KEY TRONIC CORP: MANAGEMENT REPORT AND ANALYSIS OF FINANCIAL POSITION AND RESULTS OF OPERATIONS (Form 10-K)


Insight

Key Tronic is a leading contract manufacturer offering value-added design and
manufacturing services from its facilities in the United States, Mexico, China
and Vietnam. We provide full engineering services, materials management,
worldwide manufacturing facilities, assembly services, in-house testing,
worldwide distribution and unparalleled customer service. It's customers include
some of the world's leading original equipment manufacturers. Our combined
capabilities and vertical integration are proving to be a desirable offering to
our expanded customer base.

Our international production capability provides our customers with benefits of
improved supply-chain management, reduced inventories, lower transportation
costs, and reduced product fulfillment time. We continue to make investments in
all of our operating facilities to give us the production capacity, capabilities
and logistical advantages to continue to win new business. The following
information should be read in conjunction with the consolidated financial
statements included herein and with Part II Item 1A, Risk Factors included as
part of this filing.

Our mission is to provide our customers with superior manufacturing and
engineering services at the lowest total cost for the highest quality products,
and create long-term mutually beneficial business relationships by employing our
"Trust, Commitment, Results" philosophy.

Summary

During the fourth quarter of fiscal 2022, we won new programs involving audio products, GPS devices, utility meters, personal safety devices and innovative internet solutions.

We reported net sales of $531.8 million for fiscal year 2022, the highest annual
revenue in the Company's history, and up 3% from $518.7 million for fiscal year
2021. While demand has remained strong from both new and existing customers,
revenue for the fourth quarter and for the full year of fiscal year 2022
continued to be constrained by issues related to the supply chain,
transportation and logistics and the worldwide pandemic.

During the fourth quarter of fiscal year 2022, the results were impacted by
intermittent parts supply and factory downtime. The Company's facilities in
Shanghai, China were closed for most of the fourth quarter due to a government
mandated COVID-19 shutdown. While the reopening of the Company's China facility
took longer than anticipated, operations have since resumed.

Moving into fiscal 2023, the global supply chain and COVID-19 crises continue to
present uncertainty and multiple business challenges. At the same time, global
logistics problems and heightened assurance of supply concerns continue to drive
the favorable trend of contract manufacturing returning to North America.

For the first quarter of fiscal year 2023, the Company expects to report revenue
in the range of $125 million to $135 million. Despite growing customer demand
and backlog, we expect that the ongoing disruptions from the global supply chain
and COVID-19 issues will continue to significantly limit production and
adversely impact operating efficiencies, particularly for our China-based
facilities.

We have continued to diversify our customer base by adding additional programs
and customers. Our current customer relationships involve a variety of products,
including consumer electronics, electronic storage devices, plastics, household
products, gaming devices, specialty printers, telecommunications, industrial
equipment, military supplies, computer accessories, medical, educational,
irrigation, automotive, transportation management, robotics, RFID, power supply,
off-road vehicle equipment, fitness equipment, HVAC controls, consumer products,
home building products, material handling systems, lighting equipment, consumer
security products, smart security, architectural LED lighting, power meters and
smart grid, wireless power solutions, sanitizer dispensing, automotive
controllers, oil and gas drilling, power equipment and wireless security.

Gross profit as a percent of net sales was 8.1 percent in both fiscal year 2022
and 2021. The level of gross margin is impacted by product mix, timing of the
startup of new programs, facility utilization, and pricing within the
electronics industry and material costs, which can fluctuate significantly from
quarter to quarter and year to year.

Operating profit as a percentage of net sales for fiscal 2022 was 1.7%, compared to 1.8% for fiscal 2021. The lower operating profit as a percentage of net sales was primarily due to the increase in legal fees related specifically to the DRY Review of last year’s whistleblower complaint.

Net income for fiscal year 2022 was $3.4 million or $0.31 per share, as compared
to $4.3 million or $0.39 per share for fiscal year 2021. Earnings for fiscal
2022 continued to be adversely impacted by supply chain and transportation and
logistics issues, legal and other professional service expenses related
specifically to the SEC's review of last year's whistleblower complaint, and
increased interest expense.

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We maintained a strong balance sheet with a current ratio of 2.1 and a debt to
equity ratio of 0.86. Total cash used in operating activities as defined on our
cash flow statement was $4.9 million during fiscal year 2022. We maintained
sufficient liquidity for our expected future operations. We believe cash flow
from operations, our borrowing capacity, and equipment financing should provide
adequate capital for planned growth over the long term.

RESULTS OF OPERATIONS

Comparison of the year ended July 2, 2022 with the fiscal year ended
July 3, 2021

The following table sets forth for the periods indicated certain items of the
consolidated statements of income expressed as a percentage of net sales. The
financial information and discussion below should be read in conjunction with
the consolidated financial statements and Footnotes contained in this Annual
Report on Form 10-K.

                                                                                           Fiscal Year Ended
                                                                    % of                                      % of                                %  point
                                           July 2, 2022           net sales          July 3, 2021           net sales          $ change            change
Net sales                                 $    531,815             100.0%           $    518,698             100.0%           $ 13,117                -
Cost of sales                                  488,601              91.9                 476,659              91.9              11,942                -
Gross profit                                    43,214               8.1                  42,039               8.1               1,175                -
Operating expenses:
Research, development and engineering            9,821               1.8                   9,790               1.9                  31              

(0.1)

Selling, general and administrative             24,598               4.6                  22,723               4.4               1,875               0.2

Total operating expenses                        34,419               6.4                  32,513               6.3               1,906               0.1
Operating income                                 8,795               1.7                   9,526               1.8                (731)             (0.1)
Interest expense, net                            5,104               1.0                   3,613               0.7               1,491               0.3
Income before income taxes                       3,691               0.7                   5,913               1.1              (2,222)             (0.4)
Income tax provision                               314               0.1                   1,572               0.3              (1,258)             (0.2)
Net income                                $      3,377              0.6%            $      4,341              0.8%            $   (964)             (0.2)
Effective income tax rate                          8.5  %                                   26.6  %


Net Sales
The increase in net sales of $13.1 million from prior year period was primarily
driven by an increase in new program wins and demand for current programs.
However, partially offsetting the increase in revenue during fiscal year 2022,
the Company's revenue was constrained by the global supply chain and
transportation issues that continued to limit production throughout the year and
to a lesser extent the Chinese government mandated COVID-19 shutdown of our
Shanghai, China facilities for most of the fourth quarter.

The following table shows revenue by line of business as a percentage of revenue for fiscal years 2022 and 2021:

                                    Fiscal Year Ended
                           July 2, 2022            July 3, 2021
Consumer                        48                      51
Industrial                      41                      38
Communication                   7                       5
Gaming                          1                       3
Transportation                  1                       1
Printers                        1                       1
Computer and Peripheral         1                       1
Total                          100%                    100%



We provide services to customers in a number of industries and produce a variety
of products for our customers in each industry. Key Tronic does not target any
particular industry, but rather seeks to find programs that strategically fit
our vertical manufacturing capabilities. As we continue to diversify our
customer base and win new customers, we expect to continue to see a change in
the industry concentrations of our revenue.
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Foreign sales represented 17.6% and 28.2% of our total net sales in fiscal 2022 and 2021, respectively.

Cost of sales

Total cost of sales as a percentage of net sales was 91.9% in both fiscal years 2022 and 2021.

We record our inventories at net realizable value based on specific
identification of inventory against current demand and recent usage. We also
consider our customers' ability to pay for inventory whether or not there is a
lead-time assurance agreement for a specific program. The amounts charged to
expense for these inventories were approximately $950,000 and $753,000 in fiscal
years 2022 and 2021, respectively.

We provide warranties on certain products we sell and estimate warranty costs
based on historical experience and anticipated product returns. Warranty expense
is related to workmanship claims on keyboards and other products. The amounts
charged to expense are determined based on an estimate of warranty exposure. The
net warranty expense was approximately $446,000 and $145,000 in fiscal years
2022 and 2021, respectively.

Gross Profit

Gross margin as a percentage of net sales was 8.1% in both fiscal years 2022 and 2021.

Changes in gross profit margins reflect the impact of a number of factors that
can vary from period to period, including product mix, start-up costs and
efficiencies associated with new programs, product life cycles, sales volumes,
capacity utilization of our resources, management of inventories, component
pricing and shortages, end market demand for customers' products, fluctuations
in and timing of customer orders, and competition within the contract
manufacturing industry. These and other factors can cause variations in
operating results. There can be no assurance that gross margins will not
decrease in future periods.

Research, development and engineering

Research, development and engineering expenses (RD&E) consists principally of
employee related costs, third party development costs, program materials,
depreciation and allocated information technology and facilities costs. Total
RD&E expenses were $9.8 million in both fiscal years 2022 and 2021. Total RD&E
expenses as a percent of net sales was 1.8 percent in fiscal year 2022 and 1.9
percent in fiscal year 2021.

Selling, general and administrative expenses

Selling, general and administrative expenses (SG&A) consist principally of
salaries and benefits, advertising and marketing programs, sales commissions,
travel expenses, provision for doubtful accounts, facilities costs, and
professional services. Total SG&A expenses were $24.6 million and $22.7 million
in fiscal years 2022 and 2021, respectively. Total SG&A expenses as a percent of
net sales were 4.6 percent and 4.4 percent in fiscal years 2022 and 2021,
respectively. This 0.2 percentage point increase in SG&A as a percentage of net
sales is primarily related to an increase in legal expenses related specifically
to the SEC's review of last year's whistleblower complaint.

Interest charges

We had net interest expense of $5.1 million and $3.6 million in fiscal years
2022 and 2021, respectively. The increase in interest expense is primarily
related to an increase in the average balance outstanding on our line of credit,
increased interest rates and financing leases.

Provision for income tax

We had an income tax expense of approximately $0.3 million during fiscal year
2022 and an income tax expense of approximately $1.6 million during fiscal year
2021. The income tax expense recognized during both fiscal years 2022 and 2021
was primarily a function of U.S. and foreign taxes recognized at statutory
rates, the net benefit associated with federal research and development tax
credits, the benefit of carrying back the fiscal year 2021 net operating tax
losses to years with higher federal tax rates in fiscal year 2022, the non-cash
tax impact of expired stock appreciation rights in fiscal year 2021, and the
recognition of previously unrecognized tax benefits for federal research and
development tax credits in fiscal year 2020.

We continually review our requirements for liquidity domestically to fund
current operations, revenue growth and to look for potential future
acquisitions. We anticipate repatriating a portion of our unremitted foreign
earnings. The estimated taxes associated with these expected repatriations are
included in the income tax calculation. For further information on taxes please
review Footnote "Income Taxes" of the "Notes to Consolidated Financial
Statements."

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International subsidiaries

We offer customers a complete global manufacturing solution. Our facilities
provide our customers the opportunity to have their products manufactured in the
facility that best serves specific cost, product manufacturing and distribution
needs. The locations of active foreign subsidiaries are as follows:

•Key Tronic Juarez, SA de CV owns five facilities and leases four facilities in
Juarez, Mexico. These facilities include an SMT facility, an assembly and
molding facility, a sheet metal fabrication facility, and assembly and warehouse
facilities. This subsidiary is primarily used to support our U.S. operations.

•Key Tronic Computer Peripherals (Shanghai) Co., Ltd. leases one facility with
SMT, assembly, global purchasing and warehouse capabilities in Shanghai, China,
which began operations in 1999. Its primary function is to provide contract
manufacturing services.

•Key Tronic Vietnam leases one facility in Da Nang, Vietnam. This facility
includes SMT, assembly, and warehouse capabilities. Its primary function is to
provide contract manufacturing services for export.

Foreign sales (based on shipping instructions) from our worldwide operations,
including domestic exports, were $93.8 million and $146.5 million in fiscal
years 2022 and 2021, respectively. Products and manufacturing services provided
by our subsidiary operations are often shipped to customers directly by the
parent company.

RESULTS OF OPERATIONS

Comparison of the year ended July 3, 2021 with the fiscal year ended
June 27, 2020

To review the results of operations comparison of the fiscal year ended July 3,
2021 with the fiscal year ended June 27, 2020, please refer to our Annual Report
on Form 10-K filed September 16, 2021 with the Securities and Exchange
Commission or follow the link below.

  

https://www.sec.gov/ix?doc=/Archives/edgar/data/719733/000071973321000106/ktcc-20210703.htm

Capital resources and liquidity

Operating cash flow

Net cash used in operating activities for fiscal year 2022 was $4.9 million
compared to $15.1 million and $31.0 million in fiscal years 2021 and 2020, respectively.

The $4.9 million of net cash used in operating activities during fiscal year
2022 is primarily related to $3.4 million of net income adjusted for $7.6
million of depreciation and amortization, $25.6 million increase in accounts
receivable, a $19.4 million increase in inventory, a $3.6 million increase in
other liabilities, partially offset by a $28.6 million increase in accounts
payable, and a $2.8 million decrease in contract assets.

The $15.1 million of net cash used in operating activities during fiscal year
2021 was primarily related to $4.3 million of net income adjusted for $6.9
million of depreciation and amortization, $24.3 million increase in accounts
receivable, a $23.1 million increase in inventory, a $1.0 million increase in
contract assets, a $2.3 million decrease in other assets, partially offset by a
$12.6 million increase in accounts payable, a $5.6 million increase in other
liabilities, and a $1.0 million increase in accrued compensation and vacation.

The $31.0 million of net cash used in operating activities during fiscal year
2020 was primarily related to $4.8 million of net income adjusted for $5.6
million of depreciation and amortization, $28.3 million increase in accounts
receivable, a $14.7 million increase in inventory, a $7.7 million increase in
other assets, a $1.6 million increase in contract assets, partially offset by a
$6.6 million increase in accounts payable and a $3.7 million increase in accrued
compensation and vacation.

Accounts receivable fluctuates based on the timing of shipments, terms offered
and collections. We purchase inventory based on customer forecasts and orders,
and when those forecasts and orders change, the amount of inventory may also
fluctuate. Accounts payable fluctuates with changes in inventory levels, volume
of inventory purchases, negotiated supplier terms, and taking advantage of early
pay discounts.

Investing Cash Flow

Cash flows used in investing activities were $8.1 million for fiscal year 2022.
Cash flows used in investing activities were $10.6 million and $3.6 million in
fiscal year 2021 and 2020, respectively. Our primary use of cash in investing
activities during fiscal years 2022, 2021 and 2020, was purchasing equipment to
support increased production levels for new programs. During fiscal year 2022,
cash flows used in investing activities also included prepayments on finance
lease obligations. During fiscal year 2020, our primary source of cash provided
by investing activities came from receipts of the deferred purchase price on
factored receivables.
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Leases are often utilized when potential technical obsolescence and funding
requirement advantages outweigh the benefits of equipment ownership. Capital
expenditures and periodic lease payments are expected to be financed with
internally generated funds as well as our revolving line of credit facility and
equipment term loan.

Financing Cash Flow

Cash flows provided by financing activities were $11.2 million, $28.6 million,
and $34.5 million in fiscal years 2022, 2021, and 2020. Our primary financing
activities during fiscal year 2022, were proceeds from capital equipment finance
leases and borrowings and repayments under our revolving line of credit
facility; partially offset by repayments on our term loans and principal
payments on finance leases. Our primary financing activities during fiscal year
2021 was repayments on our term loans of $11.7 million as well as borrowings and
repayments under our revolving line of credit facility. Our primary financing
activities during fiscal year 2020 was repayments on our term loans of $7.1
million as well as borrowings and repayments under our revolving line of credit
facility.

As of July 2, 2022, the Company had an outstanding balance on the line of credit
of $95.1 million. We had availability to borrow an additional $10.8 million
under the asset-based revolving credit facility and we were in compliance with
our loan covenants. Our cash requirements are affected by the level of current
operations and new programs. We believe that projected cash from operations,
funds available under the asset-based revolving credit facility and fixed asset
financing will be sufficient to meet our working and fixed capital requirements
for the foreseeable future.

As of July 2, 2022, we had approximately $1.7 million of cash held by foreign
subsidiaries. Under the Tax Cuts and Jobs Act, future cash repatriations from
these foreign subsidiaries are no longer subject to U.S. income taxes, but may
be subject to foreign withholding taxes. See additional discussion in Footnote
"Income Taxes" of the "Notes to Consolidated Financial Statements." The total
amount of foreign withholding taxes required to be paid for the amount of
foreign subsidiary cash on hand as of July 2, 2022, would approximate $8,000.
The Company also has approximately $28.9 million of foreign earnings that have
not been repatriated to the U.S. Of that amount, the Company estimates that $7.1
million is to be repatriated in the future, requiring foreign withholding taxes
of $0.7 million that is currently accrued in our deferred tax liabilities. The
remaining $21.8 million is considered to be permanently reinvested in Mexico,
China and Vietnam. If these amounts were required to be repatriated, we estimate
it would create an additional $0.7 million in foreign withholding taxes payable.

Contractual obligations

In the normal course of business, we enter into contracts which obligate us to
make payments in the future. We have certain contractual obligations that extend
beyond fiscal year 2023 under lease obligations and debt arrangements.

As of July 2, 2022, we had open purchase order commitments for materials and
other supplies. Actual needs under these blanket purchase orders fluctuate with
our manufacturing levels and as such cannot be broken out between fiscal years.
In addition, we have contracts with many of our customers that minimize our
exposure to losses for material purchased within lead-times necessary to meet
customer forecasts. Purchase orders generally can be cancelled without penalty
within specified ranges that are determined in negotiations with our suppliers.
These agreements depend in part on the type of materials purchased as well as
the circumstances surrounding any requested cancellations. We do not use
off-balance sheet financing techniques other than traditional operating leases,
and we have not guaranteed the obligations of any entity that is not one of our
wholly owned subsidiaries.
For a summary of our lease obligations as of July 2, 2022, please refer to
Footnote "Leases" of the "Notes to Consolidated Financial Statements."

For a summary of our long-term debt at July 2, 2022please refer to the footnote “Long-term debt” in the “Notes to Consolidated Financial Statements”.

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Significant Accounting Policies and Estimates

Preparation of our consolidated financial statements requires management to make
estimates and assumptions that affect the reported amount of assets,
liabilities, revenues and expenses. Footnote "Significant Accounting Policies"
of the "Notes to Consolidated Financial Statements" describes the significant
accounting policies used in the preparation of our consolidated financial
statements. Management believes the most complex and sensitive judgments,
because of their significance to our consolidated financial statements, result
primarily from the need to make estimates about effects of matters that are
inherently uncertain. The most significant areas involving management judgments
are described below. Actual results in these areas could differ from
management's estimates.

Revenue

The Company specializes in services ranging from product manufacturing to
engineering and tooling services. The first step in its process for revenue
recognition is to identify the contract with a customer. A contract is defined
as an agreement between two or more parties that creates enforceable rights and
obligations. A contract can be written, oral, or implied. The Company generally
enters into manufacturing service agreements ("MSA") with its customers that
outlines the terms of the business relationship between the customer and the
Company. This includes matters such as warranty, indemnification, transfer of
title and risk of loss, liability for excess and obsolete inventory, pricing,
payment terms, etc. The Company will also bid on a program-by-program basis for
customers in which an executed MSA may not be in place. In these instances, as
well as when we have an MSA in place, we receive customer purchase orders for
specific quantities and timing of products. As a result, the Company considers
its contract with a customer to be the combination of the MSA and the purchase
order. The transaction price is fixed and set forth in each purchase order. In
the Company's normal course of business, there are no variable pricing
components, or material amounts refunded to customers in the form of refunds or
rebates.

The Company assesses whether control of the product or services promised under
the contract is transferred to the customer at a point in time (shipment) or
over time (as we manufacture the product). The Company is first required to
evaluate whether its contracts meet the criteria for 'over-time' or
'point-in-time' recognition. The Company has determined that for the majority of
its contracts the Company is manufacturing products for which there is no
alternative use due to the unique nature of the customer-specific product, IP
and other contract restrictions. Further, the Company has an enforceable right
to payment including a reasonable profit for performance completed to date with
respect to these contracts. As a result, revenue is recognized under these
contracts 'over-time' based on the input cost-to-cost method as it better
depicts the transfer of control. This input method is based on the ratio of
costs incurred to date as compared to the total estimated costs at completion of
the performance obligation. For all other contracts that do not meet these
criteria, such as manufacturing contracts for which the terms do not provide an
enforceable right to payment for performance completed to date, the Company
recognizes revenue when it has transferred control of the related manufactured
products which generally occurs upon shipment to the customer. Revenue from
engineering services is recognized over time as the services are performed.

Valuation of inactive, obsolete and surplus inventory

Inventories are stated at the lower of cost or net realizable value. Inventory
valuation is determined using the first-in, first-out (FIFO) method. We write
down inventories that we deem inactive, obsolete or surplus to net realizable
value. The write down is calculated based upon the demand for the products that
we produce to value this related inventory at net realizable value. Demand is
determined by expected sales, customer purchase orders, or customer forecasts.
If expected sales do not materialize, excess inventory would be the result and a
write down of that inventory against earnings would occur. In the case where we
have purchased material based upon a customer's forecast or purchase orders, we
are usually covered by lead-time assurance agreements or purchase orders with
each customer. These contracts state that the financial liability for material
purchased within agreed upon lead-time and based upon the customer's forecasts,
lies with the customer. If we purchase material outside the lead-time assurance
agreement and the customer's forecasts do not materialize or if we have no
lead-time assurance agreement for a specific program, we would have the
financial liability and may have to charge inactive, obsolete or surplus
inventory against earnings. We also write down inventory values related to
specific customers covered by lead-time assurance agreements when those
customers are experiencing financial difficulties or reimbursement is not
reasonably assured.

Allowance for doubtful accounts

We value our accounts receivable net of an allowance for doubtful accounts. As
of July 2, 2022, the allowance for doubtful accounts was approximately $12,000.
As of July 3, 2021, the allowance for doubtful accounts was approximately
$275,000. This allowance is based on estimates of the portion of accounts
receivable that may not be collected in the future. The estimates used are based
primarily on specific identification of potentially uncollectible accounts. Such
accounts are identified using publicly available information in conjunction with
evaluations of current payment activity. However, if any of our customers were
to develop unexpected and immediate financial problems that would prevent
payment of open invoices, we could incur additional and possibly material
expenses that would negatively impact earnings.
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Cumulative guarantee

An accrual is made for expected warranty costs, with the related expense
recognized in cost of goods sold. We review the adequacy of this accrual
quarterly based on historical analysis and anticipated product returns and
rework costs. Our warranty period for keyboards is generally longer than that
for other products. We only warrant materials and workmanship on products, and
we do not warrant design defects for customers.

Income taxes

Income tax expense includes U.S. and international income taxes and a
provisional estimate for U.S. taxes on undistributed earnings of foreign
subsidiaries. We do not record foreign withholding taxes on undistributed
earnings of international subsidiaries that are deemed to be permanently
reinvested. Certain income and expenses are not reported in tax returns and
financial statements in the same year. The tax effect of such temporary
differences is reported as deferred income taxes. The deferred income taxes are
classified as long-term assets or liabilities. The most significant areas
involving management judgments include deferred income tax assets and
liabilities, uncertain tax positions, and research and development tax credits.
Our estimates of the realization of the deferred tax assets related to our tax
credits are based upon our estimates of future taxable income which may change.

Stock-based compensation

Stock-based compensation is accounted for according to FASB Accounting Standards
Codification (ASC) 718, Compensation-Stock Compensation. ASC 718 requires us to
expense the fair value of employee stock options, stock appreciation rights and
other forms of stock-based compensation. Under the fair value recognition
provisions of ASC 718, share-based compensation cost is estimated at the grant
date based upon the fair value of the award and is recognized as expense ratably
over the requisite service period of the award (generally the vesting period).
Determining the appropriate fair value model and calculating the fair value of
share-based awards requires judgment, including estimating the expected life of
the share-based award, the expected stock price volatility over the expected
life of the share-based award and forfeitures.

To determine the fair value of stock based awards on the date of grant we use
the Black-Scholes option-pricing model. Inherent in this model are assumptions
related to expected stock price volatility, option life, risk-free interest rate
and dividend yield. The risk-free interest rate is a less-subjective assumption
as it is based on factual data derived from public sources. We use a dividend
yield of zero as we have never paid cash dividends and have no intention to pay
cash dividends in the foreseeable future. The expected stock price volatility
and option life assumptions require a greater level of judgment. Our expected
stock-price volatility assumption is based upon the historical volatility of our
stock which is obtained from public data sources. The expected life represents
the weighted average period of time that share-based awards are expected to be
outstanding, giving consideration to vesting schedules and historical exercise
patterns. We determine the expected life assumption based upon the exercise and
post-vesting behavior that has been exhibited historically, adjusted for
specific factors that may influence future exercise patterns. If expected
volatility or expected life were to increase, that would result in an increase
in the fair value of our stock options which would result in higher compensation
charges, while a decrease in volatility or the expected life would result in a
lower fair value of our stock option awards resulting in lower compensation
charges.

We estimate forfeitures for all of our awards based upon historical experience
of stock-based pre-vesting forfeitures. We believe that our estimates are based
upon outcomes that are reasonably likely to occur. If actual forfeitures are
higher than our estimates it would result in lower compensation expense and to
the extent the actual forfeitures are lower than our estimate we would record
higher compensation expense.

Accumulation of long-term incentive compensation

Long-term incentive compensation is recognized as expense ratably over the
requisite service period of the award which is generally three years. The Board
of Directors approve target performance measures for the three year period for
each of the Company's officers and non-employee Directors. Performance measures
are based on a combination of sales growth targets and return on invested
capital targets. No cash awards will be made to participants if actual Company
performance does not exceed the minimum target performance measures. The
calculation used to determine the necessary accrual uses a combination of actual
results and projected results. We believe that our estimates are based upon
outcomes that are reasonably likely to occur. These estimates and assumptions
are based on historical results as well as future expectations. Actual results
could vary from our estimates and assumptions.

New and future accounting pronouncements

See the footnote “Significant Accounting Policies” in the “Notes to the Consolidated Financial Statements”.

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