |   |
|          |   |                                                                                             |   |   |
| Item  12.     |   | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS |   |   |
|          |   |                                                                                             |   |   |
| Item  13.     |   | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                  |   |   |
|          |   |                                                                                             |   |   |
| Item  14.     |   | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                          |   |   |
|          |   |                                                                                             |   |   |
| **PART IV**   |   |                                                                                             |   |   |
|          |   |                                                                                             |   |   |
| Item 15.      |   | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                                |   |   |
|          |   |                                                                                             |   |   |
| SIGNATURES    |   |                                                                                             |   |
|          |   |                                                                                             |   |   |
| EXHIBIT INDEX |   |                                                                                             |   |

 

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**PART I**

 

Certain statements set forth below may constitute“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Theforward-looking statements involve known and unknown risks, uncertainties andother factors that may cause the actual results, performance or achievements ofthe Company to differ from those expressed or implied by the forward-lookingstatements.  With respect to theCompany, the following factors, among others, could cause actual results oroutcomes to differ materially from current expectations:

•                  adverseeconomic conditions, particularly in the food processing industry, may alsoadversely affect the Company’s business;

•                  reductionsin capital expenditures in industries served by the Company, and the financialcapacity of customers in these industries to purchase capital equipment, maylimit sales;

•                  competitionand advances in technology may adversely affect sales and prices;

•                  failureto achieve product performance specifications may increase warranty expenses;

•                  theCompany’s new products may not compete successfully in either existing or newmarkets;

•                  theCompany may not be able to maintain or expand international operations andsales, which may adversely affect the Company’s sales;

•                  adversefluctuations in foreign currency exchange rates may adversely affect results ofoperations;

•                  theCompany’s future success is dependent upon the Company’s ability to develop,improve and market its products and services;

•                  thelimited availability and possible cost fluctuations of materials used in theCompany’s products could adversely affect the Company’s business;

•                  theCompany’s inability to protect its intellectual property may adversely affectthe Company’s competitive advantage;

•                  intellectualproperty-related litigation expenses and other costs resulting frominfringement claims asserted against the Company or its customers by thirdparties may adversely affect the Company’s results of operations and itscustomer relations; and

•                  otherfactors discussed in Exhibit 99.1 hereto which is incorporated herein byreference.

 

Given these uncertainties, readers are cautioned notto place undue reliance on the forward-looking statements.  The Company disclaims any obligationsubsequently to revise or update forward-looking statements to reflect eventsor circumstances after the date of such statements or to reflect the occurrenceof anticipated or unanticipated events.

 

**ITEM 1.****                 BUSINESS.**

 

**General**

 

Key Technology, Inc. (the “Company”) was founded in1948 as a local producer of vegetable processing equipment.  The Company has evolved into a worldwidesupplier of process automation solutions to the food processing industry andother industries such as tobacco, plastics and pharmaceuticals. The presentCompany was incorporated in 1982 as a result of a management buyout of thepredecessor organization.

 

The Company and its operating subsidiaries design,manufacture, sell and service process automation systems that process productstreams of discrete pieces to improve safety and quality.  These systems integrate electro-opticalautomated inspection and sorting systems with process systems which includespecialized conveying and preparation systems. The Company provides parts andservice for each of its

 

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product lines to customers throughout the world.  Industries served include food processingand non-food and industrial applications such as tobacco, plastics, and pharmaceuticals.

 

Sales for the year ended September 30, 2003 were $82.6million compared with $70.2 million for fiscal 2002.  The Company reported net earnings for fiscal 2003 of $5.8million, or $1.15 per diluted share, compared with a net loss of $2.0 million,or $0.53 per diluted share, for fiscal 2002. Fiscal 2002 results included a charge of $4.3 million on the impairmentof goodwill resulting from the implementation of Statement of FinancialAccounting Standards (SFAS) No. 142. Excluding this charge and the earnings from the discontinued operation,net earnings from continuing operations for fiscal 2002 were $2.3 million or$0.36 per diluted share.  Export andinternational sales for the fiscal years ended September 30, 2003, 2002 and2001 accounted for 50%, 42% and 49% of net sales in each such year,respectively.

 

**IndustryBackground**

 

***Food Processing Industry***

 

The Company’s primary market is the food processingindustry.  Food processors must processlarge quantities of raw product through different stages, including sorting toremove defective pieces and inspection for product quality and safety.  The frequency and severity of defects in theraw product is highly variable depending upon local factors affectingcrops.  Historically, defect removal andquality control in the food processing industry have been labor intensive anddependent upon and limited by the variability of the work force.  The industry has sought to replace manualmethods with automated systems that achieve higher yield, improve productquality and safety, and reduce costs.

 

The Company’s strategy is to solve processing industryproblems of high labor costs, inadequate yields and inconsistent quality andsafety by providing automated inspection systems and process systems.  The Company’s process automation systems useadvanced optical inspection technology to improve product yield (more of thegood product recovered) and quality (higher percentage of defective productbeing removed) over the manual sorting and defect removal methods historicallyused by food processors.  In a typicalapplication, process automation systems can replace 5 to 75 processing lineemployees, resulting in labor cost savings and improved yield sufficient to payfor the system in less than one year, as well as providing significantimprovements in product quality.

 

The largest markets for the Company’s products havebeen processors of potatoes, vegetables and snack foods.  The Company has also experienced recentsuccess in the dry product markets, which include cereals and pet food.  The Company believes many additionalapplications for its systems exist in both food and non-food markets.

 

The principal potato market served by the Company’ssystems is french fries.  French friescomprise approximately 90% of the over eight billion pounds of frozen potatoproducts processed annually in the United States.  The expansion of American-style fast food chains in othercountries is resulting in development of the frozen french fry marketoverseas.  Current investment in newfrench fry processing facilities has declined relative to historical levels,largely in response to changing consumer preferences.  The Company’s diversification strategies during this same periodhave resulted in less dependence on this industry although it continues to be astrategically important market segment.

 

The Company’s products are used in the fruit andvegetable processing market where field-harvested products are cleaned, graded,automatically sorted, blanched and processed prior to freezing, canning orpackaging for sale to institutional and retail markets.  Principal fruit and vegetable marketsegments for the Company are green beans, corn, carrots, peas, onions, apples,pears, cranberries and peaches.

 

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The global food processing industry has been in aconsolidation period for approximately three years.  Market conditions suggest further consolidation in thefuture.  The Company believes theresulting food processing companies are financially stronger, and yet are facedwith the need to improve profitability while satisfying external pressures tohold or reduce prices for their own products and provide safer products to theconsuming public.  Since the Company’sequipment results in higher product yields, improved product quality andsafety, as well as reduced processing costs, the Company believes thesesurviving companies will have increased interest in the Company’s products tosatisfy these needs, allowing for expanded sales into the food processingindustry in future years.  Due to theseasonal nature of the food processing industry, the Company does experiencesome seasonality of orders and shipments. Orders and shipments to this industry in the Company’s first fiscalquarter of the year tend to be lower than during the Company’s other fiscalquarters.

 

***Non-food Industries – Tobacco,Pharmaceuticals & Plastics***

 

Processors in non-food industries also implementsystems solutions to reduce costs, increase yields, and produce higher qualityproducts that are safe for consumers.

 

The largest non-food processing market for the Companyis the tobacco processing market.  Withthe acquisition of AMVC and its subsidiary SRC Vision in 2000, which had aninstalled base of over 100 automated inspection systems in the tobaccoindustry, the Company significantly increased its potential opportunities inthis market and may be able to introduce additional products to tobaccocustomers.  The Company’s products providetobacco companies sorting capability to remove impurities and foreign matterfrom a stream of stripped tobacco.  TheCompany believes that strong demand for automated tobacco inspection systemswill continue based upon the high degree of acceptance demonstrated by itscustomers and the significant size of the worldwide tobacco processingmarket.  Additionally, the Companyexpects that the tobacco market may provide opportunities for expanded sales ofprocess systems to compliment new and existing installations of automatedinspection systems.

 

At present, the pharmaceutical, plastics and othernon-food industries represent a relatively small share of the Company’s salesand installed base.  However, to furtherits growth strategy, the Company is actively pursuing expansion into newmarkets, such as chemical and plastics, and recycled paper.  The Company believes that many additionalapplications for its products exist in both food and non-food markets,particularly in the area of automated process control.

 

**Products**

 

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

 
|                          |   | **Fiscal  Year Ended September 30,** |       |
|-------------------------------|--------|--------------------------------------|------------|
|                          |   | **2003**                             |       | **2002** |   | **2001** |   |
|                          |   | **(in  thousands)**                  | ** ** |
| Automated  inspection systems |   | $                                    | 30,230     |   | 37 | % | $ | 24,965 |   | 35 | % | $ | 26,884 |   | 37 | % |
| Process systems               |   | 31,759                               |       | 38 | % | 25,767 |   | 37 | % | 27,050 |   | 37 | % |
| Parts and  service/contracts  |   | 20,633                               |       | 25 | % | 19,502 |   | 28 | % | 19,020 |   | 26 | % |
| Net sales                     |   | $                                    | 82,622     |   | 100 | % | $ | 70,234 |   | 100 | % | $ | 72,954 |   | 100 | % |

 

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

 

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The following table sets forth the percent of thetotal gross margin contributed by each product category for the periodsindicated:

 
|                          |   | **Fiscal  Year Ended September 30,** |   |
|-------------------------------|--------|--------------------------------------|--------|
|                          |   | **2003**                             |   | **2002** |   | **2001** |   |
| Automated  inspection systems |   | 42                                   | %      | 39 | % | 39 | % |
| Process systems               |   | 28                                   | %      | 28 | % | 32 | % |
| Parts and  service/contracts  |   | 30                                   | %      | 33 | % | 29 | % |
| Total gross  margin           |   | 100                                  | %      | 100 | % | 100 | % |

 

***Automated Inspection Systems***

 

Automated inspection systems are used in variousapplications to detect and eliminate defects, most often during processing ofraw and semi-finished products.  TheCompany’s product families within this group include the following:  ADR® automatic defect removal systems usedin the French fry industry; Tobacco Sorter 3TM tobacco sortingsystems used in tobacco threshing and primary processing; and the Tegra®, PrismIITM, and Optyx® sorter families which are used in a wide variety ofapplications in many industries and market segments.

 

Nearly all systems in this group use proprietarylinear array charged coupled device (“CCD”) monochromatic, color ormulti-spectral cameras.  Each of thecameras scan the product-streams, which move at 5 to 20 feet per second, at therate of 1,500 to 4,000 times per second and can identify defects as small as1/16 of an inch (1.5 mm) in diameter. Systems with monochromatic cameras generally are sold at lower pricelevels and are most effective for product that has a marked disparity in shadebetween the defective and the good product. Systems with color cameras are required when a variety of defect andproduct colors occur simultaneously or when the difference in shading betweenthe defective and the good product is more subtle.  In 1998, the Company developed multi-spectral systems which utilizeeither infrared or ultraviolet technologies, individually or in combinationwith visible light, to identify defects that may not be detectable by usingsolely visible light spectra.

 

*TegraSystem.*  Tegra hasbeen the leading seller of the Company’s automated inspection system productfamilies for many years.  Tegra isespecially well suited for particularly challenging sorting applications.

 

Tegra incorporates object-specific IntelliSortTMtechnology.  IntelliSort sortingtechnology recognizes not only color and size, but also shape.  This capability provides a solution topreviously difficult sorting problems, such as differentiation between greenbeans and green bean stems.  Tegracameras are capable of high fidelity color-image processing to scan product ata rate of over 4,000 times per second, offering a sensitivity to colorsubtleties beyond human vision.  Tegraalso incorporates KeyWareÒsoftware that substantially reduces operational complexity.  KeyWare consists of application packages,each specifically designed for a single product category that, together withthe system’s computer hardware capability and networking software, support allstandard factory control and automation interfaces.  These features allow Tegra to establish data connectivity andcommunication with a processing plant’s computer network system.  Certain present and potential applicationsfor 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.

 

*PrismSystem.*   In 1999, SRC Vision introduced the Prism sortingsystem.  Designed for stable performancein challenging environments, Prism has gained strong acceptance in segments ofthe fruit, vegetable and snack food markets. It uses a novel broad-band illumination system, and is designed torequire

 

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minimal maintenance.  In addition to present and potential applications inpotato products, vegetables, fruits, plastics, and snack foods, Prism addsspecific applications with products such as dehydrated potato flakes, plasticflake and peaches.

 

In November 2002, the Companyintroduced the new Prism II.  Thisproduct incorporates the same capabilities and strengths as its predecessor ina more economical design, enabling the Company to improve on the gross marginsavailable on the earlier version of the machine.

 

*Tobacco Sorter II and Tobacco Sorter 3.*  The tobacco industry has specialrequirements in the handling and sorting of its tobacco products, which vary insize and moisture content and other properties depending upon the type ofproduct being produced and the point of handling and inspection.  Key’s Tobacco Sorter 3 (TS3), introducedworldwide in 2001, utilizes the machine vision engine of the Prism System in aspecially constructed frame, enclosure, and material handling arrangement tomeet the specific product inspection requirements of this industry.  In addition to the installed base of itspredecessor, Tobacco Sorter II, the new TS3 has now been installed in NorthAmerica, Latin America, Europe and Asia. Customers have benefited from TS3’s improved color resolution,significantly enhanced data communications capability, and reduced maintenancerequirements.

 

*OptyxSystem*. In fiscal 2001, the company developed and introducedits new automated inspection system named Optyx. The sorter has the power andsorting capabilities of a large sorter in an economical and compact machine.Optyx employs the advanced camera, lighting, image processing, and ejectiontechnologies used in the Tegra and Prism products. The lower cost Optyx systemis ideal for smaller processors and lower volume processing lines which werepreviously unable to justify the expense of a larger sorter. Present andpotential applications include the Company’s traditional potato, fruit,vegetable and tobacco markets.   TheCompany is pleased with the market acceptance of this product.

 

*ADRSystem.*  The Company’sADR systems are used to transport, inspect and remove defects from french frypotatoes.  The Company believes its ADRsystem is the principal optical inspection and defect removal system used inthe french fry processing industry.  TheCompany’s full-capacity ADR systems can process up to 27,000 pounds of productper hour.

 

*PharmaceuticalInspection System.* Using patented spatial color analysis technology, this product lineinspects solid-dose pharmaceuticals, including tablets, capsules and soft gelcaps for broken or missing pieces, foreign products, discoloration or coatingdefects, 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 piecesper hour.  Sales of this product lineare a minor contributor to automated inspection system revenues.

 

***Process Systems***

 

Conveying and othercustom designed processing systems are utilized throughout the food industry,as well as other industries, to move large quantities of product within aprocessing plant.  The Company’s processsystems include the Iso-Floâ, HorizonTM,MarathonTM, and ImpulseTMvibratory conveyor systems.  TheCompany’s  product line is made up ofmechanical sizing, sorting, separating and grading equipment.  In addition, the process systems groupincludes food pumping systems, belt conveyors, spiral elevators and othercustom designed conveying technologies.

 

*Iso-FloVibratory Conveying Systems.* The Company’s principal specialized conveying system is its Iso-Flovibratory conveyor system.  The Iso-Floconveyor is a type of pan conveyor.  Panconveyors are common

 

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throughout industries that process product streams of discrete pieces,especially the food processing industry. Pan conveyors move product pieces by vibrating the pan at high frequencyalong a diagonal axis, upward and forward. This action propels the product ahead in small increments anddistributes it evenly for close control of movement and presentation.

 

Iso-Flo systems are used in a variety of processingapplications, including potato products, vegetables and fruits (green beans,peas, carrots, corn, peaches, pears, cranberries and apples), snack foods, cereals,pet foods, poultry, and seafood.  Nonfood processing applications include soap, tobacco, wood chips, plastics, andcertain industrial applications.

 

Other conveyor systems product lines offered by theCompany include:  Horizon, Impulse, andMarathon.

 

*TheHorizon* is a horizontal motion vibratory conveyor that uses agentle conveying action to move fragile foods, such as snacks, cereals andseasoned/coated products, through the processing stages.  The design of the Horizon eliminatesvertical bounce of the processor’s product. The revised product action results in reduced costs to certainprocessors who have a specific need for very gentle product conveying.  Cost savings result from reduced productdamage, reduced seasoning/coating loss and elimination of condiment build-up onthe conveying surface.

 

*TheImpulse* is a line of electromagnetic conveyors which combinethe advantage of quick start/stop with precise metering control.  Additionally, the Impulse conveyor drivesystems are oil-free, which limits the potential for contamination and improvesthe safety of edible food products. This conveyor system was developed for packaging applications in snackfood, dry ingredient, chemical and pharmaceutical processing.

 

*TheMarathon* is the Company’s longest conveyor and moves productup to 100 feet or more on a single conveyor bed.  This conveyor is targeted for use in high volume applicationssuch as corn, green beans and other bulk conveying markets to maximize theprocessor’s production efficiency.

 

The mechanical sizing, sorting, separating, andgrading products sold under the Farmco brand name are used in many foodprocessing systems.  These proprietaryrotary sizing and grading technologies optimize yield, increase packagingefficiency, and improve product quality primarily by removing either over orundersized and small irregular-shaped pieces of product from the line orseparating product into predetermined size categories.  In combination with other Company-providedequipment, these products can increase overall line efficiency and systemscapability.

 

*FoodPumping Systems and Belt Conveyors.*  The Company’s hydro food pumping systems are used to transportfood items over distances and elevations in processing plants.  A typical pumping system consists of astainless steel contoured tank and food pump to propel the product throughlengths of piping to a water removal/product spreading subsystem.  The systems can be configured so that foodprocessing functions, such as blanching, cooling and cutting, can also occurduring pumping.  The Company alsodesigns and manufactures belt conveyors using a variety of belt materials andframe configurations.

 

*PreparationSystems*.  The Companydesigns and manufactures raw food preparation systems to prepare vegetablesprior to freezing, canning or other processing.  Products in this group include blanchers, air cleaners, aircoolers, froth flotation cleaners, vegetable metering and blending systems, andbulk handling equipment.  These productsrepresent the Company’s most mature product line.  Sales of these products over the years have formed a customerbase for sales of other Company products and are also establishing a customerbase in markets in developing countries.

 

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Preparation system revenues may also include a varietyof third-party supplied equipment and installation services which are sold ascomponents of larger processing lines, for which the Company has assumedturn-key sales responsibility.

 

***Parts and Service/Contracts***

 

The Company provides spare parts and post-sale fieldand telephone-based repair services to support its customers’ routinemaintenance requirements and seasonal equipment startup and winterizationprocesses. The Company considers its parts and maintenance service sales to beimportant potential sources of future revenue growth.  The Company has realigned its service organization so that fieldservice personnel are now geographically located closer to its customersthroughout the world.  This strategy hascontributed to revenue growth and improved gross margins in parts andservice.  The Company also typicallyprovides system installation support services which are included in the salesprice of certain of its products, principally automated inspection systems.

 

The Company believes that there is an opportunity forthe sale of upgrade product offerings to its customers so that newer technologywith advanced features, greater reliability, and performance enhancements canbenefit owners of Key systems.  TheCompany has developed specific upgrade products at the request of certain ofits largest customers who own large numbers of the Company’s systems –particularly for its automated inspection systems.

 

**Engineering,Research and Development**

 

At September 30, 2003, the Company’s research anddevelopment department had 52 employees who conduct new product research anddevelopment and sustaining engineering for released products.  The Company’s technical staff includeselectronic, optical, mechanical and software engineers, mathematicians andtechnical support personnel.

 

The Company’s project engineering department had 41employees engaged in project engineering for custom systems.  The project engineering teams areresponsible for engineering and designing the details of each customorder.  A document control teammaintains and controls product documentation and the product modeling databasefor the development engineering and project engineering teams as well as themanufacturing department.

 

In fiscal 2003, the Company’s research and developmentexpenses, together with engineering expenses not applied to the manufacturingcosts of products, were approximately $4.9 million, compared to $4.5 millionand $5.4 million in 2002 and 2001, respectively.

 

**Manufacturing**

 

The Company maintains three domestic manufacturingfacilities, two located in Walla Walla, Washington  and one in Redmond, Oregon, and a European manufacturing facilitylocated in The Netherlands.  TheCompany’s current manufacturing facilities and its product design andmanufacturing processes integrate Computer Aided Engineering (CAE), FiniteElement Analysis (FEA), Computer Aided Design (CAD), Computer AidedManufacturing (CAM) and Computer Integrated Manufacturing (CIM) technologies.  Manufacturing activities include processengineering; fabrication, welding, finishing, and assembly of custom designed stainless steel systems; camera andelectronics assembly; subsystem assembly; and system test and integration.  The Company manufactures specific productsin the following locations:

 

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| **Location**               |   | **Size in Square Feet** |   | **Products/Services Produced**                            |   |
|----------------------------|--------|-------------------------|--------|-----------------------------------------------------------|--------|
|                       |   |                    |   |                                                      |   |
| Walla Walla, Washington    |   | 150,000                 |   | Automated  Inspection  Process Systems  Parts and Service |   |
| Walla Walla, Washington    |   | 100,000                 |   | Process Systems                                           |   |
| 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 toUnderwriters Laboratories, United States Department of Agriculture andOccupational Safety and Health Administration standards.  The Company’s domestic operations in itsWalla Walla facilities originally became qualified in January 1995 forcertification to the ISO-9001 quality management and assurance standards.   During fiscal 2002, the Company embarkedupon recertification under the new ISO-9001:2000 standards, with onsite auditsat each facility in the United States, including the Redmond and Medfordfacilities, taking place early in fiscal 2003. Certain of the Company’s products also comply with the CanadianStandards Association (CSA), European CE (Conformité Européene) and ElectronicTesting Laboratory (ETL) safety standards.

 

Certain components and subassemblies included in theCompany’s products are obtained from single-source or sole-sourcesuppliers.  The Company attempts toensure that adequate supplies are available to maintain manufacturingschedules.  Although the Company seeksto reduce its dependence on sole and limited source suppliers, the partial orcomplete loss of certain sources of supply could have an adverse effect on theCompany’s results of operations and relations with customers.

 

**Environmental**

 

The Company has not received notice of any materialviolations of environmental laws or regulations in on-going operations.

 

**Salesand Marketing**

 

The Company markets its products directly and throughindependent sales representatives.  InNorth America, the Company operates sales offices in Walla Walla, Washington;Medford, Oregon; and Redmond, Oregon. The Company’s subsidiary, Key Technology B.V., provides sales andservice to European customers.  TheCompany’s subsidiary, Key Technology Australia Pty. Ltd., provides sales andservice to customers primarily in Australia and New Zealand.  The Company supplies products from bothproduct groups - automated inspection systems and process systems - tocustomers in its primary markets through common sales and distributionchannels.  In addition, the Companysupplies parts and service through its worldwide service organization.

 

Most exports of products manufactured in the UnitedStates for shipment into international markets other than Europe and Australiahave been denominated in U.S. dollars. Sales into Europe of systems, spare parts and service, as well asproducts manufactured in Europe, are generally denominated in European currencies,most commonly Euros.  Sales into Australiaare typically denominated in its local currency.  In its export and

 

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international sales, the Company is subject to the risks of conductingbusiness internationally, including unexpected changes in regulatoryrequirements; fluctuations in the value of the U.S. dollar, which couldincrease or decrease the sales prices in local currencies of the Company’sproducts in international markets; tariffs and other barriers and restrictions;and the burdens of complying with a variety of international laws.  Additional information regarding export andinternational sales is set forth in Note 14 to the Company’s ConsolidatedFinancial Statements for the year ended September 30, 2003.

 

During fiscal 2003, 2002 and 2001, sales to McCainFoods represented approximately 7%, 16% and 17% of total net sales,respectively.  While the Companybelieves that its relationship with McCain is satisfactory, the loss of thiscustomer could have a material adverse effect on the Company’s revenues andresults of operations

 

**Backlog**

 

The Company’s backlog as of September 30, 2003 andSeptember 30, 2002 was approximately $20.1 million and $15.1 million,respectively.  Gross orders exceededshipments of Company products by $5.0 million in fiscal 2003.  The Company schedules production based onfirm customer commitments and forecasted requirements.  The Company includes in backlog only thosecustomer orders for which it has accepted purchase orders.

 

**Competition**

 

The markets for automated inspection systems andprocess systems are highly competitive. Important competitive factors include price, performance, reliability,and customer support and service.  TheCompany believes that it currently competes effectively with respect to thesefactors, although there can be no assurance that existing or future competitorswill not introduce comparable or superior products at lower prices.  Certain of the Company’s competitors mayhave substantially greater financial, technical, marketing and otherresources.  The Company’s principalcompetitors are believed to be FMC Technologies, Inc., Heat & Control,Sortex Ltd., Kiremko B.V., and BEST N.V. During fiscal 2003, BEST N.V. acquired the Pulsarr B.V. and Elbicon N.V.subsidiaries of Barco N.V.  Duringfiscal 2003, the Company encountered additional small competitors entering itsmarkets, including the introduction of potentially competing tobacco sortersinto the Chinese market manufactured by Chinese companies.  As the Company enters new markets, itexpects to encounter new niche competitors.

 

**Patentsand Trademarks**

 

The Company currently holds fifty-four United Statespatents issued from 1988 through 2003, seventeen other national patents issuedby other countries, and one issued regional patent.  The first of these patents expires in calendar 2005.  As of December 3, 2003, sixteen othernational patent applications have been filed and are pending in the UnitedStates and other countries and three regional applications are pending andthree international applications have been filed that are awaiting the nationalphase.  The Company has thirty-threeregistered trademarks and two pending applications for trademarks.

 

The Company also attempts toprotect its trade secrets and other proprietary information through proprietaryinformation agreements and security measures with employees, consultants andothers.  The laws of certain countriesin which the Company’s products are or may be manufactured or sold may notprotect the Company’s products and intellectual property rights to the sameextent as the laws of the United States. The Company is currently evaluating the protections available to itsintellectual property in China, which has been a significant source of ordersfor its tobacco sorters and has seen the recent introduction of potentially

 

9

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competing sorters.  The Company is currently attempting to invalidate three Chinesepatents that have been issued which the Company believes are derivative of  its designs.

 

**Employees**

 

At September 30, 2003, the Company had 483 full-timeemployees, including 216 in manufacturing, 93 in engineering, research anddevelopment, 121 in marketing, sales and service, and 53 in generaladministration and finance.  A total of101 employees are located outside the United States.  The Company utilizes temporary contract employees, which improvesthe Company’s ability to adjust manpower in response to changing demand forCompany products.  Of the totalemployees at September 30, 2003, 4 were contract employees.  None of the Company’s employees in theUnited States are represented by a labor union.  The manufacturing employees located at the Company’s facility inBeusichem, The Netherlands are represented by the Small Metal Union.  The Company has never experienced a workstoppage, slowdown or strike.

 

**AvailableInformation**

 

The Company’s filings with the Securities and ExchangeCommission (SEC) are made available free of charge through the InvestorRelations section of the Company’s Internet website at www.key.net as soon asreasonably practicable after the Company electronically files such materialwith the SEC.

 

10

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**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 |   | 150,000          |   | Leased with option to purchase within the lease term |   | 2015               |   | none                |   |
| Walla Walla,  Washington    |   | Manufacturing, research and development, sales and  marketing                                   |   | 100,000          |   | Leased with option to purchase                       |   | 2005               |   | 2010                |   |
| Medford, Oregon             |   | Research and development, sales and marketing (1)                                               |   | 16,000           |   | Leased                                               |   | 2007               |   | none                |   |
| Medford, Oregon             |   | Vacant Lot (2)                                                                                  |   | 50,000           |   | Owned                                                |   | N/A                |   | N/A                 |   |
| Redmond, Oregon             |   | Manufacturing, research and development, sales,  administration                                 |   | 19,000           |   | Leased                                               |   | 2007               |   | 2008                |   |
| 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                 |   |

 

----

| (1)                                                              |   | In fiscal 2001, the manufacturing activities  previously performed in Medford were moved to the Company’s facility in Walla  Walla. The Company sold its partially-vacant Medford facility in April 2002  and leased back a small portion of the building. |
|------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)                                                              |   | The Company originally acquired 150,000 square feet  of vacant land in conjunction with the acquisition of AMVC.  Subsequently, the Company has sold 100,000  square feet to various third parties and the remaining parcel is held for  sale.             |
|                                                             |   |                                                                                                                                                                                                                                                            |
| The Company also has leased office space in Dingley,  Australia. |

 

**ITEM 3.****                 LEGALPROCEEDINGS.**

 

From time-to-time, the Company is named as a defendantin legal proceedings arising out of the normal course of its business.  As of December 3, 2003, the Company was nota party to any material legal proceedings.

 

**ITEM 4.****                 SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None.

 

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**PART II**

 

**ITEM 5.****                 MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

 

*Common Stock*

 

Shares of the Company’s common stock are quoted on theNasdaq National Market System under the symbol “KTEC”.  The following table shows the high and lowbid prices per share of the Company’s common stock by quarter for the two mostrecent fiscal years ended September 30, 2003:

 
|        |   | **High** |   | **Low** |   |
|-------------|--------|----------|--------|---------|--------|
| Fiscal 2003 |   |     |   |    |   |
| 1st Quarter |   | $        | 6.000  |    | $      | 4.900 |   |
| 2nd Quarter |   | 6.000    |   | 5.160   |   |
| 3rd Quarter |   | 12.300   |   | 5.700   |   |
| 4th Quarter |   | 13.500   |   | 9.770   |   |
|        |   |     |   |    |   |
| Fiscal 2002 |   |     |   |    |   |
| 1st Quarter |   | $        | 3.360  |    | $      | 2.150 |   |
| 2nd Quarter |   | 3.800    |   | 2.350   |   |
| 3rd Quarter |   | 5.000    |   | 2.996   |   |
| 4th Quarter |   | 6.139    |   | 4.600   |   |

 

The source of these quotations for the Company’scommon stock was the Nasdaq OnlineSM Internet site.

 

The Company had approximately 2075 beneficial ownersof its common stock, of which 175 are of record, as of December 3, 2003.

 

The Company has not historically paid dividends on itscommon or preferred stock.  The Board ofDirectors does not anticipate payment of any dividends in the foreseeablefuture and intends to continue its present policy of retaining earnings forreinvestment in the operations of the Company. The current credit facility with the Company’s principal domestic bankrestricts the payment of dividends.

 

*Series B Convertible Preferred Stock*

 

Shares of the Company’s Series B convertible preferredstock were issued in the acquisition of AMVC on July 12, 2000.  The Series B Convertible Preferred stock wastraded on the Nasdaq SmallCap Market under the symbol “KTECP” until December 2,2002.  At that date, the Companyvoluntarily delisted the Series B preferred because a majority of the shareshad been redeemed for cash.  The SeriesB preferred shares are now traded on the over-the-counter market known as the“pink sheets” under the symbol “KTECP.PK.”

 

The Company had approximately 831 beneficial owners ofits Series B convertible preferred stock, of which 64 are of record, as ofDecember 3, 2003.

 

Each whole share of Key Technology Series Bconvertible preferred stock is:

 

•             convertibleat the election of the holder at any time for 2/3 of a share of Key Technologycommon stock; or

 

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•             redeemableat the election of the holder for $10.00 in cash; or

•             to beredeemed by the Company on July 12, 2005, or may be redeemed earlier by theCompany if the average closing price of Key Technology common stock exceeds$15.00 per share for 30 consecutive trading days, for $10.00 in cash plusdeclared and unpaid dividends, if any.

 

Upon closing the AMVC acquisition on July 12, 2000,the FMC Technologies, Inc. (FMC) option to purchase shares of AMVC common stockwas converted into an option to purchase 210,000 shares of Key TechnologySeries B convertible preferred stock and warrants to purchase 52,500 shares ofKey Technology common stock for $2,520,000. This option expired on October 14,2003.

 

The Series B convertible preferred stock is notentitled to dividends.  If a dividend isdeclared payable on the outstanding common stock, the holders of Series Bconvertible preferred stock are entitled to the dividend that would be payableon the common stock into which the Series B may be converted.

 

## ***Warrants***

 

Warrants were issued in the merger with AMVC on July12, 2000.  The warrants were traded onthe Nasdaq SmallCap Market under the symbol “KTECW” until December 2,2002.  At that date, the Company voluntarilydelisted the warranted because a majority of the warrants had been redeemed forcash.  The warrants are now traded onthe over-the-counter market known as the “pink sheets” under the symbol“KTECW.PK.”

 

Each whole warrant:

•             entitlesthe holder to purchase a share of Key Technology common stock for $15.00; or

•             isredeemable at the election of the holder for $10.00 in cash.

 

The warrants do not accrue any dividends or interestuntil exercised and then only to the extent inuring to the benefit of the commonshares for which they are exercised.

 

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**ITEM 6.****                 SELECTEDFINANCIAL DATA.**

 

The selected consolidated financial information setforth below for each of the five years in the period ended September 30, 2003has been derived from the audited consolidated financial statements of theCompany.  The information below shouldbe read in conjunction with Management’s Discussion and Analysis of FinancialCondition and Results of Operations and the Company’s Consolidated FinancialStatements and Notes thereto as provided in Item 7 and Item 8 of this AnnualReport on Form 10-K, respectively.

 
|                                                                           |   | **Fiscal  Year Ended September 30,**       |       |
|--------------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                           |   | **2003**                                   |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                           |   | **(in  thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                              |   |                                       |       |   |   |   |   |   |   |   |   |
| Net sales                                                                      |   | $                                          | 82,622     |   | $ | 70,234 |   | $ | 72,954 |   | $ | 67,412 |   | $ | 69,531 |   |
| Cost of sales                                                                  |   | 48,626                                     |       | 42,352 |   | 47,186 |   | 42,412 |   | 43,838 |   |
| Gross profit                                                                   |   | 33,996                                     |       | 27,882 |   | 25,768 |   | 25,000 |   | 25,693 |   |
| Operating  expenses                                                            |   | 25,221                                     |       | 23,486 |   | 28,190 |   | 25,302 |   | 21,022 |   |
| Gain (loss) on  sale of assets                                                 |   | 4                                          |       | 883 |   | 76 |   | (20 | ) | (3 | ) |
| Income (loss)  from operations                                                 |   | 8,779                                      |       | 5,279 |   | (2,346 | ) | (322 | ) | 4,668 |   |
| Other income  (expense)                                                        |   | (327                                       | )          | (1,733 | ) | (1,340 | ) | 200 |   | 493 |   |
| Earnings (loss)  from continuing operations before income taxes                |   | 8,452                                      |       | 3,546 |   | (3,686 | ) | (122 | ) | 5,161 |   |
| Income tax  (benefit) expense                                                  |   | 2,693                                      |       | 1,238 |   | (1,343 | ) | (168 | ) | 1,632 |   |
| Net earnings  (loss) from continuing operations                                |   | $                                          | 5,759      |   | $ | 2,308 |   | $ | (2,343 | ) | $ | 46 |   | $ | 3,529 |   |
| Earnings (loss)  on discontinued operation (net of tax)                        |   | —                                     |       | 39 |   | (2,581 | ) | (379 | ) | — |   |
| Change in  accounting principle (net of tax)                                   |   | —                                     |       | (4,302 | ) | — |   | — |   | — |   |
| Net earnings  (loss)                                                           |   | 5,759                                      |       | (1,955 | ) | (4,924 | ) | (333 | ) | 3,529 |   |
| Accretion of  mandatorily redeemable preferred stock                           |   | —                                     |       | (582 | ) | (939 | ) | (235 | ) | — |   |
| Net earnings  (loss) available to common shareholders                          |   | $                                          | 5,759      |   | $ | (2,537 | ) | $ | (5,863 | ) | $ | (568 | ) | $ | 3,529 |   |
| Net earnings  (loss) from continuing operations per share – basic         |   | $                                          | 1.21       |   | $ | 0.36 |   | $ | (0.69 | ) | $ | (0.04 | ) | $ | 0.75 |   |
| – diluted                                                                 |   | $                                          | 1.15       |   | $ | 0.36 |   | $ | (0.69 | ) | $ | (0.04 | ) | $ | 0.75 |   |
| Net earnings  (loss) from discontinued operation per share - basic and diluted |   | $                                          | —     |   | $ | 0.01 |   | $ | (0.55 | ) | $ | (0.08 | ) | $ | — |   |
| Change in  accounting principle per share – basic and diluted             |   | $                                          | —     |   | $ | (0.90 | ) | $ | — |   | $ | — |   | $ | — |   |
| Earnings (loss)  per share – basic                                        |   | $                                          | 1.21       |   | $ | (0.53 | ) | $ | (1.24 | ) | $ | (0.12 | ) | $ | 0.75 |   |
| – diluted                                                                 |   | $                                          | 1.15       |   | $ | (0.53 | ) | $ | (1.24 | ) | $ | (0.12 | ) | $ | 0.75 |   |
| Cash dividends  per share                                                      |   | $                                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Shares used in  per share calculation – basic                             |   | 4,774                                      |       | 4,759 |   | 4,740 |   | 4,723 |   | 4,707 |   |
| – diluted                                                                 |   | 4,989                                      |       | 4,759 |   | 4,740 |   | 4,723 |   | 4,711 |   |

 

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|                                                  |   | **September  30,**  |       |
|-------------------------------------------------------|--------|---------------------|------------|
|                                                  |   | **2003**            |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                  |   | **(in  thousands)** | ** ** |
| **Balance Sheet Data:**                               |   |                |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents and short-term investments |   | $                   | 6,442      |   | $ | 1,707 |   | $ | 738 |   | $ | 6,535 |   | $ | 6,403 |   |
| Working capital                                       |   | 17,226              |       | 7,673 |   | 10,722 |   | 25,202 |   | 22,973 |   |
| Property, plant  and equipment, net                   |   | 5,503               |       | 6,407 |   | 11,436 |   | 13,784 |   | 8,582 |   |
| Total assets                                          |   | 51,215              |       | 49,820 |   | 74,841 |   | 85,417 |   | 44,420 |   |
| Current portion  of long-term debt                    |   | 1,066               |       | 1,668 |   | 11,739 |   | 3,447 |   | 304 |   |
| Long-term debt,  less current portion                 |   | 3,249               |       | 3,747 |   | 6,581 |   | 19,483 |   | 722 |   |
| Mandatorily  redeemable preferred stock and warrants  |   | 1,882               |       | 3,467 |   | 13,531 |   | 17,105 |   | 0 |   |
| Shareholders’  equity                            |   | 30,219              |       | 23,602 |   | 25,711 |   | 31,465 |   | 32,657 |   |
|                                                       |        |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **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-opticalinspection, sorting and process systems.

 

The Company consists of Key Technology, Inc. whichdirectly owns four subsidiaries:  KeyTechnology FSC, Inc., a foreign sales corporation (FSC); Key Holdings USA LLC;Key Technology Australia Pty. Ltd.; and Key Technology AMVC LLC(inactive).  Key Holdings USA LLC ownsSuplusco Holdings B.V., its European subsidiary, which owns Key TechnologyB.V.  Key Technology AMVC LLC ownsApplied Laser System, Inc. (inactive). The Company manufactures products in Walla Walla, Washington; Redmond,Oregon; and Beusichem, The Netherlands.

 

The Company acquired Farmco and AMVC on June 1, 2000and July 12, 2000, respectively.  The operationsof the acquired entities have been integrated into the operations of theCompany and are included in the consolidated financial statements from theirrespective acquisition dates.

 

**Application of Critical AccountingPolicies**

 

The Company has identified its critical accountingpolicies, the application of which may materially affect the financialstatements, either because of the significance of the financial statement itemto which they relate, or because they require management judgment to make estimatesand assumptions in measuring, at a specific point in time, events which will besettled in the future.  The criticalaccounting policies, judgments and estimates, which management believes havethe most significant effect on the financial statements are set forth below:

•             Revenuerecognition

•             Allowancesfor doubtful accounts

•             Valuationof inventories

•             Long-livedassets and Statement of Financial Accounting Standards (“SFAS) No. 142

•             Allowancesfor warranties

 

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•             Accountingfor income taxes

 

Management has discussed the development, selectionand related disclosures of these critical accounting estimates with the auditcommittee of the Company’s board of directors.

 

*RevenueRecognition*.   The Companyrecognizes revenue when persuasive evidence of an arrangement exists, deliveryhas occurred or services have been provided, the sale price is fixed ordeterminable, and collectibility is reasonably assured.  Additionally, the Company sells its goods onterms which transfer title and risk of loss at a specified location, typicallyshipping point, port of loading or port of discharge, depending on the finaldestination of the goods.  Accordingly,revenue recognition from product sales occurs when all factors are met,including transfer of title and risk of loss, which occurs either upon shipmentby the Company or upon receipt by customers at the location specified in theterms of sale.  Revenue earned fromservices is recognized ratably over the contractual period or as the servicesare performed.  If all conditions ofrevenue recognition are not met, the Company defers revenue recognition.  In the event of revenue deferral, the salevalue is not recorded as revenue to the Company, accounts receivable arereduced by any amounts owed by the customer, and the cost of the goods orservices deferred is carried in inventory. The Company believes that revenue recognition is a “critical accountingestimate” because the Company’s terms of sale vary significantly, andmanagement exercises judgment in determining whether to defer revenuerecognition.  Such judgments maymaterially affect net sales for any period. Management exercises judgment within the parameters of accountingprinciples generally accepted in the United States of America (GAAP) indetermining when contractual obligations are met, title and risk of loss aretransferred, the sales price is fixed or determinable and collectibility isreasonably assured.   At September 30,2003, the Company had deferred $1.1 million of revenue compared to $1.5 millionfor the year ended September 30, 2002.

 

*Allowancesfor doubtful accounts.* The Company establishes allowances for doubtful accounts forspecifically identified, as well as anticipated, doubtful accounts based oncredit profiles of customers, current economic trends, contractual terms andconditions, and customers’ historical payment patterns.  Factors that affect collectibility ofreceivables include customer satisfaction and general economic or political factorsin certain countries that affect the ability of customers to meet currentobligations.  The Company activelymanages its credit risk by utilizing an independent credit rating and reportingservice, by requiring certain percentages of down payment and progress paymentson significant customer projects and by requiring secured forms of payment forcustomers with uncertain credit profiles or located in certain countries.  Forms of secured payment could include irrevocableletters of credit, bank guarantees, third-party leasing arrangements or EX-IMBank guarantees, each utilizing Uniform Commercial Code filings, or the like,with governmental entities where possible. The Company believes that the accounting estimate related to allowancesfor doubtful accounts is a “critical accounting estimate” because it requiresmanagement judgment in making assumptions relative to customer or generaleconomic factors that are outside the Company’s control.  As of September 30, 2003 the balance sheetincluded allowances for doubtful accounts of $542,000.  Actual charges to the allowance for doubtfulaccounts for fiscal 2003 and 2002 were $23,000 and $75,000, respectively.  Accruals for bad debt expense (increases inthe allowance) for fiscal 2003 and 2002 were $162,000 and $39,000,respectively.  If the Companyexperiences actual bad debt expense in excess of estimates, or if estimates areadversely adjusted in future periods, the carrying value of accounts receivablewould decrease and charges for bad debts would increase, resulting in decreasednet earnings.

 

*Valuationof inventories*. Inventories are stated at the lower of cost or market. The Company’sinventory includes purchased raw materials, manufactured components, purchasedcomponents, work in process, finished goods and demonstration equipment.  Provisions for excess and obsoleteinventories are made after periodic evaluation of historical sales, currenteconomic trends, forecasted sales, estimated product lifecycles and estimatedinventory levels.  The factors thatcontribute to inventory valuation risks are the Company’s

 

16

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purchasing practices, electronic component obsolescence, accuracy ofsales and production forecasts, introduction of new products, product lifecyclesand the associated product support.  TheCompany actively manages its exposure to inventory valuation risks bymaintaining low safety stocks and minimum purchase lots, utilizing just in timepurchasing practices, managing product end-of-life issues brought on by agingcomponents or new product introductions, and by utilizing such inventoryminimization strategies as vendor-managed inventories.  The Company believes that the accountingestimate related to valuation of inventories is a “critical accountingestimate” because it is susceptible to changes from period to period due to therequirement for management to make estimates relative to each of the underlyingfactors ranging from purchasing to sales to production to after-sale support.  At September 30, 2003, cumulative inventoryadjustments to lower of cost or market totaled $2.5 million compared to $2.3million for the year ended September 30, 2002. If actual demand, market conditions or product lifecycles are adverselydifferent from those estimated by management, inventory adjustments to lowermarket values would result in a reduction to the carrying value of inventory,an increase in inventory write-offs, a decrease to gross margins and mayadversely affect the borrowing base available under the Company’s creditfacilities.

 

*Long-livedassets and SFAS No. 142.* The Company regularly reviews all of its long-lived assets, includingproperty, plant and equipment, goodwill and other intangible assets, forimpairment whenever events or changes in circumstances indicate that thecarrying value may not be recoverable. If the total of future undiscounted cash flows is less than the carryingamount of assets, an impairment loss, if any, based on the excess of thecarrying amount over the fair value of the assets, is recorded.  As of September 30, 2003, the Company held$16.7 million of property, plant and equipment, goodwill and other intangibleassets, net of depreciation and amortization. Estimates of future cash flows arising from the utilization of theselong-lived assets and estimated useful lives associated with the assets arecritical to the assessment of fair values. The Company believes that the accounting estimate related to long-livedassets is a “critical accounting estimate” because:  (1) it is susceptible to change from period to period due to therequirement for management to make assumptions about future sales and cost ofsales generated throughout the lives of several product lines over extendedperiods of time; and (2) the potential effect that recognizing an impairmentcould have on the assets reported on the Company’s balance sheet and thepotential material adverse effect on reported earnings or loss.  Changes in these estimates could result in adetermination of asset impairment, which would result in a reduction to thecarrying value, a charge to income from continuing operations and a reductionto net earnings in the affected period, and may affect the Company’s ability tomeet the tangible net worth covenant of its credit facilities.

 

The Company elected to adopt SFAS No. 142 priorto its filing of its first quarter financial statements on Form 10-Q forthe quarter ending December 31, 2001. SFAS No. 142 requires, among other things, the discontinuance ofgoodwill amortization.  In addition, thestandard includes provisions for the reclassification of certain existingrecognized intangibles, reclassification of certain intangibles out ofpreviously reported goodwill, and the identification of reporting units forpurposes of assessing potential future impairments of goodwill.  As a result of the implementation of thischange in accounting principle, the Company recorded an impairment chargeassociated with goodwill for the automated inspection systems reporting unit,effective at the beginning of fiscal 2002, of $4.4 million, and related incometax benefits of $71,000.  The Companydetermined there was no impairment to the $2.5 million of goodwill associatedwith the process systems reporting unit. The impairment of goodwill was reported as a change in accountingprinciple, which is reported separately from the results of continuingoperations, and included separate earnings per share disclosures.  Any impairment of intangible assetssubsequent to the adoption of SFAS No. 142 would be reported as a charge toincome from continuing operations and a reduction in net earnings in theaffected period.  The Company recordedno impairment charge in fiscal 2003.

 

17

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*Allowancesfor warranties.*  TheCompany’s products are covered by warranty plans that extend between 90 daysand 2 years, depending upon the product and contractual terms of sale.  The Company establishes allowances forwarranties for specifically identified, as well as anticipated, warranty claimsbased on contractual terms, product conditions and actual warranty experienceby product line.  Company productsinclude both manufactured and purchased components, and therefore warrantyplans include third-party sourced parts which may not be covered by thethird-party manufacturer’s warranty. Ultimately, the warranty experience of the Company is directlyattributable to the quality of its products. The Company actively manages its quality program by using a structuredproduct introduction plan, process monitoring techniques utilizing statisticalprocess controls, vendor quality metrics, a quality training curriculum forevery employee and feedback loops to communicate warranty claims to designersand engineers for remediation in future production.  Warranty expense has varied widely in the past due to suchfactors as significant new product introductions containing defects and designerrors on individual projects. The Company believes that the accountingestimate related to allowances for warranties is a “critical accountingestimate” because:  (1) it issusceptible to significant fluctuation period to period due to the requirementfor management to make assumptions about future warranty claims relative topotential unknown issues arising in both existing and new products, whichassumptions are derived from historical trends of known or resolved issues; and(2) risks associated with third-party supplied components being manufacturedusing processes that the Company does not control.  As of September 30, 2003, the balance sheet included warrantyreserves of $837,000, while $1.7 million of warranty charges were incurredduring the fiscal year then ended, compared to warranty reserves of $869,000and warranty charges of $2.4 million for the year ended September 30,2002.  If the Company’s actual warrantycosts are higher than estimates, warranty plan coverages are adversely varied,or estimates are adversely adjusted in future periods, reserves for warrantywould decrease, warranty expense would increase and gross margins woulddecrease.

 

*Accountingfor income taxes.*  TheCompany’s provision for income taxes and the determination of the resultingdeferred tax assets and liabilities involves a significant amount of managementjudgment.  The quarterly provision forincome taxes is based partially upon estimates of pre-tax financial accountingincome for the full year and is affected by various differences betweenfinancial accounting income and taxable income.  Judgment is also applied in determining whether the deferred taxassets will be realized in full or in part. In management’s judgment, when it is more likely than not that all orsome portion of specific deferred tax assets such as foreign tax credit carryoverswill not be realized, a valuation allowance must be established for the amountof the deferred tax assets that are determined not to be realizable.  There was no valuation allowance atSeptember 30, 2003, due to anticipated utilization of all tax deferred taxassets.  During the period, income taxexpense was reduced by approximately $150,000 due primarily to changes in taxlaws which re-characterized previously non-deductible items.  The Company believes that the accountingestimate related to income taxes is a “critical accounting estimate” because itrelies on significant management judgment in making assumptions relative totemporary and permanent timing differences of tax effects, estimates of futureearnings, prospective application of changing tax laws in multiplejurisdictions, and the resulting ability to utilize tax assets at those futuredates.  If the Company’s operatingresults were to fall short of expectations, thereby affecting the likelihood ofrealizing the deferred tax assets, judgment would have to be applied todetermine the amount of the valuation allowance required to be included in thefinancial statements established in any given period.  Establishing or increasing a valuation allowance would reduce thecarrying value of the deferred tax asset, increase tax expense and reduce netearnings.

 

Currently, Congress is deliberating legislative actionto replace the current Extra Territorial Income Exclusion Act of 2000 (“ETI”),due to rulings by the World Trade Organization that it was an illegal exportsubsidy.  Potential legislation couldadversely affect the Company by eliminating or reducing the ETI exclusions,thereby increasing its effective tax rate or changing corporate tax rates whichcould require revaluation of the Company’s deferred tax benefits.  Tax benefits to the Company as part of thislegislation

 

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could potentially offset some, if not all, of these adverseconsequences, although not necessarily in the same fiscal year.

 

**Results ofOperations**

 

***Fiscal Year 2003 compared toFiscal Year 2002***

 

Net sales increased 18% to $82.6 million in fiscal2003, up $12.4 million from $70.2 million in fiscal 2002.  Sales growth occurred over all three of theCompany’s major product lines.  TheCompany handled two large projects totaling $9.0 million in fiscal 2003 thatadded to both automated inspection system and process system sales.  Automated inspection systems sales were 21%higher than in the previous year with increases in the Tegra, Optyx, andtobacco sorter product lines.  Processsystems sales grew by 23% in year-over-year comparison helped by vibratoryproduct line growth as well as strong growth in the Company’s Netherlandssubsidiary.  Parts sales grew by 17%over fiscal 2002 partly due to price increases but also due to orders fortobacco sorter upgrades and a greater emphasis on after-sale customer support.

 

Gross profit increased $6.1 million to $34.0 million,or 41% of net sales, in fiscal 2003 from $27.9 million, or 40% of net sales, in2002.  The gross profit, as a percentageof net sales in fiscal 2003 as compared to fiscal 2002, improved due to thegrowth in higher margin parts sales, favorable manufacturing efficiencies dueto volume, and cost reductions primarily in warranty expenses.  Warranty expenses in fiscal 2002 includednon-recurring costs related to two large European projects and to the launch ofthe Optyx product line.  Additionally,the Company’s Netherlands subsidiary showed significant improvements in manufacturingefficiencies and cost reductions.

 

Operating expenses increased $1.7 million to $25.2million in fiscal 2003 from $23.5 million in fiscal 2002, and represented 31%,and 33% of net sales in each year, respectively. While operating expensedollars rose, operating expenses as a percent of net sales dropped by 2%reflecting the Company’s continued emphasis on cost controls.

 

Selling expenses increased by 9% to $11.7 million infiscal 2003 from $10.7 million in fiscal 2002, and represented 14% and 15% ofnet sales in each year, respectively. In addition to expenses incurred to support the higher sales volume, theyear included more trade shows, and the creation of a new marketing department.The increase reflects the Company’s strategy of diversification of product andmarkets.

 

Research and development expenses increased by $0.4million to $4.9 million in fiscal 2003 from $4.5 million in fiscal 2002, andrepresented 6% of net sales in each year, respectively.  Given the maturity of the Company’s productlines, most of the fiscal 2003 research and development expenses were directedto new inspection technologies to optimize process control and other strategicinitiates.

 

General and administrative expenses increased $0.3million to $7.3 million in fiscal 2003 from $7.0 million in fiscal 2002, andrepresented 9% and 10% of net sales in each year respectively.  The Company continues to see increased costsassociated with Sarbanes-Oxley compliance in the areas of accounting fees,legal fees, and outside consulting services. It is anticipated that fiscal 2004 will see another rise in complianceexpenses and may also include additional costs related to the planned upgradeof the Company’s enterprise resource planning system.

 

Other income and expense includes interest income andexpense, royalty income and other income or expense from miscellaneoussources.  Total other income and expensereflected $0.3 million in expenses for fiscal 2003 compared to $1.7 millionexpenses for fiscal 2002.  Interestexpense in fiscal 2003 dropped $0.4 million due to lower interest bearing debtlevels, and foreign currency transaction gains of $0.2 million were

 

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recognized.  In fiscal 2002, theCompany recognized $0.3 million associated with the withdrawal of a tenderoffer for the redemption of preferred stock, and $0.7 million in losses fromthe early retirement of debt that did not repeat in 2003.

 

The Company’s effectiveincome tax rate was 31.9% in fiscal 2003, compared to 34.9% in fiscal2002.   The effective tax rate variesfrom the statutory rate of 34% due to permanent differences arising fromextra-territorial income exclusions, research and development tax credits, andother permanent differences, plus the inclusion of the effective state incometax rate. In fiscal 2003, the effective rate was also reduced by 1.8% due tochanges in tax laws which re-characterized previously non-deductible expenses.

 

Net earnings from continuing operations for fiscal2003 was $5.8 million, or $1.15 per diluted share, compared to $2.3 million, or$0.36 per diluted share, for fiscal 2002. The Company reported a net loss for fiscal 2002 of $2.0 million, or$0.53 per diluted share, after giving effect to earnings or losses fromdiscontinued operations and a change in accounting principle.

 

***Fiscal Year 2002 compared toFiscal Year 2001***

 

For the fiscal years ended September 30, 2002, and2001, the Company’s net sales were $70.2 million, and $73.0 million,respectively.  Sales of parts andservice/contracts increased by 3%, which was more than offset by decreases insales of automated inspection systems and process systems of 7% and 6%,respectively, in fiscal 2002 compared to fiscal 2001.  Acquired product lines, exclusive of parts and service, contributedapproximately 19% and 17% of the systems sold in fiscal 2002 and 2001,respectively.  The acquisition of AMVCalso helped the Company’s strategy of diversification, as net sales of non-foodsystems, principally to the tobacco industry, rose to represent 10% and 12% ofsystem sales in fiscal 2002 and 2001, respectively.

 

The incremental net sales from acquired product lineswere partially offset by decreased net sales from the Company’s traditionalbusiness, the food processing industry in the United States, during both fiscal2002 and fiscal 2001.  The soft marketsexperienced in fiscal 2001 continued through much of fiscal 2002 as sales tothe food processing industry continued to be unfavorably affected by marketfactors, including the consolidation among food processors and softness in thevegetable industry.

 

Gross profit was 40% and 35% of net sales in fiscal2002 and 2001, respectively.  The grossprofit, as a percentage of net sales in fiscal 2002 as compared to fiscal 2001,benefited from improvements in efficiencies across most product lines,including improvements in utilization of production and service capacity, andcost-cutting measures taken during fiscal 2001 and the first quarter of fiscal2002.  Automated inspection systemsgross profit, as a percent of net sales, increased by seven percentage pointsin fiscal 2002 over fiscal 2001, principally as the result of a 65% decrease inother costs of sale, largely due to improved utilization of manufacturingfacilities, with a lesser contribution coming from decreased warranty costs.  The gross profit for process systems betweenfiscal 2002 and fiscal 2001 was comparable with improvements in manufacturingefficiencies offset by increases in warranty expenses, due principally to twofrench fry projects in Europe.  Partsand service/contracts gross profit, as a percent of net sales, increased byeight percentage points in fiscal 2002 from fiscal 2001, principally as theresult of improved utilization of field service personnel.

 

Operating expenses decreased by 17% to $23.5 millionin fiscal 2002 from $28.2 million in fiscal 2001, and represented 33%, and 39%of net sales in each such year, respectively. During fiscal 2001 and the first quarter of fiscal 2002, the Companyimplemented significant cost reduction programs, which resulted in reducedoperating expenses in all areas for fiscal 2002 when compared to the priorfiscal year.

 

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Selling and marketing expenses decreased by 19% to$10.7 million in fiscal 2002 from $13.2 million in fiscal 2001, and represented15% and 18% of net sales in each such year, respectively.  In fiscal 2002, selling and marketingexpenses decreased principally due to reductions in programs and the associatedmanpower.  At the same time, the Companyinvested in improved sales coverage in the Asia Pacific area with the openingof its new office in Australia.

 

Research and development expenses decreased by 17% to$4.5 million in fiscal 2002 from $5.4 million in fiscal 2001, and represented6% and 7% of net sales in each such year, respectively.  Activities in fiscal 2002 focused onextending the capabilities and applications of the technologies contained inOptyx, Tegra and Prism, and development of new inspection technologies.  The reduced levels of research anddevelopment expenses experienced in fiscal 2002 were the result of the fullintegration of the research and development activities of the acquiredcompanies.

 

General and administrative expenses decreased 7% to$7.0 million in fiscal 2002 from $7.5 million in fiscal 2001, and represented10% of net sales in each such year, respectively.  General and administrative expenses decreased in fiscal 2002compared to fiscal 2001 as a result of elimination of nonrecurring andredundant costs experienced in fiscal 2001 as the Company integrated theacquisitions made in fiscal 2000.  Thesecost savings were partially offset by increased accounting and legal costsincurred during fiscal 2002 with regard to the SFAS No. 142 implementation andwork on alternatives to meet the potential preferred stock redemptionobligation.

 

The 37% decrease in amortization of intangibles,representing 1% of net sales, for fiscal 2002 when compared to fiscal 2001 isthe result of implementation of SFAS No. 142, which eliminated amortization ofgoodwill and certain intangible assets. The Company obtained independent appraisals of the fair market value ofthe AMVC intangible assets acquired. Acquired intangible assets, including patents, existing technologies,trademarks, trade names and purchased customer development, are amortized overthe shorter of their remaining lives or periods of 10 years.

 

Other income and expense includes interest income andexpense, royalty income and other income or expense from miscellaneoussources.  Net interest expense in fiscal2002 was $734,000 compared to $1.5 million in fiscal 2001.  The decrease in net interest expense infiscal 2002 compared to fiscal 2001 resulted from decreases in interest rates,both as a result of reductions in prime rate and reduced rates on refinanceddebt, and decreases in total debt. During fiscal 2002, as part of the Company’sefforts to establish alternatives to meet the potential obligation arising fromthe redemption of preferred stock, the Company embarked upon a tender offer toholders of that stock.  With the successof the refinance of the Company’s credit facilities, which provided funds forredemption, the tender offer was discontinued and $270,000 of associated costswas charged to other expense.  TheCompany also recognized loan amortization costs of $144,000 for fiscal 2002while fiscal 2001 had no such costs. During fiscal 2002, the Company received royalty payments of $9,000compared to total royalty income of $131,000 in fiscal 2001.  During fiscal 2002, the Company recognizedforeign currency transaction gains totaling $80,000 on cash and accountsreceivable held primarily in Euros and Dutch guilders.  This compares to foreign currencytransaction gains of $242,000 in fiscal 2001. During the second quarter of fiscal 2002, the Company restructured itscredit facility with its senior lender and, in the fourth fiscal quarter,refinanced its credit facility with a new senior lender.  Each of these activities resulted in theexpensing of unamortized loan origination fees.  In addition, during the third quarter of fiscal 2002, the Companysold its surplus manufacturing facility in Medford, Oregon, moved its Medfordstaff into a smaller leased portion of that same facility and paid off themortgage secured by that facility.  Theearly payoff of the mortgage resulted in a prepayment penalty and write-off ofassociated unamortized loan costs.  Thetotal charge for these items during fiscal 2002 was $736,000 compared to nosuch charges in fiscal 2001.

 

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On October 31, 2001, the Company completed the sale ofits wholly owned subsidiary, Ventek, Inc, which supplied machine vision systemsto the forest products industry.  Ventekwas acquired as part of the acquisition of AMVC.  As a result of the sale of Ventek, the Company recorded a loss onthe sale of discontinued operations of approximately $2.1 million, net of tax,in fiscal 2001.  The Company alsoreported net earnings from this discontinued operation of $39,000 net of tax infiscal 2002, compared to net losses from the discontinued operation of$436,000, net of tax, for fiscal 2001. See Note 2 to the Company’s Consolidated Financial Statements for a morecomplete description of the sale of Ventek.

 

Net earnings from continuing operations for fiscal2002 was $2.3 million, or $0.36 per diluted share, compared with a net lossfrom continuing operations of $2.3 million, or $0.69 per diluted share, forfiscal 2001.  Net earnings or loss foreach period is adjusted by the accretion of mandatorily redeemable preferredstock in calculating the associated earnings per share.  The increase in net income from continuingoperations in fiscal 2002 was due to the cost-cutting measures employed in latefiscal 2001 and early 2002 to reduce spending and return the Company toprofitability, and improvements in gross margins and operating expenses fromthe non-recurrence of merger-related and integration charges incurred in fiscal2001, which totaled $3.4 million, or $2.1 million after tax.

 

The Company reported a net loss for fiscal 2002 of$2.0 million, or $0.53 per diluted share, after giving effect to earnings froma discontinued operation and the losses due to the change in accountingprinciple.  This compares to a net lossof $4.9 million, or $1.24 per diluted share, in fiscal 2001.  The reported basic and diluted earnings orloss per share for the respective periods are the same, due to theanti-dilutive effect of the common share equivalents.

 

**Liquidityand Capital Resources**

 

*Fiscal Year 2003*

 

During fiscal 2003, net cash provided by operatingactivities totaled $14.5 million.  Cashflow was favorably affected by non-cash expenses reflected in the ConsolidatedStatement of Operations such as depreciation and amortization of $3.7 million,and non-cash tax expense of $2.1 million due to application of deferred incometax benefits and carryovers from previous years.  In addition, cash provided by operating activities was positivelyaffected by a decrease in inventories of $0.8 million, changes in assets  and other liabilities netting $2.3 million,and an increase in customer deposits of $1.3 million. These cash inflows werepartially offset by an increase in accounts receivable of $1.6 million.  Cash generated from these sources providedfunds to reduce the interest-bearing debt, and to redeem preferred stock andwarrants in fiscal 2003. Management continues to focus on cash generationthrough profitable operations but cash flow will be somewhat effected by areduction in the level of the deferred income tax benefits carryover that theCompany received in FY 2003.  Managementdoes expect to maintain emphasis on working capital controls, especially in thearea of inventory turns, to improve the Company’s return on assets employed.

 

Net cash resources used in investing activitiestotaled $0.8 million in fiscal 2003 and represented the Company’s acquisitionof capital equipment.  At September 30,2003, the Company had no material commitments for capital expenditures.

 

Cash flows used in financing activities in fiscal 2003netted to $9.4 million and reflect proceeds from the issuance of long-term debtof $0.5 million, payments for the reduction of short-term borrowings of $6.7million, long-term debt reduction of $1.7 million, and the redemption of preferredstock and warrants of $1.6 million. Proceeds from the issuance of common stock under the Company’s employeestock option and stock purchase plans during fiscal 2003 was $0.1 million.

 

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The Company’s domestic credit facility provides acredit accommodation totaling $13.2 million in the United States consisting ofa term loan of $3.2 million and a revolving credit facility of up to the lesserof $10.0 million or the available borrowing base, which is based on varyingpercentages of eligible accounts receivable and inventories.  The revolving credit facility matures onJuly 31, 2004.  The term loanrequires quarterly payments of principal of $200,000 and matures onJuly 31, 2007.  The term loan andrevolving credit facility bear interest at the Wall Street Journal prime rate,which was 4.00% at September 30, 2003. The credit facility is secured by all of the U.S. personal property,including patents and other intangibles of the Company and its subsidiaries,and contains covenants which require the maintenance of a defined debt serviceratio, a defined debt ratio, minimum working capital and current ratio, andminimum profitability.  AtSeptember 30, 2003, the Company was in compliance with all loan covenantsand had an available borrowing base of approximately $6.9 million under therevolving credit facility.  AtSeptember 30, 2003, borrowings under the term loan were $3.2 million.  There were no borrowings under the revolvingcredit facility.

 

Additionally, the Company’s credit accommodation witha commercial bank in The Netherlands provides a credit facility for itsEuropean subsidiary.  This creditaccommodation totals $3.7 million  andincludes a term loan facility of $814,000, an operating line of the lesser of$1.7 million or the available borrowing base, which is based on varyingpercentages of eligible accounts receivable and inventories, and a bankguarantee facility of $1.2 million.  Theterm loan facility requires quarterly principal payments of $36,000 and maturesin August 2012.  It is secured by realproperty of the Company’s European subsidiary, while the operating line andbank guarantee facility are secured by all of the subsidiary’s personalproperty.  The credit facility bearsinterest at the bank’s prime rate plus 1.75%, which at September 30, 2003was 4.50%.  At September 30, 2003,the Company had borrowings under this facility of approximately $814,000 interm loans.  Additionally, the Companyhad secured bank guarantees of  $882,000under this agreement.

 

The Company made meaningful progress in managingworking capital and reducing its interest bearing debt in 2003.  The Company believes its principal lenderwill renew the Company’s revolving credit line when it matures in July 2004.

 

*PriorYears – Fiscal 2002 and 2001*

 

Cash provided by operating activities in fiscal 2002totaled $11.2 million compared to $2.7 million in fiscal 2001.  Cash provided by operating activities infiscal 2002 was favorably affected by non-cash expenses reflected in theConsolidated Statement of Operations such as depreciation and amortization of$3.8 million, the non-cash charge for the change of accounting principle of$4.3 million and non-cash tax expense of $1.5 million due to application ofdeferred income taxes resulting from the application of net operating loss andtax benefit carryovers from previous years, much of which was acquired with theAMVC acquisition. In addition, cash provided by operating activities wasaffected by a decrease in accounts receivable of $6.0 million, a decrease ininventory of $0.8 million, income tax refunds or other reductions to income taxreceivables of $0.8 million, increases in payroll, commissions and otherliabilities netting $0.1 million and an increase in customer deposits of $1.1million. These cash inflows were partially offset by a decrease in accountspayable of $4.1 million, an increase in prepaid expenses and other currentassets of $0.7 million, and a decrease in income taxes payable of $0.3 million.

 

Cash provided by operating activities in fiscal 2001totaled $2.7 million and was also favorably affected by non-cash expensesreflected in the Consolidated Statement of Operations such as depreciation andamortization of $4.5 million and the non-cash charge for loss on the operationand sale of the discontinued operation of $2.6 million, partially offset by thenon-cash tax benefits which increased deferred income taxes by $1.3million.  These deferred tax benefitswere added to existing carryovers of net operating losses and other taxbenefits, which were available to reduce the cash tax requirement in futurefiscal years.  During fiscal 2001, cashprovided by operating activities was adversely affected by an increase inaccounts

 

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receivable totaling $4.2 million that resulted from slower paymentpatterns of certain European customers and the grant of extended payment termsto certain customers.  Operatingactivities during 2001 provided $5.1 million in cash from a decrease ininventory.  Increases in trade accountspayable, income taxes payable and a decrease in prepaid expenses, partiallyoffset by decreases in accrued payroll liabilities, accrued customer supportand warranty costs, other accrued liabilities and customer deposits providedcash of $1.3 million during fiscal 2001.

 

Net cash resources from investing activities totaled$7.4 million in fiscal 2002, coming principally from the sale of the Company’sVentek subsidiary and its Medford manufacturing facility.  This compares to the sale of propertytotaling $478,000 in fiscal 2001. Acquisitions of capital equipment totaled $532,000 in 2002 and $545,0000in 2001.

 

Financing activities were affected in fiscal 2002 bythe refinance of the Company’s credit facilities, which resulted in $15.1million in new long-term debt, payments on or retirements of long-term debttotaling $23.5 million, redemption of $8.7 million of preferred stock andwarrants and payment of a $516,000 prepayment penalty on the early extinguishmentof debt upon the sale of the Company’s Medford facility.  Financing activities were affected in fiscal2001 by cash generated from short-term borrowings of $2.0 million.  The Company repaid long-term debt duringfiscal 2001 totaling $5.6 million.  Proceedsfrom the issuance of common stock under the Company’s employee stock option andstock purchase plans during fiscal 2002 and 2001 totaled $49,000 and $71,000, respectively.  During fiscal 2001 the Company redeemed forcash warrants totaling $2.1 million. During fiscal 2001, the Company redeemed for cash all of its series Cpreferred stock totaling $2.4 million.

 

The Company’s operating, investing and financingactivities during fiscal 2002 resulted in an increase of cash and cashequivalents totaling $1.0 million, compared to a decrease totaling $5.7 millionin fiscal 2001.  The balance of cash andcash equivalents totaled $1.7 million at the end of fiscal 2002, and $0.7million at the end of fiscal 2001.

 

On October 31, 2001, the Company completed the sale ofVentek, Inc. to Veneer Technology, Inc. The Company received a cash payment of approximately $3.6 million, adeferred payment obligation of approximately $900,000 and the tender forcancellation of Veneer Technology’s holdings of Key Technology Series Bconvertible preferred stock having a stated redemption value of $2.0million.  The cash proceeds from thesale were used to pay down Company debt and increase cash reserves.

 

*Contractual Obligations*

 

In connection with the acquisition of AMVC, the Companyissued Series B Convertible Preferred stock, Series C Convertible Preferredstock and warrants, each of which carries conversion or redemptionprivileges.  A complete description ofthese instruments is contained in the Company’s Registration Statement on FormS-4, Post-Effective Amendment No. 1, filed March 23, 2001.  The Series C Convertible Preferred stock wasfully redeemed during fiscal 2001 for $2.4 million.  A brief description of the securities outstanding at September30, 2003 is as follows:

 

•                  OutstandingSeries B Convertible Preferred stock totaled 152,630 shares.  Each share is convertible at any time at theelection of the holder for 2/3 share of the Company’s Common stock, orredeemable at the election of the holder for $10.00 per share.

•                  Outstandingwarrants totaled 35,553.  Each five-yearwarrant entitles the holder to purchase one share of the Company’s Common stockfor $15.00 or is redeemable at $10.00 per warrant at any time at the electionof the holder.

 

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As of September 30, 2003, if all remaining holderswere to redeem their preferred stock and warrants, the cash requirements wouldbe $1.9 million.  On December 2, 2002,the Company delisted the Series B Convertible Preferred stock and the warrants,which had previously traded on the Nasdaq SmallCap Market under the symbols“KTECP” and “KTECW”, respectively.  Atthat date, the majority of these securities had been redeemed for cash.  The securities were delisted due to thesmall number of outstanding shares and warrants that were available for tradingand the minimal trading volume.

 

The Company’s continuing contractual obligations andcommercial commitments existing on September 30, 2003 are as follows:

 
|                               |   | **Payments  due by period (in Thousands)** |   |
|------------------------------------|--------|--------------------------------------------|--------|
| **Contractual Obligations**        |   | **Total**                                  |   | **Less than 1  year** |   | **1-3 years** |   | **4-5 years** |   | **After 5  years** |   |
|                               |   |                                       |   |   |   |   |   |   |   |   |   |
| Long-term debt  *        |   | $                                          | 4,014  |   | $ | 943 |   | $ | 1,886 |   | $ | 937 |   | $ | 248 |   |
| Capital lease obligations          |   | 301                                        |   | 123 |   | 176 |   | 2 |   | — |   |
| Operating leases                   |   | 12,385                                     |   | 1,429 |   | 2,938 |   | 2,549 |   | 5,469 |   |
| Warrant redemption obligations     |   | 356                                        |   | 356 |   | — |   | — |   | — |   |
| Series B redemption obligations    |   | 1,526                                      |   | 1,526 |   | — |   | — |   | — |   |
| Total contractual cash obligations |   | $                                          | 18,582 |   | $ | 4,377 |   | $ | 5,000 |   | $ | 3,488 |   | $ | 5,717 |   |

 

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

 

At September 30, 2003, theCompany had standby letters of credit totaling $1.4 million, which includessecured letters of credit under the Company’s credit facility in Europe andletters of credit securing certain self-insurance contracts and leasecommitments.

 

The Company has nooff-balance sheet financing arrangements or transactions, arrangements orrelationships with “special purpose entities”.

 

***Future Accounting Changes***

 

In August 2001, the FASB issuedSFAS No. 143, *Accounting for AssetRetirement Obligations*, which is effective October 1,2003.  SFAS No. 143 requires,among other things, the accounting and reporting of legal obligations associatedwith the retirement of long-lived assets that result from the acquisition,construction, development, or normal operation of a long-lived asset.  The Company does not believe this will havea material effect on its financial statements.

 

In November 2002, the Emerging Issues Task Force(“EITF”) ratified a consensus on Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*,which is effective for the Company beginning October 1, 2003.  Issue No. 00-21 addresses accountingand reporting of a company’s delivery or performance of multiple products,services, or rights customers might have to use a company’s held assets tofulfill its needs, with delivery or performance that may occur at differentpoints in time or over different periods of time.  

 

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Management believes Issue No. 00-21 will not have a material effect onthe Company’s consolidated financial statements.

 

In December 2002, the FASB issued SFAS No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure*, which iseffective for fiscal years ending after December 31, 2002.  SFAS No. 148 provides alternativemethods of transition for a voluntary change to the fair value method ofaccounting for stock-based employee compensation.  In addition, this statement amends the disclosure requirements ofSFAS No. 123 to require prominent disclosures about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results.  The Companyhas adopted the disclosure requirements. The Company has elected not to implement any transitional method ofaccounting for stock-based compensation. The Company will defer action until the FASB has issued its finaldefinitive pronouncement on this issue, which is expected sometime in 2004.

 

In November 2002, the FASB issued FinancialInterpretation No. (“FIN”) 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*,on the accounting and disclosure guidance for guarantors.  The standard requires guarantors torecognize at inception the fair value of all its obligations it has undertakento issue a guarantee and requires additional disclosures related to suchobligations.  This statement, as itrelates to the recognition and measurement of the liability, if any, would beeffective in fiscal 2004 and the Company does not believe this will have amaterial effect on its financial statements.

 

**ITEM 7A.****        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

The Company has assessed its exposure to market risksfor its financial instruments and has determined that its exposures to suchrisks are generally limited to those affected by the strength of the U.S.Dollar against the Euro and to a lesser extent the Australian dollar.

 

The terms of sales to European customers are typicallydenominated in either Euros, U.S. Dollars, or to a far lesser extent, therespective legacy currencies of its European customers.  The terms of sales to customers in Australiaare typically denominated in their local currency. The Company expects that itsstandard terms of sale to international customers, other than those in Europeand Australia, will continue to be denominated in U.S. dollars.  For sales transactions between internationalcustomers, including European customers, and the Company’s domestic operationswhich are denominated in currencies other than U.S. dollars, the Companyassesses its currency exchange risk and may enter into a currency hedgingtransaction to minimize such risk.  AtSeptember 30, 2003, the Company was not a party to any currency hedgingtransaction.  As of September 30, 2003,management estimates that a 10% change in foreign exchange rates would affectnet income before taxes by approximately $192,000 on an annual basis as aresult of converted cash and accounts receivable denominated in foreigncurrencies.

 

During the Company’s fiscal 2003, the Euro gained anet of 16% in value against the U.S. dollar. The effect of the weaker dollar on the operations and financial resultsof the Company were:

 
| • |   | Translation adjustments of $746,000, net of income  tax, were recognized as a component of comprehensive income in the Company’s  Consolidated Statement of Shareholders’ Equity as a result of converting the  Euro denominated balance sheet of Key Technology B.V. into U.S. dollars.                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| • |   | Foreign exchange gains of $242,000 were recognized  in the other income and expense section of the consolidated income statement  as a result of conversion of Euro and other foreign currency denominated  receivables and cash carried on the balance sheet of the U.S. operations, as  well as the result of the |

 

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|   |   | conversion of other non-functional currency receivables,  payables and cash carried on the balance sheet of the European  operations.  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|

 

A relatively weaker U.S. dollar on the world marketsmakes the Company’s U.S.-manufactured goods relatively less expensive tointernational customers when denominated in U.S. dollars or potentially moreprofitable to the Company when denominated in a foreign currency.  A relatively weaker U.S. dollar on the worldmarkets, especially as measured against the Euro, may favorably affect theCompany’s market and economic outlook for international sales.

 

Under the Company’s current credit facilities theCompany may borrow at the lender’s prime rate plus between 0 - 175 basispoints.  At September 30, 2003, theCompany had $3.2 million of borrowings which had variable interest rates.During the year then ended, interest on its various credit facilities variedfrom 4.00% to 6.75%.  At September 30,2003, the rate was 4.00% on its domestic credit facility and 4.50% on itsEuropean credit facility.  As ofSeptember 30, 2003, management estimates that a 100 basis point change in theinterest rates would affect net income before taxes by approximately $32,000 onan annual basis.

 

27

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**ITEM8.     FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA.**

 
| **Title**                                                                                                       |   |   |
|-----------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                            |   |   |
| Independent Auditors’  Report                                                                              |   |   |
|                                                                                                            |   |   |
| Consolidated  Balance Sheets at September 30, 2003 and 2002                                                     |   |   |
|                                                                                                            |   |   |
| Consolidated  Statements of Operations for the three years ended    September 30, 2003                |   |   |
|                                                                                                            |   |   |
| Consolidated  Statements of Shareholders’ Equity for the three years ended    September 30, 2003 |   |   |
|                                                                                                            |   |   |
| Consolidated  Statements of Cash Flows for the three years ended    September 30, 2003                |   |   |
|                                                                                                            |   |   |
| Notes to  Consolidated Financial Statements                                                                     |   |   |
|                                                                                                            |   |   |
| Supplementary  Data                                                                                             |   |   |

 

28

----

 

**INDEPENDENT AUDITORS’ REPORT**

 

Board of Directors and ShareholdersKey Technology, Inc.Walla Walla, Washington

 

We have audited the accompanying consolidated balance sheets of KeyTechnology, Inc. and subsidiaries as of September 30, 2003 and 2002, andthe related consolidated statements of operations, shareholders’ equity, andcash flows for each of the three years in the period ended September 30,2003.  The consolidated financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of Key Technology, Inc. andsubsidiaries as of September 30, 2003 and 2002, and the results of theiroperations and their cash flows for each of the three years in the period endedSeptember 30, 2003 in conformity with accounting principles generallyaccepted in the United States of America.

 

As discussed in Note 1 to the consolidated financial statements,the Company adopted Statement of Financial Accounting Standards No. 145, *Rescissionof FASB Statements No. 4, 44, and 64, Amendment of FASB StatementNo. 13, and Technical Corrections*, which resulted in amountsrecorded in fiscal year 2002 as an extraordinary item from the earlyextinguishment of debt to be reclassified as part of net income from continuingoperations.  As discussed in Notes 1 and4 to the consolidated financial statements, effective October 1, 2001, theCompany adopted Statement of Financial Accounting Standards No. 142, *Goodwill and Other Intangible Assets.*

 

 

Portland, OregonDecember 16, 2003

 

29

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**KEY TECHNOLOGY, INC. AND SUBSIDIARIES**

** **

**CONSOLIDATEDBALANCE SHEETS**

**SEPTEMBER 30, 2003 AND 2002**

(In thousands)

 
|                                |   | **2003** |       | **2002** |       |
|-------------------------------------|--------|----------|------------|----------|------------|
| **ASSETS**                          |   |     | ** ** |     | ** ** |
|                                |   |     | ** ** |     | ** ** |
| CURRENT ASSETS:                     |   |     |       |     |       |
| Cash and cash equivalents           |   | $        | 6,442      |     | $          | 1,707 |   |
| Trade accounts receivable, net      |   | 9,479    |       | 7,556    |       |
| Inventories                         |   | 13,968   |       | 13,969   |       |
| Deferred income taxes               |   | 1,935    |       | 1,730    |       |
| Prepaid expenses and other assets   |   | 1,062    |       | 1,477    |       |
|                                |   |     |       |     |       |
| Total current assets                |   | 32,886   |       | 26,439   |       |
|                                |   |     |       |     |       |
| PROPERTY, PLANT, AND EQUIPMENT, Net |   | 5,503    |       | 6,407    |       |
|                                |   |     |       |     |       |
| DEFERRED INCOME TAXES               |   | 768      |       | 3,472    |       |
|                                |   |     |       |     |       |
| OTHER ASSETS                        |   | 819      |       | 940      |       |
|                                |   |     |       |     |       |
| GOODWILL AND OTHER INTANGIBLES, Net |   | 11,239   |       | 12,562   |       |
|                                |   |     |       |     |       |
| TOTAL                               |   | $        | 51,215     |     | $          | 49,820 |   |

(Continued)

See notes to consolidatedfinancial statements.

 

30

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**KEY TECHNOLOGY, INC. AND SUBSIDIARIES**

** **

**CONSOLIDATED BALANCE SHEETS**

**SEPTEMBER 30, 2003 AND 2002**

(In thousands, except shares)

 
|                                                                                                                                       |   | **2003** |       | **2002** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                              |   |     | ** ** |     | ** ** |
|                                                                                                                                       |   |     | ** ** |     | ** ** |
| CURRENT  LIABILITIES:                                                                                                                      |   |     |       |     |       |
| Short-term borrowings                                                                                                                      |   | $        | —     |     | $          | 6,596 |   |
| Accounts payable                                                                                                                           |   | 1,587    |       | 1,437    |       |
| Accrued payroll liabilities and commissions                                                                                                |   | 4,547    |       | 2,769    |       |
| Accrued customer support and warranty costs                                                                                                |   | 1,058    |       | 999      |       |
| Income tax payable                                                                                                                         |   | 185      |       | —   |       |
| Other accrued liabilities                                                                                                                  |   | 2,419    |       | 1,969    |       |
| Customers’ deposits                                                                                                                   |   | 4,798    |       | 3,328    |       |
| Current portion of long-term debt                                                                                                          |   | 1,066    |       | 1,668    |       |
|                                                                                                                                       |   |     | ** ** |     | ** ** |
| Total current liabilities                                                                                                                  |   | 15,660   |       | 18,766   |       |
|                                                                                                                                       |   |     |       |     |       |
| LONG-TERM DEBT                                                                                                                             |   | 3,249    |       | 3,747    |       |
|                                                                                                                                       |   |     |       |     |       |
| DEFERRED INCOME TAXES                                                                                                                      |   | 205      |       | 238      |       |
|                                                                                                                                       |   |     |       |     |       |
| MANDATORILY REDEEMABLE PREFERRED STOCK                                                                                                     |   | 1,526    |       | 2,815    |       |
|                                                                                                                                       |   |     |       |     |       |
| WARRANTS                                                                                                                                   |   | 356      |       | 652      |       |
|                                                                                                                                       |   |     |       |     |       |
| 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; 4,785,961 and 4,767,206 issued and outstanding 2003 and 2002,  respectively |   | 9,568    |       | 9,456    |       |
| Retained earnings                                                                                                                          |   | 20,729   |       | 14,970   |       |
| Other accumulated comprehensive income (loss)                                                                                              |   | (78      | )          | (824     | )          |
|                                                                                                                                       |   |     |       |     |       |
| Total shareholders’ equity                                                                                                            |   | 30,219   |       | 23,602   |       |
|                                                                                                                                       |   |     |       |     |       |
| TOTAL                                                                                                                                      |   | $        | 51,215     |     | $          | 49,820 |   |

(Concluded)

See notes to consolidatedfinancial statements.

 

31

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**KEY TECHNOLOGY, INC. ANDSUBSIDIARIES**

** **

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**THREE YEARS ENDED SEPTEMBER 30, 2003**

(Inthousands, except per share data)

 
|                                                            |   | **2003** |       | **2002** |       | **2001** |       |
|-----------------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
|                                                            |   |     | ** ** |     | ** ** |     | ** ** |
| NET SALES                                                       |   | $        | 82,622     |     | $          | 70,234   |       | $ | 72,954 |   |
|                                                            |   |     |       |     |       |     |       |
| COST OF SALES                                                   |   | 48,626   |       | 42,352   |       | 47,186   |       |
|                                                            |   |     |       |     |       |     |       |
| Gross profit                                                    |   | 33,996   |       | 27,882   |       | 25,768   |       |
|                                                            |   |     |       |     |       |     |       |
| OPERATING EXPENSES:                                             |   |     |       |     |       |     |       |
| Selling                                                         |   | 11,695   |       | 10,733   |       | 13,248   |       |
| Research and development                                        |   | 4,874    |       | 4,467    |       | 5,371    |       |
| General and administrative                                      |   | 7,329    |       | 6,963    |       | 7,487    |       |
| Amortization of intangibles                                     |   | 1,323    |       | 1,323    |       | 2,084    |       |
|                                                            |   |     |       |     |       |     |       |
| Total operating expenses                                        |   | 25,221   |       | 23,486   |       | 28,190   |       |
|                                                            |   |     |       |     |       |     |       |
| GAIN ON SALE OF ASSETS                                          |   | 4        |       | 883      |       | 76       |       |
|                                                            |   |     |       |     |       |     |       |
| INCOME (LOSS) FROM OPERATIONS                                   |   | 8,779    |       | 5,279    |       | (2,346   | )          |
|                                                            |   |     |       |     |       |     |       |
| OTHER INCOME (EXPENSE):                                         |   |     |       |     |       |     |       |
| Royalty income                                                  |   | 18       |       | 9        |       | 131      |       |
| Interest income                                                 |   | 59       |       | 109      |       | 126      |       |
| Interest expense                                                |   | (399     | )          | (843     | )          | (1,673   | )          |
| Other, net                                                      |   | (5       | )          | (1,008   | )          | 76       |       |
|                                                            |   |     |       |     |       |     |       |
| Total other income (expense)—net                           |   | (327     | )          | (1,733   | )          | (1,340   | )          |
|                                                            |   |     |       |     |       |     |       |
| Earnings (loss) from continuing operations before  income taxes |   | 8,452    |       | 3,546    |       | (3,686   | )          |
|                                                            |   |     |       |     |       |     |       |
| Income tax (benefit) expense                                    |   | 2,693    |       | 1,238    |       | (1,343   | )          |
|                                                            |   |     |       |     |       |     |       |
| Net earnings (loss) from continuing operations                  |   | 5,759    |       | 2,308    |       | (2,343   | )          |
|                                                            |   |     |       |     |       |     |       |
| Earnings (loss) from discontinued operation net of  tax         |   | —   |       | 39       |       | (436     | )          |
| Loss on sale of discontinued operation, net of tax              |   | —   |       | —   |       | (2,145   | )          |
|                                                            |   |     |       |     |       |     |       |
| Total earnings (loss) from discontinued operation               |   | —   |       | 39       |       | (2,581   | )          |
|                                                                 |        |          |            |          |            |          |            |  |  |  |

(Continued)

See notes to consolidatedfinancial statements.

 

32

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|                                                                                     |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) before change in accounting  principle                               |   | $        | 5,759  |     | $      | 2,347    |   | $ | (4,924 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Change in accounting principle, net of tax                                               |   | —   |   | (4,302   | )      | —   |   |
|                                                                                     |   |     |   |     |   |     |   |
| NET EARNINGS (LOSS)                                                                      |   | 5,759    |   | (1,955   | )      | (4,924   | )      |
|                                                                                     |   |     |   |     |   |     |   |
| Accretion of mandatorily redeemable preferred stock                                      |   | —   |   | (582     | )      | (939     | )      |
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) available to common shareholders                                     |   | $        | 5,759  |     | $      | (2,537   | )      | $ | (5,863 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) from continuing operations per  share—basic                     |   | $        | 1.21   |     | $      | 0.36     |   | $ | (0.69 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) from continuing operations per  share—diluted                   |   | $        | 1.15   |     | $      | 0.36     |   | $ | (0.69 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) from discontinued operation per  share—basic and diluted        |   | $        | — |     | $      | 0.01     |   | $ | (0.55 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) before change in accounting  principle per common share—basic   |   | $        | 1.21   |     | $      | 0.37     |   | $ | (1.24 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Net earnings (loss) before change in accounting  principle per common share—diluted |   | $        | 1.15   |     | $      | 0.37     |   | $ | (1.24 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| Net loss from change in accounting principle per  common share—basic and diluted    |   | $        | — |     | $      | (0.90    | )      | $ | — |   |
|                                                                                     |   |     |   |     |   |     |   |
| EARNINGS (LOSS) PER SHARE—Basic                                                     |   | $        | 1.21   |     | $      | (0.53    | )      | $ | (1.24 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| EARNINGS (LOSS) PER SHARE—Diluted                                                   |   | $        | 1.15   |     | $      | (0.53    | )      | $ | (1.24 | ) |
|                                                                                     |   |     |   |     |   |     |   |
| SHARES USED IN PER SHARE CALCULATION—Basic                                          |   | 4,774    |   | 4,759    |   | 4,740    |   |
|                                                                                     |   |     |   |     |   |     |   |
| SHARES USED IN PER SHARE CALCULATION—Diluted                                        |   | 4,989    |   | 4,759    |   | 4,740    |   |

(Concluded)

See notes to consolidatedfinancial statements.

 

33

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**KEY TECHNOLOGY, INC. ANDSUBSIDIARIES**

** **

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY**

**THREE YEARS ENDEDSEPTEMBER 30, 2003**

(Dollars in thousands)

 
|                                                                           |   |             |   |                   |      |   |   | **Other  Accumulated  Comprehensive  Income (Loss)** |   |   |   |
|--------------------------------------------------------------------------------|--------|------------------|--------|------------------------|-----------|--------|--------|------------------------------------------------------|--------|--------|--------|
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |
|                                                                           |   | **Common Stock** |   | **Retained  Earnings** |      |   |   |
|                                                                           |   | **Shares**       |   | **Amount**             | **Total** |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Balance at October 1,  2000                                               |   | 4,733,560        |   | $                      | 9,329     |   | $      | 23,370                                               |   | $      | (1,234 | ) | $ | 31,465 |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Components of comprehensive  income (loss):                                    |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Net loss                                                                       |   |             |   |                   |      | (4,924 | )      |                                                 |   | (4,924 | )      |
| Comprehensive  income—foreign currency translation adjustment, net of tax |   |             |   |                   |      |   |   | 31                                                   |   | 31     |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Total comprehensive loss                                                       |   |             |   |                   |      |   |   |                                                 |   | (4,893 | )      |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Accretion of mandatorily  redeemable preferred stock                           |   |             |   |                   |      | (939   | )      |                                                 |   | (939   | )      |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Issuance of common stock  upon exercise of preferred stock and warrants        |   | 602              |   | 7                      |      |   |   |                                                 |   | 7      |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Issuance of stock for  Employee Stock Purchase Plan                            |   | 17,184           |   | 71                     |      |   |   |                                                 |   | 71     |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Balance at  September 30, 2001                                            |   | 4,751,346        |   | 9,407                  |      | 17,507 |   | (1,203                                               | )      | 25,711 |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Components of comprehensive  income (loss):                                    |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Net loss                                                                       |   |             |   |                   |      | (1,955 | )      |                                                 |   | (1,955 | )      |
| Comprehensive income—foreign  currency translation adjustment, net of tax |   |             |   |                   |      |   |   | 379                                                  |   | 379    |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Total comprehensive loss                                                       |   |             |   |                   |      |   |   |                                                 |   | (1,576 | )      |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Accretion of mandatorily  redeemable preferred stock                           |   |             |   |                   |      | (582   | )      |                                                 |   | (582   | )      |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Issuance of stock for  Employee Stock Purchase Plan                            |   | 15,860           |   | 49                     |      |   |   |                                                 |   | 49     |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Balance at  September 30, 2002                                            |   | 4,767,206        |   | 9,456                  |      | 14,970 |   | (824                                                 | )      | 23,602 |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Components of comprehensive  income (loss):                                    |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Net earnings                                                                   |   |             |   |                   |      | 5,759  |   |                                                 |   | 5,759  |   |
| Comprehensive  income—foreign currency translation adjustment, net of tax |   |             |   |                   |      |   |   | 746                                                  |   | 746    |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Total comprehensive income                                                     |   |             |   |                   |      |   |   |                                                 |   | 6,505  |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Issuance of common stock  upon exercise of stock options                       |   | 11,837           |   | 67                     |      |   |   |                                                 |   | 67     |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Issuance of stock for  Employee Stock Purchase Plan                            |   | 6,918            |   | 45                     |      |   |   |                                                 |   | 45     |   |
|                                                                           |   |             |   |                   |      |   |   |                                                 |   |   |   |
| Balance at  September 30, 2003                                            |   | 4,785,961        |   | $                      | 9,568     |   | $      | 20,729                                               |   | $      | (78    | ) | $ | 30,219 |   |

 

See notes to consolidated financial statements.

 

34

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**KEY TECHNOLOGY, INC. ANDSUBSIDIARIES**

** **

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**THREE YEARS ENDED SEPTEMBER 30, 2003**

(Inthousands)

 
|                                                                                        |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                       |   |     |   |     |   |     |   |
| Net earnings (loss)                                                                         |   | $        | 5,759  |     | $      | (1,955   | )      | $ | (4,924 | ) |
| Adjustments to reconcile net earnings (loss) to net  cash provided by operating activities: |   |     |   |     |   |     |   |
| Loss from sale of discontinued operation, net of tax                                        |   | —   |   | —   |   | 2,145    |   |
| (Earnings) loss from discontinued operation, net of  tax                                    |   | —   |   | (39      | )      | 436      |   |
| (Gain) loss on sale of assets                                                               |   | (4       | )      | (883     | )      | (76      | )      |
| Losses on early extinguishment of debt, net of tax                                          |   | —   |   | 471      |   | —   |   |
| Foreign currency exchange (gain) loss                                                       |   | (242     | )      | (80      | )      | (242     | )      |
| Depreciation and amortization                                                               |   | 3,698    |   | 3,791    |   | 4,530    |   |
| Change in accounting principle—provision for  goodwill, net of tax                     |   | —   |   | 4,302    |   | —   |   |
| Deferred income taxes                                                                       |   | 2,080    |   | 1,503    |   | (1,343   | )      |
| Deferred rent                                                                               |   | 66       |   | 279      |   | 26       |   |
| Bad debt expense                                                                            |   | 162      |   | 39       |   | 63       |   |
| Changes in assets and liabilities:                                                          |   |     |   |     |   |     |   |
| Trade accounts receivable                                                                   |   | (1,646   | )      | 5,956    |   | (4,204   | )      |
| Inventories                                                                                 |   | 799      |   | 816      |   | 5,052    |   |
| Prepaid expenses and other current assets                                                   |   | 365      |   | (651     | )      | 830      |   |
| Income taxes receivable                                                                     |   | 76       |   | 831      |   | —   |   |
| Accounts payable                                                                            |   | 27       |   | (4,063   | )      | 2,212    |   |
| Accrued payroll liabilities and commissions                                                 |   | 1,702    |   | 210      |   | (1,259   | )      |
| Accrued customer support and warranty costs                                                 |   | 35       |   | (17      | )      | (104     | )      |
| Income taxes payable                                                                        |   | 237      |   | (346     | )      | 171      |   |
| Other accrued liabilities                                                                   |   | 317      |   | 612      |   | (735     | )      |
| Customers’ deposits                                                                    |   | 1,275    |   | 1,081    |   | (183     | )      |
| Other                                                                                       |   | (183     | )      | (696     | )      | 323      |   |
|                                                                                        |   |     |   |     |   |     |   |
| Cash provided by operating activities                                                       |   | 14,523   |   | 11,161   |   | 2,718    |   |
|                                                                                        |   |     |   |     |   |     |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                       |   |     |   |     |   |     |   |
| Proceeds from sale of subsidiary                                                            |   | —   |   | 3,577    |   | —   |   |
| Proceeds from sale of property                                                              |   | 12       |   | 4,355    |   | 478      |   |
| Purchases of property, plant, and equipment                                                 |   | (836     | )      | (532     | )      | (545     | )      |
|                                                                                        |   |     |   |     |   |     |   |
| Cash provided by (used in) investing activities                                             |   | (824     | )      | 7,400    |   | (67      | )      |
|                                                                                             |        |          |        |          |        |          |        |  |  |  |

(Continued)

See notes to consolidatedfinancial statements.

 

35

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|                                                                              |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| CASH FLOWS FROM FINANCING ACTIVITIES:                                             |   |     |   |     |   |     |   |
| Proceeds from (repayments of) short-term borrowings                               |   | $        | (6,650 | )        | $      | 4,596    |   | $ | 2,000 |   |
| Payments on long-term debt                                                        |   | (1,740   | )      | (23,535  | )      | (5,591   | )      |
| Proceeds from issuance of long-term debt                                          |   | 500      |   | 10,500   |   | —   |   |
| Prepayment penalty on early extinguishment of debt                                |   | —   |   | (516     | )      | —   |   |
| Redemption of warrants                                                            |   | (296     | )      | (170     | )      | (2,122   | )      |
| Redemption of mandatorily redeemable preferred stock                              |   | (1,289   | )      | (8,559   | )      | (2,382   | )      |
| Proceeds from issuance of common stock                                            |   | 112      |   | 49       |   | 71       |   |
|                                                                              |   |     |   |     |   |     |   |
| Cash used in financing activities                                                 |   | (9,363   | )      | (17,635  | )      | (8,024   | )      |
|                                                                              |   |     |   |     |   |     |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH                                           |   | 399      |   | 220      |   | (42      | )      |
|                                                                              |   |     |   |     |   |     |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS  FROM CONTINUING OPERATIONS  |   | 4,735    |   | 1,146    |   | (5,415   | )      |
|                                                                              |   |     |   |     |   |     |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS  FROM DISCONTINUED OPERATION |   | —   |   | (177     | )      | (274     | )      |
|                                                                              |   |     |   |     |   |     |   |
| CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR                                      |   | 1,707    |   | 738      |   | 6,427    |   |
|                                                                              |   |     |   |     |   |     |   |
| CASH AND CASH EQUIVALENTS, END OF YEAR                                            |   | $        | 6,442  |     | $      | 1,707    |   | $ | 738 |   |
|                                                                              |   |     |   |     |   |     |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                                |   |     |   |     |   |     |   |
| Cash paid during the year for interest                                            |   | $        | 443    |     | $      | 783      |   | $ | 1,818 |   |
| Cash paid (received) during the year for income  taxes                            |   | 306      |   | (472     | )      | (731     | )      |
|                                                                              |   |     |   |     |   |     |   |
| SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND  FINANCING ACTIVITIES:           |   |     |   |     |   |     |   |
| Equipment obtained through capital leases                                         |   | $        | — |     | $      | 110      |   | $ | 126 |   |
| Accounts payable paid through lease financing                                     |   | —   |   | —   |   | 856      |   |

(Concluded)

See notes to consolidatedfinancial statements.

 

36

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**KEY TECHNOLOGY, INC. ANDSUBSIDIARIES**

** **

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**THREEYEARS ENDED SEPTEMBER 30, 2003**

 

**1.**                      THE COMPANYAND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Key Technology, Inc. and its wholly -ownedsubsidiaries (the “Company”) design, manufacture, and sell process automationsystems, integrating electro-optical inspection and sorting, specialized conveyingand product preparation equipment.  Theconsolidated financial statements include the accounts of Key Technology, Inc.and its wholly-owned subsidiaries, Key Technology Holdings U.S.A., LLC, KeyTechnology AMVC LLC, Key Technology Australia Pty. Ltd., and Key TechnologyFSC, Inc., a foreign sales corporation (FSC). Suplusco Holding B.V., a wholly-owned European subsidiary of KeyTechnology Holdings U.S.A., LLC includes the accounts of Key Technology B.V.  Key Technology AMVC LLC includes the accountsof Applied Laser Systems, Inc. (inactive). All significant intercompany accounts and transactions have beeneliminated.

*** ***

***Revenue Recognition***—Salesrevenue net of allowances is recognized at the time equipment is shipped tocustomers or when title and risk of loss passes, or in the case of trial units,upon the customers’ acceptance of the product. Revenue from maintenance and support contracts is recognized over theperiod the service is provided.  Revenuefrom other service contracts is recognized at the time the service isprovided.  Upon receipt of an order, theCompany generally receives a deposit which is recorded as customers’deposits.  The Company makes periodicevaluations of the creditworthiness of its customers and generally does notrequire collateral.  An allowance forcredit losses is provided based upon historical experience and anticipatedlosses.

*** ***

***Cash and Cash Equivalents******—***The Companyconsiders all highly liquid investments with original maturities of 90 days orless at date of acquisition to be cash equivalents.

*** ***

***Inventories***are stated at the lower of cost (first-in, first-out method) or market.

*** ***

***Property, Plant, andEquipment*** are recorded at cost and depreciatedover estimated useful lives on the straight-line method.  The range in lives for assets is as follows:

 
|                                       |   | **Years** |       |
|--------------------------------------------|--------|-----------|------------|
|                                       |   |      | ** ** |
| Buildings and improvements                 |   | 7 to 40   |       |
| Manufacturing equipment                    |   | 5 to 10   |       |
| Office equipment,  furniture, and fixtures |   | 3 to 7    |       |

 

 

***Goodwill and OtherIntangibles***—Prior to October 1, 2001,goodwill was amortized over the estimated useful lives of the related goodwillor 15 years, whichever was shorter. Beginning October 1, 2001, the Company adopted Statement ofFinancial Accounting Standards (SFAS) No. 142, *Goodwill and Other Intangible Assets*,and as a result, ceased amortization of goodwill.  Assessment of potential goodwill impairment is performed by theCompany on an annual basis or sooner, if necessary.

 

Other intangibles which consist of patents, developedtechnologies, trademarks and trade names, and purchased customer developmentare amortized over the estimated useful lives of the related assets, which is10 years for the majority of the assets. Management periodically evaluates the recoverability

 

37

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of other intangibles based upon current andanticipated net income and undiscounted future cash flows.  Amortization of other intangibles (includinggoodwill in fiscal 2001) was $1,323,000, $1,323,000, and $2,084,000 for theyears ended September 30, 2003, 2002, and 2001, respectively (seeNote 4).

*** ***

***Accrued Customer Supportand Warranty Costs***—The Company provides customersupport services consisting of installation and training to its customers.  The Company also provides a warranty on itsproducts ranging from ninety days to two years following the date ofshipment.  Management establishesallowances for customer support and warranty costs based upon the types ofproducts shipped, customer support and product warranty experience andestimates such costs for related new products where experience is notavailable.  The provision of customersupport and warranty costs is charged to cost of sales at the time such costsare known or estimable.

 

A reconciliation for the changes in the Company’sallowances for warranties is as follows (in thousands):

 
|                     |   | **2003** |       | **2002** |       |
|--------------------------|--------|----------|------------|----------|------------|
|                     |   |     | ** ** |     | ** ** |
| Beginning balance        |   | $        | 869        |     | $          | 748 |   |
|                     |   |     |       |     |       |
| Warranty costs incurred  |   | (1,736   | )          | (2,426   | )          |
| Warranty expense accrued |   | 1,680    |       | 2,545    |       |
| Translation adjustments  |   | 24       |       | 2        |       |
|                     |   |     |       |     |       |
| Ending balance           |   | $        | 837        |     | $          | 869 |   |

 

***Income Taxes***—Deferredincome taxes are provided for the effects of temporary differences arising fromdifferences in the reporting of revenues and expenses for financial statementand income tax purposes under the asset and liability method using currentlyenacted tax rates.

 

***Foreign CurrencyTranslation***—Assets and liabilities denominated ina foreign currency are translated to U.S. dollars at the exchange rate on thebalance sheet date.  Translationadjustments are shown as part of other accumulated comprehensive income(loss).  Revenues, costs, and expensesare translated using an average rate. Realized and unrealized foreign currency transaction gains and losses areincluded in the consolidated statement of operations.

*** ***

***Impairment of Long-LivedAssets******—***TheCompany evaluates its long-lived assets for financial impairments based uponundiscounted cash flows and will continue to evaluate them if events or changesin circumstances indicate the carrying amount of such assets may not be fullyrecoverable.

*** ***

***Estimates******—***Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and reported amounts of revenues and expenses duringthe reporting period.  Actual resultscould differ from those estimates.

*** ***

***Financial Instruments***—Thecarrying value of the Company’s cash and cash equivalents, short-terminvestments, accounts and notes receivable, trade payables, and other accruedliabilities approximates their estimated fair values due to the shortmaturities of those instruments.

*** ***

***38***

----

*** ***

***Earnings Per Share***—Basicearnings (loss) per share (“EPS”) has been computed by dividing net earnings(loss) available to common shareholders by the weighted average number ofshares outstanding during each period. Diluted EPS has been computed by dividing net earnings (loss) availableto common shareholders by the weighted average common stock and common stockequivalent shares outstanding during each period using the treasury stockmethod for employee stock option plans and warrants, and the if-convertedmethod for mandatorily redeemable preferred stock, if the common equivalentshares were not anti-dilutive.  Infiscal years 2002 and 2001, all common stock equivalents wereanti-dilutive.  Net earnings (loss) forthe calculation of both basic and diluted EPS is the same for each periodpresented.  The calculation of theweighted average outstanding shares is as follows (in thousands):

 
|                                              |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                              |   |     |   |     |   |     |   |
| Weighted average shares  outstanding—basic   |   | 4,774    |   | 4,759    |   | 4,740    |   |
| Common stock options and  warrants                |   | 215      |   | —   |   | —   |   |
|                                              |   |     |   |     |   |     |   |
| Weighted average shares  outstanding—diluted |   | 4,989    |   | 4,759    |   | 4,740    |   |

 

Options to purchase 714,125, 818,933, and 699,433shares of common stock were outstanding as of September 30, 2003, 2002,and 2001, respectively, but were not included in the computation of diluted EPSfor the year then ended because the options were anti-dilutive.  These options expire on dates beginning in January 2004through February 2013.  As of September 30,2003, common equivalent shares of 35,553 from assumed conversion of warrantswere not included in the computation of diluted EPS due to anti-dilution.  As of September 30, 2002, commonequivalent shares of 187,663 and 65,162 from assumed conversion of mandatorilyredeemable preferred stock and warrants, respectively, were not included in thecomputation of diluted EPS due to anti-dilution.  As of September 30, 2001, common equivalent shares of892,756 and 82,200 from assumed conversion of mandatorily redeemable preferredstock and warrants, respectively, were not included in the computation ofdiluted EPS due to anti-dilution.

*** ***

***Accounting forStock-Based Compensation***—During 1995, theFinancial Accounting Standards Board (FASB) issued SFAS No. 123, *Accountingfor Stock-Based Compensation*, which defines a fair value basedmethod of accounting for employee stock options and similar equity instrumentsand encourages all entities to adopt that method of accounting for all of theiremployee stock compensation plans. However, it also allows an entity to continue to measure compensationcost for those plans using the method of accounting prescribed by AccountingPrinciples Board Opinion No. 25 (“APB 25”).  Entities electing to remain with theaccounting in APB 25 must make pro forma disclosures of net income and, ifpresented, earnings per share, as if the fair value based method of accountingdefined in SFAS No. 123 has been adopted.

 

The Company has elected to account for its stock-basedcompensation plans under APB 25. The Company has computed, for pro forma disclosure purposes, the valueof all stock and stock options granted under the Employee Stock Purchase Planand the Restated Employees’ Stock Option Plan during 2003, 2002, and 2001 usingthe Black-Scholes option pricing model as prescribed by SFAS No. 123using the following weighted average assumptions for the years endedSeptember 30, 2003, 2002, and 2001:

 

39

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|                     |   | **2003**    |   | **2002**   |   | **2001**   |   |
|--------------------------|--------|-------------|--------|------------|--------|------------|--------|
|                     |   |        |   |       |   |       |   |
| Risk-free  interest rate |   | 2.36        | %      | 1.6        | %      | 3.7        | %      |
| Expected  dividend yield |   | 0           | %      | 0          | %      | 0          | %      |
| Expected  lives          |   | 4.55  years |   | 6.0  years |   | 5.5  years |   |
| Expected  volatility     |   | 74          | %      | 75         | %      | 71         | %      |

 

Using the Black-Scholesmethodology, the total value of stock options granted during 2003, 2002, and2001 was $991,000, $311,000, and $192,000, respectively, which would beamortized on a pro forma basis over the vesting period of the options(typically five years).  The weightedaverage fair value of options granted under the Restated Employees’ StockOption Plan during 2003, 2002, and 2001 was $5.43 per share, $1.94 per share,and $5.03 per share, respectively.

 

The total compensatoryvalue of stock purchased under the Employee Stock Purchase Plan during 2003,2002, and 2001 was $8,000, $9,000, and $12,000, respectively.  The weighted average fair value of the stockpurchased during 2003, 2002, and 2001 was $1.14 per share, $0.54 per share, and$0.73 per share, respectively.

 

If the Company hadaccounted for the Restated Employee’s Stock Option Plan and Employee StockPurchase Plan in accordance with SFAS No. 123, the Company’s netearnings and earnings per share would approximate the pro forma disclosuresbelow (in thousands, except per share amounts):

 
|                             |   | **Year Ended  September 30, 2003** |   | **Year Ended  September 30, 2002** |   | **Year Ended  September 30, 2001** |   |
|----------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|
|                             |   | **As Reported**                         |   | **Pro Forma**                           |   | **As Reported**                         |   | **Pro Forma** |   | **As Reported** |   | **Pro Forma** |   |
|                             |   |                                    |   |                                    |   |                                    |   |   |   |   |   |   |   |
| Net  earnings (loss)             |   | $                                       | 5,759  |                                    | $      | 5,261                                   |   | $ | (1,955 | ) | $ | (2,408 | ) | $ | (4,924 | ) | $ | (5,542 | ) |
| Earnings  (loss) per share— |   |                                    |   |                                    |   |                                    |   |   |   |   |   |   |   |
| basic                            |   | $                                       | 1.21   |                                    | $      | 1.11                                    |   | $ | (0.53 | ) | $ | (0.63 | ) | $ | (1.24 | ) | $ | (1.37 | ) |
| diluted                          |   | $                                       | 1.15   |                                    | $      | 1.06                                    |   | $ | (0.53 | ) | $ | (0.63 | ) | $ | (1.24 | ) | $ | (1.37 | ) |

 

The effects of applyingSFAS No. 123 in this pro forma disclosure are not indicative of futureamounts.  SFAS No. 123 doesnot apply to awards prior to October 1, 1995, and additional awards mayoccur in future years.

*** ***

***Future AccountingChanges******—***InAugust 2001, the FASB issued SFAS No. 143, *Accounting for Asset Retirement Obligations*,which is effective October 1, 2003. SFAS No. 143 requires, among other things, the accounting andreporting of legal obligations associated with the retirement of long-livedassets that result from the acquisition, construction, development, or normaloperation of a long-lived asset.  TheCompany does not believe this will have a material effect on its financialstatements.

 

In November 2002,the Emerging Issues Task Force (“EITF”) ratified a consensus on IssueNo. 00-21, *Revenue Arrangements with Multiple Deliverables*, which iseffective for the Company beginning October 1, 2003.  Issue No. 00-21 addresses accountingand reporting of a company’s delivery or performance of multiple products,services, and/or rights customers might have to use a company’s held assets tofulfill its needs, with delivery or performance that may occur at differentpoints in time or over different periods of time.  Management believes this will not have a material effect on theCompany’s consolidated financial statements.

 

40

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In December 2002,the FASB issued SFAS No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure*, which is effective for fiscal years ending afterDecember 31, 2002.  SFASNo. 148 provides alternative methods of transition for a voluntary changeto the fair value method of accounting for stock-based employeecompensation.  In addition, thisstatement amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results.  The Company has adopted the disclosurerequirements.  The Company has electednot to implement any transitional method of accounting for stock-based compensation.  The Company will defer action until the FASBhas issued its final definitive pronouncement on this issue, which is expectedsometime in 2004.

 

In November 2002,the FASB issued Financial Interpretation No. (“FIN”) 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*, on the accounting anddisclosure guidance for guarantors.  Thestandard requires guarantors to recognize at inception the fair value of allits obligations it has undertaken to issue a guarantee and requires additionaldisclosures related to such.  Thisstatement, as it relates to the recognition and measurement of the liability,if any, would be effective in fiscal 2004 and the Company does not believe thiswill have a material effect on its financial statements.

 

***Reclassifications******—***Certainreclassifications have been made to prior year amounts to conform to thecurrent year presentation.

 

In April 2002, theFASB issued SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections*,which was effective October 1, 2002. SFAS No. 145, among other things, rescinds the requirement of SFASNo. 4 to treat gains and losses on the early extinguishment of debt asextraordinary items.  Reclassificationof prior periods is required.  As aresult of the adoption of this statement, amounts recorded in fiscal year 2002as extraordinary items from the early extinguishment of debt have beenreclassified to part of net income from continuing operations.

 

**2.**                      DISCONTINUED OPERATION

** **

Prior toSeptember 30, 2001, management, with Board of Directors approval,committed to a plan to sell Ventek, Inc. (“Ventek”), a wholly-owned subsidiarythat supplied machine vision systems to the forest products industry.  Ventek was acquired by the Company as partof its acquisition of Advanced Machine Vision Corporation (“AMVC”) inJuly 2000.  In October 2001,the Company signed a definitive agreement to sell Ventek to Veneer Technology, Inc.,a company owned by four current managers of Ventek.  The terms of the sale include a cash payment of approximately$3.6 million, a note for $0.9 million and the cashless tender of VeneerTechnology’s holdings of Key Technology Series B convertible preferred stockhaving a stated redemption value of $2.0 million.  As a result of the sale of Ventek, the Company recorded aone-time charge of approximately $2.1 million, with no tax effect, in itsfiscal 2001 results.

 

Accordingly, thefinancial statements for fiscal years 2001 and 2002 reflect Ventek as adiscontinued operation.

 

For the one month offiscal year 2002 prior to the sale, Ventek revenues were $577,000 with pre-taxearnings of $61,000.  In fiscal year2001, Ventek revenues were $4,992,000 with a pre-tax loss of $678,000.

 

41

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**3.**                      SALE OF BUILDING

** **

In April 2002, theCompany completed the sale of its Medford facility, which had a net book valueof approximately $3.5 million, for $4.6 million and moved its remaining Medfordoperations into a small leased portion of the facility.  The proceeds of the sale were used to retirethe mortgage on the building totaling $2.8 million, requiring an early paymentpenalty of $516,000, resulting in net cash proceeds from the sale of $972,000after paying the costs associated with the sale.  The lease is for a five-year term at approximately $9,600 permonth, plus shared occupancy costs.  Thebase lease is being accounted for as an operating lease.

 

**4.**                      GOODWILL AND OTHER INTANGIBLEASSETS

** **

In July 2001, theFASB issued SFAS No. 142, *Goodwill and Other Intangible Assets*,which was effective October 1, 2002 and may be adopted early.  The Company elected to adoptSFAS No. 142 prior to its filing of its first quarter financialstatements on Form 10-Q for the quarter ended December 31, 2001.  SFAS No. 142 requires, among otherthings, the discontinuance of goodwill amortization.  In addition, the standard includes provisions for thereclassification of certain existing recognized intangibles, reclassificationof certain intangibles out of previously reported goodwill, and theidentification of reporting units for purposes of assessing potential futureimpairments of goodwill.  SFAS No. 142also required the Company to complete a transitional goodwill impairment testwithin six months from the date of adoption. As a result of the implementation of this change in accountingprinciple, the Company recorded an impairment of goodwill associated with theautomated inspection systems reporting unit, based on a discontinued cash flowanalysis, effective at the beginning of fiscal 2002, of $4.4 million, andrelated income tax benefits of $71,000. The Company determined there was no impairment of the $2.5 million ofgoodwill associated with the process systems reporting unit.

 

As of September 30,2001, the Company had approximately $6.9 million of intangible assetswhich are no longer being amortized. Amortization of these assets was $749,000 in the year endedSeptember 30, 2001.  In addition,amortization of goodwill and other indefinite life intangible assets includedin discontinued operations was $197,000 in the year ended September 30,2001.  In compliance withSFAS No. 142, the results for the year ended September 30, 2001have not been restated.  Areconciliation of net loss and loss per share as if SFAS No. 142,exclusive of the charges for the impairment of goodwill, had been adopted inthe prior period is shown below.

 
|                                                                              |   | **September 30, 2001** |       |
|-----------------------------------------------------------------------------------|--------|-----------------------------|------------|
| **As  Previously  Reported**                                                      |   | **Adjustments**             | ** ** | **Pro Forma** | ** ** |
| Net  earnings (loss) from continuing operations—net of tax                   |   | $                           | (2,343     | ) | $ | 601 |   | $ | (1,742 | ) |
|                                                                              |   |                        |       |   |   |   |   |
| Net earnings (loss)  from discontinued operation—net of tax                  |   | (2,581                      | )          | 126 |   | (2,455 | ) |
|                                                                              |   |                        |       |   |   |   |   |
| Net earnings (loss)                                                               |   | (4,924                      | )          | 727 |   | (4,197 | ) |
|                                                                              |   |                        |       |   |   |   |   |
| Net earnings (loss)  from continuing operations per share—basic and diluted  |   | (0.69                       | )          | 0.13 |   | (0.56 | ) |
|                                                                              |   |                        |       |   |   |   |   |
| Net earnings (loss)  from discontinued operation per share—basic and diluted |   | (0.55                       | )          | 0.03 |   | (0.52 | ) |
|                                                                              |   |                        |       |   |   |   |   |
| Net earnings (loss) per  share— basic and diluted                            |   | (1.24                       | )          | 0.16 |   | (1.08 | ) |
|                                                                                   |        |                             |            |  |  |  |  |  |  |  |

 

42

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As of September 30,2003, the Company has approximately $10.9 million of intangible assets relatedto patents and developed technologies with a net book value of approximately$7.0 million; $1.7 million of intangible assets related to purchased trademarksand trade names with a net book value of approximately $1.1 million; and$900,000 of intangible assets related to purchased customer development with anet book value of approximately $600,000. The significant majority of these assets are being amortized over 10years.  Amortization expense for thenext five fiscal years is expected to be approximately $1.3 million peryear.

 

As of September 30,2003, the Company had $2.5 million of goodwill associated with the processsystems reporting unit which is not being amortized.

 

**5.**                      TRADE ACCOUNTS RECEIVABLE

** **

Trade accounts receivableconsist of the following (in thousands):

 
|                                  |   | **September 30,** |   |
|---------------------------------------|--------|------------------------|--------|
|                                  |   | **2003**               |   | **2002** |   |
|                                  |   |                   |   |   |   |
| Trade  accounts receivable            |   | $                      | 10,021 |   | $ | 7,942 |   |
| Allowance  for doubtful accounts      |   | (542                   | )      | (386 | ) |
|                                  |   |                   |   |   |   |
| Total  trade accounts receivable, net |   | $                      | 9,479  |   | $ | 7,556 |   |

 

**6.**                      INVENTORIES

** **

Inventories consist ofthe following (in thousands):

 
|                                   |   | **September 30,** |   |
|----------------------------------------|--------|------------------------|--------|
|                                   |   | **2003**               |   | **2002** |   |
|                                   |   |                   |   |   |   |
| Purchased components and raw materials |   | $                      | 6,746  |   | $ | 6,416 |   |
| Sub-assemblies                         |   | 1,476                  |   | 1,770 |   |
| Work-in-process                        |   | 3,907                  |   | 3,550 |   |
| Finished goods                         |   | 1,839                  |   | 2,233 |   |
|                                   |   |                   |   |   |   |
| Total inventories                      |   | $                      | 13,968 |   | $ | 13,969 |   |

 

**7.**                      PROPERTY, PLANT, AND EQUIPMENT

** **

Property, plant, andequipment consist of the following (in thousands):

 

43

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|                                       |   | **September 30,** |   |
|--------------------------------------------|--------|------------------------|--------|
|                                       |   | **2003**               |   | **2002** |   |
|                                       |   |                   |   |   |   |
| Land                                       |   | $                      | 434    |   | $ | 394 |   |
| Buildings  and improvements                |   | 3,855                  |   | 3,547 |   |
| Manufacturing  equipment                   |   | 12,192                 |   | 11,872 |   |
| Office  equipment, furniture, and fixtures |   | 11,128                 |   | 10,686 |   |
|                                       |   |                   |   |   |   |
|                                       |   | 27,609                 |   | 26,499 |   |
| Accumulated  depreciation                  |   | (22,106                | )      | (20,092 | ) |
|                                       |   |                   |   |   |   |
| Total  property, plant, and equipment, net |   | $                      | 5,503  |   | $ | 6,407 |   |

** **

**8.**                      FINANCING AGREEMENTS

** **

The Company’s domesticcredit facility provides a credit accommodation totaling $13.2 million inthe United States consisting of a term loan of $3.2 million and arevolving credit facility of up to the lesser of $10.0 million or the availableborrowing base, which is based on varying percentages of eligible accountsreceivable and inventories.  Therevolving credit facility matures on July 31, 2004.  The term loan requires quarterly payments ofprincipal of $200,000 and matures on July 31, 2007.  The term loan and operating line bearinterest at the Wall Street Journal prime rate, which was 4.00% atSeptember 30, 2003.  The credit facilityis secured by all of the U.S. personal property, including patents and otherintangibles of the Company and its subsidiaries, and contains covenants whichrequire the maintenance of a defined debt service ratio, a defined debt ratio,minimum working capital and current ratio, and minimum profitability.  At September 30, 2003, the Company wasin compliance with all loan covenants and had an available borrowing base ofapproximately $6.9 million under the revolving credit facility.  At September 30, 2003, borrowings underthe term loan were $3.2 million. There were no borrowings under the revolving credit facility.  At September 30, 2002, borrowings were$6.6 million under the revolving credit facility, and borrowings under the termloan and under a standby line of credit were $4.0 million and $500,000,respectfully.

 

Additionally, the Company’scredit accommodation with a commercial bank in The Netherlands provides acredit facility for its European subsidiary. This credit accommodation totals $3.7 million and includes a termloan facility of $814,000, an operating line of the lesser of $1.7 millionor the available borrowing base, which is based on varying percentages ofeligible accounts receivable and inventories, and a bank guarantee facility of$1.2 million.  The term loanfacility requires quarterly principal payments of $36,000 and matures inAugust 2012.  It is secured by real property of theCompany’s European subsidiary, while the operating line and bank guaranteefacility are secured by all of the subsidiary’s personal property.  The credit facility bears interest at thebank’s prime rate plus 1.75%, which at September 30, 2003 was 4.5%.  At September 30, 2003, the Company hadborrowings under this facility of approximately $814,000 in term loans.  Additionally, the Company had received bankguarantees of $882,000 under this agreement.

 

44

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Long-term debt consistsof the following (in thousands):

 
|                                                                                                                                                                                                                                             |   | **September 30,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|
|                                                                                                                                                                                                                                             |   | **2003**               |       | **2002** |   |
| Term  loan dated August 2002, variable interest payable quarterly at the  bank’s prime rate (4.0% at September 30, 2003), due in quarterly  principal payments of $200,000 through July 2007. Secured by business  property. |   | $                      | 3,200      |   | $ | 4,000 |   |
|                                                                                                                                                                                                                                             |   |                   |       |   |   |
| Reducing  non-revolving $4 million note dated August 2002, fully maturing in  July 2003.  Secured by business  property.                                                                                                          |   | —                 |       | 500 |   |
|                                                                                                                                                                                                                                             |   |                   | ** ** |   | ** ** |
| Note  payable, interest of 5.25%, due in quarterly principal and interest  installments through August 2012, secured by certain land and buildings.                                                                                         |   | 539                    |       | — |   |
|                                                                                                                                                                                                                                             |   |                   |       |   |   |
| Note  payable, interest rate of 5.25%, due in quarterly principal and interest  installments through October 2006, secured by certain land and  buildings.                                                                                  |   | 275                    |       | 302 |   |
|                                                                                                                                                                                                                                             |   |                   |       |   |   |
| Capital  leases, interest rates between 6% and 11%, due in principal and interest  installments through September 2005, secured by certain office and  manufacturing equipment.                                                             |   | 301                    |       | 613 |   |
|                                                                                                                                                                                                                                             |   |                   |       |   |   |
|                                                                                                                                                                                                                                             |   | 4,315                  |       | 5,415 |   |
| Current  portion                                                                                                                                                                                                                                 |   | (1,066                 | )          | (1,668 | ) |
|                                                                                                                                                                                                                                             |   |                   |       |   |   |
| Total  long-term debt                                                                                                                                                                                                                            |   | $                      | 3,249      |   | $ | 3,747 |   |

 

Principal payments onlong-term debt are as follows (in thousands):

 
| **Year Ending  September 30** |   |   | ** ** |
|------------------------------------|--------|--------|------------|
|                               |   |   |       |
| 2004                               |   | $      | 1,066      |   |
| 2005                               |   | 1,088  |       |
| 2006                               |   | 974    |       |
| 2007                               |   | 881    |       |
| 2008                               |   | 58     |       |
| Thereafter                         |   | 248    |       |
|                               |   |   |       |
| Total                              |   | $      | 4,315      |   |

 

Based on the borrowingrates currently available to the Company for loans with similar terms andaverage maturities, the fair value of long-term debt at September 30, 2003approximates carrying value.

 

**9.**                      LEASES

** **

The Company hasagreements with the Port of Walla Walla to lease two operating facilities oneof which expires in 2010 and the other in 2015.  The Company currently has the option to purchase the land andplant under both of the agreements.  Thepurchase price of one facility is determined by reducing the original plantconstruction costs of approximately $8,800,000 by one thirty-fifth for eachlease year prior to the exercise of the option and adding $600,000 for theland, subject to further

 

45

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reductions if exercisedafter the fifteenth year of the lease. The other facility may be purchased at the appraised fair marketvalue.  The Company also has two leasedoperating facilities in Oregon.  Bothleases expire in 2007.  The Company hasleased an operating facility in The Netherlands.  This lease expires in 2008.

 

Rent expense isrecognized on a straight-line basis over the term of the lease.  Rental expense for the Company’s operatingleases referred to above was $1,367,000 for the year ended September 30,2003, $1,368,000 for the year ended September 30, 2002, and $1,322,000 forthe year ended September 30, 2001.

 

The following is aschedule of future minimum rental payments required under operating leasesand future rental expense (in thousands):

 
| **Year Ending  September 30** |   | **Rental  Payments** |   | **Rental  Expense** |   |
|------------------------------------|--------|----------------------|--------|---------------------|--------|
|                               |   |                 |   |                |   |
| 2004                               |   | $                    | 1,429  |                | $      | 1,376 |   |
| 2005                               |   | 1,456                |   | 1,376               |   |
| 2006                               |   | 1,482                |   | 1,376               |   |
| 2007                               |   | 1,393                |   | 1,278               |   |
| 2008                               |   | 1,156                |   | 1,082               |   |
| Thereafter                         |   | 5,469                |   | 5,046               |   |
|                               |   |                 |   |                |   |
| Total                              |   | $                    | 12,385 |                | $      | 11,534 |   |

 

**10.**               MANDATORILY REDEEMABLE PREFERRED STOCKAND WARRANTS

** **

The Company issued1,340,366 shares of Series B convertible preferred stock (“Series B”) at aprice of $8.60 per share in conjunction with the acquisition of AMVC.  Each share of Series B, par value of$0.01 per share, may be converted into 2/3 of a share of common stock.  The Series B is convertible at the option ofthe holder at any time, unless previously redeemed, or by the Company upon amerger, consolidation, share exchange or sale of substantially all of itsassets.  The holders of Series Bmay require the Company to repurchase any or all of their shares at any timeafter July 12, 2002 at the redemption price of $10.00.  If not converted to common stock or redeemedat the option of the Series B holder after July 12, 2002, the Companymust redeem the Series B for $10.00 per share on July 12, 2005.  The redemption date may be accelerated ifthe average closing price of Key Technology common stock, as listed on theNasdaq National Market, is $15.00 or more for thirty consecutive tradingdays.  The Series B was accretedfrom its issue price to its scheduled redemption price using the effectiveinterest method.  In connection with thesale of Ventek (see Note 2), 200,595 shares of Series B were redeemedin a cash-less tender of Veneer Technology’s holdings.

 

The holders ofSeries B are entitled to vote on all matters based on the number of wholeshares of common stock into which the holder’s stock could be converted.  The holders of Series B are notentitled to any dividends.  In the eventof any liquidation, dissolution, or winding up of the company’s business, theholders of Series B would be entitled to a payment of $10.00 per sharebefore any amount is distributed to holders of common stock.  If assets were insufficient to permit thispayment to the holders of Series B, the entire assets available fordistribution to holders of capital stock would be distributed ratably among theholders of Series B.

 

46

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The Company also issued119,106 shares of Series C convertible preferred stock (“Series C”) at aprice of $20.00 per share in conjunction with the acquisition of AMVC.  In fiscal year 2001, the Series Cshareholder redeemed the entire outstanding amount of its shares and warrants.

 

The Company issued365,222 warrants at a fair market value of $10.00 per warrant in conjunctionwith the issuance of the convertible preferred stock.  Each warrant entitles its holder to purchase at any time for aperiod of five years from July 12, 2000 one share of common stock at$15.00 per share, subject to certain adjustments.  The warrants permit the holder to engage in a net exercise of thewarrants if the fair market value of one share of common stock is greater than$15.00 per share on the date of exercise. Prior to the expiration date of the warrant, the holder may require theCompany to redeem the warrant for cash at a price equal to $10.00 for eachwhole share of common stock that may be purchased under the warrant.  The warrant holders do not have the right tovote or participate in any matters as shareholders.

 

As of September 30,2003, there were 152,630 shares of Series B convertible preferred stockoutstanding and 35,553 warrants which had not been redeemed or converted.

 

**11.**               INCOME TAXES

** **

The provision (benefit)for income taxes from continuing operations consists of the following (inthousands):

 
|                                |   | **Year Ended September 30,** |   |
|-------------------------------------|--------|-----------------------------------|--------|
|                                |   | **2003**                          |   | **2002** |   | **2001** |   |
| Current:                            |   |                              |   |   |   |   |   |
| Federal                             |   | $                                 | 352    |   | $ | — |   | $ | — |   |
| State                               |   | 261                               |   | — |   | — |   |
|                                |   |                              |   |   |   |   |   |
|                                |   | 613                               |   | — |   | — |   |
| Deferred:                           |   |                              |   |   |   |   |   |
| Federal                             |   | 2,133                             |   | 1,127 |   | (1,247 | ) |
| State                               |   | (53                               | )      | 111 |   | (96 | ) |
|                                |   |                              |   |   |   |   |   |
|                                |   | 2,080                             |   | 1,238 |   | (1,343 | ) |
|                                |   |                              |   |   |   |   |   |
| Total  income tax expense (benefit) |   | $                                 | 2,693  |   | $ | 1,238 |   | $ | (1,343 | ) |

 

The tax effects oftemporary differences that give rise to significant portions of deferred taxassets and deferred tax liabilities are as follows (in thousands):

 

47

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|                                    |   | **September 30,** |   |
|-----------------------------------------|--------|------------------------|--------|
|                                    |   | **2003**               |   | **2002** |   |
| Deferred  tax asset:                    |   |                   |   |   |   |
| Reserves  and accruals                  |   | $                      | 2,014  |   | $ | 2,126 |   |
| NOL  and other tax credit carryforwards |   | 3,391                  |   | 5,756 |   |
| Translation  adjustment to equity       |   | 40                     |   | 425 |   |
| Deferred  tax liability:                |   |                   |   |   |   |
| Accumulated  depreciation               |   | (224                   | )      | (259 | ) |
| Intangible  assets                      |   | (2,723                 | )      | (3,084 | )  |
|                                    |   |                   |   |   |   |
| Net  deferred tax asset                 |   | $                      | 2,498  |   | $ | 4,964 |   |
|                                    |   |                   |   |   |   |
| Deferred  tax:                          |   |                   |   |   |   |
| Current  asset                          |   | $                      | 1,935  |   | $ | 1,730 |   |
| Long-term  asset                        |   | 768                    |   | 3,472 |   |
| Long-term  liability                    |   | (205                   | )      | (238 | )  |
|                                    |   |                   |   |   |   |
| Net  deferred tax asset                 |   | $                      | 2,498  |   | $ | 4,964 |   |

 

Income tax expense(benefit) is computed at rates different than statutory rates.  The reconciliation between effective andstatutory rates is as follows:

 
|                                                  |   | **Year Ended  September 30,** |   |
|-------------------------------------------------------|--------|------------------------------------|--------|
|                                                  |   | **2003**                           |   | **2002** |   | **2001** |   |
|                                                  |   |                               |   |   |   |   |   |
| Statutory rates                                       |   | 34.0                               | %      | 34.0 | % | (34.0 | )% |
| Increase (reduction) in income taxes resulting  from: |   |                               |   |   |   |   |   |
| ETI deductions                                        |   | (2.3                               | )      | (2.0 | ) | (3.5 | ) |
| R&D credit                                        |   | (0.3                               | )      | (0.6 | ) | (1.6 | ) |
| State income taxes, net of federal benefit            |   | 1.6                                |   | 2.0 |   | (1.7 | ) |
| Change in tax laws                                    |   | (1.8                               | )      | — |   | — |   |
| Other permanent differences                           |   | 0.7                                |   | 1.5 |   | 4.3 |   |
|                                                  |   |                               |   |   |   |   |   |
| Income tax combined effective rate                    |   | 31.9                               | %      | 34.9 | % | (36.5 | )% |

 

At September 30,2003, there were $8.5 million of net operating loss carryforwards whichexpire between 2007 and 2019, $110,000 of research and development creditcarryforwards which expire between 2020 and 2022, $335,000 of foreign taxcredit carryforwards which expire between 2005 and 2007, and $74,000 of AMTcredit carryforwards which do not expire.

 

**12.**               SHAREHOLDERS’ EQUITY

** **

***Employee StockPurchase Plan******—***Mostemployees are eligible to participate in the Company’s Employee Stock PurchasePlan (the “Purchase Plan”).  Shares arenot available to employees who already own 5% or more of the Company’sstock.  Employees can withhold, bypayroll deductions, up to 5% of their regular compensation to purchase sharesat a purchase price of 85% of the fair market value of the common stock on thepurchase date.  There were 500,000shares reserved for purchase under the Purchase Plan.  During the years ended September 30, 2003, 2002, and 2001,the Company issued shares totaling 6,918, 15,860, and 17,184, respectively,under the Purchase Plan.

 

***Employees’ StockOption Plan***—Under the Restated Employees’ StockOption Plan (the “Option Plan”), eligible employees may receive eitherincentive stock options or nonstatutory stock options and such options may beexercised only after an employee has remained in continuous employment for oneyear after the date of grant. Thereafter, the options become exercisable as stipulated by theindividual

 

48

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option agreements,generally 25% per year on the anniversary date of the grant.  The option price is fair market valuedetermined at date of grant.  Thefollowing table summarizes activity under this Option Plan:

 
|                           |   | **Outstanding  Options** |   |
|--------------------------------|--------|--------------------------|--------|
|                           |   | **Number of   Shares**   |   | **Weighted  Average  Price  Per Share** |   |
|                           |   |                     |   |   |   |
| Balance  at October 1, 2000    |   | 724,833                  |   | $ | 12.20 |   |
|                           |   |                     |   |   |   |
| Options  granted               |   | 40,000                   |   | $ | 7.89 |   |
| Options  forfeited             |   | (65,400                  | )      | $ | 13.21 |   |
|                           |   |                     |   |   |   |
| Balance  at September 30, 2001 |   | 699,433                  |   | $ | 11.86 |   |
|                           |   |                     |   |   |   |
| Options  granted               |   | 169,100                  |   | $ | 2.96 |   |
| Options  forfeited             |   | (49,600                  | )      | $ | 9.85 |   |
|                           |   |                     |   |   |   |
| Balance  at September 30, 2002 |   | 818,933                  |   | $ | 10.14 |   |
|                           |   |                     |   |   |   |
| Options  granted               |   | 182,500                  |   | $ | 8.98 |   |
| Options  exercised             |   | (11,837                  | )      | $ | 5.71 |   |
| Options  forfeited             |   | (52,033                  | )      | $ | 9.32 |   |
|                           |   |                     |   |   |   |
| Balance  at September 30, 2003 |   | 937,563                  |   | $ | 10.02 |   |

 

At September 30,2003, the total number of shares reserved for option exercises was 1,187,483,of which 238,083 were available for grant. At that date, options for 565,046 shares were exercisable at prices from$2.51 to $23.25 per share.  AtSeptember 30, 2002, the total number of shares reserved for optionexercises was 1,187,483, of which 368,550 were available for grant.  At that date, options for 493,958 shareswere exercisable at prices from $7.00 to $23.25 per share.  At September 30, 2001, the total numberof shares reserved for option exercises was 1,187,483, of which 488,050 wereavailable for grant.  At that date,options for 410,066 shares were exercisable at prices from $7.00 to $23.25 pershare.

 

49

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The following tablesummarizes information about stock options outstanding at September 30,2003:

 
| **Options Outstanding**        |   | **Options Exercisable** |   |
|--------------------------------|--------|-------------------------|--------|
| **Range of  Exercise  Prices** |   | **Number  Outstanding** |   | **Weighted  Average  Remaining  Contractual  Life (years)** |   | **Weighted  Average  Exercise  Price** |   | **Number of  Shares  Exercisable** |   | **Weighted  Average  Exercise  Price** |   |
|                           |   |                    |   |   |   |   |   |   |   |   |   |
| $2.51  - 5.00                  |   | 149,538                 |   | 4.1 |   | $ | 2.95 |   | 33,585 |   | $ | 2.95 |   |
| $5.00  - 10.00                 |   | 496,825                 |   | 3.3 |   | 8.63 |   | 260,261 |   | 8.52 |   |
| $10.01  - 15.00                |   | 129,700                 |   | 4.3 |   | 11.46 |   | 109,700 |   | 11.69 |   |
| $15.01  - 20.00                |   | 88,700                  |   | 3.4 |   | 17.25 |   | 88,700 |   | 17.25 |   |
| $20.01  - 23.25                |   | 72,800                  |   | 2.6 |   | 22.58 |   | 72,800 |   | 22.58 |   |
|                           |   |                    |   |   |   |   |   |   |   |   |   |
| $2.51  - 23.25                 |   | 937,563                 |   | 3.5 |   | $ | 10.02 |   | 565,046 |   | $ | 11.99 |   |
|                                |        |                         |        |  |  |  |  |  |  |  |  |  |  |  |

 

**13.**               EMPLOYEE BENEFIT PLANS

** **

The Company has a 401(k)profit sharing plan which covers substantially all employees.  The Company is required to match 50% ofemployee contributions up to 2% of each participating employee’scompensation.  The Company contributed$285,000, $250,000, and $331,000 in matching funds to the plan for the yearsended September 30, 2003, 2002, and 2001, respectively.

 

The 401(k) plan alsopermits the Company to make discretionary profit sharing contributions to allemployees.  Discretionary profit sharingcontributions are determined annually by the Board of Directors.  Profit sharing plan expense was $860,000,$238,000, and zero for the years ended September 30, 2003, 2002, and 2001,respectively.

 

**14.**               SEGMENT INFORMATION

** **

The Company’s businessunits serve customers in its primary market—the food processing andagricultural products industry—through common sales and distributionchannels.  Therefore, the Companyreports on one segment.  The followingtable summarizes information about products and services (in thousands).

 
|                                 |   | **Year Ended September 30,** |   |
|--------------------------------------|--------|-----------------------------------|--------|
|                                 |   | **2003**                          |   | **2002** |   | **2001** |   |
| Net  sales by product category:      |   |                              |   |   |   |   |   |
| Automated  inspection systems        |   | $                                 | 30,230 |   | $ | 24,965 |   | $ | 26,884 |   |
| Process  systems                     |   | 31,759                            |   | 25,767 |   | 27,050 |   |
| Parts  and service/contracts         |   | 20,633                            |   | 19,502 |   | 19,020 |   |
|                                 |   |                              |   |   |   |   |   |
| Total  net sales by product category |   | $                                 | 82,622 |   | $ | 70,234 |   | $ | 72,954 |   |

 

Net sales forservice/contracts were less than 10% of total net sales for the years endedSeptember 30, 2003, 2002, and 2001, respectively, and are thereforesummarized with parts.

 

50

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The following tablesummarizes information about geographic areas:

 
|                     |   | **Year Ended September 30,** |   |
|--------------------------|--------|-----------------------------------|--------|
|                     |   | **2003**                          |   | **2002** |   | **2001** |   |
| Net  sales:              |   |                              |   |   |   |   |   |
| Domestic                 |   | $                                 | 41,538 |   | $ | 40,590 |   | $ | 37,496 |   |
| International            |   | 41,084                            |   | 29,644 |   | 35,458 |   |
|                     |   |                              |   |   |   |   |   |
| Total  net sales         |   | $                                 | 82,622 |   | $ | 70,234 |   | $ | 72,954 |   |
|                     |   |                              |   |   |   |   |   |
| Long-lived  assets:      |   |                              |   |   |   |   |   |
| Domestic                 |   | $                                 | 14,067 |   | $ | 16,286 |   | $ | 26,995 |   |
| International            |   | 2,677                             |   | 2,683 |   | 3,031 |   |
|                     |   |                              |   |   |   |   |   |
| Total  long-lived assets |   | $                                 | 16,744 |   | $ | 18,969 |   | $ | 30,026 |   |

 

There was no customerthat accounted for greater than 10% of net sales during fiscal 2003.  During fiscal 2002 and 2001, net sales toone major customer amounted to approximately 16% and 17% of total net sales,respectively.

 

During 2003, net sales tovarious customers in Canada accounted for approximately 11% of total netsales.  During 2001, net sales tovarious customers in France accounted for approximately 10% of total net sales.  No single international geographic locationaccounted for more than 10% of net sales during 2002.  Location of the customer is the basis for the categorization ofnet sales.

 

**15.**               ROYALTY INCOME

** **

As part of a settlementagreement entered into during 1997, the Company received royalty paymentsthrough 2001 related to the sale of certain equipment to a selectedmarket.  The payment may be reduced by apercentage of the purchases of equipment from the Company by the otherparty.  The Company recognized royaltyincome from this agreement of zero, zero, and $122,000 during the years endedSeptember 30, 2003, 2002, and 2001, respectively.

 

* * * * * *

 

51

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**SUPPLEMENTARYDATA**

 

**QUARTERLY FINANCIAL INFORMATION***(Unaudited)*

** **

The following is asummary of operating results by quarter for the years ended September 30,2003 and 2002 (in thousands, except per share data):

 
| **2003 Quarter Ended**               |   | **December 31,** |   | **March 31,** |   | **June 30,** |   | **September 30,** |   | **Total** |   |
|--------------------------------------|--------|-----------------------|--------|--------------------|--------|-------------------|--------|------------------------|--------|-----------|--------|
|                                 |   |                  |   |               |   |              |   |                   |   |      |   |
| Net  sales                           |   | $                     | 15,395 |               | $      | 20,927            |   | $                      | 25,013 |      | $      | 21,287 |   | $ | 82,622 |   |
| Gross  profit                        |   | 6,305                 |   | 8,115              |   | 10,983            |   | 8,593                  |   | 33,996    |   |
| Net  earnings                        |   | 221                   |   | 1,153              |   | 3,002             |   | 1,383                  |   | 5,759     |   |
| Net  earnings per share—basic   |   | 0.05                  |   | 0.24               |   | 0.63              |   | 0.29                   |   | 1.21      |   |
| Net  earnings per share—diluted |   | 0.04                  |   | 0.23               |   | 0.60              |   | 0.27                   |   | 1.15      |   |
|                                      |        |                       |        |                    |        |                   |        |                        |        |           |        |  |  |  |  |  |

 
| **2002 Quarter Ended**                                                         |   | **December 31,** |   | **March 31,** |   | **June 30,** |   | **September 30,** |   | **Total** |   |
|--------------------------------------------------------------------------------|--------|-----------------------|--------|--------------------|--------|-------------------|--------|------------------------|--------|-----------|--------|
|                                                                           |   |                  |   |               |   |              |   |                   |   |      |   |
| Net  sales                                                                     |   | $                     | 13,945 |               | $      | 18,849            |   | $                      | 19,890 |      | $      | 17,550 |   | $ | 70,234 |   |
| Gross  profit                                                                  |   | 5,445                 |   | 7,512              |   | 8,283             |   | 6,642                  |   | 27,882    |   |
| Net  earnings (loss) from continuing operations                                |   | (323                  | )      | 823                |   | 1,390             |   | 418                    |   | 2,308     |   |
| Net  earnings from discontinued operation                                      |   | 39                    |   | —             |   | —            |   | —                 |   | 39        |   |
| Net  loss from change in accounting principle                                  |   | (4,302                | )      | —             |   | —            |   | —                 |   | (4,302    | )      |
| Net  earnings (loss)                                                           |   | (4,586                | )      | 823                |   | 1,390             |   | 418                    |   | (1,955    | )      |
| Net  earnings (loss) from continuing operations per share—basic           |   | (0.11                 | )      | 0.13               |   | 0.25              |   | 0.09                   |   | 0.36      |   |
| Net  earnings (loss) from continuing operations per share—diluted         |   | (0.11                 | )      | 0.13               |   | 0.25              |   | 0.08                   |   | 0.36      |   |
| Net  earnings from discontinued operations per share—basic and diluted    |   | 0.01                  |   | —             |   | —            |   | —                 |   | 0.01      |   |
| Net  loss from change in accounting principle per share—basic and diluted |   | (0.90                 | )      | —             |   | —            |   | —                 |   | (0.90     | )      |
| Net  earnings (loss) per share—basic                                      |   | (1.00                 | )      | 0.13               |   | 0.25              |   | 0.09                   |   | (0.53     | )      |
| Net  earnings (loss) per share—diluted                                    |   | (1.00                 | )      | 0.13               |   | 0.25              |   | 0.08                   |   | (0.53     | )      |
|                                                                                |        |                       |        |                    |        |                   |        |                        |        |           |        |  |  |  |  |  |

 

* * * * * *

 

52

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**ITEM9.****                 CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

 

None.

 

**ITEM9A.****     CONTROLSAND PROCEDURES.**

 

The Company’s Presidentand Chief Executive Officer and the Chief Financial Officer have reviewed thedisclosure controls and procedures relating to the Company atSeptember 30, 2003 and concluded that such controls and procedures wereeffective to provide reasonable assurance that all material information aboutthe financial and operational activities of the Company was made known tothem.  There were no changes in theCompany’s internal control over financial reporting during the quarter endedSeptember 30, 2003 that materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**PARTIII**

 

**ITEM10.****                DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT.**

 

There is herebyincorporated by reference the information under the captions “Election ofDirectors” and “Section 16(a) Beneficial Ownership Reporting Compliance”in the Company’s definitive Proxy Statement to be filed pursuant to Regulation14A, which Proxy Statement is anticipated to be filed with the Securities andExchange Commission within 120 days after the end of Registrant’s fiscal yearended September 30, 2003.

 

**ITEM11.****                EXECUTIVECOMPENSATION.**

 

There is herebyincorporated by reference the information under the caption “ExecutiveCompensation” in the Company’s definitive Proxy Statement to be filed pursuantto Regulation 14A, which Proxy Statement is anticipated to be filed with theSecurities and Exchange Commission within 120 days after the end ofRegistrant’s fiscal year ended September 30, 2003.

 

**ITEM12.****                SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS.**

 

There is herebyincorporated by reference the information under the caption “PrincipalShareholders” in the Company’s definitive Proxy Statement to be filed pursuantto Regulation 14A, which Proxy Statement is anticipated to be filed with theSecurities and Exchange Commission within 120 days after the end ofRegistrant’s fiscal year ended September 30, 2003.

 

53

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**Equity Compensation Plan Information**

 

The following tableprovides information as of September 30, 2003 with respect to the sharesof the Company’s Common Stock that may be issued under the Company’s existingequity compensation plans.

 
|                                                       |   | **A**                                                                        |   | **B**                                                        |   | **C**                                                                                                                                             |    |
|------------------------------------------------------------|--------|------------------------------------------------------------------------------|--------|--------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|---------|
| **Plan Category**                                          |   | **Number of Securities to  be Issued upon Exercise  of Outstanding Options** |   | **Weighted Average  Exercise Price of  Outstanding Options** |   | **Number of Securities Remaining  Available for Future Issuance  Under Equity Compensation  Plans (Excluding Securities  Reflected in Column A)** |    |
| Equity Compensation  Plans Approved by Shareholders        |   |                                                                         |   |                                                         |   |                                                                                                                                              |    |
| Restated Employees  Stock Option Plan                      |   | 937,653                                                                      |   | $                                                            | 10.02  |                                                                                                                                              | 238,083 |   |
| 1996 Employees’ Stock  Purchase Plan                  |   |                                                                         | (1)    |                                                         | (1)    | 421,095                                                                                                                                           |    |
| Equity Compensation  Plans Not Approved by Shareholders(2) |   |                                                                         |   |                                                         |   |                                                                                                                                              |    |
| Total                                                      |   | 937,653                                                                      |   | $                                                            | 10.02  |                                                                                                                                              | 659,178 |   |

 

----

(1)          We are unable toascertain with specificity the number of securities to be issued upon exerciseof outstanding rights under the 1996 Employee Stock Purchase Plan or theweighted average exercise price of outstanding rights under the plan.  Under the plan, eligible employees may makecontributions to the plan of not more than five percent of the participant’scompensation during each pay period in the offering period.  The offering periods commence quarterlybeginning October 1, January 1, April 1, and July 1 of eachyear.  Purchases are made on the lastbusiness day of each offering period at a purchase price per share equal to 85%of the fair market value of the Common Stock on the purchase date.  There are 500,000 shares of Common Stockreserved under the plan.

(2)          There are noEquity Compensation Plans that have not been approved by Shareholders.

 

**ITEM13.****                CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS.**

 

On July 14, 2003, with the approval of its boardof directors, the Company entered into a Consulting Agreement with formerPresident and CEO, Thomas C. Madsen to be in effect from January 1, 2004through December 31, 2006.  Theagreement provides for a monthly fee of $6,250, wherein Mr. Madsen, as anindependent contractor, is responsible for all attributable taxes.  The agreement contains a non-competeprovision whereby Mr. Madsen will not solicit for hire or assist others in thesolicitation for hire of any employees of the Company, or engage in anyactivity, whether directly or through or on behalf of one or more entities orother persons, that competes directly or indirectly with any product or serviceprovided by the Company to its customers in any geographic region then served bythe Company.

 

**ITEM14.****                PRINCIPALACCOUNTANT FEES AND SERVICES.**

 

There is hereby incorporated by reference theinformation under the caption “Audit Committee Report and Other RelatedMatters” in the Company’s definitive Proxy Statement to be filed pursuant toRegulation 14A, which Proxy Statement is anticipated to be filed with theSecurities and Exchange Commission within 120 days after the end ofRegistrant’s fiscal year ended September 30, 2003.

 

54

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**PARTIV**

 

**ITEM 15****.****                EXHIBITS,FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.**

 
|                                                               | **PAGE** |
|--------------------------------------------------------------------|----------|
| **(a) The following documents are filed as part of this  report:** |     |
|                                                               |     |
|                                                               | **1.**   | **Financial Statements:** |   |
|                                                               |     |   |   |
|                                                               |     | Reference is made to  Part II, Item 8, for a listing of required financial statements filed with  this report | 28 |
|                                                               |     |   |
|                                                               | **2.**   | **Financial Statement Schedules:** |
|                                                               |     |   |
|                                                               |     | Financial statement  schedules are omitted because they are not applicable or the required  information is included in the accompanying consolidated financial statements  or notes thereto. |
|                                                               |     |   |
|                                                               | **3.**   | **Exhibits:** |
|                                                               |     |   |
|                                                               |     | (3) | Articles of  Incorporation and Bylaws |
|                                                               |     |   |   |   |
|                                                               |     |   | (3.1) | Restated Articles of  Incorporation (filed as Exhibit 3.1 to the Registration Statement on Form S-1  (Registration No. 33-63194) filed with the Securities and Exchange Commission  on May 24, 1993 and incorporated herein by reference) |
|                                                               |     |   | (3.2) | Registrant’s Restated  Bylaws dated February 7, 2001 (filed as Exhibit 3.2 to the Form 10-Q  filed with the Securities and Exchange Commission on May 15, 2002 and  incorporated herein by reference) |
|                                                               |     |   |   |   |
|                                                               |     | (10) | Material contracts |
|                                                               |     |   |   |   |
|                                                               |     |   | (10.1) | Construction and Lease  Agreement dated October 17, 1989 between the Port of Walla Walla and  Registrant (filed as Exhibit 10.1 to the Registration Statement on Form S-1  (Registration No. 33-63194) filed with the Securities and Exchange Commission  on May 24, 1993 and incorporated herein by reference) |
|                                                               |     |   | (10.2)* | Registrant’s 1989  Employees’ Stock Option Plan, as amended (filed as Exhibit 10.5 to the  Registration Statement on Form S-1 (Registration No. 33-63194) filed with the  Securities and Exchange Commission on May 24, 1993 and incorporated  herein by reference) |
|                                                               |     |   | (10.3)* | Registrant’s 401(k)  Profit Sharing Plan dated May 11, 1992 (filed as Exhibit 10.6 to  Amendment No. 1 to Form S-1 (Registration No. 33-63194) filed with the  Securities and Exchange Commission on May 24, 1993 and incorporated  herein by reference) |
|                                                               |     |   | (10.4)* | Registrant’s Restated  1989 Employees’ Stock Option Plan, as amended (filed as Exhibit 10.1 to the  Form 10-Q filed with the Securities and Exchange Commission on May 12,  1995 and incorporated herein by reference) |
|                                                               |     |   | (10.5)* | Registrant’s 1996  Employees’ Stock Option Plan (filed as Exhibit 10.1 to the Form 10-Q filed  with the Securities and Exchange Commission on May 2, 1996 and  incorporated herein by reference) |
|                                                                    |          |  |  |  |  |

 

55

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|   |   |   | (10.6)*                                                                                                                           | Registrant’s 1996  Employee Stock Purchase Plan (filed as Exhibit 10.2 to the Form 10-Q filed  with the Securities and Exchange Commission on May 2, 1996 and  incorporated herein by reference)                                                                                       |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   | (10.7)                                                                                                                            | Lease Agreement dated  April 18, 1996 between the Port of Walla Walla and Registrant (filed as  Exhibit 10.1 to the Form 10-Q filed with the Securities and Exchange  Commission on August 7, 1996 and incorporated herein by reference)                                               |
|   |   |   | (10.8)*                                                                                                                           | Registrant’s Restated  Employees’ Stock Option Plan (1996 Plan as amended through July 12, 2000                                                                                                                                                                                   |
|   |   |   | (10.9)*                                                                                                                           | Registrant’s Profit  Sharing and 401(k) Plan 2001 Restatement                                                                                                                                                                                                                               |
|   |   |   | (10.10)*                                                                                                                          | Registrant’s Profit  Sharing and 401(k) Plan 2001 Restatement, Amendment No. 1                                                                                                                                                                                                              |
|   |   |   | (10.11)*                                                                                                                          | Registrant’s Profit  Sharing and 401(k) Plan 2001 Restatement, Amendment No. 2                                                                                                                                                                                                              |
|   |   |   | (10.12)*                                                                                                                          | Registrant’s Profit  Sharing and 401(k) Plan 2001 Restatement, Amendment No. 3                                                                                                                                                                                                              |
|   |   |   | (10.13)                                                                                                                           | Loan Agreement dated  August 9, 2002 between Registrant and Banner Bank                                                                                                                                                                                                                     |
|   |   |   | (10.14)                                                                                                                           | Revolving Note dated  August 9, 2002 between Registrant and Banner Bank                                                                                                                                                                                                                     |
|   |   |   | (10.15)                                                                                                                           | Term Note dated  August 9, 2002 between Registrant and Banner Bank                                                                                                                                                                                                                          |
|   |   |   | (10.16)                                                                                                                           | Reducing Non-Revolving  Note dated August 9, 2002 between Registrant and Banner Bank                                                                                                                                                                                                        |
|   |   |   | (10.17)                                                                                                                           | Credit Agreement dated  August 8, 2002 between Suplusco Holding B.V., Key Technology B.V. and  ABN AMRO Bank N.V. (filed as Exhibit 10.22 to the Form 10-Q filed with the  Securities and Exchange Commission on February 14, 2003 and incorporated  herein by reference)              |
|   |   |   | (10.18)                                                                                                                           | Amendment to Loan  Documents dated December 11, 2002 between Registrant and Banner Bank  (filed as Exhibit 10.23 to the Form 10-Q filed with the Securities and  Exchange Commission on February 14, 2003 and incorporated herein by  reference)                                       |
|   |   |   | (10.19)                                                                                                                           | Addendum No. 1 to  Construction and Lease Agreement executed December 31, 2002 between the  Port of Walla Walla and Registrant (filed as Exhibit 10.24 to the Form 10-Q  filed with the Securities and Exchange Commission on February 14, 2003  and incorporated herein by reference) |
|   |   |   | (10.20)                                                                                                                           | Amendment  to Loan Documents dated July 31, 2003 between Registrant and Banner Bank                                                                                                                                                                                                         |
|   |   | (14)   | Policy on Business  Ethics for Directors and Officers                                                                             |
|   |   | (21)   | List of Subsidiaries                                                                                                              |
|   |   | (23)   | Consent of Deloitte  & Touche LLP                                                                                             |
|   |   | (31.1) | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                     |
|   |   | (31.2) | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                     |
|   |   | (32.1) | Certification pursuant  to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|   |   | (32.2) | Certification pursuant  to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|   |   | (99.1) | Forward-Looking  Statement Risk and Uncertainty Factors                                                                           |
|   |   |   |                                                                                                                              |
|        |
|   |   | *      | Management contract or  compensatory plan or arrangement.                                                                         |
|        |        |        |                                                                                                                                   |                                                                                                                                                                                                                                                                                                  |  |

 

56

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| **(b) Reports on Form 8-K** |
|-----------------------------|
|                        |
|                        | The following reports  on Form 8-K were filed during the fourth quarter of fiscal 2003: |
|                        |
|                        | 1. | Registrant’s Form 8-K  dated July 24, 2003 and filed with the Securities and Exchange  Commission on July 24, 2003 related to a press release regarding Key’s  financial results for its third fiscal quarter ended June 30, 2003. |

 

57

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***SIGNATURES***

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|   |   | KEY TECHNOLOGY, INC. |
|--------|--------|----------------------|
|   |   |                 |
|   |   |                 | By: | /s/  Kirk W. Morton |   |
|   |   |                 |   | Kirk W. Morton |
|   |   |                 |   | President and Chief  Executive Officer |
|   |   |                 |   |   |
|   |   |                 | By: | /s/  Phyllis C. Best |   |
|   |   |                 |   | Phyllis C. Best |
|   |   |                 |   | Chief Financial Officer  (Principal Financial and Accounting Officer) |

 

December 19, 2003

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.

 

 
| /s/  Thomas C. Madsen                                                              |   | December 19, 2003 |
|-----------------------------------------------------------------------------------------|--------|------------------------|
| Thomas C. Madsen,  Chairman                                                             |   |                   |
|                                                                                    |   |                   |
| /s/  John E.  Pelo                                                                 |   | December 19, 2003 |
| John E. Pelo, Director                                                                  |   |                   |
|                                                                                    |   |                   |
| /s/  Michael L. Shannon                                                            |   | December 19, 2003 |
| Michael L. Shannon,  Director                                                           |   |                   |
|                                                                                    |   |                   |
| /s/  Peter H. van Oppen                                                            |   | December 19, 2003 |
| Peter H. van Oppen, Director                                                            |   |                   |
|                                                                                    |   |                   |
| /s/  Donald A. Washburn                                                            |   | December 19, 2003 |
| Donald A. Washburn, Director                                                            |   |                   |
|                                                                                    |   |                   |
| /s/  Gordon Wicher                                                                 |   | December 19, 2003 |
| Gordon Wicher, Director                                                                 |   |                   |
|                                                                                    |   |                   |
| /s/  Kirk W. Morton                                                                |   | December 19, 2003 |
| Kirk W. Morton,  President and Chief Executive Officer                                  |   |                   |
|                                                                                    |   |                   |
| /s/  Phyllis C. Best                                                               |   | December 19, 2003 |
| Phyllis  C. Best, Chief Financial Officer (Principal Financial and  Accounting Officer) |   |                   |

 

58

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KEY TECHNOLOGY, INC.

** **

**FORM10-K**

**EXHIBIT INDEX**

 
| **EXHIBIT  NUMBER** |   |                                                                                                                               |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                               |
| 10.20               |   | Amendment to Loan  Documents dated July 31, 2003 between Registrant and Banner Bank                                           |
|                |   |                                                                                                                               |
| 14                  |   | Policy on Business  Ethics for Directors and Officers                                                                              |
|                |   |                                                                                                                               |
| 21.1                |   | List of Subsidiaries                                                                                                               |
|                |   |                                                                                                                               |
| 23.1                |   | Consent of Deloitte  & Touche LLP                                                                                              |
|                |   |                                                                                                                               |
| 31.1                |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                      |
|                |   |                                                                                                                               |
| 31.2                |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                      |
|                |   |                                                                                                                               |
| 32.1                |   | Certification pursuant  to 18 U.S. C. Section 1350 as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 |
|                |   |                                                                                                                               |
| 32.2                |   | Certification pursuant  to 18 U.S. C. Section 1350 as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 |
|                |   |                                                                                                                               |
| 99.1                |   | Forward-Looking  Statement Risk and Uncertainty Factors                                                                            |

 

59

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