UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


WASHINGTON,
D.C.   20549


_____________________________________________


FORM
10-K


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


SECURITIES
EXCHANGE ACT OF 1934


for the
fiscal year ended September 30, 2008


or


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


SECURITIES
EXCHANGE ACT OF 1934


For the
transition period from ____ to ____.




Commission
File No. 0-21820


____________________________________________


KEY
TECHNOLOGY, INC.


(Exact
name of registrant as specified in its charter)





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





150
      Avery Street
              Walla
      Walla, Washington
              (Address
      of Principal Executive Offices)
            99362
              (Zip
      Code)





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


_____________________________________________


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


Title of each class
              Common
      Stock, no par value
            Name of each exchange on which
      registered
              Nasdaq
      Global Market


_____________________________________________


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


None




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




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




Indicate
by check mark whether the Registrant (1) has filed all reports required to be
filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the Registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.    Yes  ý No   ̈




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




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




Large
      accelerated filer  ̈
            Accelerated
      filer ýNon-accelerated
      filer  ̈ (Do
      not check if a smaller reporting company.)
            Smaller
      reporting company  ̈




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




The
aggregate market value of the Registrant's common stock held by non-affiliates
on March 31, 2008 (based on the last sale price of such shares) was
approximately $156,144,255.




There
were 5,257,621 shares of the Registrant's common stock outstanding on December
5, 2008.




DOCUMENTS
INCORPORATED BY REFERENCE


Parts of
Registrant's Proxy Statement dated on or about January 5, 2009 prepared in
connection with the Annual Meeting of Shareholders to be held on February 4,
2009 are incorporated by reference into Part III of this Report.




Table
of Contents


KEY TECHNOLOGY, INC.


2008
FORM 10-K


TABLE
OF CONTENTS





PAGEINFORMATION
      CONCERNING FORWARD-LOOKING STATEMENTS
                  1PART
      IItem
      1.
                  BUSINESS
                  2Item
      1A.
                  RISK
      FACTORS
                  10Item
      2.
                  PROPERTIES
                  15Item
      3.
                  LEGAL PROCEEDINGS
                  15Item
      4.
                  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
                  15PART IIItem
      5.
                  MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
                  16Item
      6.
                  SELECTED FINANCIAL DATA
                  19Item
      7.
                  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS
                  20Item
      7A.
                  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
                  32Item
      8.
                  FINANCIAL STATEMENTS AND SUPPLEMENTARY
    DATA
                  34Item
      9.
                  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
      AND FINANCIAL DISCLOSURE
                  61Item
      9A.
                  CONTROLS AND PROCEDURES
                  61PART IIIItem
      10.
                  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
      GOVERNANCE
                  62Item
      11.
                  EXECUTIVE COMPENSATION
                  62Item
      12.
                  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT AND RELATED STOCKHOLDER MATTERS
                  62Item
      13.
                  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND
      DIRECTOR INDEPENDENCE
                  63Item
      14.
                  PRINCIPAL ACCOUNTANT FEES AND SERVICES
                  63PART IVItem
      15.
                  EXHIBITS AND FINANCIAL STATEMENT
    SCHEDULES
                  63SIGNATURES
                  
                  66EXHIBIT INDEX
                  
                  67
 Table
of Contents




INFORMATION CONCERNING FORWARD-LOOKING
STATEMENTS





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





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


·
            current
      worldwide economic conditions may adversely affect the Company’s business
      and results of operations, and the business of the Company’s
      customers;


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


·
            the
      loss of any of the Company’s significant customers could reduce the
      Company’s revenues and
profitability;


·
            the
      Company is subject to pricing pressure from its larger customers which may
      reduce the Company’s profitability;


·
            the
      failure of any of the Company's independent sales representatives to
      perform as expected would harm the Company's net
  sales;


·
            the
      Company may make acquisitions that could disrupt the Company’s operations
      and harm the Company’s operating
results;


·
            issues
      arising during the implementation of the Company's enterprise resource
      planning (“ERP”) system could affect the Company’s operating results and
      ability to manage the Company’s business
  effectively;


·
            if
      the Company's ERP system is not implemented properly, it could cause
      errors in the Company's financial
reporting;


·
            the
      Company's international operations subject the Company to a number of
      risks that could adversely affect the Company’s revenues, operating
      results and growth;


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


·
            failure
      of the Company’s new products to compete successfully in either existing
      or new markets;


·
            the
      Company's inability to retain and recruit experienced personnel may
      adversely affect the Company’s business and prospects for
      growth;


·
            the
      loss of members of the Company’s management team could substantially
      disrupt the Company’s business
operations;


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


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


·
            the
      Company's dependence on certain suppliers may leave the Company
      temporarily without adequate access to raw materials or
      products;


·
            the
      limited availability and possible cost fluctuations of materials used in
      the Company’s products could adversely affect the Company’s gross profits;
      and


·
            the
      price of the Company's common stock may fluctuate significantly and this
      may make it difficult for shareholders to resell common stock when they
      want or at prices they find
attractive.





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


1
 Table
of Contents


PART I





ITEM
1.                     BUSINESS.





General





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





The
Company and its operating subsidiaries design, manufacture, sell and service
process automation systems that process product streams of discrete pieces to
improve safety and quality.  These systems integrate electro-optical
automated inspection and sorting systems with process systems that include
specialized conveying and preparation equipment. The Company provides parts and
service for each of its product lines to customers throughout the
world.





Net sales
for the year ended September 30, 2008 were $134.1 million compared with $107.5
million for fiscal 2007.  The Company reported net earnings for fiscal
2008 of $7.5 million, or $1.35 per diluted share, compared with net earnings of
$7.4 million, or $1.37 per diluted share, for fiscal 2007, which included a
$750,000 gain, or $0.14 per share, from the 2007 sale of the Company’s 50%
interest in its InspX joint venture.  Export and international sales
for the fiscal years ended September 30, 2008, 2007 and 2006 accounted for 50%,
46% and 51% of net sales in each such year, respectively.





Industry
Background





Food
Processing Industry





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





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





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





The
principal potato market served by the Company’s systems is french
fries.  French fries comprise a significant portion of the frozen
potato products processed annually in the United States.  The
expansion of American-style fast food chains in other countries is resulting in
continued development of the frozen french fry market
overseas.  Current domestic investment in new french fry processing
facilities has flattened relative to historical levels, largely in response to
changing consumer preferences.  However, investments in process yield
enhancement and in greater process throughputs from existing plants remain
significant items for the Company and


2
 Table
of Contents


its
customers in the potato market.  The Company’s recent diversification
strategies have resulted in less dependence on this industry although it
continues to be a strategically important market.





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





The
Company believes the food processing companies are financially strong, yet are
faced with the need to improve profitability while satisfying external pressures
to hold constant or reduce prices for their own products and provide safer
products to the consuming public.  Since the Company’s equipment
results in higher process yields, improved product quality and safety, as well
as reduced processing costs, the Company believes these companies will have
increased interest in the Company’s products to satisfy these needs, allowing
for expanded sales into the food processing industry in future
years.  Due to the seasonal nature of the food processing industry,
the Company does experience some seasonality of orders and
shipments.  Orders and shipments for this industry in the Company’s
first two fiscal quarters of the year tend to be lower than during the Company’s
other fiscal quarters.  Demand for the Company’s products remained
strong during fiscal 2008 due to positive market and geographical opportunities,
and new product introductions by the Company.





Non-food
Industries – Tobacco, Pharmaceuticals and Nutraceuticals





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





In fiscal
2008, the tobacco industry represented less than 5% of the Company’s
sales.  The Company’s products provide tobacco companies sorting
capability to remove foreign matter from a stream of stripped
tobacco.





In fiscal
2008, the pharmaceutical and nutraceutical industries also represented less than
5% of the Company’s sales.  The Company’s products provide
pharmaceutical and nutraceutical manufacturers with capabilities to verify
correct doses and meet acceptable quality levels for finished
products.





Products





The
following table sets forth sales by product category for the periods indicated
(in thousands):





Fiscal
      Year Ended September 30,2008
                      
                      
                      2007
                      
                      
                      2006Automated
      inspection systems
                      
                      $
                      55,968
                      
                      
                      
                      42
                      %
                      
                      $
                      46,858
                      
                      
                      
                      44
                      %
                      
                      $
                      30,264
                      
                      
                      
                      36
                      %Process
      systems
                      
                      
                      56,603
                      
                      
                      
                      42
                      %
                      
                      
                      40,947
                      
                      
                      
                      38
                      %
                      
                      
                      34,925
                      
                      
                      
                      41
                      %Parts
      and
      service
                      
                      
                      21,515
                      
                      
                      
                      16
                      %
                      
                      
                      19,735
                      
                      
                      
                      18
                      %
                      
                      
                      19,651
                      
                      
                      
                      23
                      %Net sales
                      
                      $
                      134,086
                      
                      
                      
                      100
                      %
                      
                      $
                      107,540
                      
                      
                      
                      100
                      %
                      
                      $
                      84,840
                      
                      
                      
                      100
                      %





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





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


3
 Table
of Contents





Fiscal
      Year Ended September 30,2008
                        
                        
                        2007
                        
                        
                        2006Automated
      inspection
      systems
                        
                        
                        45
                        %
                        
                        
                        51
                        %
                        
                        
                        44
                        %Process
      systems
                        
                        
                        37
                        %
                        
                        
                        30
                        %
                        
                        
                        30
                        %Parts
      and
      service
                        
                        
                        18
                        %
                        
                        
                        19
                        %
                        
                        
                        26
                        %Total gross
margin
                        
                        
                        100
                        %
                        
                        
                        100
                        %
                        
                        
                        100
                        %





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





Automated
Inspection Systems





Automated
inspection systems are used in various applications to detect and remove defects
and foreign materials from production lines, most often during processing of raw
and semi-finished products.  The Company’s product families within
this group include the following:  MantaTM, Tegra®and
Optyx®, which
are used in a variety of applications and industries; Tobacco SorterTM
3  tobacco sorting systems used in tobacco threshing and primary
processing; ADR®
automatic defect removal systems used in the french fry industry; and Optyx®SG used
in the pharmaceutical and nutraceutical industry.





The
Company’s automated inspection systems incorporate object-based sorting
technology that recognizes not only color, size and shape characteristics, but
also density and fluorescence sensing.  This capability provides a
solution to previously difficult sorting problems, such as differentiation
between green beans and green bean stems.  To ease operation, the
sorters are equipped with application-specific software packs called
KeyWare®, which
are designed for a single product category.  Object Linking and
Embedding for Process Control (“OPC”)-compliant network communication software,
introduced in 2008, allows the systems to easily interface with plant networks,
extending machine monitoring and communication control capabilities beyond the
plant floor to the control room.  The systems operate on Key’s
advanced G6 electro-optical platform, which features a controller, modular
vision engine and high-resolution cameras.  Modular designs and the
use of industry-wide connectivity standards ease future upgrades to keep the
systems up to date and performing optimally as technology advances.





Nearly
all systems in this group use proprietary linear array, charged coupled device
(“CCD”) monochromatic, color or multi-spectral cameras.  Additionally,
Manta and Optyx can be equipped with Raptor Laser Technology or FluoRaptorTM, a
fluorescence-sensing laser, in combination with the cameras.  The
cameras and laser-sensors scan the product-streams, which move at 5 to 20 feet
per second, at the rate of 1,500 to 8,000 times per second and can identify
defects as small as 1/128 of an inch in diameter.  Systems with
monochromatic cameras generally are sold at lower price levels and are most
effective for product that has a marked disparity in shade between the defective
and the good product.  Systems with color cameras are required when a
variety of defect and product colors occur simultaneously, when the difference
in shading between the defective and the good product is more subtle, and when
shape sorting is required.  Multi-spectral systems can utilize
infrared or ultraviolet technologies, individually or in combination with
visible light, to identify defects that are best differentiated from good
product outside the visible light spectra.  Systems with laser
technology detect foreign matter based on differences in the structural
properties of the objects, regardless of color or shape.





Manta.  Introduced
in 2008, Manta is the Company’s highest capacity optical
sorter.  Featuring high-resolution inspection and a 79-inch scan width
within a space-saving footprint, Manta handles up to 60,000 pounds of processed
vegetables or fruit per hour.  With the highest number of sensors and
image processing modules, Manta maintains the high resolution of the finest
narrow-belt sorters on its wider, higher-capacity frame.  Key can
configure Manta with up to eight top-mounted color or Vis/IR (visible infrared)
cameras and up to two top-mounted Raptor or FluoRaptor
lasers.  Optional bottom-mounted sensors can be added to meet the
specific needs of each application.  Manta’s dynamic design supports
on-belt viewing as well as off-belt, in-air viewing.  In addition to
processed vegetables and fruit, Manta is being developed for other industry
applications.





Tegra
System.  Inspecting product in-air using cameras configured in
a tilted-X geometry that look at oblique angles, Tegra views product from all
sides.  A unique metal-mesh catenary C-belt® uses
gravity and centrifugal force


4
 Table
of Contents


–
not friction – to gently accelerate, stabilize and launch product into the
inspection zone.  Ideal for highly three-dimensional products such as
slices, dices and larger round objects that may have small defects on one
surface, applications include potato products, green beans, dried beans, corn,
carrots, pears, peaches and coffee.  Tegra is available with a 60-inch
wide platform to sort up to 45,000 pounds of product an hour and a 30-inch wide
platform to sort up to 22,500 pounds of product an hour, depending on the
product.





Optyx
System.  Using a combination of on-belt and in-air sorting,
Optyx is a versatile family of sorters that can be equipped with cameras or a
combination of cameras and lasers.  The lower cost Optyx 3000 series
features a 24-inch scan width to sort up to 18,000 pounds of product an hour,
offering the power and sorting capabilities of a larger sorter in an economical
and compact machine ideal for smaller processors and lower volume processing
lines.  The Optyx 6000 series features a 48-inch scan width to sort up
to 36,000 pounds of product an hour.  Optyx sorters have gained strong
acceptance in segments of the fruit, vegetable, processed potato, dried fruit,
nut, and snack food markets. Additionally, Optyx has been placed in applications
inspecting pharmaceuticals, nutraceuticals, tobacco and recycled commodities
such as paper and plastic.





Laser-sensing
technology, including the Company’s Raptor Laser Technology and FluoRaptor, a
fluorescence-sensing laser, can be integrated into Manta and Optyx sorters,
along with cameras.  Color cameras enable the sorter to analyze size
and shape and millions of subtle color differences while the lasers detect
foreign matter based on differences in the structural properties of the objects,
regardless of color or shape.  Combining color sorting with laser
technology achieves the most complete sort, maximizing the removal of defects
and foreign matter.  Raptor is ideal for a variety of fresh, frozen
and dried fruits and vegetables, including frozen potato products, tree nuts,
raisins and other foods.  FluoRaptor inspects product based on
differing levels of chlorophyll and is ideal for a variety of fresh and frozen
vegetables and potato products.





Tobacco Sorter
3.  The tobacco industry has special requirements in the
handling and sorting of its tobacco products, which vary in size and moisture
content and other properties depending upon the type of product being produced
and the point of handling and inspection.  Key’s Tobacco Sorter 3
(TS3) utilizes a specially constructed frame, enclosure and material handling
arrangement to meet the specific product inspection requirements of this
industry.  TS3 recognizes millions of colors, detecting and removing
foreign materials, as well as subtle product defects from strip tobacco, tobacco
stem and other leafy product (such as tea). This technology helps achieve high
purity standards to reduce exposure to product liability claims.  TS3
has been installed in North America, Latin America, Europe and
Asia.





ADR
System.  Featuring a belt conveyor, LED light source, Vis/IR
cameras, air-actuated knives on a patented rotary cutter and Iso-Flo®
vibratory conveyor, ADR 5 aligns, singulates, inspects and trims defects from
peeled and peel-on French fries and removes the defects from the product
stream.  The Company believes its ADR system is the principal defect
removal system used in the french fry processing industry.  ADR5
combines the wide footprint of ADR III with the high speed accuracy of ADR 4 to
handle as much as 17,000 to 27,000 pounds of product per hour, depending on the
cut size.  The system can also cut excessively long strips to control
product length, a function especially valuable for fast-food
products.  In 2008, ADR®First was introduced which
gives french fry processors the capability of using the ADR earlier in the
primary processing line than it has traditionally been placed.





Pharmaceutical and Nutraceutical
Inspection Systems.  In fiscal 2007, the Company introduced the
OptyxSG/P and OptyxSG/N inspection systems, the ImpulseTM size grading system,
and the PulseScrubber® softgel
polishing system.  In fiscal 2008, pharmaceutical and nutraceutical
customers successfully installed and qualified all of these products, including
validations required for GAMP (Good Automated Manufacturing Practices) and
21CFR11 required by the FDA.  The Company also introduced its concept
of Continuous Softgel Finishing Lines which is based on replacement of
individual, manual processing steps with continuous processes that use the
Company's Impulse/P size grader, PulseScrubber, and OptyxSG system together in
one continuous line.  In fiscal 2008, the Company sold several systems in
this configuration which indicates growing acceptance of this concept for the
pharmaceutical and nutraceutical industry.





The
OptyxSG/P enables the Company to offer a fully FDA 21CFR11-compliant,
high-volume inspection solution to solid dose pharmaceutical
manufacturing.  Applicable to over the counter and prescription drugs,
the OptyxSG/P meets validation requirements pharmaceutical customers face when
selecting automation for their FDA-


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regulated
production lines.  The OptyxSG/N is targeted at the nutraceutical
market and includes many of the features of the OptyxSG/P without the specific
enhancements required for the regulated pharmaceutical market.





The
Impulse/P, derived from the Company’s Impulse vibratory conveyor technology,
provides high-volume vibratory size grading that complements other automation
solutions like the OptyxSG-series.  Since the introduction of the
Impulse/P solid dose size grading product line, the Company continues to build
toward more comprehensive “full line” solutions.





The
PulseScrubber product is targeted at the softgel manufacturing segment and
provides a fully-automated, high-volume continuous-flow alternative to
traditional batch-oriented softgel polishing.  Like the Impulse/P, the
PulseScrubber complements other systems to provide customers the economic
benefits of highly-integrated continuous automation.





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





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





Process
Systems





Conveying
and process systems are utilized worldwide throughout processing industries to
move and process product within a production plant.  The Company’s
conveying and process systems include the SmartShaker®
vibratory solutions of Iso-Flo® and
ImpulseTM branded conveyor systems, Farmco rotary grading systems, Turbo-Flo® steam
blanchers, Freshline products for fresh-cut, and additional conveying and
processing equipment.  The functions of these product lines include
conveying, transferring, distributing, aligning, feeding, metering, separating
and grading, as well as blanching, cooking, pasteurizing, cooling, cleaning,
washing, drying and packaging.  The process systems group includes
standard products as well as custom designed equipment.





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





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





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





Rotary grading systems.The
mechanical sizing, sorting, separating, and grading products manufactured at the
Redmond, Oregon manufacturing site are used in many food processing and fresh
vegetable packing operations.  These rotary sizing and grading
technologies optimize yield, increase packaging efficiency, and improve product
quality by either removing oversized, undersized and small irregular-shaped
pieces of product from the line or


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separating
product into predetermined size categories.  In combination with other
Company-provided equipment, these products increase overall line efficiency and
systems capability.





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





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





Freshline
products.  This product line addresses the fresh-cut produce
industry by providing a range of low to high volume equipment, including low to
high volume washers and automatic dryers.  This range of processing
solutions consists of individual machines and large-scale production lines with
automated control systems.





Parts
and Service





The
Company has a large installed base of inspection and processing systems. This
installed base generates potential business for the Company’s parts and service
products.  The Company has made parts and service an area of strategic
focus, and realigned its organization to leverage the large installed base and
its strong customer support organization.





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





Engineering,
Research and Development





At
September 30, 2008, the Company’s research and development department had
49 employees who conduct new product research and development and
sustaining engineering for released products.  The Company’s technical
staff includes electronic, optical, mechanical and software engineers,
mathematicians and technical support personnel.





At
September 30, 2008, the Company’s project engineering department had 43
employees engaged in project engineering for custom systems.  The
project engineering teams are responsible for engineering and designing the
details of each custom order.  A document control team maintains and
controls product documentation and the product modeling database for the
development engineering and project engineering teams as well as the
manufacturing department.





In fiscal
2008, the Company’s research and development expenses, together with engineering
expenses not applied to the manufacturing costs of products, were approximately
$8.7 million, compared to $5.5 million and $6.4 million in 2007 and 2006,
respectively.





Manufacturing





The
Company maintains two domestic manufacturing facilities, one located in Walla
Walla, Washington and one in Redmond, Oregon.  The Company also has a
European manufacturing facility located in The Netherlands.


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The
Company’s current manufacturing facilities and its product design and
manufacturing processes integrate Computer Aided Engineering (CAE), Finite
Element Analysis (FEA), Computer Aided Design (CAD), Computer Aided
Manufacturing (CAM) and Computer Integrated Manufacturing (CIM)
technologies.  Manufacturing activities include process engineering;
fabrication, welding, finishing, and assembly of custom designed stainless steel
systems; camera and electronics assembly; subsystem assembly; and system test
and integration.  The following table provides a summary of the
Company’s manufacturing locations and manufacturing floor space:





Location
            Manufacturing
      Size in Square Feet
            Products/Services
      ProducedWalla
      Walla, Washington
            132,000
            Automated
      Inspection
              Process
      Systems
              Parts
      and ServiceRedmond,
      Oregon
            17,000
            Process
      Systems
              Parts
      and ServiceBeusichem,
      The Netherlands
            38,000
            Process
      Systems
              Parts
      and Service





The
Company manufactures certain of its products to Underwriters Laboratories and
United States Department of Agriculture standards.  Certain of the
Company’s products also comply with the Canadian Standards Association (CSA),
European CE (Conformité Européene) and Electronic Testing Laboratory (ETL)
safety standards.  Certain products for the
pharmaceutical/nutraceutical industry are FDA 21CFR11-compliant and designed
using GAMP4 guidelines.  The Company’s domestic facilities were
recertified to the ISO 9001:2000 standard in 2006.





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





Environmental





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





Sales
and Marketing





The
Company markets its products worldwide both directly and through independent
sales representatives.  In fiscal 2008, sales by independent sales
representatives accounted for approximately 26% of the Company's consolidated
net sales.  In North America, the Company operates sales offices in
Walla Walla, Washington; Medford, Oregon; Redmond, Oregon; and Santiago de
Querétaro, Mexico.  The Company’s subsidiary, Key Technology B.V.,
provides sales and service to European and Middle Eastern and South African
customers.  The Company’s subsidiary, Key Technology Australia Pty
Ltd., provides sales and service to customers primarily in Australia and New
Zealand.  The Company’s subsidiary Productos Key Mexicana S. de R.L.
de C.V. provides sales and service to customers in Mexico, Central and South
America.  The Company’s subsidiary, Key Technology (Shanghai) Trading
Company Ltd., provides sales and service to customers in greater
China.  The Company supplies products from both product groups -
automated inspection systems and process systems - to customers in its primary
markets through common sales and distribution channels.  In addition,
the Company supplies parts and service through its worldwide service
organization.





Most
exports of products manufactured in the United States for shipment into
international markets, other than Europe, have been denominated in U.S.
dollars.  Sales into Europe of systems, spare parts and service, as
well as products manufactured in Europe, are generally denominated in European
currencies, most commonly Euros.  As the Company expands its
operations in Australia, Latin America and China, transactions denominated in
the local currencies of these countries may increase.  In its export
and international sales, the Company is subject to the risks of conducting
business internationally, including unexpected changes in regulatory
requirements; fluctuations in the value of the U.S. dollar, which could increase
or decrease the sales prices in local currencies of the
Company’s


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products
in international markets; tariffs and other barriers and restrictions; and the
requirements of complying with a variety of international
laws.  Additional information regarding export and international sales
is set forth in Note 14 to the Company’s Consolidated Financial Statements for
the fiscal year ended September 30, 2008





During
fiscal 2008, 2007 and 2006, sales to our largest customer, McCain Foods,
represented approximately 14%, 9% and 17% of total net sales,
respectively.  During fiscal 2008, sales to Frito-Lay were
approximately 13% of total net sales.  While the Company believes that
its relationship with these customers is satisfactory, the loss of these
customers could have a material adverse effect on the Company’s revenues and
results of operations.





Backlog





The
Company’s backlog as of September 30, 2008 and September 30, 2007 was
approximately $33.8 million and $30.9 million, respectively.  The
Company schedules production based on firm customer commitments and forecasted
requirements.  The Company includes in backlog only those customer
orders for which it has accepted purchase orders.





Competition





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





Patents
and Trademarks





The
Company currently holds forty-three United States patents issued from 1991
through 2008, and twelve other national patents issued by other
countries.  The first of these patents expires in calendar 2009, and
the Company believes that expiration will not have a significant effect on the
Company.  As of December 5, 2008, fourteen other national patent
applications have been filed and are pending in the United States and other
countries, and three international or regional applications have been filed that
are awaiting the national phase.  The Company has forty registered
trademarks and six pending applications for trademarks.





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





Employees





At
September 30, 2008, the Company had 612 full-time employees, including 297 in
manufacturing, 92 in engineering, research and development, 153 in marketing,
sales and service, and 66 in general administration and finance.  A
total of 140 employees are located outside the United States.  The
Company utilizes temporary contract employees, which improves the Company’s
ability to adjust manpower in response to changing demand for Company
products.  Of the total employees at September 30, 2008, fifteen were
contract employees.  None of the Company’s employees in the United
States are represented by a labor union.  The manufacturing employees
located at the Company’s facility in Beusichem, The Netherlands are represented
by the Small Metal Union.  The Company has never experienced a work
stoppage, slowdown or strike.




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Available
Information





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








ITEM
1A.           RISK
FACTORS.





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





Current
worldwide economic conditions may adversely affect the Company’s business and
results of operations, and the business of the Company’s customers.





The
Company’s business may be affected by general economic conditions and
uncertainty that may cause customers to defer or cancel new orders and sales
commitments previously made to us.  Recent economic difficulties in
the United States credit markets and certain international markets may lead to
an economic recession in some or all of the markets in which the Company
operates.  A recession or even the risk of a potential recession may
be sufficient reason for customers to delay, defer or cancel purchase decisions,
including decisions previously made.





The
recent disruptions in credit and other financial markets and deterioration of
national and global economic conditions, could, among other things:





·
              adversely
      affect the Company’s expansion
plans;


·
            impair
      the financial condition of some of the Company’s customers and suppliers,
      thereby increasing customer bad debts or non-performance by
      suppliers;


·
              negatively
      affect global demand for the Company’s customers' products, particularly
      in the food industry, which could result in a reduction of sales,
      operating income and cash
flows;


·
            negatively
      affect the Company’s customer’s ability to get financing, which could
      result in a reduction in sales, operating income and cash
      flows;


·
              decrease
      the value of the Company’s cash investments in marketable
      securities;


·
            make
      it more difficult or costly for the Company to obtain financing for the
      Company’s operations or
investments;


·
              negatively
      affect the Company’s risk management activities if the Company is required
      to record losses related to financial instruments or experience
      counterparty failure;


·
            require
      asset write-downs; or


·
              impair
      the financial viability of the Company’s
  insurers.




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





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




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The
loss of any of the Company’s significant customers could reduce the Company’s
revenues and profitability.





The
Company does have significant, strategic customers and the Company anticipates
that its operating results may continue to depend on these customers for the
foreseeable future.  The loss of any one of those customers, or a
significant decrease in the volume of products they purchase from the Company,
could adversely affect the Company's revenues and materially adversely affect
its profitability.  Any difficulty in collecting outstanding amounts
due from one of those customers may also harm the Company's sales.  In
addition, sales to any particular large customer may fluctuate significantly
from quarter to quarter causing fluctuations in the Company’s quarterly
operating results.





The
Company is subject to pricing pressure from its larger customers which may
reduce the Company’s profitability.





The
Company faces significant pricing pressures from its larger
customers.  Because of their purchasing volume, the Company’s larger
customers can influence market participants to compete on price
terms.  Such customers also use their buying power to negotiate lower
prices.  If the Company is not able to offset price reductions
resulting from these pressures by improved operating efficiencies and reduced
expenditures, such price reductions may have an adverse effect on the Company’s
profit margins and net earnings.





The
failure of any of the Company's independent sales representatives to perform as
expected would harm the Company's net sales.





In fiscal
2008, sales by independent sales representatives accounted for approximately 26%
of the Company's consolidated net sales.  If the Company's independent
sales representatives fail to market, promote and sell the Company’s products
adequately, the Company's business will be adversely affected.  The
Company's independent sales representatives could reduce or discontinue sales of
its products, or they may not devote the resources necessary to sell the
Company's products in the volumes and within the time frames that the Company
expects, either of which events could adversely affect the Company's revenues
and net earnings.





The
Company may make acquisitions that could disrupt the Company’s operations and
harm the Company’s operating results.





The
Company may in the future make acquisitions of businesses that offer products,
services, or technologies that the Company believes would complement its
business.  Acquisitions present significant challenges and risks and
there can be no assurances that the Company will manage acquisitions
successfully.  Acquisitions involve numerous risks,
including:




·
                significant
      potential expenditures of cash, stock, and management
      resources;
 ·
              difficulty
      achieving the potential financial and strategic benefits of the
      acquisition;
 ·
                difficulties
      in integrating acquired operations or products, including the potential
      loss of key employees from the acquired
  business;
 ·
              difficulties
      and costs associated with integrating and evaluating the information
      systems and internal control systems of the acquired
    business;
 ·
                impairment
      of assets related to goodwill resulting from the acquisition, and
      reduction in the Company’s future operating results from amortization of
      intangible assets;
 ·
              diversion
      of management's attention from the Company’s core business, including loss
      of management focus on marketplace
development;
 ·
                potential
      difficulties in complying with foreign regulatory requirements, including
      multi-jurisdictional competition
rules;
 ·
              adverse
      effects on existing business relationships with suppliers and customers,
      including the potential loss of suppliers and customers of the acquired
      business;
 ·
                assumption
      of liabilities, known and unknown, related to litigation and other legal
      process involving the acquired
business;
 ·
              entering
      geographic areas or distribution channels in which the Company has limited
      or no prior experience; and
 ·
                those
      risks related to general economic and political
  conditions.
 
 11
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  There can
be no assurance that attractive acquisition opportunities will be available to
us, that we will be able to obtain financing for or otherwise consummate any
acquisition, or that any acquisition that we do consummate will prove to be
successful.


Issues
arising during the implementation of the Company's enterprise resource planning
system could affect the Company’s operating results and ability to manage the
Company’s business effectively.





The
Company is in the process of implementing an enterprise resource planning, or
ERP, system in the near future to enhance operating efficiencies and provide
more effective management of the Company's business operations.  If
the Company experiences problems with the implementation of the ERP system, the
resulting disruption could adversely affect the Company's sales, manufacturing
processes, results of operations and financial
condition.  Implementing the Company's ERP system involves numerous
risks, including:





·
              the
      possibility that the complexities related to switching certain management
      information functions to the ERP system will be greater than
      expected;


·
            the
      possibility that the implementation could disrupt operations if the
      transition to the ERP system creates new or unexpected difficulties, or if
      the ERP system does not perform as
expected;


·
              difficulties
      integrating the new ERP system with the Company's current
      operations;


·
            potential
      delays in processing customer orders for shipment of
    products;


·
              diversion
      of management's attention from normal daily business
      operations;


·
            dependence
      on an unfamiliar system while the Company continues to train employees on
      the ERP system; and


·
              increased
      operating expenses resulting from training, conversion and transition
      support activities.





If
the Company's ERP system is not implemented properly, it could cause errors in
the Company's financial reporting.





The
Company may experience difficulties in transitioning to the ERP system that
could disrupt its ability to timely and accurately process and report key
components of the Company's results of operations, financial position and cash
flows.  Any disruptions or difficulties that may occur in connection
with implementing, making changes to or enhancing the Company's ERP system could
also adversely affect its ability to complete the evaluation of its internal
controls and attestation activities pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002.





The
Company's international operations subject the Company to a number of risks that
could adversely affect the Company’s revenues, operating results and
growth.





The
Company conducts business outside the United States, which subjects it to the
risks inherent in international operations.  In fiscal 2008, the
Company's international sales represented approximately 50% of its consolidated
net sales, compared to 46% of its consolidated net sales in fiscal
2007.  Risks inherent in international operations include the
following:




·
                unexpected
      changes in regulatory
requirements;
 ·
              restrictive
      governmental actions (such as restrictions on the transfer or repatriation
      of funds and trade protection measures, including export duties and
      quotas, customs duties and tariffs, or trade barriers erected by either
      the United States or other countries where the Company does
      business);
 ·
                scrutiny
      of foreign tax authorities which could result in significant fines,
      penalties and additional
taxes;
 ·
              changes
      in import or export licensing
requirements;
 ·
                longer
      payment cycles;
 ·
              transportation
      delays;
 ·
                pricing
      pressure that the Company may experience
  internationally;
  12
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  ·
              economic
      downturns, civil disturbances or political
  instability;
 ·
                geopolitical
      turmoil, including terrorism or
war;
 ·
              currency
      restrictions and exchange rate
fluctuations;
 ·
                difficulties
      and costs of staffing and managing geographically disparate
      operations;
 ·
              changes
      in labor standards;
 ·
                laws
      and business practices favoring local
companies;
 ·
              limitations
      on the Company's ability under local laws to protect its intellectual
      property;
 ·
                changes
      in domestic and foreign tax rates and laws;
and
 ·
              difficulty
      in obtaining sales representatives and servicing products in foreign
      countries.
  Competition
and advances in technology may adversely affect sales and prices.





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





The
Company’s new products may not compete successfully in either existing or new
markets, which would adversely affect sales.





The
future success and growth of the Company is dependent upon its ability to
develop, market, and sell products and services in certain food processing
markets as well as to introduce new products into other existing and potential
markets.  There can be no assurance the Company can successfully
penetrate these potential markets or expand into new international markets with
its current or new and future products.  Many of the Company’s
competitors manufacture their products in jurisdictions with substantially lower
corporate tax rates than in the United States which adversely affects the
Company’s ability to compete in certain potential markets.





The
Company's inability to retain and recruit experienced personnel may adversely
affect the Company’s business and prospects for growth.





The
Company's success depends in part on the skills and experience of its key
employees.  The loss of services of such employees could adversely
affect the Company's business until suitable replacements can be
found.  In addition, the Company's headquarters are located in Walla
Walla, Washington, a small, relatively remote geographic location.  As
such, there may be a limited number of individuals locally with the requisite
skill and experience, and the Company has from time-to-time experienced
difficulty recruiting individuals from larger metropolitan areas. Consequently,
the Company may not be able to retain and recruit a sufficient number of
qualified individuals on acceptable terms to maintain its business or achieve
planned growth.





The
loss of members of the Company’s management team could substantially disrupt the
Company’s business operations.





Our
success depends to a significant degree upon the continued individual and
collective contributions of our management team.  A limited number of
individuals have primary responsibility for managing our business, including our
relationships with key customers.  These individuals are integral to
our success based on their expertise and knowledge of our business and
products.  The loss of the services of members of the management team
and other key employees could have a material adverse effect on the
Company.





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





The
Company’s competitive position may be affected by its ability to protect its
proprietary technology.  The Company has obtained certain patents and
has filed a number of patent applications.  The Company also
anticipates filing applications for protection of its future products and
technology.  There can be no assurance that any such


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patents
will provide meaningful protection for the Company’s product innovations, or
that the issuance of a patent will give the Company any material advantage over
its competition in connection with any of its products.  The Company
may experience additional intellectual property risks in international markets
where it may lack patent protection.  The patent laws of other
countries, such as China, may differ from those of the U.S. as to the
patentability of the Company’s products and processes.  Moreover, the
degree of protection afforded by foreign patents may be different from that of
U.S. patents.





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





The
technologies used by the Company may infringe the patents or proprietary
technology of others, and the Company has been required in the past to initiate
litigation to protect its patents.  The cost of enforcing the
Company’s patent rights in lawsuits that it may bring against infringers or of
defending itself against infringement charges by other patent holders or other
third parties, including customers, may be high and could have an adverse effect
on the Company’s results of operations and its customer relations.





The
Company's dependence on certain suppliers may leave the Company temporarily
without adequate access to raw materials or products.





The
Company relies on third-party domestic and foreign suppliers for certain raw
materials and component products, particularly in the Company’s automated
inspection equipment product line.  Several of these suppliers are the
single source of the raw material or component provided to the
Company.  The Company does not have long-term contracts with any
supplier.  The Company may be adversely affected in the event that
these suppliers cease operations or if pricing terms become less
favorable.  The loss of a key vendor may force the Company to purchase
its necessary raw materials and components in the open market, which may not be
possible or may be at higher prices, until it could secure another
source.  There is no assurance that the terms of any subsequent supply
arrangements the Company may enter into would be as favorable as the supply
arrangements the Company currently has in place.  If the Company is
unable to replace a key supplier, it may face delays in delivering finished
products, which could have an adverse effect on the Company’s sales and
financial performance.





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





Certain
basic materials, such as stainless steel, are used extensively in the Company’s
product fabrication processes.  Such basic materials have in the
recent past been subject to worldwide shortages or price fluctuations related to
the supply of or demand for raw materials, such as nickel, which are used in
their production by the Company’s suppliers.  A significant increase
in the price or decrease in the availability of one or more of these components,
subassemblies or basic materials could adversely affect the Company’s results of
operations.





The
price of the Company's common stock may fluctuate significantly, and this may
make it difficult for shareholders to resell common stock when they want or at
prices they find attractive.





The
Company expects that the price of its common stock could fluctuate as a result
of a variety of factors, many of which are beyond its control.  These
factors include:




·
                quarterly
      variations in the Company's operating
results;
 ·
              operating
      results that vary from the expectations of management, securities analysts
      and investors;
 ·
                significant
      acquisitions or business combinations, strategic partnerships, joint
      ventures or capital commitments involving the Company or its
      competitors;
 ·
              changes
      in expectations as to the Company's future financial
      performance;
 ·
                the
      operating and securities price performance of other companies that
      investors believe are comparable to the
Company;
 ·
              future
      sales of the Company's equity or equity-related
  securities;
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·
                changes
      in general conditions in the Company's industry and in the economy, the
      financial markets and the domestic or international political situation;
      and
 ·
              departures
      of key personnel.


In
addition, in recent periods the stock market in general has experienced
unprecedented price and volume fluctuations.  This volatility has had
a significant effect on the market price of securities issued by many companies
for reasons often unrelated to their operating performance.  These
broad market fluctuations may adversely affect the Company's stock price,
regardless of its operating results.








ITEM
2.            PROPERTIES.





The
Company owns or leases the following properties:





Location
            Purpose
            Square
      Feet
            Owned
      or Leased
            Lease
      Expires
            Renewal
      PeriodWalla
      Walla, Washington
            Corporate
      office, manufacturing, research and development, sales and marketing,
      administration
            173,000
            Owned
      (1)
            n/a
            n/aRedmond,
      Oregon
            Manufacturing,
      research and development, sales, administration
            19,000
            Leased
            2012
            2017Beusichem,
      The Netherlands
            Manufacturing,
      sales and marketing, administration
            45,000
            Leased
            2013
            Renewable
      in 5 year incrementsBeusichem,
      The Netherlands
            Parts
      warehouse, future manufacturing expansion
            18,000
            Owned
      (2)
            n/a
            n/a





(1)
            Subsequent
      to the end of the fiscal year, the Company purchased this
      facility.(2)
            Subsequent
      to the end of the fiscal year, the Company approved a plan to list this
      property with a broker and sell this
facility.





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





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





ITEM
3.             LEGAL
PROCEEDINGS.





From
time-to-time, the Company is named as a defendant in legal proceedings arising
out of the normal course of its business.  As of December 5, 2008, the
Company was not a party to any material legal proceedings.





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





None.




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PART II





ITEM 5.
            MARKET
      FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES.




Common
Stock





Shares of
the Company’s common stock are quoted on the Nasdaq Global Market under the
symbol “KTEC”.  The following table shows the high and low sales
prices per share of the Company’s common stock by quarter for the two most
recent fiscal years ending September 30, 2008:





Stock
      price by quarter
              
              High
              
              LowFiscal
      year ended September 30, 2008First Quarter
              
              $36.250
              
              $25.000Second Quarter
              
              $38.830
              
              $25.870Third Quarter
              
              $39.470
              
              $27.860Fourth Quarter
              
              $35.310
              
              $21.230Fiscal
      year ended September 30, 2007First Quarter
              
              $15.230
              
              $11.311Second Quarter
              
              $16.870
              
              $13.500Third Quarter
              
              $23.100
              
              $15.190Fourth Quarter
              
              $30.950
              
              $21.170





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





The
Company had approximately 2,174 beneficial owners of its common stock, of which
228 are of record, as of December 5, 2008.





The
Company has not historically paid dividends on its common or preferred
stock.  The Board of Directors presently intends to continue its
policy of retaining earnings for reinvestment in the operations of the
Company.





Issuer Purchases of Equity
Securities





The
following table provides information about purchases made by or on behalf of the
Company during the quarter ended September 30, 2008 of equity securities
registered by the Company under Section 12 of the Securities Exchange Act of
1934.





Stock
      Repurchase ProgramPeriod
                                          
                                          Total
      Number of Shares Purchased (1)
                                          
                                          
                                          Average
      Price Paid per Share (1)
                                          
                                          
                                          Total
      Number of Shares Purchased as Part of Publicly Announced Plans or
      Programs
                                          
                                          Maximum
      Number of Shares that May Yet Be Purchased Under the Plans or
      ProgramsJuly
      1-31, 2008
                                          
                                          0
                                          
                                          
                                          -
                                          
                                          
                                          0August
      1-31, 2008
                                          
                                          3,307
                                          
                                          
                                          $
      32.95
                                          
                                          
                                          0September
      1-30, 2008
                                          
                                          1,906
                                          
                                          
                                          $23.70
                                          
                                          
                                          0Total
                                          
                                          5,213
                                          
                                          
                                          $29.56
                                          
                                          
                                          0
                                          
                                          411,748(2)





(1)
            Represents
      shares of restricted stock surrendered to satisfy tax withholding
      obligations.


(2)
            The
      Company initiated a stock repurchase program effective November 27,
      2006.  The Company was authorized to purchase up to 500,000
      shares of its common stock under the program.  Pursuant to the
      program, the Company repurchased 88,252 shares in fiscal
      2007.  The Company did not repurchase any shares in fiscal
      2008.  Subsequent to the end of fiscal 2008, the Board of
      Directors restored the number of shares that may be repurchased to the
      original 500,000 share amount, and subsequently increased
    the




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number of
shares that may be repurchased under the share repurchase program to 750,000
shares.  During the period from October 1, 2008 through December 5,
2008, the Company purchased an additional 388,511 shares at an average price of
$12.32 per share.




17
 Table
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STOCK
PERFORMANCE GRAPH





COMPARISON OF FIVE-YEAR
CUMULATIVE TOTAL RETURN


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









TOTAL
      RETURN ANALYSIS9/30/2003
              9/30/2004
              9/30/2005
              9/30/2006
              9/30/2007
              9/30/2008Key
      Technology
              $   100.00
              $    94.79
              $   119.63
              $   107.66
              $   253.54
              $   199.63New
      Peer Group
              $   100.00
              $   151.68
              $   161.24
              $   148.03
              $   227.34
              $   300.86Old
      Peer Group *
              $   100.00
              $   153.38
              $   176.69
              $   192.47
              $   344.57
              $   351.84Russell
      Microcap
              $   100.00
              $   114.86
              $   134.35
              $   143.77
              $   157.69
              $   122.17





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





NEW
PEER GROUP:  Cognex Corp., Perceptron, Inc., Flir Systems, Inc., Elbit
Vision Systems Ltd., PPT Vision, Inc., Robotic Vision Systems, Inc., John Bean
Technologies Corporation, K-Tron International, Inc.





*
In reviewing its’ current “old” Peer Group, the Company believes that it is no
longer representative of the Company’s Peers for performance comparison
purposes. The Company believes that the “new” Peer Group, as listed above, is a
more appropriate representation of its’ Peers. Thus, beginning with the 2009
Form 10-K, the Company will replace the “old” Peer Group with the “new” Peer
Group.





**
FMC Technologies, currently included in the “old” Peer Group, spun off John Bean
Technologies Corporation in July of 2008. As a result, the Company has removed
FMC Technologies from the Peer Group, and replaced it with John Bean
Technologies Corporation, whose line of business it believes to be much closer
to that of the Company.






18
 Table
of Contents




ITEM
6.                      SELECTED
FINANCIAL DATA.





The
selected consolidated financial information set forth below for each of the five
years in the period ended September 30, 2008 has been derived from the audited
consolidated financial statements of the Company.  The information
below should be read in conjunction with Management's Discussion and Analysis of
Financial Condition and Results of Operations and the Company’s Consolidated
Financial Statements and Notes thereto as provided in Item 7 and Item 8 of this
Annual Report on Form 10-K, respectively.




Fiscal
      Year Ended September 30,2008
                      
                      
                      2007
                      
                      
                      2006
                      
                      
                      2005
                      
                      
                      2004(in
      thousands, except per share data)Statement
      of Operations Data:Net
      sales
                      
                      $
                      134,086
                      
                      
                      $
                      107,540
                      
                      
                      $
                      84,840
                      
                      
                      $
                      80,322
                      
                      
                      $
                      80,610Cost
      of
      sales
                      
                      
                      80,893
                      
                      
                      
                      66,099
                      
                      
                      
                      53,041
                      
                      
                      
                      49,145
                      
                      
                      
                      46,887Gross
      profit
                      
                      
                      53,193
                      
                      
                      
                      41,441
                      
                      
                      
                      31,799
                      
                      
                      
                      31,177
                      
                      
                      
                      33,723Operating
      expenses
                      
                      
                      42,952
                      
                      
                      
                      32,839
                      
                      
                      
                      31,743
                      
                      
                      
                      27,193
                      
                      
                      
                      28,295Gain
      on sale of
      assets
                      
                      
                      81
                      
                      
                      
                      23
                      
                      
                      
                      109
                      
                      
                      
                      28
                      
                      
                      
                      5Income
      from
      operations
                      
                      
                      10,322
                      
                      
                      
                      8,625
                      
                      
                      
                      165
                      
                      
                      
                      4,012
                      
                      
                      
                      5,433Other
      income
      (expense)
                      
                      
                      666
                      
                      
                      
                      1,961
                      
                      
                      
                      (980
                      )
                      
                      
                      (419
                      )
                      
                      
                      (132
                      )Earnings
      (loss) from continuing operations before income taxes
                      
                      
                      10,988
                      
                      
                      
                      10,586
                      
                      
                      
                      (815
                      )
                      
                      
                      3,593
                      
                      
                      
                      5,301Income
      tax (benefit)
      expense
                      
                      
                      3,515
                      
                      
                      
                      3,176
                      
                      
                      
                      (22
                      )
                      
                      
                      902
                      
                      
                      
                      1,617Net
      earnings
                      
                      
                      7,473
                      
                      
                      
                      7,410
                      
                      
                      
                      (793
                      )
                      
                      
                      2,691
                      
                      
                      
                      3,684Assumed
      dividends on mandatorily redeemable preferred stock
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      (33
                      )
                      
                      
                      (69
                      )Net
      earnings (loss) available to common shareholders
                      
                      $
                      7,473
                      
                      
                      $
                      7,410
                      
                      
                      $
                      (793
                      )
                      
                      $
                      2,658
                      
                      
                      $
                      3,615Earnings
      (loss) per
      share                    –
      basic
                      
                      $
                      1.38
                      
                      
                      $
                      1.41
                      
                      
                      $
                      (0.15
                      )
                      
                      $
                      0.53
                      
                      
                      $
                      0.74–
      diluted
                      
                      $
                      1.35
                      
                      
                      $
                      1.37
                      
                      
                      $
                      (0.15
                      )
                      
                      $
                      0.52
                      
                      
                      $
                      0.71Cash
      dividends per share
                      
                      $
                      --
                      
                      
                      $
                      --
                      
                      
                      $
                      --
                      
                      
                      $
                      --
                      
                      
                      $
                      --Shares
      used in per share calculation – basic
                      
                      
                      5,430
                      
                      
                      
                      5,265
                      
                      
                      
                      5,205
                      
                      
                      
                      5,041
                      
                      
                      
                      4,909–
      diluted
                      
                      
                      5,517
                      
                      
                      
                      5,407
                      
                      
                      
                      5,205
                      
                      
                      
                      5,219
                      
                      
                      
                      5,222Balance
      Sheet Data:Cash
      and cash equivalents and short-term investments
                      
                      $
                      36,322
                      
                      
                      $
                      27,880
                      
                      
                      $
                      15,246
                      
                      
                      $
                      13,181
                      
                      
                      $
                      8,817Working
      capital
                      
                      
                      47,531
                      
                      
                      
                      40,946
                      
                      
                      
                      30,057
                      
                      
                      
                      28,164
                      
                      
                      
                      20,991Property,
      plant and equipment, net.
                      
                      
                      8,705
                      
                      
                      
                      4,671
                      
                      
                      
                      4,275
                      
                      
                      
                      4,264
                      
                      
                      
                      5,046Total
      assets
                      
                      
                      89,625
                      
                      
                      
                      75,497
                      
                      
                      
                      57,938
                      
                      
                      
                      57,527
                      
                      
                      
                      52,514Current
      portion of long-term debt
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      1
                      
                      
                      
                      1,121
                      
                      
                      
                      1,210Long-term
      debt, less current portion
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      1,199
                      
                      
                      
                      2,323Mandatorily
      redeemable preferred stock and warrants, including current
      portion
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      1,595Shareholders'
      equity
                      
                      $
                      60,368
                      
                      
                      $
                      50,393
                      
                      
                      $
                      41,252
                      
                      
                      $
                      40,471
                      
                      
                      $
                      36,044




Certain
reclassifications have been made to prior year amounts to conform to the current
year presentation.
  19
 Table
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ITEM 7.
            MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS.





Introduction





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





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





Overview





Sales for
the year ended September 30, 2008 were $134.1 million compared with $107.5
million for fiscal 2007.  The Company reported net earnings for fiscal
2008 of $7.5 million, or $1.35 per diluted share, compared with net earnings of
$7.4 million, or $1.37 per diluted share, for fiscal 2007.  Fiscal
year 2007 included a $750,000 gain, or $0.14 per share, of non-operating income
associated with the sale of the Company’s 50% interest in its InspX joint
venture.  Net earnings increased in fiscal 2008 compared to fiscal
2007 as a result of a 24.7% increase in sales volume, reflecting the 18.7%
increase in orders for fiscal 2008, as well as the improvement of gross margins
to 39.7% in fiscal 2008 from 38.5% in fiscal 2007.  These increases
were partially offset by increased operating expenses of $43.0 million, or 32%
of net sales, compared to $32.8 million, or 30.5% of net sales, for fiscal 2007
and unfavorable changes in foreign currency exchange rates, particularly in the
fourth quarter of fiscal 2008.  Automated inspection systems sales
were up 19%, process systems sales were up 38%, and parts and service sales
increased 9% over the prior fiscal year.  The primary market forces
driving demand for our products are: the increased concerns about food safety
and security, the inability of food and pharmaceutical processors to obtain cost
effective labor, and the Company’s expansion into international
markets.  Export and international sales for the fiscal years ended
September 30, 2008, 2007 and 2006 accounted for 50%, 46% and 51% of net sales in
each year, respectively.





In 2008,
the Company focused efforts on four major initiatives to achieve its long-term
revenue growth plan:





·
            Continue
      to grow the Company’s core food processing markets including potatoes,
      fresh-cut, and processed fruit and
vegetables;


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


·
            Strengthen
      and grow the level of international business, including the Asia Pacific
      and Latin America regions; and


·
            Continue
      to grow the Company’s aftermarket product
lines.





In 2008,
sales in our core food processing businesses, including upgrades, accounted for
a significant portion of the company’s increased revenues.  Sales in
potatoes, fresh-cut, and processed fruit and vegetables all increased
significantly in 2008, and orders for the fresh-cut business grew 278% over
fiscal 2007.  Significant progress, however, was also realized with
respect to the other three major initiatives.  The pharmaceutical
initiative began in the fourth quarter of 2005 with the formation of the
SYMETIX® business
unit.  This business unit was formed to dedicate a team of employees
to develop and grow Key’s business in the pharmaceutical and nutraceutical
market.  Anticipated penetration into this market will extend and
advance the Company’s existing patented, high-resolution inspection technology
and material handling platforms.  Revenue increased $2.8 million in
fiscal 2008 to $4.9 million as efforts on the pharmaceutical initiative began to
make progress.





The
Company has historically been successful in selling tobacco sorters in
China.  Larger opportunities exist there in the food processing
business, and the Company invested in China during fiscal 2006 to enhance sales,
service and applications support to build upon its established
base.  In 2006, the Company opened an office and located personnel
in-country.  In 2008, order volume in China increased 166% over fiscal
2007, indicating that the


20
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Company’s
expansion efforts gained some traction.  However, a significant
portion of the order volume increase related to tobacco orders, and the Company
is still developing its marketing and product strategies to be more successful
in the Chinese food processing market.  In 2008, the Company was
successful in increasing its penetration in the Latin America markets, where
orders increased 84% over orders received in fiscal 2007.





The
Company also focused on its aftermarket product lines (which include
parts/service and upgrades) during fiscal 2008.  With the introduction
of the G6 family of products in 2005, this enhanced vision engine technology
provided additional product upgrade opportunities.  Upgrades are an
important aspect of the aftermarket product lines, and the modular G6 product
family, which provides advanced image processing capability, has been well
received by the Company’s current customers.  Aftermarket sales
(including upgrades which are classified in automated inspection systems)
increased in fiscal 2008 over fiscal 2007 by 17% to $38.5 million.





The
Company’s strategic initiatives for 2009 are to continue to build upon the
direction and solid revenue base the Company developed during
2008.  The focus for the coming year is to continue to grow sales in
the Company’s core markets and geographical regions, and invest in a
market-driven technology road map that provides the new products required by our
customers.  In addition, the Company will focus on four primary
industries: potatoes, fresh cut produce, processed fruit and vegetables, and
pharmaceutical/nutraceutical, and focus on four developing regions: China, Latin
America, Eastern Europe and the Middle East.





The
Company also plans to continue to make significant investments in research and
development expenditures and to implement its global Enterprise Resource
Planning, or ERP, system.  Efforts in research and development will
continue to focus on customer solutions, providing new products that meet
current needs as well as anticipated future functionality
requirements.  The Company began preliminary work on developing a
global ERP system in the third and fourth quarters of fiscal
2007.  Implementation will be spread over a three-year period into
fiscal year 2010.  A significant portion of the ERP implementation
costs will be capitalized.  During fiscal 2008, the Company incurred
operating expenses of $1.2 million and capital expenditures of approximately
$2.3 million associated with the implementation of the ERP
system.  Cumulative ERP-related operating expenses and capital
expenditures are $1.2 million and $3.0 million, respectively.





Application
of Critical Accounting Policies





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





·
            Revenue
      recognition


·
            Allowances
      for doubtful accounts


·
            Valuation
      of inventories


·
            Long-lived
      assets


·
            Allowances
      for warranties


·
            Accounting
      for income taxes





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





Revenue
Recognition.  The Company recognizes revenue when persuasive
evidence of an arrangement exists, delivery has occurred or services have been
provided, the sale price is fixed or determinable, and collectability is
reasonably assured.  Additionally, the Company sells its goods on
terms which transfer title and risk of loss at a specified location, typically
shipping point, port of loading or port of discharge, depending on the final
destination of the goods.  Accordingly, revenue recognition from
product sales occurs when all criteria are met, including transfer of title and
risk of loss, which occurs either upon shipment by the Company or upon receipt
by customers at the location specified in the terms of sale.  Sales of
system upgrades are recognized as revenue upon completion of


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the
conversion of the customer’s existing system when this conversion occurs at the
customer site.  Revenue earned from services (maintenance,
installation support, and repairs) is recognized ratably over the contractual
period or as the services are performed.  If any contract provides for
both equipment and services (multiple deliverables), the sales price is
allocated to the various elements based on objective evidence of fair
value.  Each element is then evaluated for revenue recognition based
on the previously described criteria.  The Company’s sales
arrangements provide for no other significant post-shipment
obligations.  If all conditions of revenue recognition are not met,
the Company defers revenue recognition.  In the event of revenue
deferral, the sale value is not recorded as revenue to the Company, accounts
receivable are reduced by any amounts owed by the customer, and the cost of the
goods or services deferred is carried in inventory.  In addition, the
Company periodically evaluates whether an allowance for sales returns is
necessary.  Historically, the Company has experienced few sales
returns.  If the Company believes there are potential sales returns,
the Company will provide any necessary provision against sales.  In
accordance with the Financial Accounting Standard Board’s Emerging Issues Task
Force Issue No. 01-9, “Accounting for Consideration Given
by a Vendor to a Customer or a Reseller of the Vendor’s Product,” the
Company accounts for cash consideration (such as sales incentives) that are
given to customers or resellers as a reduction of revenue rather than as an
operating expense unless an identified benefit is received for which fair value
can be reasonably estimated.  The Company believes that revenue
recognition is a “critical accounting estimate” because the Company’s terms of
sale vary significantly, and management exercises judgment in determining
whether to recognize or defer revenue based on those terms.  Such
judgments may materially affect net sales for any period.  Management
exercises judgment within the parameters of accounting principles generally
accepted in the United States of America (GAAP) in determining when contractual
obligations are met, title and risk of loss are transferred, the sales price is
fixed or determinable and collectability is reasonably assured.  At
September 30, 2008, the Company had invoiced $2.9 million compared to $2.3
million at September 30, 2007 for which the Company has not recognized
revenue.





Allowances for doubtful
accounts.  The Company establishes allowances for doubtful
accounts for specifically identified, as well as anticipated, doubtful accounts
based on credit profiles of customers, current economic trends, contractual
terms and conditions, and customers’ historical payment
patterns.  Factors that affect collectability of receivables include
general economic or political factors in certain countries that affect the
ability of customers to meet current obligations.  The Company
actively manages its credit risk by utilizing an independent credit rating and
reporting service, by requiring certain percentages of down payments, and by
requiring secured forms of payment for customers with uncertain credit profiles
or located in certain countries.  Forms of secured payment could
include irrevocable letters of credit, bank guarantees, third-party leasing
arrangements or EX-IM Bank guarantees, each utilizing Uniform Commercial Code
filings, or the like, with governmental entities where possible.  The
Company believes that the accounting estimate related to allowances for doubtful
accounts is a “critical accounting estimate” because it requires management
judgment in making assumptions relative to customer or general economic factors
that are outside the Company’s control.  As of September 30, 2008, the
balance sheet included allowances for doubtful accounts of
$308,000.  Amounts charged to bad debt expense for fiscal 2008 and
2007 were $116,000 and $16,000, respectively.  Actual charges to the
allowance for doubtful accounts for fiscal 2008 and 2007 were $230,000 and
$98,000, respectively.  If the Company experiences actual bad debt
expense in excess of estimates, or if estimates are adversely adjusted in future
periods, the carrying value of accounts receivable would decrease and charges
for bad debts would increase, resulting in decreased net earnings.





Valuation of
inventories.  Inventories are stated at the lower of cost or
market. The Company’s inventory includes purchased raw materials, manufactured
components, purchased components, service and repair parts, work in process,
finished goods and demonstration equipment.  Write downs for excess
and obsolete inventories are made after periodic evaluation of historical sales,
current economic trends, forecasted sales, estimated product lifecycles and
estimated inventory levels.  The factors that contribute to inventory
valuation risks are the Company’s purchasing practices, electronic component
obsolescence, accuracy of sales and production forecasts, introduction of new
products, product lifecycles and the associated product support.  The
Company actively manages its exposure to inventory valuation risks by
maintaining low safety stocks and minimum purchase lots, utilizing just in time
purchasing practices, managing product end-of-life issues brought on by aging
components or new product introductions, and by utilizing inventory minimization
strategies such as vendor-managed inventories.  The Company believes
that the accounting estimate related to valuation of inventories is a “critical
accounting estimate” because it is susceptible to changes from period-to-period
due to the requirement for management to make estimates relative to each of the
underlying factors ranging from purchasing to sales to production to after-sale
support.  At


22
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September
30, 2008, cumulative inventory adjustments to lower of cost or market totaled
$1.7 million compared to $1.8 million as of September 30,
2007.  Amounts charged to expense to record inventory at lower of cost
or market for fiscal 2008 and 2007 were $708,000 and $386,000,
respectively.  Actual charges to the cumulative inventory adjustments
upon disposition or sale of inventory were $801,000 and $903,000 for fiscal 2008
and 2007, respectively.  If actual demand, market conditions or
product lifecycles are adversely different from those estimated by management,
inventory adjustments to lower market values would result in a reduction to the
carrying value of inventory, an increase in inventory write-offs, and a decrease
to gross margins.





Long-lived
assets.  The Company regularly reviews all of its long-lived
assets, including property, plant and equipment, and amortizable intangible
assets, for impairment whenever events or changes in circumstances indicate that
the carrying value may not be recoverable.  If the total of projected
future undiscounted cash flows is less than the carrying amount of these assets,
an impairment loss based on the excess of the carrying amount over the fair
value of the assets is recorded.  In addition, goodwill is reviewed
based on its fair value at least annually.  As of September 30, 2008,
the Company held $13.5 million of property, plant and equipment, goodwill and
other intangible assets, net of depreciation and amortization.  There
were no changes in the Company’s long-lived assets that would result in an
adjustment of the carrying value for these assets.  Estimates of
future cash flows arising from the utilization of these long-lived assets and
estimated useful lives associated with the assets are critical to the assessment
of recoverability and fair values.  The Company believes that the
accounting estimate related to long-lived assets is a “critical accounting
estimate” because:  (1) it is susceptible to change from period to
period due to the requirement for management to make assumptions about future
sales and cost of sales generated throughout the lives of several product lines
over extended periods of time; and (2) the potential effect that recognizing an
impairment could have on the assets reported on the Company’s balance sheet and
the potential material adverse effect on reported earnings or
loss.  Changes in these estimates could result in a determination of
asset impairment, which would result in a reduction to the carrying value and a
reduction to net earnings in the affected period.





Allowances for
warranties.  The Company’s products are covered by standard
warranty plans included in the price of the products ranging from 90 days to
five years, depending upon the product and contractual terms of
sale.  The Company establishes allowances for warranties for
specifically identified, as well as anticipated, warranty claims based on
contractual terms, product conditions and actual warranty experience by product
line.  Company products include both manufactured and purchased
components and, therefore, warranty plans include third-party sourced parts
which may not be covered by the third-party manufacturer’s
warranty.  Ultimately, the warranty experience of the Company is
directly attributable to the quality of its products.  The Company
actively manages its quality program by using a structured product introduction
plan, process monitoring techniques utilizing statistical process controls,
vendor quality metrics, a quality training curriculum for every employee, and
feedback loops to communicate warranty claims to designers and engineers for
remediation in future production.  The Company believes that the
accounting estimate related to allowances for warranties is a “critical
accounting estimate” because:  (1) it is susceptible to significant
fluctuation period to period due to the requirement for management to make
assumptions about future warranty claims relative to potential unknown issues
arising in both existing and new products, which assumptions are derived from
historical trends of known or resolved issues; and (2) risks associated with
third-party supplied components being manufactured using processes that the
Company does not control.  As of September 30, 2008, the balance sheet
included warranty reserves of $1.7 million, while $2.7 million of warranty
charges were incurred during the fiscal year then ended, compared to warranty
reserves of $1.4 million as of September 30, 2007 and warranty charges of $2.1
million for the fiscal year then ended.  If the Company’s actual
warranty costs are higher than estimates, future warranty plan coverages are
different, or estimates are adversely adjusted in future periods, reserves for
warranty expense would need to increase, warranty expense would increase and
gross margins would decrease.





Accounting for income
taxes.  The Company’s provision for income taxes and the
determination of the resulting deferred tax assets and liabilities involves a
significant amount of management judgment.  The quarterly provision
for income taxes is based partially upon estimates of pre-tax financial
accounting income for the full year and is affected by various differences
between financial accounting income and taxable income.  Judgment is
also applied in determining whether the deferred tax assets will be realized in
full or in part.  In management’s judgment, when it is more likely
than not that all or some portion of specific deferred tax assets, such as
foreign tax credit carryovers, will not be realized, a valuation allowance must
be established for the amount of the deferred tax assets that are determined not
to be realizable.  At September 30, 2008, the Company had valuation
reserves of approximately


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$450,000
for deferred tax assets related to the sale of the investment in the InspX joint
venture and the valuation reserve for notes receivable and contingent payments,
and offsetting amounts for U.S. and Chinese deferred tax assets and liabilities,
primarily related to net operating loss carry forwards in the foreign
jurisdictions that the Company believe will not be utilized during the
carryforward period.  During fiscal 2008, $60,000 of net valuation
reserves for combined U.S. and Australian deferred taxes were eliminated due to
the final dissolution of the related Australian entity.  There were no
other valuation allowances at September 30, 2008 due to anticipated utilization
of all the deferred tax assets as the Company believes it will have sufficient
taxable income to utilize these assets.  The Company maintains
reserves for estimated tax exposures in jurisdictions of
operation.  These tax jurisdictions include federal, state and various
international tax jurisdictions.  Potential income tax exposures
include potential challenges of various tax credits, export-related tax
benefits, and issues specific to state and local tax
jurisdictions.  Exposures are typically settled primarily through
audits within these tax jurisdictions, but can also be affected by changes in
applicable tax law or other factors, which could cause management of the Company
to believe a revision of past estimates is appropriate.  During fiscal
2008 and 2007, there have been no significant changes in these
estimates.  Management believes that an appropriate liability has been
established for estimated exposures; however, actual results may differ
materially from these estimates.  The Company believes that the
accounting estimate related to income taxes is a “critical accounting estimate”
because it relies on significant management judgment in making assumptions
relative to temporary and permanent timing differences of tax effects, estimates
of future earnings, prospective application of changing tax laws in multiple
jurisdictions, and the resulting ability to utilize tax assets at those future
dates.  If the Company’s operating results were to fall short of
expectations, thereby affecting the likelihood of realizing the deferred tax
assets, judgment would have to be applied to determine the amount of the
valuation allowance required to be included in the financial statements in any
given period.  Establishing or increasing a valuation allowance would
reduce the carrying value of the deferred tax asset, increase tax expense and
reduce net earnings.





The
federal Research and Development Credit (“R&D credit”) expired on December
31, 2007.  Subsequent to the end of the Company’s fiscal year, the
Emergency Economic Stabilization Act of 2008 was enacted.  As part of
the legislation, the existing R&D credit was retroactively renewed and
extended to December 31, 2009.  Due to this subsequent change in tax
law, the Company expects to record approximately $160,000 of additional R&D
tax credits in the first quarter of fiscal 2009 related to R&D expenditures
incurred during fiscal 2008.





The
Company adopted the provisions of FASB Interpretation 48, Accounting for
Uncertainty in Income Taxes, on October 1, 2007. Previously, the Company had
accounted for tax contingencies in accordance with Statement of Financial
Accounting Standards 5, Accounting for Contingencies. As required by
Interpretation 48, which clarifies Statement 109, Accounting for Income Taxes,
the Company recognizes the financial statement benefit of a tax position only
after determining that the relevant tax authority would more likely than not
sustain the position following an audit. For tax positions meeting the
more-likely-than-not threshold, the amount recognized in the financial
statements is the largest benefit that has a greater than 50 percent likelihood
of being realized upon ultimate settlement with the relevant tax authority. At
the adoption date, the Company applied Interpretation 48 to all tax positions
for which the statute of limitations remained open. As a result of the
implementation of Interpretation 48, the Company recognized a decrease of
approximately $250,000 in the liability for unrecognized tax benefits, which was
accounted for as an increase to the October 1, 2007 balance of retained
earnings.


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Comparison
      of Fiscal 2008 to Fiscal 2007Fiscal
      Year Ended September 30,2008
                              
                              
                              2007
                              
                              
                              Change
      $
                              
                              
                              Change
      %(in
      thousands)Statement
      of Operations DataNet
      sales
                              
                              $
                              134,086
                              
                              
                              $
                              107,540
                              
                              
                              $
                              26,546
                              
                              
                              
                              24.7Gross
      profit
                              
                              
                              53,193
                              
                              
                              
                              41,441
                              
                              
                              
                              11,752
                              
                              
                              
                              28.4Research
      and development
                              
                              
                              8,744
                              
                              
                              
                              5,520
                              
                              
                              
                              3,224
                              
                              
                              
                              58.4Sales
      and marketing
                              
                              
                              21,373
                              
                              
                              
                              17,191
                              
                              
                              
                              4,182
                              
                              
                              
                              24.3General
      and administrative
                              
                              
                              11,528
                              
                              
                              
                              8,821
                              
                              
                              
                              2,707
                              
                              
                              
                              30.7Amortization
                              
                              
                              1,307
                              
                              
                              
                              1,307
                              
                              
                              
                              -
                              
                              
                              
                              0.0Total
      operating expense
                              
                              
                              42,952
                              
                              
                              
                              32,839
                              
                              
                              
                              10,113
                              
                              
                              
                              30.8Gain
      on sale of assets
                              
                              
                              81
                              
                              
                              
                              23
                              
                              
                              
                              58
                              
                              
                              
                              n/m
                              *Income
      from operations
                              
                              
                              10,322
                              
                              
                              
                              8,625
                              
                              
                              
                              1,697
                              
                              
                              
                              19.7Other
      income and expense
                              
                              
                              666
                              
                              
                              
                              1,961
                              
                              
                              
                              (1,295
                              )
                              
                              
                              -66.0Income
      tax expense
                              
                              
                              3,515
                              
                              
                              
                              3,176
                              
                              
                              
                              339
                              
                              
                              
                              10.7Net
      income
                              
                              
                              7,473
                              
                              
                              
                              7,410
                              
                              
                              
                              63
                              
                              
                              
                              0.9Balance
      Sheet DataCash
      and cash equivalents
                              
                              
                              36,322
                              
                              
                              
                              27,880
                              
                              
                              
                              8,442
                              
                              
                              
                              30.3Accounts
      receivable
                              
                              
                              13,577
                              
                              
                              
                              14,020
                              
                              
                              
                              (443
                              )
                              
                              
                              -3.2Inventories
                              
                              
                              21,915
                              
                              
                              
                              18,753
                              
                              
                              
                              3,162
                              
                              
                              
                              16.9Other
      Data (unaudited)Orders
      for year ended September 30
                              
                              
                              136,874
                              
                              
                              
                              115,276
                              
                              
                              
                              21,598
                              
                              
                              
                              18.7Backlog
      at fiscal year end
                              
                              
                              33,804
                              
                              
                              
                              30,931
                              
                              
                              
                              2,873
                              
                              
                              
                              9.3*
      Not meaningful


25
 Table
of Contents


Results
of Operations





Fiscal
2008 compared to Fiscal 2007





Net sales
for the year ended September 30, 2008 were $134.1 million, a 25% increase over
the $107.5 million reported for fiscal 2007.  The Company ended the
year strongly with a record fourth quarter of $40.2 million in sales, a 27%
increase over the corresponding period in fiscal 2007.





Sales in
the Company’s automated inspection systems product line increased by 19% to
$56.0 million in fiscal 2008, accounting for 42% of total revenues, compared to
$46.9 million in fiscal 2007 and 44% of total revenues.  The most
significant increase was in upgrade sales which increased $4.3 million or 34% to
$16.9 million.   Sales increased over the prior year in almost
all automated inspection product lines including the new Manta automated
inspection product which was introduced in fiscal 2008.  Process
systems sales in fiscal 2008 were $56.6 million, a 38% increase over the $40.9
million reported for fiscal 2007.  Sales of process systems accounted
for 42% of total revenues in fiscal 2008 compared to 38% in fiscal
2007.  Shipments of process systems in fiscal 2008 from United States
operating locations increased nearly 46% and from the Netherlands increased by
nearly 23%.  Parts and service sales increased from the prior year by
$1.8 million or 9%, and represented 16% of sales in fiscal 2008, compared to 18%
of sales in fiscal 2007.





New
orders increased 19%, or $21.6 million, to $136.9 million in fiscal 2008 over
the $115.3 million in orders received in fiscal 2007.  Backlog at
September 30, 2008 increased to $33.8 million compared to the $30.9 million
reported at the end of fiscal 2007.  The order mix for the more recent
year improved over fiscal 2007.  For fiscal 2008, the Company’s higher
margin automated inspection systems orders increased by $14.3 million, or 30%,
representing almost 46% of order volume in fiscal 2008 compared to 42% in the
prior year.  This increase was due in large part to an almost 31%
increase in upgrade orders.





Gross
profits increased to $53.2 million for fiscal 2008 compared to $41.4 million in
fiscal 2007, or 39.7% and 38.5% of net sales, respectively.  The
principle driver for the $11.8 million increase in gross profit relates to the
nearly 25% increase in sales volume.  The improvement in the gross
profit percentage relates to the lower other cost of sales relating to improved
manufacturing and overhead variances.





Research
and development spending increased $3.2 million to $8.7 million, or 6.5% of
sales, in fiscal 2008 from $5.5 million and 5.1% of sales in fiscal
2007.  The increase was driven largely by increases in the research
and development team, as well as significant investments in research and
development for SYMETIX projects.





Sales and
marketing spending in fiscal 2008 increased to $21.4 million, compared to the
$17.2 million spent in fiscal 2007.  As a percentage of sales, sales
expense decreased 0.1% from the 16.0% of sales reported in fiscal 2007 to 15.9%
of sales reported in fiscal 2008.  The primary drivers for the
increase in spending were the significantly higher sales volume, continued
investment in the Company’s SYMETIX initiative in the pharmaceutical and
nutraceutical industry, and an increase in the mix of sales through independent
representatives which incur higher commission rates.





General
and administrative spending in fiscal 2008 was $11.5 million and 8.6% of sales
for the year, compared to $8.8 million and 8.2% of sales for fiscal
2007.  The increase in fiscal 2008 was due to the investment in the
Company’s new ERP system, increases in incentive and stock compensation, and new
employee salary and relocation expenses.





Other
income and expense was $666,000 of income for fiscal 2008 compared to $2.0
million of income for fiscal 2007.  Interest income increased slightly
to $735,000 in fiscal 2008 from the $726,000 reported for fiscal
2007.  The Company recognized exchange losses of $157,000 in fiscal
2008 compared with exchange gains of $570,000 in fiscal 2007.  During
fiscal 2007, the Company recognized a gain of $750,000 from the sale of its
investment in the InspX joint venture.





The
effective tax rate for the Company was 32.0% in fiscal 2008 compared to 30.0% in
fiscal 2007.  The effective tax rate for fiscal 2007 was primarily
affected by the reversal of valuation reserves recorded in fiscal
2006




26
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related
to the Company’s valuation of its investment in the InspX joint
venture.  Other items, such as permanent differences arising from
extra-territorial income exclusions, domestic production deductions, research
and development tax credits, tax exempt interest, and other permanent
differences, caused the effective tax rate to vary from the 34% statutory rate
in both fiscal 2008 and 2007.





Net
earnings in fiscal 2008 were $7.5 million, or $1.35 per diluted share, compared
to net earnings of $7.4 million, or $1.37 per diluted share, in fiscal
2007.  The principal reasons for the increase in earnings for fiscal
2008 compared to fiscal 2007 were increased sales volumes and improved gross
profit margins which were partially offset by increased operating expenses and
the unfavorable effects of changes in foreign currency exchange
rates.  Earnings in fiscal 2007 were favorably impacted by the
$750,000 gain, or $0.14 per share, from the sale of the Company’s 50% interest
in its InspX joint venture.





Fiscal
2007 compared to Fiscal 2006





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





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





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





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





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





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


27
 Table
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General
and administrative spending in fiscal 2007 was $8.8 million and 8.2% of sales
for the year, compared to $9.2 million and 10.8% of sales for fiscal
2006.  The decrease in fiscal 2007 was due to the closure of the
Company’s operations in Australia and reduced management consulting
costs.  General and administrative costs incurred in 2006 included
non-recurring costs related to information system upgrades.  General
and administrative costs decreased in fiscal 2007 despite the $500,000 of
external costs incurred to comply with Section 404 of the Sarbanes-Oxley
Act.





Other
income and expense was $2.0 million of income for fiscal 2007 compared to $1.0
million of expense for fiscal 2006.  During fiscal 2007, the Company
recognized a gain of $750,000 from the sale of the investment in the InspX joint
venture.  In fiscal 2006, the Company booked a charge of $865,000
related to the write-off of it’s investment in InspX.  During fiscal
2006, the Company’s equity in the earnings of InspX was an additional loss of
$389,000.  Interest income increased to $726,000 in fiscal 2007 from
the $391,000 reported for fiscal 2006 due to increased investment of cash
generated by operations.  The Company also recognized exchange gains
of $570,000 in fiscal 2007 compared with $86,000 in the prior year.





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





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





Liquidity
and Capital Resources





Fiscal
2008





For
fiscal year 2008, net cash increased by $8.4 million, or over 30%, to $36.3
million on September 30, 2008.  The Company generated $13.1 million in
cash from operating activities, generated $938,000 from financing activities and
consumed $5.4 million in investing activities.





The net
cash provided by operating activities during fiscal 2008 of $13.1 million
included net earnings for the year of $7.5 million, non-cash expenses for
depreciation and amortization of $2.8 million and non-cash share based payments
and deferred income tax benefits of $1.5 million and $549,000,
respectively.  Non-cash working capital at September 30, 2008 declined
from the same time last year, contributing $2.7 million to the cash provided by
operating activities.  Inventory increased due to strategic
investments in inventory related to new products and increased business activity
at the end of fiscal 2008.  These increases were more than offset by
increases in accounts payable, customer deposits, customer support and warranty
accruals, income taxes payable, as well as higher yearly incentive
accruals.  Despite the increase in sales during fiscal 2008, the
Company’s ending accounts receivable balance did not change significantly
compared to the prior fiscal year.





Cash used
in investing activities totaled $5.4 million during fiscal
2008.  Capital expenditures during fiscal 2008 were approximately $5.5
million for the fiscal year, including $2.3 million for the global ERP
implementation project and $750,000 for an equipment purchase.  Cash
used for investing activities in fiscal 2007 was $749,000.





Cash
generated from financing activities totaled $938,000 in fiscal
2008.  $687,000 of cash was generated from the issuance of common
stock related to option exercises.  Financing activities also
benefited from the $251,000 excess tax benefit from share based
payments.  During the prior fiscal year, the Company repurchased
88,252 shares of its common stock using $1.3 million of cash.  At the
end of both fiscal 2007 and 2008, the Company had no long term debt
outstanding.


28
 Table
of Contents


The
Company’s domestic credit facility provides for a revolving credit line of up to
$10 million and credit sub-facilities of $3.0 million each for sight commercial
letters of credit and standby letters of credit.  The credit facility
matures on June 30, 2009.  The credit facility bears interest, at the
Company’s option, of either the bank prime rate minus 1.75% or LIBOR plus 1.0%
per annum.  At September 30, 2008, the interest rate would have been
3.25%.  The credit facility is secured by all U.S. accounts
receivable, inventory and fixed assets.  The credit facility contains
covenants which require the maintenance of a defined net worth ratio, a
liquidity ratio and an EBITDA coverage ratio.  The credit facility
also restricts mergers and acquisitions, incurrence of additional indebtedness,
and transactions, including purchases and retirements, in the Company’s own
common stock without the prior consent of the Lender.  At September
30, 2008, the Company had no borrowings outstanding under the credit facility
and $380,000 in standby letters of credit of which $230,000 related to lease
obligations.  This portion was cancelled subsequent to the end of the
Company’s fiscal year.  At September 30, 2008, the Company was in
compliance with its loan covenants, and had received the consent of the lender
for its stock repurchase program.  At September 30, 2007, the Company
had no borrowings outstanding under the credit facility and $530,000 in standby
letters of credit.





The
Company’s credit accommodation with a commercial bank in The Netherlands
provides a credit facility for its European subsidiary.  This credit
accommodation totals $3.5 million and includes an operating line of the
lesser of $2.1 million or the available borrowing base, which is based on
varying percentages of eligible accounts receivable and inventories, and a bank
guarantee facility of $1.4 million.  The operating line and bank
guarantee facility are secured by all of the subsidiary’s personal
property.  The credit facility bears interest at the bank’s prime
rate, with a minimum of 3.00%, plus 1.75%.  At September 30, 2008, the
interest rate was 8.15%.  At September 30, 2008, the Company had no
borrowings under this facility and had received bank guarantees of $1.2 million
under the bank guarantee facility.  At September 30, 2007, the Company
had no borrowings under this facility and had received bank guarantees of
$668,000 under the bank guarantee facility.  The credit facility
allows overages on the bank guarantee facility.  Any overages reduce
the available borrowings from the operating line.





The
Company anticipates that the ongoing cash flows from operations and borrowing
capacity under currently available operating credit lines will be sufficient to
fund the Company’s operating needs for the foreseeable future.  Cash
provided by operating activities was $13.1 million, $12.4 million and $5.5
million in each of the last three years, respectively.  This operating
cash flow has allowed the Company to fund capital asset purchases and eliminate
the long-term debt outstanding.  The Company anticipates that its cash
needs will continue to be met from cash from operations as it embarks on its
initiatives to grow the pharmaceutical, nutraceutical and aftermarket
businesses, and expand its operations in world-wide
locations.  Subsequent to the end of fiscal 2008, the Company
exercised its purchase option and purchased its Walla Walla, Washington
headquarters facility and grounds for approximately $6.5 million.  The
Company intends to pursue long-term financing for the property and expects to
finalize financing by the end of the first quarter of fiscal
2009.  The Company also anticipates cash expenditures over the
2009-2010 fiscal years for the development of a global ERP system, a significant
portion of which will be capitalized.  In addition, due to the rate of
growth, the Company is investigating opportunities for increased office and
plant space, primarily through leased facilities in the Walla Walla
area.  The Company had no material commitments for capital
expenditures at September 30, 2008.





Prior
Years - Fiscal 2007 and 2006





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





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


29
 Table
of Contents


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





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





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





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





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





Cash used
in financing activities totaled $2.0 million in fiscal 2006.  During
the fiscal year, the Company used cash to payoff both the current and long term
portion of debt in the amount of $2.3 million.  Borrowings at
September 30, 2005 consisted of a term loan with a balance of $1.6 million,
notes payable totaling $0.5 million and capital leases totaling $0.2
million.  At the end of fiscal 2006, the Company had no long term debt
outstanding.  These applications of cash were partially offset by the
receipt of $0.3 million due to the issuance of common stock pursuant to the
exercise of stock options.





Contractual
Obligations





The
Company’s continuing contractual obligations and commercial commitments existing
on September 30, 2008 are as follows (as adjusted for the subsequent purchase of
the Company’s Walla Walla headquarters facility):




Payments due by period (in
      thousands)Contractual
      Obligations (1)
              
              Total
              
              
              Less
      than 1 year
              
              
              1 –
      3 years
              
              
              4 –
      5 years
              
              
              After
      5 yearsOperating
      leases
              
              $
              2,075
              
              
              $
              591
              
              
              $
              915
              
              
              $
              569
              
              
              
              -Total contractual cash
      obligations
              
              $
              2,075
              
              
              $
              591
              
              
              $
              915
              
              
              $
              569
              
              
              $
              -





(1)
            The
      Company also has $110,000 of contractual obligations related to uncertain
      tax positions for which the timing and amount of payment can not be
      reasonably estimated due to the nature of the uncertainties and the
      unpredictability of jurisdictional examinations in relation to the statue
      of limitations.





At
September 30, 2008, the Company had standby letters of credit totaling $1.6
million, which includes secured bank guarantees under the Company’s credit
facility in Europe and letters of credit securing certain self-insurance
contracts and lease commitments.  Subsequent to the end of the fiscal
year, a letter of credit in the amount of $230,000 securing lease payments was
cancelled as the leased facility was purchased.  If the Company fails
to meet


30
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its
contractual obligations, these bank guarantees and letters of credit may become
liabilities of the Company.  The Company has no off-balance sheet
arrangements or transactions, or arrangements or relationships with “special
purpose entities.”





Future
Accounting Changes




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





In
February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-2, “Effective
Date of FASB Statement No. 157,” to delay the effective date of FASB Statement
157 for one year for certain nonfinancial assets and nonfinancial liabilities,
excluding those that are recognized or disclosed in financial statements at fair
value on a recurring basis (that is, at least annually).  For purposes
of applying the FSP, nonfinancial assets and nonfinancial liabilities include
all assets and liabilities other than those meeting the definition of a
financial asset or a financial liability in FASB Statement 159.  This
FSP defers the effective date of Statement 157 to fiscal years beginning after
November 15, 2008, and interim periods within those fiscal years for items
within the scope of this FSP.





In
February 2007, the FASB issued Statement 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.”  This Statement permits
entities to elect to measure certain financial instruments and other items at
fair value.  The fair value option may be applied on an instrument by
instrument basis, is irrevocable and is applied only to entire
instruments.  SFAS 159 requires additional financial statement
presentation and disclosure requirements for those entities that elect to adopt
the standard and is effective for fiscal years beginning after November 15,
2007.  The Company does not expect the adoption of SFAS 159 to have a
material effect on its financial position, results of operations or cash
flows.





In June
2008, the FASB issued FASB Staff Position EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities.” This position states that unvested share-based payment awards that
contain nonforfeitable rights to dividends (whether paid or unpaid) are
participating securities and shall be included in the computation of earnings
per share (EPS) under the two-class method described in paragraphs 60 and 61 of
FASB Statement No. 128, “Earnings per Share.” FSP EITF 03-6-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008.
All prior period EPS data will be required to be adjusted to conform to the
provisions of this pronouncement and early application is prohibited. The
Company does have participating securities as described under this pronouncement
and is currently evaluating the impact of FSP EITF 03-6-1.





In March
2008, the FASB issued Statement 161 “Disclosures about Derivative Instruments
and Hedging Activities” an amendment to FASB No. 133.  This statement
changes the disclosure requirements for derivative instruments and hedging
activities.  Entities are required to provide enhanced disclosures
about (a) how and why and entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under Statement 133 and
its related interpretations, and (c) how derivative instruments and related
hedged items affect an entity’s financial position, financial performance, and
cash flows.  This statement is effective for financial statements
issued for fiscal years and interim periods beginning after November 15,
2008.  Early application is encouraged.  The Company does
not expect the adoption of SFAS 161 to have a material impact on its financial
position, results of operations or cash flows.





In
December 2007, the Financial Accounting Standards Board ratified a consensus
opinion reached by the Emerging Issues Task Force (EITF) on EITF Issue 07-1,
“Accounting for Collaborative Arrangements.” The guidance in EITF Issue 07-1
defines collaborative arrangements and establishes presentation and disclosure
requirements for transactions within a collaborative arrangement (both with
third parties and between participants in the arrangement).  The
consensus in EITF Issue 07-1 is effective for fiscal years, and interim periods
within those


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fiscal
years, beginning after December 15, 2008. The consensus requires retrospective
application to all collaborative arrangements existing as of the effective date,
unless retrospective application is impracticable. The impracticability
evaluation and exception should be performed on an arrangement-by-arrangement
basis.  The Company is evaluating the impact EITF Issue 07-1 will have
on its financial statements. The Company currently does not believe that the
adoption of EITF Issue 07-1 will have a significant effect on its financial
statements.





ITEM 7A.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK.





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





The terms
of sales to European customers are typically denominated in
Euros.  The Company expects that its standard terms of sale to
international customers, other than those in Europe, will continue to be
denominated in U.S. dollars, although as the Company expands its operations in
Australia, Latin America and China, transactions denominated in the local
currencies of these countries may increase.  For sales transactions
between international customers, including European customers, and the Company’s
domestic operations, which are denominated in currencies other than U.S.
dollars, the Company assesses its currency exchange risk and may enter into
forward contracts to minimize such risk.  At September 30, 2008, the
Company held a 30-day forward contract for $2.0 million Euros.  As of
September 30, 2008, management estimates that a 10% change in foreign exchange
rates would affect net earnings before taxes by approximately $200,000 on an
annual basis as a result of converted cash, accounts receivable, loans to
foreign subsidiaries, and sales or other contracts denominated in foreign
currencies.





As of
September 30, 2008, the Euro lost a net of 1% in value against the U.S. dollar
compared to its value at September 30, 2007.  During the twelve-month
period ended September 30, 2008, changes in the value of the Euro against the
U.S. dollar ranged between a 1% loss and a 10% gain as compared to the value at
September 30, 2007.  The weakening of the Euro was predominately in
the fourth fiscal quarter of 2008, as at June 30, 2008, the Euro had gained 10%
in value as compared to the value at September 30, 2007, but ended the fiscal
year at a 1% net loss in value.  Other foreign currencies showed
varied changes in value against the U.S. dollar during fiscal
2008.  The effect of these fluctuations on the operations and
financial results of the Company were:





·
            Translation
      adjustments of ($131,000), net of income tax, were recognized as a
      component of comprehensive income as a result of converting the Euro
      denominated balance sheets of Key Technology B.V. and Suplusco Holding
      B.V. into U.S. dollars, and to a lesser extent, the Australian dollar
      balance sheets of Key Technology Australia Pty Ltd., the RMB balance sheet
      of Key Technology (Shanghai) Trading Co., Ltd., the Singapore dollar
      balance sheet of Key Technology Asia-Pacific Pte. Ltd., and the Peso
      balance sheet of Productos Key
Mexicana.





·
            Foreign
      exchange losses of $157,000 were recognized in the other income and
      expense section of the consolidated statement of operations as a result of
      conversion of Euro and other foreign currency denominated receivables,
      intercompany loans, and cash carried on the balance sheet of the U.S.
      operations, as well as the result of the conversion of other
      non-functional currency receivables, payables and cash carried on the
      balance sheets of the European, Australian, Chinese, Singapore and Mexican
      operations.





Compared
to historical exchange rates, the U.S. dollar is still in a relatively weak
position on the world markets but, subsequent to the end of the Company’s fiscal
year, the value of the dollar gained significantly on the world
markets.  A relatively weaker U.S. dollar makes the Company’s
U.S.-manufactured goods relatively less expensive to international customers
when denominated in U.S. dollars or potentially more profitable to the Company
when denominated in a foreign currency.  On the other hand, materials
or components imported into the U.S. may be more expensive.  A
relatively weaker U.S. dollar on the world markets, especially as measured
against the Euro, may favorably affect the Company’s market and economic outlook
for international sales.  Conversely, when the dollar strengthens on
the world markets, the Company’s market and economic outlook for international
sales could be negatively affected as export sales to international customers
become relatively more expensive.  The Company’s Netherlands-based
subsidiary transacts business primarily in Euros and does not have significant
exports to the U.S, but does import a significant portion of its products from
its U.S.-based parent company.


32
 Table
of Contents


Under the
Company’s current credit facilities, the Company may borrow at the lender’s
prime rate minus 175 basis points on its domestic credit facility and at the
lenders prime rate plus 175 basis points on its European credit
facility.  At September 30, 2008, the Company had no borrowings which
had variable interest rates.  During the year then ended, interest
rates applicable to its variable rate credit facilities ranged from 3.25% to
8.15%.  At September 30, 2008, the rate was 3.25% on its domestic
credit facility and 8.15% on its European credit facility.  As of
September 30, 2008, management estimates that a 100 basis point change in these
interest rates would not affect net income before taxes because the Company had
no borrowings outstanding under its variable interest rate
facilities.


33
 Table
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ITEM
8.             FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA.





Title
                PageReport
      of Independent Registered Public Accounting Firm
                35Report
      of Independent Registered Public Accounting Firm
                36Consolidated
      Balance Sheets at September 30, 2008 and 2007
                37Consolidated
      Statements of Operations for the three years ended September 30,
      2008
                39Consolidated
      Statements of Shareholders' Equity for the three years ended September 30,
      2008
                40Consolidated
      Statements of Cash Flows for the three years ended September 30,
      2008
                41Notes
      to Consolidated Financial Statements
                43Supplementary
      Data
                60





34
 Table
of Contents


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM








Board of
Directors and Shareholders of Key Technology, Inc.





We have
audited the accompanying consolidated balance sheets of Key Technology, Inc. (an
Oregon corporation) as of September 30, 2008 and 2007, and the related
consolidated statements of operations, shareholders’ equity, and cash flows for
each of the three years in the period ended
September 30, 2008.  These financial statements are the
responsibility of the Company’s management.  Our responsibility is to
express an opinion on these financial statements based on our
audits.





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





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Key Technology, Inc. as of
September 30, 2008 and 2007, and the results of its operations and its
cash flows for each of the three years in the period ended
September 30, 2008 in conformity with accounting principles generally
accepted in the United States of America.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States) Key Technology Inc.’s internal control over
financial reporting as of September 30, 2008, based on criteria
established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) and our report dated
December 8, 2008 expressed an unqualified opinion on the effectiveness
of the Company’s internal control over financial reporting.





/s/ GRANT
THORNTON LLP





Seattle,
Washington


December
8, 2008




35
 Table
of Contents


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








Board of
Directors and Shareholders of Key Technology, Inc.





We have
audited the internal control over financial reporting of Key Technology, Inc.
(the Company) as of September 30, 2008, based on criteria established
in Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).  Key Technology,
Inc.’s management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting, included in the accompanying Management’s
Annual Report on Internal Control over Financial Reporting.  Our
responsibility is to express an opinion on the Company’s internal control over
financial reporting based on our audit.





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





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





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





In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of September 30, 2008, based on
criteria established in Internal Control—Integrated Framework issued by
COSO.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the accompanying consolidated balance sheets of
Key Technology, Inc. as of September 30, 2008 and 2007, and the
related consolidated statements of operations, stockholders’ equity, and cash
flows for each of the three years in the period ended
September 30, 2008 and our report dated December 8, 2008
expressed an unqualified opinion on these financial statements.





/s/ GRANT
THORNTON LLP





Seattle,
Washington


December
8, 2008


36
 Table
of Contents
  KEY
      TECHNOLOGY, INC. AND SUBSIDIARIESCONSOLIDATED
      BALANCE SHEETSSEPTEMBER
      30, 2008 AND 2007(In
      thousands)2008
                        
                        
                        2007ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
                        
                        $
                        36,322
                        
                        
                        $
                        27,880Trade
      accounts receivable, net
                        
                        
                        13,577
                        
                        
                        
                        14,020Inventories
                        
                        
                        21,915
                        
                        
                        
                        18,753Deferred
      income taxes
                        
                        
                        2,340
                        
                        
                        
                        2,120Prepaid
      expenses and other assets
                        
                        
                        1,873
                        
                        
                        
                        1,954Total
      current assets
                        
                        
                        76,027
                        
                        
                        
                        64,727PROPERTY,
      PLANT AND EQUIPMENT, Net
                        
                        
                        8,705
                        
                        
                        
                        4,671DEFERRED
      INCOME TAXES
                        
                        
                        101
                        
                        
                        
                        -INTANGIBLES,
      Net
                        
                        
                        2,266
                        
                        
                        
                        3,573GOODWILL,
      Net
                        
                        
                        2,524
                        
                        
                        
                        2,524OTHER
      ASSETS
                        
                        
                        2
                        
                        
                        
                        2TOTAL
                        
                        $
                        89,625
                        
                        
                        $
                        75,497See
      notes to consolidated financial statements.
                        
                        
                        
                        
                        
                        (Continued)
  37
 Table
of Contents
  KEY
      TECHNOLOGY, INC. AND SUBSIDIARIESCONSOLIDATED
      BALANCE SHEETSSEPTEMBER
      30, 2008 AND 2007(In
      thousands, except shares)2008
                        
                        
                        2007LIABILITIES
      AND SHAREHOLDERS’ EQUITYCURRENT
      LIABILITIES:Accounts payable
                        
                        $
                        7,556
                        
                        
                        $
                        5,692Accrued payroll liabilities and commissions
                        
                        
                        7,558
                        
                        
                        
                        6,663Accrued customer support and warranty costs
                        
                        
                        2,545
                        
                        
                        
                        1,946Income tax payable
                        
                        
                        417
                        
                        
                        
                        181Customer purchase plans
                        
                        
                        1,443
                        
                        
                        
                        651Other accrued liabilities
                        
                        
                        942
                        
                        
                        
                        798Customers’ deposits
                        
                        
                        8,035
                        
                        
                        
                        7,850Total
      current liabilities
                        
                        
                        28,496
                        
                        
                        
                        23,781DEFERRED
      INCOME TAXES
                        
                        
                        -
                        
                        
                        
                        722LONG-TERM
      DEFERRED RENT
                        
                        
                        605
                        
                        
                        
                        601OTHER
      LONG TERM LIABILITIES
                        
                        
                        156
                        
                        
                        
                        -COMMITMENTS
      AND CONTINGENCIES
                        
                        
                        -
                        
                        
                        
                        -SHAREHOLDERS’
      EQUITY:Preferred stock—no par value; 5,000,000 shares authorized;none issued and outstanding
                        
                        
                        -
                        
                        
                        
                        -Common stock—no par value; 45,000,000 shares authorized;5,629,566 and 5,508,658 issued and outstanding at September 30, 2008 and
      2007, respectively
                        
                        
                        19,489
                        
                        
                        
                        17,105Retained earnings
                        
                        
                        40,381
                        
                        
                        
                        32,659Accumulated other comprehensive income
                        
                        
                        498
                        
                        
                        
                        629Total
      shareholders’ equity
                        
                        
                        60,368
                        
                        
                        
                        50,393TOTAL
                        
                        $
                        89,625
                        
                        
                        $
                        75,497See
      notes to consolidated financial statements.
                        
                        
                        
                        
                        
                        (Concluded)
  38
 Table
of Contents
  KEY
      TECHNOLOGY, INC. AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF OPERATIONSTHREE
      YEARS ENDED SEPTEMBER 30, 2008(In
      thousands, except per share data)2008
                            
                            
                            2007
                            
                            
                            2006NET
      SALES
                            
                            $
                            134,086
                            
                            
                            $
                            107,540
                            
                            
                            $
                            84,840COST
      OF SALES
                            
                            
                            80,893
                            
                            
                            
                            66,099
                            
                            
                            
                            53,041Gross
      profit
                            
                            
                            53,193
                            
                            
                            
                            41,441
                            
                            
                            
                            31,799OPERATING
      EXPENSES:Selling
                            
                            
                            21,373
                            
                            
                            
                            17,191
                            
                            
                            
                            14,784Research and development
                            
                            
                            8,744
                            
                            
                            
                            5,520
                            
                            
                            
                            6,444General and administrative
                            
                            
                            11,528
                            
                            
                            
                            8,821
                            
                            
                            
                            9,185Amortization of intangibles
                            
                            
                            1,307
                            
                            
                            
                            1,307
                            
                            
                            
                            1,330Total
      operating expenses
                            
                            
                            42,952
                            
                            
                            
                            32,839
                            
                            
                            
                            31,743GAIN
      ON SALE OF ASSETS
                            
                            
                            81
                            
                            
                            
                            23
                            
                            
                            
                            109INCOME
      FROM OPERATIONS
                            
                            
                            10,322
                            
                            
                            
                            8,625
                            
                            
                            
                            165OTHER
      INCOME (EXPENSE):Royalty income
                            
                            
                            38
                            
                            
                            
                            31
                            
                            
                            
                            17Interest income
                            
                            
                            735
                            
                            
                            
                            726
                            
                            
                            
                            391Interest expense
                            
                            
                            (8
                            )
                            
                            
                            (12
                            )
                            
                            
                            (36
                            )Equity in earnings (loss) of joint venture
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (389
                            )Gain on sale of joint venture
                            
                            
                            -
                            
                            
                            
                            750
                            
                            
                            
                            -Impairment charge on investment in joint venture
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (865
                            )Other, net
                            
                            
                            (99
                            )
                            
                            
                            466
                            
                            
                            
                            (98
                            )Total
      other income (expense)—net
                            
                            
                            666
                            
                            
                            
                            1,961
                            
                            
                            
                            (980
                            )Earnings
      (loss) before income taxes
                            
                            
                            10,988
                            
                            
                            
                            10,586
                            
                            
                            
                            (815
                            )Income
      tax expense (benefit)
                            
                            
                            3,515
                            
                            
                            
                            3,176
                            
                            
                            
                            (22
                            )Net
      earnings (loss)
                            
                            $
                            7,473
                            
                            
                            $
                            7,410
                            
                            
                            $
                            (793
                            )EARNINGS
      (LOSS) PER SHARE—Basic
                            
                            $
                            1.38
                            
                            
                            $
                            1.41
                            
                            
                            $
                            (0.15
                            )EARNINGS
      (LOSS) PER SHARE—Diluted
                            
                            $
                            1.35
                            
                            
                            $
                            1.37
                            
                            
                            $
                            (0.15
                            )SHARES
      USED IN PER SHARE CALCULATION—Basic
                            
                            
                            5,430
                            
                            
                            
                            5,265
                            
                            
                            
                            5,205SHARES
      USED IN PER SHARE CALCULATION—Diluted
                            
                            
                            5,517
                            
                            
                            
                            5,407
                            
                            
                            
                            5,205See
      notes to consolidated financial statements.
  39
 Table
of Contents
  KEY
      TECHNOLOGY, INC. AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF SHAREHOLDERS’ EQUITYTHREE
      YEARS ENDED SEPTEMBER 30, 2008(Dollars
      in thousands)Deferred
                                        
                                        
                                        
                                        
                                        
                                        AccumulatedCommon
      Stock
                                        
                                        
                                        Stock-
                                        
                                        
                                        
                                        
                                        
                                        OtherBased
                                        
                                        
                                        Retained
                                        
                                        
                                        ComprehensiveShares
                                        
                                        
                                        Amount
                                        
                                        
                                        Compensation
                                        
                                        
                                        Earnings
                                        
                                        
                                        Income
      (Loss)
                                        
                                        
                                        TotalBalance
      at September 30, 2005
                                        
                                        
                                        5,347,784
                                        
                                        
                                        
                                        15,301
                                        
                                        
                                        
                                        (2,057
                                        )
                                        
                                        
                                        27,104
                                        
                                        
                                        
                                        123
                                        
                                        
                                        
                                        40,471Components
      of comprehensive income:Net loss
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (793
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (793
                                        )Comprehensive income—foreign currency translation adjustment, net of tax
      of $62
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        120
                                        
                                        
                                        
                                        120Total
      comprehensive income
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (673
                                        )Tax
      benefits from share-based payments
                                        
                                        
                                        -
                                        
                                        
                                        
                                        262
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        262Share
      based payments
                                        
                                        
                                        -
                                        
                                        
                                        
                                        910
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        910Issuance
      of stock upon exercise of stock options
                                        
                                        
                                        40,412
                                        
                                        
                                        
                                        220
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        220Issuance
      of stock for Employee Stock Purchase Plan
                                        
                                        
                                        5,765
                                        
                                        
                                        
                                        62
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        62Stock
      grants - employment-based
                                        
                                        
                                        25,926
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Stock
      grants - performance-based
                                        
                                        
                                        (34,199
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Reversal
      of deferred stock compensation on adoption of FASB
      123(R)                                                                                                                     -
                                        
                                        
                                        
                                        (2,057
                                        )
                                        
                                        
                                        2,057
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Balance
      at September 30, 2006
                                        
                                        
                                        5,385,688
                                        
                                        
                                        
                                        14,698
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        26,311
                                        
                                        
                                        
                                        243
                                        
                                        
                                        
                                        41,252Components
      of comprehensive income:Net earnings
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        7,410
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        7,410Comprehensive income—foreign currency translation adjustment, net of tax
      of $228
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        443
                                        
                                        
                                        
                                        443Less: Reclassification to net earnings (net of tax benefit of
      $29)
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (57
                                        )
                                        
                                        
                                        (57
                                        )Total
      comprehensive income
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,796Tax
      benefits from share-based payments
                                        
                                        
                                        -
                                        
                                        
                                        
                                        58
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        58Share
      based payments
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,031
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,031Issuance
      of stock upon exercise of stock options
                                        
                                        
                                        174,184
                                        
                                        
                                        
                                        1,495
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,495Issuance
      of stock for Employee Stock Purchase Plan
                                        
                                        
                                        4,176
                                        
                                        
                                        
                                        64
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        64Stock
      buyback
                                        
                                        
                                        (88,252
                                        )
                                        
                                        
                                        (241
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (1,062
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (1,303
                                        )Stock
      grants - employment-based
                                        
                                        
                                        70,736
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Stock
      forfeitures and retirements
                                        
                                        
                                        (37,874
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Balance
      at September 30, 2007
                                        
                                        
                                        5,508,658
                                        
                                        
                                        
                                        17,105
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        32,659
                                        
                                        
                                        
                                        629
                                        
                                        
                                        
                                        50,393Cumulative
      effect of adoption of FIN48
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        249
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        249Components
      of comprehensive income:Net earnings
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        7,473
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        7,473Comprehensive income—foreign currency translation adjustment, net of tax
      benefit of $67
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (131
                                        )
                                        
                                        
                                        (131
                                        )Total
      comprehensive income
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,342Tax
      benefits from share-based payments
                                        
                                        
                                        -
                                        
                                        
                                        
                                        999
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        999Share
      based payments
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,491
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,491Issuance
      of stock upon exercise of stock options
                                        
                                        
                                        56,238
                                        
                                        
                                        
                                        595
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        595Issuance
      of stock for Employee Stock Purchase Plan
                                        
                                        
                                        3,757
                                        
                                        
                                        
                                        92
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        92Stock
      grants - performance-based
                                        
                                        
                                        26,603
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Stock
      grants - employment-based
                                        
                                        
                                        65,238
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Restricted
      stock surrendered in payment of taxes
                                        
                                        
                                        (23,834
                                        )
                                        
                                        
                                        (793
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (793
                                        )Stock
      forfeitures and retirements
                                        
                                        
                                        (7,094
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Balance
      at September 30, 2008
                                        
                                        
                                        5,629,566
                                        
                                        
                                        $
                                        19,489
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        40,381
                                        
                                        
                                        $
                                        498
                                        
                                        
                                        $
                                        60,368See
      notes to consolidated financial statements.
  40
 Table
of Contents
  KEY
      TECHNOLOGY, INC. AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF CASH FLOWSTHREE
      YEARS ENDED SEPTEMBER 30, 2008(In
      thousands)2008
                            
                            
                            2007
                            
                            
                            2006CASH
      FLOWS FROM OPERATING ACTIVITIES:Net earnings (loss)
                            
                            $
                            7,473
                            
                            
                            $
                            7,410
                            
                            
                            $
                            (793
                            )Adjustments to reconcile net earnings (loss) to net cashprovided by operating activities:Equity in (earnings) loss of joint venture
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            389Gain on sale of investment in joint venture
                            
                            
                            -
                            
                            
                            
                            (750
                            )
                            
                            
                            -Impairment charge for investment in joint venture
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            865Gain on sale of assets
                            
                            
                            (81
                            )
                            
                            
                            (23
                            )
                            
                            
                            (109
                            )Foreign currency exchange (gain) loss
                            
                            
                            157
                            
                            
                            
                            (570
                            )
                            
                            
                            (86
                            )Depreciation and amortization
                            
                            
                            2,771
                            
                            
                            
                            2,596
                            
                            
                            
                            2,950Share based payments
                            
                            
                            1,540
                            
                            
                            
                            987
                            
                            
                            
                            910Excess tax benefit from share based payments
                            
                            
                            (999
                            )
                            
                            
                            (320
                            )Deferred income taxes
                            
                            
                            (549
                            )
                            
                            
                            721
                            
                            
                            
                            (218
                            )Deferred rent
                            
                            
                            4
                            
                            
                            
                            (57
                            )
                            
                            
                            (65
                            )Bad debt expense
                            
                            
                            116
                            
                            
                            
                            16
                            
                            
                            
                            29Changes in assets and liabilities:Trade accounts receivable
                            
                            
                            190
                            
                            
                            
                            (3,283
                            )
                            
                            
                            598Inventories
                            
                            
                            (3,279
                            )
                            
                            
                            (1,929
                            )
                            
                            
                            (995
                            )Prepaid expenses and other current assets
                            
                            
                            14
                            
                            
                            
                            129
                            
                            
                            
                            (468
                            )Income taxes receivable
                            
                            
                            74
                            
                            
                            
                            225
                            
                            
                            
                            124Accounts payable
                            
                            
                            1,869
                            
                            
                            
                            1,592
                            
                            
                            
                            1,651Accrued payroll liabilities and commissions
                            
                            
                            875
                            
                            
                            
                            2,106
                            
                            
                            
                            402Accrued customer support and warranty costs
                            
                            
                            642
                            
                            
                            
                            733
                            
                            
                            
                            (649
                            )Income taxes payable
                            
                            
                            1,262
                            
                            
                            
                            194
                            
                            
                            
                            (83
                            )Other accrued liabilities
                            
                            
                            886
                            
                            
                            
                            247
                            
                            
                            
                            (1,171
                            )Customers’ deposits
                            
                            
                            145
                            
                            
                            
                            2,348
                            
                            
                            
                            2,217Other
                            
                            
                            28
                            
                            
                            
                            -
                            
                            
                            
                            35Cash
      provided by operating activities
                            
                            
                            13,138
                            
                            
                            
                            12,372
                            
                            
                            
                            5,533CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds from sale of property
                            
                            
                            96
                            
                            
                            
                            64
                            
                            
                            
                            143Purchases of property, plant, and equipment
                            
                            
                            (5,509
                            )
                            
                            
                            (1,563
                            )
                            
                            
                            (1,560
                            )Sale of investment in joint venture
                            
                            
                            -
                            
                            
                            
                            750
                            
                            
                            
                            -Cash
      used in investing activities
                            
                            
                            (5,413
                            )
                            
                            
                            (749
                            )
                            
                            
                            (1,417
                            )See
      notes to consolidated financial statements.
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (Continued)
  41
 Table
of Contents
  KEY
      TECHNOLOGY, INC. AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF CASH FLOWSTHREE
      YEARS ENDED SEPTEMBER 30, 2008(In
      thousands)2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006CASH
      FLOWS FROM FINANCING ACTIVITIES:Payments on long-term debt
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        (1
                                        )
                                        
                                        $
                                        (2,311
                                        )Proceeds from issuance of common stock
                                        
                                        
                                        687
                                        
                                        
                                        
                                        1,559
                                        
                                        
                                        
                                        282Stock buyback
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (1,303
                                        )
                                        
                                        
                                        -Excess tax benefits from share based payments
                                        
                                        
                                        999
                                        
                                        
                                        
                                        320
                                        
                                        
                                        
                                        -Exchange of shares for statutory withholding
                                        
                                        
                                        (748
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Cash
      provided by (used in) financing activities
                                        
                                        
                                        938
                                        
                                        
                                        
                                        575
                                        
                                        
                                        
                                        (2,029
                                        )EFFECT
      OF EXCHANGE RATE CHANGES ON CASH
                                        
                                        
                                        (221
                                        )
                                        
                                        
                                        436
                                        
                                        
                                        
                                        (22
                                        )NET
      INCREASE  IN CASH AND CASH EQUIVALENTS
                                        
                                        
                                        8,442
                                        
                                        
                                        
                                        12,634
                                        
                                        
                                        
                                        2,065CASH
      AND CASH EQUIVALENTS, BEGINNING OF YEAR
                                        
                                        
                                        27,880
                                        
                                        
                                        
                                        15,246
                                        
                                        
                                        
                                        13,181CASH
      AND CASH EQUIVALENTS, END OF YEAR
                                        
                                        $
                                        36,322
                                        
                                        
                                        $
                                        27,880
                                        
                                        
                                        $
                                        15,246SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW INFORMATION:Cash paid during the year for interest
                                        
                                        $
                                        3
                                        
                                        
                                        $
                                        12
                                        
                                        
                                        $
                                        61Cash paid during the year for income taxes
                                        
                                        
                                        2,702
                                        
                                        
                                        
                                        2,018
                                        
                                        
                                        
                                        99Exchange of shares for statutory withholding
                                        
                                        
                                        45
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -See
      notes to consolidated financial statements.
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (Concluded)


42
 Table
of Contents


KEY
TECHNOLOGY, INC. AND SUBSIDIARIES




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


THREE
YEARS ENDED SEPTEMBER 30, 2008


1.
            THE
      COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING
  POLICIES




Key
Technology, Inc. and its wholly-owned subsidiaries (the “Company”) design,
manufacture, and sell process automation systems, integrating electro-optical
inspection and sorting, specialized conveying and product preparation
equipment.  The consolidated financial statements include the accounts
of Key Technology, Inc. and its wholly-owned subsidiaries:  Key
Technology Holdings USA LLC; Key Technology AMVC LLC; Productos Key Mexicana S.
de R. L. de C.V.; Key Technology (Shanghai) Trading Co. Ltd.; Key Technology
Asia-Pacific Pte. Ltd.; and Key Technology Australia Pty
Ltd.  Suplusco Holding B.V. is a wholly-owned European subsidiary of
Key Technology Holdings USA LLC that includes the accounts of Key Technology
B.V.  All significant intercompany accounts and transactions have been
eliminated.  The financial statements also include the Company’s
investment in InspX LLC, a 50% owned joint venture accounted for by the equity
method (See Note 6).




Revenue
Recognition—The Company recognizes revenue when persuasive evidence of an
arrangement exists, delivery has occurred or services have been provided, the
sale price is fixed or determinable, and collectability is reasonably
assured.  Additionally, the Company sells its goods on terms which
transfer title and risk of loss at a specified location, typically shipping
point, port of loading or port of discharge, depending on the final destination
of the goods.  Accordingly, revenue recognition from product sales
occurs when all factors are met, including transfer of title and risk of loss,
which occurs either upon shipment by the Company or upon receipt by customers at
the location specified in the terms of sale.  Sales of system upgrades
are recognized as revenue upon completion of the conversion of the customer’s
existing system when this conversion occurs at the customer
site.  Revenue earned from services (maintenance, installation
support, and repairs) is recognized ratably over the contractual period or as
the services are performed.  If any contract provides for both
equipment and services (multiple deliverables), the sales price is allocated to
the various elements based on objective evidence of fair value.  Each
element is then evaluated for revenue recognition based on the previously
described criteria.  The Company’s sales arrangements provide for no
other significant post shipment obligations.  If all conditions of
revenue recognition are not met, the Company defers revenue
recognition.  In the event of revenue deferral, the sale value is not
recorded as revenue to the Company, accounts receivable are reduced by any
amounts owed by the customer, and the cost of the goods or services deferred is
carried in inventory.  In addition, the Company periodically evaluates
whether an allowance for sales returns is necessary.  Historically,
the Company has experienced few sales returns.  If the Company
believes there are potential sales returns, the Company would provide any
necessary provision against sales.  Upon receipt of an order, the
Company generally receives a deposit which is recorded as customers’
deposits.  The Company makes periodic evaluations of the
creditworthiness of its customers and generally does not require
collateral.  An allowance for credit losses is provided based upon
historical experience and anticipated losses.  The Company records
revenues net of any taxes, such as sales tax, which are passed through to the
customer.




In
accordance with the Financial Accounting Standard Board’s Emerging Issues Task
Force Issue (“EITF”) No. 01-9, “Accounting for Consideration Given
by a Vendor to a Customer or a Reseller of the Vendor’s Product,” the
Company accounts for cash consideration (such as sales incentives) that are
given to customers or resellers as a reduction of revenue rather than as an
operating expense unless an identified benefit is received for which fair value
can be reasonably estimated.




Cash and Cash
Equivalents—The Company considers all highly liquid investments with
original maturities of 90 days or less at date of acquisition to be cash
equivalents.




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




43
 Table
of Contents


Property, Plant, and
Equipment are recorded at cost and depreciated over estimated useful
lives on the straight-line basis, and depreciation commences at the time assets
are placed in service.  Leasehold improvements are amortized over the
lesser of useful life or the term of the applicable lease using the
straight-line method.  The range of useful lives for fixed assets is
as follows:




YearsBuildings
      and improvements
                      7
      to 40Manufacturing
      equipment
                      5
      to 10Office
      equipment, furniture, and fixtures
                      3
      to
7
  Goodwill and
Other Intangibles—The Company accounts for goodwill in accordance with
Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible
Assets.  Goodwill is not amortized, but an assessment of
potential goodwill impairment is performed by the Company on an annual basis in
its fourth fiscal quarter, or sooner, if necessary.  The Company’s
annual assessment determined that there has been no impairment of
goodwill.




Other
intangibles, which consist of patents, developed technologies, trademarks and
trade names, and customer related intangible assets, are amortized over the
estimated useful lives of the related assets, which are 10 years for the
majority of the assets.  Management periodically evaluates the
recoverability of other intangibles based upon current and anticipated results
of operations and undiscounted future cash flows.  Amortization of
other intangibles was $1,307,000, $1,307,000 and $1,330,000 for the years ended
September 30, 2008, 2007, and 2006, respectively (see
Note 2).




Accrued Customer
Support and Warranty Costs—The Company provides customer support services
consisting of start-up assistance and evaluation and training to its
customers.  The Company also provides a warranty on its products
ranging from ninety days to five years following the date of
shipment.  Management establishes allowances for customer support and
warranty costs based upon the types of products shipped, customer support and
product warranty experience.  The provision of customer support and
warranty costs is charged to cost of sales at the point of sale, and it is
periodically assessed for adequacy based on changes in these
factors.




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




2008
                    
                    
                    2007Beginning
      balance
                    
                    $
                    1,433
                    
                    
                    $
                    979Warranty
      costs incurred
                    
                    
                    (2,660
                    )
                    
                    
                    (2,122
                    )Warranty
      expense accrued
                    
                    
                    2,929
                    
                    
                    
                    2,518Translation
      adjustments
                    
                    
                    2
                    
                    
                    
                    58Ending
      balance
                    
                    $
                    1,704
                    
                    
                    $
                    1,433





Deferred Income
Taxes—Deferred income taxes are provided for the effects of temporary
differences arising from differences in the reporting of revenues and expenses
for financial statement and for income tax purposes under the asset and
liability method using currently enacted tax rates.




Research and
Development—Expenditures for research and development are expensed when
incurred.




Foreign Currency
Translation—Assets and liabilities denominated in a foreign currency are
translated to U.S. dollars at the exchange rate on the balance sheet
date.  Translation adjustments are shown as part of accumulated other
comprehensive income (loss).  Revenues, costs, and expenses are
translated using an average rate.  Realized and unrealized foreign
currency transaction gains and losses are included in the consolidated statement
of operations.




44
 Table
of Contents


Impairment of
Long-Lived Assets—The Company regularly reviews
all of its long-lived assets, including property, plant and equipment, and
amortizable intangible assets, for impairment whenever events or changes in
circumstances indicate that the carrying value may not be
recoverable.  If the total of future undiscounted cash flows is less
than the carrying amount of these assets, an impairment loss, if any, based on
the excess of the carrying amount over the fair value of the assets, is
recorded.  In addition, goodwill is reviewed based on its implied fair
value at least annually.




Estimates—The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.




Financial Instruments—The carrying value of the Company’s cash and cash
equivalents, accounts and notes receivable, accounts payable, accrued payroll
liabilities and commissions, accrued customer support and warranty costs, and
other accrued liabilities approximates their estimated fair values due to the
short maturities of those instruments.




Derivative Financial
Instruments—The Company recognizes all derivatives on the balance sheet
at fair value.  Forward foreign currency exchange contracts are used
from time to time to reduce foreign currency risk.  The Company enters
into such contracts only with financial institutions of good standing, and the
total credit exposure related to non-performance by those institutions is not
material to the operations of the Company.




During fiscal
2008, approximately $33,000 of net settlement gains was reflected in net
income.  The balance sheet at September 30, 2008 includes
approximately $33,000 of settled net forward contracts receivable.  In
addition, the Company had a 30-day forward exchange contract of $2 million Euros
at September 30, 2008 which had a fair value of zero at that
date.  There were no derivative financial instruments reflected in the
accounts for fiscal 2007 and 2006.




Earnings Per Share—Basic
earnings (loss) per share (“EPS”) is computed by dividing net earnings (loss)
available to common shareholders by the weighted average number of shares
outstanding for the period.  Diluted EPS is computed by dividing net
earnings (loss) available to common shareholders by the weighted average common
stock and common stock equivalent shares outstanding during each period using
the treasury stock method for employee stock option plans and service-based
stock awards.  The calculation of the basic and diluted EPS from
continuing operations is as follows (in thousands except per share
data):





For
      the year ended September 30, 2008Earnings
                  
                  
                  Shares
                  
                  
                  Per-Share
      AmountBasic
      EPS:Net
      earnings available to common shareholders
                  
                  $
                  7,473
                  
                  
                  
                  5,430
                  
                  
                  $
                  1.38Effect
      of dilutive securities:Common
      stock options
                  
                  
                  -
                  
                  
                  
                  51Common
      stock awards
                  
                  
                  -
                  
                  
                  
                  36Diluted
      EPS:Net
      earnings available to common shareholders plus assumed
      conversions
                  
                  $
                  7,473
                  
                  
                  
                  5,517
                  
                  
                  $
                  1.35





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For
      the year ended September 30, 2007Earnings
                  
                  
                  Shares
                  
                  
                  Per-Share
      AmountBasic
      EPS:Net
      earnings available to common shareholders
                  
                  $
                  7,410
                  
                  
                  
                  5,265
                  
                  
                  $
                  1.41Effect
      of dilutive securities:Common
      stock options
                  
                  
                  -
                  
                  
                  
                  97Common
      stock awards
                  
                  
                  -
                  
                  
                  
                  45Diluted
      EPS:Net
      earnings available to common shareholders plus assumed
      conversions
                  
                  $
                  7,410
                  
                  
                  
                  5,407
                  
                  
                  $
                  1.37








For
      the year ended September 30, 2006Loss
                  
                  
                  Shares
                  
                  
                  Per-Share
      AmountBasic
      EPS:Net
      loss available to common shareholders
                  
                  $
                  (793
                  )
                  
                  
                  5,205
                  
                  
                  $
                  (0.15
                  )Effect
      of dilutive securities:None
                  
                  
                  -
                  
                  
                  
                  -Diluted
      EPS:Net
      loss available to common shareholders plus assumed
    conversions
                  
                  $
                  (793
                  )
                  
                  
                  5,205
                  
                  
                  $
                  (0.15
                  )





The
weighted average number of diluted shares does not include potential common
shares which are anti-dilutive, nor does it include performance-based restricted
stock awards if the performance measurement has not been met.  The
following potential common shares were not included in the calculation of
diluted EPS as they were anti-dilutive:




For
      the year ended September 30,2008
                  
                  
                  2007
                  
                  
                  2006Common
      shares from:Assumed
      exercise of stock options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  389,702Assumed
      exercise of:-  employment
      based stock grants
                  
                  
                  2,650
                  
                  
                  
                  -
                  
                  
                  
                  70,926-  performance
      based stock grants
                  
                  
                  24,607
                  
                  
                  
                  -
                  
                  
                  
                  88,301-  non-employee
      stock grants
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,000





The
options expire on dates beginning in February 2009 through February
2015.  The restrictions on stock grants may lapse between October 2008
and October 2011.




Accounting for
Stock-Based Compensation—Effective October 1, 2005, the Company adopted
the fair value recognition provisions of FASB Statement No. 123(R), Share-Based
Payment, using the modified-prospective-transition
method.  Under that transition method, compensation cost recognized in
fiscal 2006 and thereafter includes: (a) compensation cost for all share-based
payments granted prior to, but not yet vested as of October 1, 2005, based on
the grant date fair value estimated in accordance with the original provisions
of Statement 123, and (b) compensation cost for all share-based payments granted
subsequent to October 1, 2005, based on the grant-date fair value estimated in
accordance with the provisions of Statement 123(R).  Prior to the
adoption of Statement 123(R), the Company accounted for stock-based awards to
employees and directors using the intrinsic value method in accordance with
APB 25 as allowed under Statement No. 123,




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“Accounting for
Stock-Based Compensation.”Upon adoption of Statement 123(R),
the $2.1 million increase in common stock and the offsetting amount in deferred
stock-based compensation, that are both reflected in shareholders’ equity at
September 30, 2005, have been reversed as required by Statement
123(R).  The net effect has no change in total shareholders’
equity.




Accounting for
Income Taxes— The Company adopted the provisions of FASB Interpretation
48, Accounting for Uncertainty in Income Taxes, on October 1, 2007. Previously,
the Company had accounted for tax contingencies in accordance with Statement of
Financial Accounting Standards 5, Accounting for Contingencies. As required by
Interpretation 48, which clarifies Statement 109, Accounting for Income Taxes,
the Company recognizes the financial statement benefit of a tax position only
after determining that the relevant tax authority would more likely than not
sustain the position following an audit. For tax positions meeting the
more-likely-than-not threshold, the amount recognized in the financial
statements is the largest benefit that has a greater than 50 percent likelihood
of being realized upon ultimate settlement with the relevant tax authority. At
the adoption date, the Company applied Interpretation 48 to all tax positions
for which the statute of limitations remained open. As a result of the
implementation of Interpretation 48, the Company recognized a decrease of
approximately $250,000 in the liability for unrecognized tax benefits, which was
accounted for as an increase to the October 1, 2007 balance of retained
earnings.




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




In
February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-2, “Effective
Date of FASB Statement No. 157,” to delay the effective date of FASB Statement
157 for one year for certain nonfinancial assets and nonfinancial liabilities,
excluding those that are recognized or disclosed in financial statements at fair
value on a recurring basis (that is, at least annually).  For purposes
of applying the FSP, nonfinancial assets and nonfinancial liabilities include
all assets and liabilities other than those meeting the definition of a
financial asset or a financial liability in FASB Statement 159.  This
FSP defers the effective date of Statement 157 to fiscal years beginning after
November 15, 2008, and interim periods within those fiscal years for items
within the scope of this FSP.




In
February 2007, the FASB issued Statement 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.”  This Statement permits
entities to elect to measure certain financial instruments and other items at
fair value.  The fair value option may be applied on an instrument by
instrument basis, is irrevocable and is applied only to entire
instruments.  SFAS 159 requires additional financial statement
presentation and disclosure requirements for those entities that elect to adopt
the standard and is effective for fiscal years beginning after November 15,
2007.  The Company does not expect the adoption of SFAS 159 to have a
material effect on its financial position, results of operations or cash
flows.




In June
2008, the FASB issued FASB Staff Position EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities.” This position states that unvested share-based payment awards that
contain nonforfeitable rights to dividends (whether paid or unpaid) are
participating securities and shall be included in the computation of earnings
per share (EPS) under the two-class method described in paragraphs 60 and 61 of
FASB Statement No. 128, “Earnings per Share.” FSP EITF 03-6-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008.
All prior period EPS data will be required to be adjusted to conform to the
provisions of this pronouncement and early application is prohibited. The
Company does have participating securities as described under this pronouncement
and is currently evaluating the impact of FSP EITF 03-6-1.




In March
2008, the FASB issued Statement 161 “Disclosures about Derivative Instruments
and Hedging Activities” an amendment to FASB No. 133.  This statement
changes the disclosure requirements for




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derivative
instruments and hedging activities.  Entities are required to provide
enhanced disclosures about (a) how and why and entity uses derivative
instruments, (b) how derivative instruments and related hedged items are
accounted for under Statement 133 and its related interpretations, and (c) how
derivative instruments and related hedged items affect an entity’s financial
position, financial performance, and cash flows.  This statement is
effective for financial statements issued for fiscal years and interim periods
beginning after November 15, 2008.  Early application is
encouraged.  The Company does not expect the adoption of SFAS 161 to
have a material impact on its financial position, results of operations or cash
flows.




In
December 2007, the Financial Accounting Standards Board ratified a consensus
opinion reached by the Emerging Issues Task Force (EITF) on EITF Issue 07-1,
“Accounting for Collaborative Arrangements.” The guidance in EITF Issue 07-1
defines collaborative arrangements and establishes presentation and disclosure
requirements for transactions within a collaborative arrangement (both with
third parties and between participants in the arrangement).  The
consensus in EITF Issue 07-1 is effective for fiscal years, and interim periods
within those fiscal years, beginning after December 15, 2008. The consensus
requires retrospective application to all collaborative arrangements existing as
of the effective date, unless retrospective application is impracticable. The
impracticability evaluation and exception should be performed on an
arrangement-by-arrangement basis.  The Company is evaluating the
impact EITF Issue 07-1 will have on its financial statements. The Company
currently does not believe that the adoption of EITF Issue 07-1 will have a
significant effect on its financial statements.




2.
            GOODWILL
      AND OTHER INTANGIBLE ASSETS




As of
September 30, 2008, the Company had the following intangible assets (in
thousands):




Cost
                
                
                Net
      Book ValuePatents
      and developed technologies
                
                $
                11,085
                
                
                $
                1,811Purchased
      trademarks and trade names
                
                
                1,700
                
                
                
                298Customer
      related intangibles
                
                
                900
                
                
                
                157$
                13,685
                
                
                $
                2,266





The
significant majority of these assets are being amortized over 10
years.  Amortization expense for the next five fiscal years is
expected to be approximately:




Year
      Ended September 30
                  
                  (In
      thousands)2009
                  
                  $
                  1,2692010
                  
                  
                  9302011
                  
                  
                  152012
                  
                  
                  152013
                  
                  
                  15Thereafter
                  
                  
                  22Total
                  
                  $
                  2,266





As of
September 30, 2008, the Company had $2.5 million of goodwill which is
not being amortized.  There was no change to goodwill during the
fiscal years ended September 30, 2008 and 2007.




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3.
            TRADE
      ACCOUNTS RECEIVABLE




Trade
accounts receivable consist of the following (in thousands):




September
      30,2008
                            
                            
                            2007Trade
      accounts receivable
                            
                            $
                            13,885
                            
                            
                            $
                            14,434Allowance
      for doubtful accounts
                            
                            
                            (308
                            )
                            
                            
                            (414
                            )Total
      trade accounts receivable, net
                            
                            $
                            13,577
                            
                            
                            $
                            14,020




Amounts
charged to bad debt expense for fiscal 2008, 2007, and 2006 were $116,000,
$16,000, and $29,000, respectively.  Actual charges to the allowance
for doubtful accounts for fiscal 2008, 2007, and 2006 were $230,000, $98,000,
and $83,000, respectively.




4.
            INVENTORIES




Inventories consist of the following (in thousands):




September
      30,2008
                    
                    
                    2007Purchased
      components and raw materials
                    
                    $
                    8,671
                    
                    
                    $
                    7,104Sub-assemblies
                    
                    
                    1,385
                    
                    
                    
                    1,722Work-in-process
                    
                    
                    5,215
                    
                    
                    
                    5,081Finished
      goods
                    
                    
                    6,644
                    
                    
                    
                    4,846Total
      inventories
                    
                    $
                    21,915
                    
                    
                    $
                    18,753




At
September 30, 2008 and 2007, respectively, cumulative inventory adjustments to
lower of cost or market totaled $1.7 million and $1.8
million.  Amounts charged to expense to record inventory at lower of
cost or market for fiscal 2008 were $708,000, $386,000 for fiscal 2007, and $1.6
million for fiscal 2006.  Actual charges to the cumulative inventory
adjustments upon disposition or sale of inventory were $801,000, $903,000 and
$2.3 million for fiscal 2008, 2007, and 2006, respectively.




5.
            PROPERTY,
      PLANT AND EQUIPMENT




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




September
      30,2008
                    
                    
                    2007Land
                    
                    $
                    303
                    
                    
                    $
                    306Buildings
      and improvements
                    
                    
                    3,390
                    
                    
                    
                    2,944Manufacturing
      equipment
                    
                    
                    11,843
                    
                    
                    
                    11,410Office
      equipment, furniture and fixtures
                    
                    
                    8,502
                    
                    
                    
                    7,353Construction
      in progress
                    
                    
                    3,085
                    
                    
                    
                    83327,123
                    
                    
                    
                    22,846Accumulated
      depreciation
                    
                    
                    (18,418
                    )
                    
                    
                    (18,175
                    )Total
      property, plant and equipment, net
                    
                    $
                    8,705
                    
                    
                    $
                    4,671




Depreciation
expense was $1.5 million, $1.3 million and $1.6 million for fiscal 2008, 2007
and 2006, respectively.





Construction
in progress at September 30, 2008 includes approximately $2.6 million related to
the Company’s development of a new ERP system, with the remainder primarily
related to building renovations and




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architectural
plans for future expansion.  Total capital expenditures related to the
new ERP system were $3.0 million at September 30, 2008, including computer
hardware already placed in service.





Subsequent
to the end of fiscal 2008, the Company exercised its purchase option for its
Walla Walla facility and grounds.  The purchase price was
approximately $6.5 million.  Approximately $600,000 in deferred rents
will be offset against the purchase price as required by FASB 13, “Accounting
for Leases.”  Also subsequent to the end of the fiscal year, the
Company decided to sell its facility and grounds in the
Netherlands.  The net book value of the facility is approximately $1.2
million, and the Company expects to fully realize this amount upon
sale.




6.
            INVESTMENT
      IN JOINT VENTURE




In July
2004, the Company entered into a joint venture with Peco LLC to form InspX LLC
for the product development, manufacturing and sales of x-ray inspection
systems.  The Company invested $2.0 million cash in the joint venture
plus approximately $0.1 million in capitalized acquisition costs for a 50%
equity interest in the joint venture and was subject to additional voluntary
capital calls if necessary to finance the joint venture
operations.  The investment in the joint venture was being accounted
for under the equity method of accounting.  The Company shared equally
(50%) in the earnings or loss of the joint venture.  For the period
ended September 30, 2006, the Company’s equity in earnings of the joint venture
was a loss of approximately $389,000.   During fiscal 2006, the
Company also earned approximately $33,000 on sales commissions from InspX for
sales of InspX equipment.  During fiscal 2006, the Company purchased
$676,000 of equipment from the InspX joint venture.




The
Company reached an agreement with its joint venture partner in December 2006
pursuant to which the Company sold its interest in InspX to the InspX joint
venture.  Under the agreement, InspX redeemed the Company’s 50%
interest in the joint venture in exchange for $1,500,000 plus a contingent
payment.  The $1,500,000 portion of the sale price consists
of  $750,000 in cash that was paid to the Company in December 2006 and
a $750,000 term note payable on September 30, 2009 bearing interest at 5% per
annum payable quarterly until the note is paid in full.  The note is
unsecured and, due to uncertainty related to the ultimate collectability of the
note, the Company has established an allowance for the doubtful note receivable
for the full amount of the note.  The contingent portion of the sale
price consists of an additional $500,000, which is payable in the event (1)
InspX revenues for the year ended December 31, 2008 are $9,000,000 or higher, or
(2) of the sale prior to December 31, 2008 by InspX or any existing owner of
InspX of equity in InspX for $2,000,000 or more at an enterprise value for InspX
of $10,000,000 or more.  The contingent payment is payable to the
Company at InspX’s election either within 45 days after the event giving rise to
the payment or in four equal annual installments (plus interest) beginning one
year after the event giving rise to the payment.  As the contingent
event has not occurred, and as the Company believes the likelihood of the
contingent event occurring is remote, there has been no value recorded related
to the contingent amount.  The cash payment received with respect to
the Company’s sale of its interest in the InspX joint venture added
approximately $750,000 to pre- and after-tax income to the Company’s net
earnings in the first quarter of fiscal 2007.  The Company and its
former joint venture partner have agreed not to compete in the development or
sale of certain x-ray based products for 18 months from the date of the
agreement and agreed informally to cooperate regarding future sales of the
products sold by the former joint venture.




7.
            FINANCING
      AGREEMENTS




The
Company’s domestic credit facility provides for a revolving credit line of up to
$10 million and credit sub-facilities of $3.0 million each for sight commercial
letters of credit and standby letters of credit.  The credit facility
matures on June 30, 2009.  The credit facility bears interest, at the
Company’s option, of either the bank prime rate minus 1.75% or LIBOR plus 1.0%
per annum.  At September 30, 2008, the interest rate would have been
3.25%.  The credit facility is secured by all U.S. accounts
receivable, inventory and fixed assets.  The credit facility contains
covenants which require the maintenance of a defined net worth ratio, a
liquidity ratio and an EBITDA coverage ratio.  The credit facility
also restricts mergers and acquisitions, incurrence of additional indebtedness,
and transactions, including purchases and retirements, in the




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Company’s
own common stock without the prior consent of the Lender.  At
September 30, 2008, the Company had no borrowings outstanding under the credit
facility and $380,000 in standby letters of credit of which $230,000 related to
lease obligations.  This portion was cancelled subsequent to the end
of the Company’s fiscal year.  At September 30, 2008, the Company was
in compliance with its loan covenants, and had received the consent of the
lender for its stock repurchase program.  At September 30, 2007, the
Company had no borrowings outstanding under the credit facility and $530,000 in
standby letters of credit.





The
Company’s credit accommodation with a commercial bank in The Netherlands
provides a credit facility for its European subsidiary.  This credit
accommodation totals $3.5 million and includes an operating line of the
lesser of $2.1 million or the available borrowing base, which is based on
varying percentages of eligible accounts receivable and inventories, and a bank
guarantee facility of $1.4 million.  The operating line and bank
guarantee facility are secured by all of the subsidiary’s personal
property.  The credit facility bears interest at the bank’s prime
rate, with a minimum of 3.00%, plus 1.75%.  At September 30, 2008, the
interest rate was 8.15%.  At September 30, 2008, the Company had no
borrowings under this facility and had received bank guarantees of $1.2 million
under the bank guarantee facility.  At September 30, 2007, the Company
had no borrowings under this facility and had received bank guarantees of
$668,000 under the bank guarantee facility.  The credit facility
allows overages on the bank guarantee facility.  Any overages reduce
the available borrowings from the operating line.





8.
            LEASES




The Company
had an agreement with the Port of Walla Walla to lease its primary operating
facility in Walla Walla.  The Company amended its lease agreement on
its primary operating facility in June 2005, which extended the lease term to
2020, and added approximately 23,000 square feet of manufacturing and office
space under the lease in 2006.  The Company had the option to purchase
the land and plant under the agreement.  Subsequent to the end of the
fiscal year, the Company exercised its option and purchased the facility and
grounds.  The purchase price was approximately $6.5
million.  Approximately $600,000 in deferred rents will be offset
against the purchase price as required by FAS 13.




The Company
also has a leased operating facility in Oregon which expires in 2012, with a
five-year renewal option.  The Company has leased an operating
facility in The Netherlands under a lease that expires in 2013, with successive
five-year renewal options.  The Company also has leased office space
for sales and service and other activities in Oregon, Australia, Mexico, Belgium
and China, and other leased facilities in Walla Walla.




Rental
expense is recognized on a straight-line basis over the term of the
lease.  Rental expense for the Company’s operating leases referred to
above was $1,520,000 for the year ended September 30, 2008, $1,431,000 for the
year ended September 30, 2007, and $1,519,000 for the year ended September 30,
2006.




The
following is a schedule of future minimum rental payments (as adjusted for the
purchase subsequent to the end of the fiscal year of the Company’s Walla Walla
facility noted above) required under operating leases and future rental expense
(in thousands):




Year
      Ending September 30
                    
                    Rental
      Payments and Expense2009
                    
                    $
                    5912010
                    
                    
                    4662011
                    
                    
                    4492012
                    
                    
                    4072013
                    
                    
                    162Thereafter
                    
                    
                    -Total
                    
                    $
                    2,075


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9.
            CONTRACTUAL
      GUARANTEES AND INDEMNITIES




Intellectual
property and general contractual indemnities




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




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




Director
and officer indemnities




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




Bank
guarantees and letters of credit




At September
30, 2008, the Company had standby letters of credit totaling $1.6 million, which
includes secured bank guarantees under the Company’s credit facility in Europe
and letters of credit securing certain self-insurance contracts and lease
commitments.  If the Company fails to meet its contractual
obligations, these bank guarantees and letters of credit may become liabilities
of the Company.  This amount is comprised of approximately $1.2
million of outstanding performance guarantees secured by bank guarantees under
the Company’s European subsidiaries credit facility in Europe, a standby letter
of credit for $150,000 securing certain self-insurance contracts related to
workers compensation and a standby letter of credit for $230,000 securing
payments under a lease contract for a domestic production
facility.  (Subsequent to the end of the fiscal year, this letter of
credit was cancelled as the leased facility was purchased.)  Bank
guarantees arise when the European subsidiary collects customer deposits prior
to order fulfillment.  The customer deposits received are recorded as
current liabilities on the Company’s balance sheet.  The bank
guarantees repayment of the customer deposit in the event an order is not
completed.  The bank guarantee is canceled upon shipment and transfer
of title.  These bank guarantees arise in the normal course of the
Company’s European business and are not deemed to expose the Company to any
significant risks since they are satisfied as part of the design and
manufacturing process.




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10.
            INCOME
      TAXES




The provision
for income taxes from continuing operations consists of the following (in
thousands):




Year
      Ended September 30,2008
                    
                    
                    2007
                    
                    
                    2006Current:Federal
                    
                    $
                    2,519
                    
                    
                    $
                    2,253
                    
                    
                    $
                    -Foreign
                    
                    
                    434
                    
                    
                    
                    187
                    
                    
                    
                    173State
                    
                    
                    212
                    
                    
                    
                    210
                    
                    
                    
                    403,165
                    
                    
                    
                    2,650
                    
                    
                    
                    213Deferred:Federal
                    
                    
                    110
                    
                    
                    
                    1,041
                    
                    
                    
                    (365
                    )Foreign
                    
                    
                    280
                    
                    
                    
                    (281
                    )
                    
                    
                    (276
                    )State
                    
                    
                    20
                    
                    
                    
                    37
                    
                    
                    
                    (49
                    )410
                    
                    
                    
                    797
                    
                    
                    
                    (690
                    )Valuation
      reserves:Federal
                    
                    
                    304
                    
                    
                    
                    (529
                    )
                    
                    
                    56Foreign
                    
                    
                    (364
                    )
                    
                    
                    281
                    
                    
                    
                    366State
                    
                    
                    -
                    
                    
                    
                    (23
                    )
                    
                    
                    33(60
                    )
                    
                    
                    (271
                    )
                    
                    
                    455Total
      income tax expense (benefit)
                    
                    $
                    3,515
                    
                    
                    $
                    3,176
                    
                    
                    $
                    (22
                    )
  The
Company accounts for its deferred tax assets and liabilities, including excess
tax benefits of share-based payments, based on the tax ordering of deductions to
be used on its tax returns.  The tax effects of temporary differences
that give rise to significant portions of deferred tax assets and deferred tax
liabilities are as follows (in thousands):





September
      30,2008
                    
                    
                    2007Deferred
      tax asset:Reserves
      and accruals
                    
                    $
                    2,769
                    
                    
                    $
                    2,165Tax
      benefits of share-based payments
                    
                    
                    731
                    
                    
                    
                    629Translation
      adjustment to equity
                    
                    
                    (257
                    )
                    
                    
                    (324
                    )Accumulated
      depreciation
                    
                    
                    106
                    
                    
                    
                    178Deferred
      tax liability:Intangible
      assets
                    
                    
                    (908
                    )
                    
                    
                    (1,250
                    )Net
      deferred tax asset
                    
                    $
                    2,441
                    
                    
                    $
                    1,398Net
      deferred tax:Current
      asset
                    
                    $
                    2,340
                    
                    
                    $
                    2,120Long-term
      asset
                    
                    
                    101
                    
                    
                    
                    -Long-term
      liability
                    
                    
                    -
                    
                    
                    
                    (722
                    )Net
      deferred tax asset
                    
                    $
                    2,441
                    
                    
                    $
                    1,398




At
September 30, 2008, the Company had valuation reserves of approximately $450,000
for deferred tax assets related to the sale of the investment in the InspX joint
venture and the valuation reserve for notes receivable and contingent payments
and offsetting amounts for U.S. and Chinese deferred tax assets and liabilities,
primarily related to net operating loss carry forwards in the foreign
jurisdictions that the Company believes will not be utilized during the
carryforward period.  During fiscal 2008, $60,000 of net valuation
reserves for combined U.S. and Australian deferred taxes were eliminated due to
the final dissolution of the related Australian entity.  There were no
other valuation allowances at September 30, 2008 due to anticipated utilization
of all the deferred tax assets as the Company believes it will have sufficient
taxable income to utilize these assets.


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During
fiscal 2007, the Company recorded $281,000 of valuation reserves for deferred
tax assets related to Australian and Chinese net operating losses which were
offset by an equal amount of U.S. deferred tax liabilities related to these
operating losses.  The Company believes these amounts will not be
realized due to the closure of operations in Australia and the likelihood of the
Company’s ability to fully utilize net operating losses in China during the
carryforward period.  The Company also reversed valuation reserves of
a net $271,000 for deferred tax assets related to the Company’s valuation of its
investment in the InspX joint venture and the subsequent sale of its investment
in the first quarter of fiscal 2007.





During
fiscal 2006, the Company recorded valuation reserves of $58,000 for the net U.S.
and Australian deferred tax assets and liabilities that would not be realized
once the Company completed its closure of operations at Freshline Machines Pty
Ltd.  In addition, the Company recorded valuation reserves of $397,000
for deferred tax assets related to its investment in, and valuation reserve for,
the InspX joint venture.





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




Year
      Ended September 30,2008
                    
                    
                    2007
                    
                    
                    2006Statutory
      rates
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %
                    
                    
                    (34.0
                    )%Increase (reduction) in income taxes resulting from:Extraterratorial income exclusion
                    
                    
                    -
                    
                    
                    
                    (0.2
                    )
                    
                    
                    (14.3
                    )Domestic production deduction
                    
                    
                    (1.7
                    )
                    
                    
                    (0.8
                    )
                    
                    
                    -Research and development credit
                    
                    
                    (0.2
                    )
                    
                    
                    (0.7
                    )
                    
                    
                    (7.2
                    )State income taxes, net of federal benefit
                    
                    
                    1.4
                    
                    
                    
                    1.4
                    
                    
                    
                    1.9Tax exempt interest
                    
                    
                    (1.9
                    )
                    
                    
                    (2.1
                    )
                    
                    
                    (14.3
                    )Valuation reserve - InspX
                    
                    
                    -
                    
                    
                    
                    (2.4
                    )
                    
                    
                    48.7Valuation reserve - Freshline
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    7.1Meals and entertainment deduction limitation
                    
                    
                    0.8
                    
                    
                    
                    0.6
                    
                    
                    
                    7.2Non-deductible stock compensation
                    
                    
                    0.1
                    
                    
                    
                    0.3
                    
                    
                    
                    7.4Other permanent differences
                    
                    
                    (0.5
                    )
                    
                    
                    0.1
                    
                    
                    
                    (5.2
                    )Income
      tax combined effective rate
                    
                    
                    32.0
                    %
                    
                    
                    30.2
                    %
                    
                    
                    (2.7
                    )%
  The
federal Research and Development Credit (“R&D credit”) expired on December
31, 2007.  Subsequent to the end of the Company’s 2008 fiscal year,
the Emergency Economic Stabilization Act of 2008 was enacted.  As part
of the legislation, the existing R&D credit was retroactively renewed and
extended to December 31, 2009.  Due to this subsequent change in tax
law, the Company expects to record approximately $160,000 of additional R&D
tax credits in the first quarter of fiscal 2009 related to R&D expenditures
incurred during fiscal 2008.





On October 1,
2007, the Company adopted the provisions of FIN 48.  Differences
between the amount recognized in the consolidated financial statements prior to
the adoption of FIN 48 and the amounts reported as a result of adoption have
been accounted for as a cumulative effect adjustment recorded to the October 1,
2007 retained earnings balance.  The adoption of FIN 48 increased the
October 1, 2007 balance of retained earnings by $250,000.  In
addition, the Company reclassified tax reserves for which a cash tax payment is
not expected in the next twelve months from current to non-current
liabilities.





The amount of
unrecognized tax benefits as of October 1, 2007 was approximated $91,000 which,
if ultimately recognized, will reduce the Company’s annual effective tax
rate.





A
reconciliation of the beginning and ending amount of unrecognized tax benefits
is as follows (in thousands):


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Balance
      at October 1, 2007
                    
                    $
                    91,000Additions
      based on tax positions related to the current period
                    
                    
                    21,000Additions
      for tax positions of prior period
                    
                    
                    -Reductions
      for tax positions of prior periods
                    
                    
                    (2,000
                    )Settlements
                    
                    
                    -Balance
      at September 30, 2008
                    
                    $
                    110,000




As of
September 30, 2008, the amount of unrecognized tax benefits, which if
recognized, would favorably affect the company’s effective tax rate is
$110,000.





The Company
is subject to income taxes in the U.S. federal jurisdiction and various state
and foreign jurisdictions.  Tax regulations within each jurisdiction
are subject to the interpretation of the related tax laws and regulations and
require significant judgment to apply.   With few exceptions, the
Company is no longer subject to U.S. federal, state and local, or non-U.S.
income tax examinations by tax authorities for the years before
2003.





The Company
is not currently under examination by any U.S. federal or state jurisdictions,
or foreign jurisdictions, and there are no expected material changes in the
unrecognized tax benefit liability within the next twelve
months.  While it is often difficult to predict the final outcome or
the timing of resolution of any particular uncertain tax positions, the Company
believes its liabilities for income taxes represent the most probable
outcome.  The Company adjusts these liabilities in light of changing
facts and circumstances.





The Company
recognizes interest accrued related to unrecognized tax benefits in interest
expense and penalties in other income and expense for all periods
presented.  The Company had accrued approximately $37,000 for the
payment of interest and penalties at October 1, 2007.  As of September
30, 2008, the Company had accrued $46,000 of interest and
penalties.





11.
            STOCK
      COMPENSATION PLANS




At September
30, 2008, the Company had two stock-based compensation plans, which are
shareholder-approved, as described below.  The Company has also
awarded shares to non-employees.  The Company issues new shares of
common stock for exercises and awards under these plans and non-employee
awards.  Effective October 1, 2005, the Company began accounting for
stock-based compensation under FASB No. 123(R) (see Note 1).





Stock
compensation costs charged against income are as follows:




Fiscal
      year ended September 30, 2008
                    
                    
                    Fiscal
      year ended September 30, 2007Cost
      of goods sold
                    
                    $
                    214
                    
                    
                    $
                    197Operating
      expenses
                    
                    
                    1,326
                    
                    
                    
                    790Total
      share-based compensation expense
                    
                    
                    1,540
                    
                    
                    
                    987Income
      tax benefit
                    
                    
                    548
                    
                    
                    
                    326


Approximately
$5,000 and $54,000 of share-based compensation expense remained capitalized in
inventory as of September 30, 2008 and September 30, 2007,
respectively.





As of
September 30, 2008, the total unrecognized compensation cost related to these
plans was $2.5 million and was comprised of:  $1.85 million related to
service-based stock awards that is expected to be recognized over a
weighted-average period of 1.61 years, and $625,000 related to performance-based
stock awards that is expected to be recognized over a period of 1.9
years.


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Employees’ Stock
Incentive Plan—Under the 2003 Restated Employees’ Stock Incentive Plan
(the “Incentive Plan”), eligible employees may receive either incentive stock
options or non-qualified stock options and such options may be exercised only
after an employee has remained in continuous employment for one year after the
date of grant.  Thereafter, the options become exercisable as
stipulated by the individual option agreements, generally 25% per year on the
anniversary date of the grant for incentive stock options and 100% on the one
year anniversary for non-qualified stock options.  The contractual
term for these options varies from 5-10 years.  The option exercise
price is the fair market value of the underlying stock at the date of
grant.  In addition, under the Incentive Plan, eligible employees may
be granted restricted stock awards which vest either on employment-based or
performance-based measures.  At September 30, 2008, the total number
of shares reserved for issuance under the Incentive Plan was 638,303, of which
408,154 were available for grant.  The fair value of each option award
is estimated on the date of grant using a Black-Scholes option valuation
model.  Expected volatilities are based on historical volatility of
the Company’s stock, and other factors.  The Company uses historical
data to estimate option exercise and employee termination within the valuation
model:  separate groups of employees that have similar historical
exercise behavior are considered separately for valuation
purposes.  The expected term of options granted is derived from the
output of the option valuation model and represents the period of time that
options granted are expected to be outstanding.  The risk-free rate
for periods within the contractual life of the option is based on the U.S.
Treasury Note five-year rate in effect at the time of grant.  There
were no options granted in fiscal 2008, 2007 or 2006.





Incentive Stock
Options





A summary
of option activity under the Incentive Plan as of September 30, 2008 and the
year then ended is presented below:




Options
                    
                    Number of Shares
                    
                    
                    Weighted-Average Exercise
    Price
                    
                    
                    Weighted-Average Remaining Contractual
      Term
                    
                    
                    Aggregate Intrinsic Value
      ($000)Outstanding
      at October 1, 2007
                    
                    
                    136,238
                    
                    
                    $
                    9.43
                    
                    
                    
                    -
                    
                    
                    
                    -Granted
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Exercised
                    
                    
                    (56,238
                    )
                    
                    $
                    10.56
                    
                    
                    
                    -
                    
                    
                    
                    -Forfeited or expired
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Outstanding
      at September 30, 2008
                    
                    
                    80,000
                    
                    
                    $
                    8.64
                    
                    
                    
                    3.71
                    
                    
                    $
                    1,205Exercisable
      at September 30, 2008
                    
                    
                    80,000
                    
                    
                    $
                    8.64
                    
                    
                    
                    3.71
                    
                    
                    $
                    1,205


The total
intrinsic value of options exercised during the years ended September 30, 2008,
2007 and 2006 was $1.3 million, $1.6 million and $295,000,
respectively.  The fair value of shares vested during fiscal 2008,
2007 and 2006 was $16,000, $562,000 and $344,000, respectively.





As of
September 30, 2008, there was no unrecognized compensation cost related to stock
options granted under the Incentive Plan.





Service-Based Stock Awards—Under the Incentive Plan,
the Company may award service-based stock grants to selected executives and
other key employees whose vesting is contingent upon meeting the required
service period, generally three years, and in the case of certain executives,
ratably over a three-year period, or in the case of members of the Board of
Directors, one year.  The fair value of these grants is based on the
closing fair market value at the grant date.  The restrictions on the
grants lapse at the end of the required service period.  Stock
compensation expense is recognized based on the grant date fair value of the
stock over the vesting period.


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The summary
of activity for service-based stock awards as of September 30, 2008, and changes
during the year then ended, is presented below:





Service-Based Stock Awards
                    
                    Number of Shares
                    
                    
                    Weighted-Average Grant Date Fair
      ValueNon-vested
      balance at October 1, 2007
                    
                    
                    108,187
                    
                    
                    $
                    14.39Granted
                    
                    
                    63,238
                    
                    
                    $
                    33.62Vested
                    
                    
                    (55,186
                    )
                    
                    $
                    15.01Forfeited
                    
                    
                    (1,498
                    )
                    
                    $
                    28.24Non-vested
      balance at September 30, 2008
                    
                    
                    114,741
                    
                    
                    $
                    24.51


The
number of shares granted in fiscal 2008 that vest in one year was 9,193; 21,895
vest in ratable annual increments over three years; and 32,150 vest in three
years.  As of September 30, 2008, there was $1.8 million of total
unrecognized compensation cost related to service-based stock awards that is
expected to be recognized over a weighted-average period of 1.6
years.





Employee Performance-Based
Stock Awards—In fiscal 2008, the Company awarded  shares of
performance-based stock grants to selected executives, the lapse of restrictions
on which is contingent on performance objectives, as determined by the
Compensation Committee of the Board of Directors, over a three-year period
ending September 30, 2010.  In fiscal 2007, the Company did not award
any performance-based stock.  In fiscal 2006, the Company awarded
performance-based stock to the Company’s Chief Executive Officer, the lapse of
restrictions on which is contingent on performance objectives, as determined by
the Compensation Committee over a three-year period ending September 30,
2009.  Recipients of performance-based stock awards must also continue
to be employed by the Company into the month of December following the end of
the three-year period for the restrictions on the awards to lapse.





Compensation
expense is recognized over the period the employee performs related services
based on the estimated number of shares expected to vest at the grant date fair
value and assumes it is probable that between 75% to 100% of the performance
goal will be achieved.  If the performance goals are not met or the
service period is not fulfilled, no compensation cost is recognized and any
recognized compensation cost will be reversed.





A summary
of the activity for performance-based stock awards as of September 30, 2008, and
changes during the year then ended, is presented below:




Performance-Based Stock
    Awards
                    
                    Number of Shares
                    
                    
                    Weighted-Average Grant Date Fair
      ValueNon-vested
      balance at October 1, 2007
                    
                    
                    58,801
                    
                    
                    $
                    13.63Granted
                    
                    
                    26,603
                    
                    
                    $
                    34.78Vested
                    
                    
                    (44,400
                    )
                    
                    $
                    13.79Forfeited
                    
                    
                    (5,596
                    )
                    
                    $
                    21.26Non-vested
      balance at September 30, 2008
                    
                    
                    35,408
                    
                    
                    $
                    28.13




As of
September 30, 2008, there was $625,000 of total unrecognized compensation cost
related to performance-based stock awards that is expected to be recognized over
a period of 1.9 years.


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Employee Stock
Purchase Plan—Most employees are eligible to participate in the Company’s
Employee Stock Purchase Plan (the “Purchase Plan”).  Shares are not
available to employees who already own 5% or more of the Company’s
stock.  Employees can withhold, by payroll deductions, up to 5% of
their regular compensation to purchase shares at a purchase price of 85% of the
fair market value of the common stock on the purchase date.  There
were 500,000 shares reserved for purchase under the Purchase Plan of which
399,956 remained available at September 30, 2008.





During
the year ended September 30, 2008, the Company issued 3,757 shares under the
Purchase Plan and recorded compensation cost based on the 15% discount from
market price paid by the employees.





Non-Employee
Service-Based Stock Awards—The Company may award shares of service-based
stock grants to non-employees.  At September 30, 2008, there were no
shares outstanding.  There were 2,000 shares granted during the year
on which the restrictions lapsed during fiscal 2008.  In accordance
with EITF 96-18 “Accounting
for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or
in Conjunction with Selling, Goods or Services”, the value of the
instrument is amortized to expense over the vesting period with final valuation
measured on the vesting date.  The weighted-average fair value of
these shares was $33.40 at the grant date, and at the vesting dates the
aggregate intrinsic value of these shares was $67,000.





Cash
received from option and employee stock purchase plan exercises was $687,000,
$1.6 million and $282,000 for the year ended September 30, 2008, 2007 and 2006,
respectively.  The tax benefit to be realized for the tax deductions
from option exercises under the share-based payment arrangements was $1.7
million, $613,000 and $71,000 for the years ended September 30, 2008, 2007 and
2006, respectively.




12.
            STOCK
      REPURCHASE PROGRAM




The
Company initiated a stock repurchase program effective November 27,
2006.  The Company may purchase up to 500,000 shares of its common
stock under the program.  The Company intends to retire the shares
upon repurchase.  There were no repurchases during fiscal
2008.  In the period ended September 30, 2007, the Company repurchased
and retired 88,252 shares of common stock at an average purchase price of $14.77
per share.  The aggregate purchase price of the repurchased shares has
been reflected as a reduction in shareholders’ equity.




Subsequent
to the end of fiscal 2008, the Board of Directors restored the number of shares
that may be repurchased to the original 500,000 share amount, and subsequently
increased the number of shares that may be repurchased under the share
repurchase program to 750,000 shares.  During the period from October
1, 2008 through December 5, 2008, the Company purchased an additional 388,511
shares at an average price of $12.32 per share.  Included in these
amounts was the repurchase of 23,325 shares of its Common Stock from Michael L.
Shannon, an independent director of the Company.  The shares were
purchased at an average price of $15.01 per share based on the daily closing
price of the Company’s Common Stock on The Nasdaq Global Market, less $0.03 per
share.  The total purchase price paid to Mr. Shannon was approximately
$350,000.  The purchase transactions were previously approved by the
Nominating and Corporate Governance Committee and the Company’s Board of
Directors.




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% of employee
contributions for a maximum match of 4% in fiscal 2008, 3% in fiscal 2007 and 2%
in fiscal 2006 of each participating employee’s compensation.  The
Company contributed $754,000, $470,000, and $291,000 in matching funds to the
plan for the years ended September 30, 2008, 2007, and 2006,
respectively.




The
401(k) plan also permits the Company to make discretionary profit sharing
contributions to all employees.  Discretionary profit sharing
contributions are determined annually by the Board of Directors.




58
 Table
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Profit
sharing plan expense was $527,000, $443,000, and $0 for the years ended
September 30, 2008, 2007, and 2006, respectively.




14.
            SEGMENT
      INFORMATION




The
Company’s business units serve customers in its primary market—the food
processing and agricultural products industry—through common sales and
distribution channels.  Therefore, the Company reports on one
segment.  The following table summarizes information about products
and services (in thousands).




Year
      Ended September 30,2008
                    
                    
                    2007
                    
                    
                    2006Net
      sales by product category:Automated
      inspection systems
                    
                    $
                    55,968
                    
                    
                    $
                    46,858
                    
                    
                    $
                    30,264Process
      systems
                    
                    
                    56,603
                    
                    
                    
                    40,947
                    
                    
                    
                    34,925Parts
      and service
                    
                    
                    21,515
                    
                    
                    
                    19,735
                    
                    
                    
                    19,651Total
      net sales by product category
                    
                    $
                    134,086
                    
                    
                    $
                    107,540
                    
                    
                    $
                    84,840
  Net sales
for service were less than 10% of total net sales for the years ended
September 30, 2008, 2007, and 2006, respectively, and are therefore
summarized with parts and service.  Upgrades of automated inspection
systems are included with automated inspection systems.




The
following table summarizes information about geographic areas:




Year
      Ended September 30,2008
                    
                    
                    2007
                    
                    
                    2006Net
      sales:Domestic
                    
                    $
                    66,731
                    
                    
                    $
                    58,351
                    
                    
                    $
                    41,665International
                    
                    
                    67,355
                    
                    
                    
                    49,189
                    
                    
                    
                    43,175Total
      net sales
                    
                    $
                    134,086
                    
                    
                    $
                    107,540
                    
                    
                    $
                    84,840Long-lived
      assets:Domestic
                    
                    $
                    11,196
                    
                    
                    $
                    8,286
                    
                    
                    $
                    9,109International
                    
                    
                    2,301
                    
                    
                    
                    2,484
                    
                    
                    
                    2,568Total
      long-lived assets
                    
                    $
                    13,497
                    
                    
                    $
                    10,770
                    
                    
                    $
                    11,677
  There
were two customers that accounted for 14% and 13%, respectively, of net sales
during fiscal 2008.  There was no customer that accounted for greater
than 10% of net sales during fiscal 2007.  There was one customer that
accounted for approximately 17% of net sales during fiscal 2006.




No single
country outside the United States accounted for more than 10% of net sales in
2008, 2007 or 2006.  Location of the customer is the basis for the
categorization of net sales.




* * * * *
*




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SUPPLEMENTARY
DATA




QUARTERLY FINANCIAL INFORMATION(Unaudited)


The
following is a summary of operating results by quarter for the years ended
September 30, 2008 and 2007 (in thousands, except per share
data):




2008
      Quarter Ended
                  
                  December
      31
                  
                  
                  March
      31
                  
                  
                  June
      30
                  
                  
                  September
      30
                  
                  
                  TotalNet
      sales
                  
                  $
                  28,943
                  
                  
                  $
                  29,110
                  
                  
                  $
                  35,831
                  
                  
                  $
                  40,202
                  
                  
                  $
                  134,086Gross
      profit
                  
                  
                  11,467
                  
                  
                  
                  11,297
                  
                  
                  
                  15,036
                  
                  
                  
                  15,392
                  
                  
                  
                  53,193Net
      earnings
                  
                  
                  1,090
                  
                  
                  
                  1,193
                  
                  
                  
                  2,963
                  
                  
                  
                  2,227
                  
                  
                  
                  7,473Net
      earnings per share—basic
                  
                  $
                  0.20
                  
                  
                  $
                  0.22
                  
                  
                  $
                  0.54
                  
                  
                  $
                  0.41
                  
                  
                  $
                  1.38Net
      earnings per share—diluted
                  
                  $
                  0.20
                  
                  
                  $
                  0.22
                  
                  
                  $
                  0.53
                  
                  
                  $
                  0.40
                  
                  
                  $
                  1.352007
      Quarter Ended
                  
                  (1)
      December 31
                  
                  
                  March
      31
                  
                  
                  June
      30
                  
                  
                  September
      30
                  
                  
                  TotalNet
      sales
                  
                  $
                  22,609
                  
                  
                  $
                  22,165
                  
                  
                  $
                  31,019
                  
                  
                  $
                  31,747
                  
                  
                  $
                  107,540Gross
      profit
                  
                  
                  8,720
                  
                  
                  
                  8,343
                  
                  
                  
                  12,473
                  
                  
                  
                  11,906
                  
                  
                  
                  41,441Net
      earnings
                  
                  
                  1,566
                  
                  
                  
                  608
                  
                  
                  
                  2,939
                  
                  
                  
                  2,297
                  
                  
                  
                  7,410Net
      earnings per share—basic
                  
                  $
                  0.30
                  
                  
                  $
                  0.12
                  
                  
                  $
                  0.56
                  
                  
                  $
                  0.43
                  
                  
                  $
                  1.41Net
      earnings per share—diluted
                  
                  $
                  0.29
                  
                  
                  $
                  0.11
                  
                  
                  $
                  0.54
                  
                  
                  $
                  0.42
                  
                  
                  $
                  1.37




(1)
            The
      first quarter of fiscal 2007 included a $750,000 gain, or $0.14 per share,
      of non-operating income associated with the sale of the Company’s 50%
      interest in its InspX joint
venture.





Note:  Annual
totals may not agree to the summarization of quarterly information due to
insignificant rounding and the required calculation conventions.





* * * * *
*




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ITEM 9.
            CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE.





None.





ITEM 9A.
            CONTROLS
      AND PROCEDURES.





Evaluation
of Disclosure Controls and Procedures





The
Company’s management, with the participation of its Chief Executive Officer and
Chief Financial Officer, conducted an evaluation of the effectiveness of the
design and operation of the Company’s disclosure controls and procedures, as
required by Exchange Act Rule 13a-15.  Based on that evaluation, the
Chief Executive Officer and Chief Financial Officer have concluded that, as of
the end of the period covered by this report, the Company’s disclosure controls
and procedures were effective to ensure that information required to be
disclosed by the Company in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified by the SEC’s rules and forms and such information is
accumulated and communicated to management as appropriate to allow timely
decisions regarding required disclosures.





Management’s
Report on Internal Control over Financial Reporting





The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting.  The Company’s internal
control over financial reporting is a process designed under the supervision of
its Chief Executive Officer and Chief Financial Officer to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of the Company’s financial statements for external reporting in accordance with
accounting principles generally accepted in the United States of
America.  Management evaluates the effectiveness of the Company’s
internal control over financial reporting using the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
Internal Control – “Integrated Framework.”  Management, under the
supervision and with the participation of the Company’s Chief Executive Officer
and Chief Financial Officer, assessed the effectiveness of the Company’s
internal control over financial reporting as of September 30, 2008 and concluded
that it is effective.





The
Company’s independent registered public accounting firm, Grant Thornton LLP, has
audited the effectiveness of the Company’s internal control over financial
reporting as of September 30, 2008, and has expressed an unqualified opinion in
their report which appears in this Form 10-K.





Changes
in Internal Controls





There
were no changes in the Company’s internal control over financial reporting
identified in connection with the evaluation referred to above that occurred
during the fourth quarter of the fiscal year ended September 30, 2008 that have
materially affected, or are reasonably likely to materially affect, the
registrant’s internal control over financial reporting.





Limitations
on the Effectiveness of Controls





The
Company believes that a control system, no matter how well designed and
operated, cannot provide absolute assurance that the objectives of the control
system are met, and no evaluation of controls can provide absolute assurance
that all controls issues and instances of fraud, if any, within a company have
been detected.  The Company’s disclosure controls and procedures are
designed to provide reasonable assurance of achieving their objectives, and the
Company’s Chief Executive Officer and Chief Financial Officer have concluded
that such controls and procedures are effective at the “reasonable assurance”
level.


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PART III





ITEM 10.
            DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE
GOVERNACE.





There is
hereby incorporated by reference the information under the captions “Election of
Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance” and
“Report of the Audit Committee of the Board of Directors” in the Company’s
definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy
Statement is anticipated to be filed with the Securities and Exchange Commission
within 120 days after the end of Registrant's fiscal year ended September 30,
2008.





ITEM 11.
            EXECUTIVE
      COMPENSATION.





There is
hereby incorporated by reference the information under the captions “Executive
Compensation,”  “Compensation Discussion and Analysis” and
“Compensation and Management Development Committee Report” in the Company’s
definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy
Statement is anticipated to be filed with the Securities and Exchange Commission
within 120 days after the end of Registrant's fiscal year ended September 30,
2008.





ITEM 12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS.





There is
hereby incorporated by reference the information under the caption “Principal
Shareholders” in the Company’s definitive Proxy Statement to be filed pursuant
to Regulation 14A, which Proxy Statement is anticipated to be filed with the
Securities and Exchange Commission within 120 days after the end of Registrant's
fiscal year ended September 30, 2008.





Equity
Compensation Plan Information





The
following table provides information as of September 30, 2008 with respect to
the shares of the Company’s Common Stock that may be issued under the Company’s
existing equity compensation plans.





A
              
              B
              
              CPlan
      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 Shareholders2003
      Restated Employees’ Stock Incentive Plan
              
              80,000
              
              $8.64
              
              408,154(1)Restated
      1996 Employee Stock Purchase Plan
              
              (2)
              
              (2)
              
              399,956Equity
      Compensation Plans Not Approved by Shareholders (3)
              
              -
              
              -
              
              -Total
              
              80,000
              
              $8.64
              
              808,110




(1)
            The
      number of securities remaining may be used for issuance of either options
      or restricted stock.


(2)
            We
      are unable to ascertain with specificity the number of securities to be
      issued under the 1996 Employee Stock Purchase Plan or the weighted average
      purchase price of the shares that may be purchased under the
      plan.  Under the plan, eligible employees may make contributions
      to the plan of not more than five percent of the participant’s
      compensation during each pay period in the offering period.  The
      offering periods commence quarterly beginning October 1, January 1, April
      1, and July 1 of each year.  Purchases are made on the last
      business 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 Stock reserved under
      the plan.


(3)
            There
      are no Equity Compensation Plans that have not been approved by
      Shareholders.


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ITEM 13.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE.





On
December 1 and December 2, 2008, the Company purchased 23,325 shares of its
common stock from Michael L. Shannon, an independent director of the
Company.  The shares were purchased under of the Company’s current
stock repurchase plan at a price of $14.45 per share on December 1, and $15.43
per share on December 2, the closing price of the Company’s common stock on each
day, respectively, on The Nasdaq Global Market, less $0.03 per
share.  The total purchase price paid to Mr. Shannon was approximately
$350,000. Prior to the sale, Mr. Shannon advised the Company that the
transaction was involuntary under the terms of certain financings related to Mr.
Shannon's real estate investment activities.  The purchase
transactions were previously approved by the Nominating and Corporate Governance
Committee and the Company’s Board of Directors.





There is
hereby incorporated by reference the information under the caption “Election of
Directors” in the Company’s definitive Proxy Statement to be filed pursuant to
Regulation 14A, which Proxy Statement is anticipated to be filed with the
Securities and Exchange Commission within 120 days after the end of Registrant's
fiscal year ended September 30, 2008.








ITEM 14.
            PRINCIPAL
      ACCOUNTANT FEES AND SERVICES.





There is
hereby incorporated by reference the information under the caption “Audit
Committee Report and Other Related Matters” in the Company’s definitive Proxy
Statement to be filed pursuant to Regulation 14A, which Proxy Statement is
anticipated to be filed with the Securities and Exchange Commission within 120
days after the end of Registrant's fiscal year ended September 30,
2008.








PART IV





ITEM 15.
            EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES.


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
                  34





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 of Key Technology, Inc. (as of May 6, 2008)
      (filed as Exhibit 3.1 to the Form 10-Q filed with the Securities and
      Exchange Commission on May 9, 2008 and incorporated herein by
      reference)


(3.2)
            Registrant’s
      Amended and Restated Bylaws (as amended through May 7,
    2008)





(4)           Instruments
defining the rights of security holders, including indentures





(4.1)
            Registrant’s
      Second Amended and Restated Rights Agreement, dated as of November 13,
      2007, between the Registrant and American Stock Transfer & Trust
      Company (filed as Exhibit 10.1 to the Form 8-K filed with the
      Securities


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and
Exchange Commission on November 19, 2007 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
      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)


(10.4)*
            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)


(10.5)*
              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)


(10.6)*
            Registrant’s
      Restated Employees’ Stock Option Plan (1996 Plan as amended through July
      12, 2000) (filed as Exhibit 10.13 to the Form 10-K filed with the
      Securities and Exchange Commission on December 19, 2002 and incorporated
      herein by reference)


(10.7)
              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)


(10.8)
            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)


(10.9)*
              Registrant’s
      2003 Restated Employees’ Stock Incentive Plan, (1996 Plan as amended and
      restated as of December 15, 2003) (filed as Exhibit 10.1 to Form 10-Q
      filed with the Securities and Exchange Commission on May 14, 2004 and
      incorporated herein by
reference)


(10.10)
            Addendum
      No. 2 to Construction and Lease Agreement executed June 8, 2005 between
      the Port of Walla Walla and Registrant (filed as Exhibit 10.1 to the Form
      8-K filed with the Securities and Exchange Commission on June 13, 2005 and
      incorporated herein by reference)


(10.11)*
              Form
      of Restricted Stock Bonus Agreement (Continued Employment Vesting) (filed
      as Exhibit 10.1 to the Form 8-K filed with the Securities and Exchange
      Commission on September 12, 2005 and incorporated herein by
      reference)


(10.12)*
            Form
      of Restricted Stock Bonus Agreement (Performance Vesting) (filed as
      Exhibit 10.2 to the Form 8-K filed with the Securities and Exchange
      Commission on September 12, 2005 and incorporated herein by
      reference)


(10.13)*
              2003
      Restated Employee’s Stock Incentive Plan (as approved by the shareholders
      of the Company on February 8, 2006) (filed as Exhibit 10.1 to the Form 8-K
      filed with the Securities and Exchange Commission on February 14, 2006 and
      incorporated herein by
reference)


(10.14)*
            Form
      of Restricted Stock Agreement (filed as Exhibit 10.2 to the Form 8-K filed
      with the Securities and Exchange Commission on February 14, 2006 and
      incorporated herein by
reference)


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(10.15)*
              Restated
      1996 Employee Stock Purchase Plan (including Amendment No. 1) (filed as
      Exhibit 10.1 to the Form 10-Q filed with the Securities and Exchange
      Commission on May 12, 2006 and incorporated herein by
      reference)


(10.16)
            Credit
      Agreement dated July 27, 2006 between Registrant and Wells Fargo HSBC
      Trade Bank, N.A. (filed as Exhibit 10.1 to the Form 8-K filed with the
      Securities and Exchange Commission on August 2, 2006 and incorporated
      herein by reference)


(10.17)
              Revolving
      Credit Loans Note dated July 27, 2006 between Registrant and Wells Fargo
      HSBC Trade Bank, N.A. (filed as Exhibit 10.2 to the Form 8-K filed with
      the Securities and Exchange Commission on August 2, 2006 and incorporated
      herein by reference)


(10.18)
            First
      Amendment to Credit Agreement dated December 21, 2007 between Registrant
      and Wells Fargo HSBC Trade Bank, N.A. (filed as Exhibit 10.1 to the Form
      8-K filed with the Securities and Exchange Commission on December 28, 2007
      and incorporated herein by
reference)


(10.19)
              Revolving
      Credit Loans Note dated December 21, 2007 between Registrant and Wells
      Fargo HSBC Trade Bank, N.A. (filed as Exhibit 10.2 to the Form 8-K filed
      with the Securities and Exchange Commission on December 28, 2007 and
      incorporated herein by
reference)


(10.20)*
            2003
      Restated Employee’s Stock Incentive Plan (as approved by the shareholders
      of the Company on February 6, 2008) (filed as Exhibit 10.1 to the Form 8-K
      filed with the Securities and Exchange Commission on April 28, 2008 and
      incorporated herein by reference)


(14)
              Registrant’s
      amended Code of Business Conduct and Ethics, dated November 19, 2008
      (filed as Exhibit 14.1 to the Form 8-K filed with the Securities and
      Exchange Commission on November 21, 2008 and incorporated herein by
      reference)


(21)
            List
      of Subsidiaries


(23.1)
              Consent
      of Independent Registered Public Accounting
Firm


(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








*
Management contract or compensatory plan or arrangement.


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SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





KEY TECHNOLOGY, INC.





By:
            /s/  David
      M. CampDavid
      M. CampPresident
      and Chief Executive Officer





By:
            /s/  John
      J. EhrenJohn
      J. EhrenSenior
      Vice President and Chief Financial Officer
              (Principal
      Financial Officer)





By:
            /s/  James
      R. BrausenJames
      R. BrausenCorporate
      Controller
              (Principal
      Accounting Officer)





December
12, 2008








Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.








/s/  Charles
      H. Stonecipher
            
            December
      12, 2008Charles
      H. Stonecipher, Chairman/s/  John
      E. Pelo
            
            December
      12, 2008John
      E. Pelo, Director/s/  Richard
      Lawrence
            
            December
      12, 2008Richard
      Lawrence, Director/s/  Gary
      F. Locke
            
            December
      12, 2008Gary
      F. Locke, Director/s/  Michael
      L. Shannon
            
            December
      12, 2008Michael
      L. Shannon, Director/s/  Donald
      A. Washburn
            
            December
      12, 2008Donald
      A. Washburn, Director/s/  David
      M. Camp
            
            December
      12, 2008David
      M. Camp, Director, President and Chief Executive Officer


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KEY
TECHNOLOGY, INC.




FORM 10-K


EXHIBIT
INDEX





EXHIBIT


NUMBER





3.2
            Registrant’s
      Amended and Restated Bylaws (as amended through May 7,
    2008)21
            List
      of Subsidiaries23.1
            Consent
      of Independent Registered Public Accounting Firm31.1
            Certification
      pursuant to Section 302 of the Sarbanes-Oxley Act of
  200231.2
            Certification
      pursuant to Section 302 of the Sarbanes-Oxley Act of
  200232.1
            Certification
      pursuant to 18 U.S. C. Section 1350 as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 200232.2
            Certification
      pursuant to 18 U.S. C. Section 1350 as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002