Craig Gates - President and CEO Ronald Klawitter - EVP of Administration and CFO.

Bill Dezellem - Tieton Capital Management George Melas - MKH Management [Avad Yazinski] - Jordan Capital Chris Sansone - Sansone Capital.

Good day, and welcome to the Key Tronic first quarter fiscal 2015 conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Craig Gates. Please go ahead, sir..

Good afternoon, everyone. I’m Craig Gates, President and Chief Executive Officer of Key Tronic. I'd like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Ron Klawitter, our Chief Financial Officer. Today, we released our results for the first quarter of fiscal 2015.

These were in line with our previously announced preliminary results. As expected, our revenue and earnings in the first quarter were impacted by a large revenue reduction by a certain customer and an unfavorable product mix and unusually high operating costs.

However, despite these disappointing near term financial results, we see this as an exciting time for our company. Over the past two years, our total revenue has been primarily impacted by declining business with our two largest customers.

While we have actually gained market share within these accounts, these large customers have unfortunately both experienced a dramatic decline in their businesses. In the first quarter of fiscal 2013, these two customers represented $46 million or 50% of our total revenue.

During the first quarter of fiscal 2015, they generated only $16 million or 21% of revenue. In the second quarter of fiscal 2015, we expect them to be about 16% of our revenue. Years ago, we were very cognizant that having two customers account for nearly half of our revenue concentration was not healthy.

On the other hand, running profitability at peak revenue levels allowed us to pay off our debt and fund the actions required to enable building a more diverse customer base.

Along with our continued upgrades to our plant and equipment in Juarez, the purchase of Sabre metals a year ago, and the recent purchase of Ayrshire are of key importance in our customer diversification and growth strategy. We are convinced that the Ayrshire and Key Tronic combination offers one plus one equals three potential.

Key Tronic is not a typical EMS company. Less than 30% of our business has been print circuit assembly, or PCA. That percentage is much higher for most of our competitors. In most cases, a PCA account can be transferred in about six months and entails relatively low risk and not much work for the OEM compared to a full product transfer.

As we have discussed, onboarding a new customer has historically taken us about 12 to 24 months. In cases that involve us designing or helping to design a new product, that timeline tends to skew towards 24 months.

The downside of our unique non-PCA-centric business model is that it takes much longer and requires more risk and work from the OEM to transfer an existing complex complete product build to us. The upside is that once we have won and transferred an account, is very sticky business.

By this, we mean that we lose very few accounts and programs over time, and we typically gain market share within our accounts. In many cases, we have seen that OEMs with a complete product to source like to start the relationship with a PCA transfer, and then after the relationship has been proven, start to transfer a complex product.

While Ayrshire was a profitable EMS company in their own right, they were PCA-centric. In the natural progression of PCA programs, some succeed and become high volume.

In these cases, in order to gain the economies of higher volume production and outsource more of a full production, Ayrshire’s customers would historically be forced to reluctantly move the program offshore to a new supplier. This created risk and cost for the OEM and lost opportunity for Ayrshire.

By acquiring Ayrshire, we believe that many of these programs with growing volume and progress transitioning to full product builds will now naturally flow to Key Tronics instead of to larger Ayrshire competitors. With the addition of Ayrshire, we also expect to reduce our average onboarding time for many new full product programs.

During the second quarter, we’ve already had two Ayrshire customers award us additional business because of our combined capabilities and global logistics. Without our combined strengths, we would not have won these programs, and we believe that these recent wins are indicative of the added leverage of our combined capabilities and global logistics.

In effect, we believe that we have mitigated the downside of both Ayrshire and Key Tronics’ business models. Another one plus one equals three of the Ayrshire/Key Tronic combination is our expanded customer diversification.

Given Ayrshire’s close proximity and strong working relationships with customers’ design teams and the excellent job they do of providing low volume [unintelligible] services to these customers, Ayrshire built an extensive and superb list of very loyal customers.

With the approximately 104 current customers that Ayrshire brought to us, we were generating revenue from 165 distinct customers at the end of the first quarter of fiscal 2015, up from 57 Key Tronic customers a year ago.

Looking ahead, our broader and more diversified customer base significantly lowers the potential risk and impact of a slowdown by any one customer. As we deal with the longer term decline of our two largest customers, we are managing the consequences of our new program wins in the short term.

We currently have over 13 new programs in the process of onboarding and several are nearing the end of the design phase and moving toward the production stage.

This is an unprecedented level of new business for us and getting all this new business up and running does adversely impact our expense line in advance of revenue, so while we could cut our expenses and return to higher margin, we generally have been balancing current profitability with onboarding costs.

In the first quarter of fiscal 2015, however, we got caught in a three-way squeeze of unanticipated reduction in production levels for one of our two largest customers and unfavorable product mix and inefficiencies associated with accelerated ramping of new product. As a result, we had the first operating loss in a decade.

In the second quarter of fiscal 2015, we anticipate stronger revenue growth and a return to profitability, as some of the new programs begin to contribute margin and Ayrshire’s operations contribute revenue and profit for the full quarter. In coming periods, we expect our product mix and margins to gradually return to normal patterns.

Although costs associated with new product launches will continue to impact operating efficiencies, we do not expect them to be at the same unusually high levels as they were in the first quarter.

However, we have continued to see a robust pipeline of potential new business and have further diversified our future revenue base, including recent wins from new customers involving two different medical devices. In short, we’re more encouraged than every about our long term potential.

Now, I'd like to turn the call over to Ron to review our financial performance, then I'll come back to discuss our strategy and recent acquisition as we move into fiscal 2015.

Ron?.

Thanks, Craig. As always, I would like to remind you that during the course of this call, we might make projections or other forward-looking statements regarding future events of the company's future financial performance. Please remember that such statements are only predictions. Actual events or results may differ materially.

For more information, you may review the risk factors outlined in the documents the company has filed with the SEC, specifically our latest 10-K, quarterly 10-Qs, and 8-Ks. Please note that on this call we will discuss historical financial and other statistical information regarding our business and operations.

Some of this information is included in today's press release and a recorded version of this call will be available on our website. For the quarter ended September 27, 2014, we reported total revenue of $86.3 million. This is up 11% from $78 million in the same period of fiscal 2014.

Results for the first quarter of fiscal 2015 include approximately $11 million in revenue contribution from Ayrshire, which was acquired on September 3, 2014. Excluding Ayrshire’s contributions in September, our core revenue was adversely impacted by a larger than anticipated reduction in production levels for a longstanding customer.

During the first quarter of fiscal 2015, we also had an unfavorable product mix that caused higher material costs and we had inefficiencies associated with ramping production of a new product in a shorter time period than originally planned that resulted in higher than expected operating expenses.

As a result, our gross margins were considerably lower than historic levels. Our gross margin was approximately 5% for the first quarter of fiscal 2015, well below our normal levels and our long term target of 9%. Our total operating expenses were $5.9 million in the first quarter of fiscal 2015, up 35% from the previous quarter.

This increase primarily reflects the addition of Ayrshire’s operations for approximately one month as well as transaction and integration costs related to the Ayrshire acquisition.

As expected, our lower than anticipated revenue in the first quarter, combined with an unfavorable product mix and unusually high operating costs, resulted in our first quarterly net loss since 2004. These items have an impact on earnings of approximately $1.8 million or $0.17 per share.

In addition, transaction and integration costs related to the Ayrshire acquisition had an impact on earnings of approximately $700,000 or $0.06 per share. As a result, our net loss for the first quarter of fiscal 2015 was $1.5 million or $0.14 per share, compared to net income of $1.7 million or $0.15 per share for the same period of fiscal 2014.

Turning to the balance sheet, we have continued to maintain a strong financial position, but the consolidation of Ayrshire’s operations has made some significant changes to our balance sheet.

Our inventory was $74.7 million, up 34% from the previous quarter, reflecting the addition of Ayrshire as well as the unanticipated slowdown and delays in certain programs. We expect to see our inventories decrease in coming periods.

Our trade receivables were $73.7 million at the end of the first quarter, 48% from the previous quarter, reflecting the addition of Ayrshire, which has had historically higher days sales outstanding than Key Tronic did. Our consolidated DSOs were approximately 56 days and we would expect that our DSOs will remain in the 55 to 60 day range.

During the first quarter, we completed the acquisition of Ayrshire for about $49 million. We used about $5 million from cash on hand, $35 million from a new term loan, and $9 million from our line of credit for the transaction.

The other $9 million increase in our line of credit reflects us not utilizing our accounts receivable factoring line during the quarter. In coming periods, we expect to gradually pay down bank debt.

Our capital expenditures for the first quarter of fiscal 2015 were approximately $2.2 million as we continue to expand our sheet metal fabrication, plastic injection molding, and electrical assembly capabilities. We expect our capex for the fiscal year to be about $6.7 million.

Moving into the second quarter of fiscal 2015, we anticipate more of our new customer programs moving into production and gradually ramping up, increasingly offsetting the recent reductions in production levels by some of our large longstanding customers in recent quarters.

Taking these factors into consideration and the full quarter contribution of Ayrshire, we anticipate that the second quarter of fiscal 2015 will have revenue in the range of $105 million to $115 million. We expect our product mix and margins to gradually return to normal patterns in coming periods.

Although costs associated with new product launches will continue to impact operating efficiencies, we do not anticipate them to be at the same level as the first quarter. We expect our gross margin to be around 7% to 8% in the second quarter and move back toward 9% as the year progresses.

While most of the integration costs related to Ayrshire were expensed in the first quarter, we do expect some expenses related to optimizing our combined resources and enhancing Ayrshire’s systems in coming periods. Taking these factors into consideration, we expect earnings in the range of $0.08 to $0.12 per share for the second quarter.

This expected earnings range assumes an effective tax rate of 35%. In summary, we expect to see stronger growth in the second quarter as our new customer programs continue to ramp up and Ayrshire contributes fully to our growth.

Overall, the financial health of the company is excellent and we believe we’re well-positioned to continue to profitably expand our business over the longer term. Okay, Craig, that’s it for me. .

All right. Thanks, Ron. The slowdowns by our two largest customers over the past two years and unusually high costs incurred in the first quarter have been disappointing.

Yet, from our perspective, these events have masked production ramps with several new customers, many new programs being onboarded, and the positive impact and significant potential of our recent Ayrshire acquisition.

We continue to believe our fundamental strategy remains sound, and we expect it to be rewarded with a return to organic growth and profitability. As we’ve discussed before, we have three long term major competitive advantages.

First, increasing costs in China are driving demand for more localized production, Mexico, for North America users and China for Asian end users. Among EMS providers, we stand alone in the excellence and breadth of our Mexican operations. As more previously outsourced manufacturing business moves back from China, we stand to continue to benefit.

Second, our unique organizational structure, which we have honed over years of experience running offshore operations, bring significant advantages to OEMs. Our growing portfolio of customers increasingly want offshore cost savings, but without the fear of IP loss, offshore schedule risk, and inventory uncertainty.

They do not want to manage an offshore relationship, and want US-based engineering and prototyping. Beyond the level of cost and service we provide from our Mexican and US-based facilities, we offer an exceptional level of experience.

Third, our size and responsiveness, compared to our degree of vertical integration and engineering capabilities become even more attractive as the push for localized production intensifies.

To this end, we are continually investing in the enhancement of our capabilities, including our plastic molding, PCB assembly, metal fabrication, complete product assembly, design engineering, and test engineering services.

Our acquisition of Ayrshire in the first quarter represents a major step forward in our continued strategic focus on providing all the EMS services available from a much larger company while still bringing the flexibility and high customer service levels our clients expect from us.

Moreover, we see the Ayrshire and Key Tronic combination as a one plus one equals three formula. First, we believe that as some of Ayrshire’s PCA customers move to higher volumes and transition to full product builds, Key Tronic will stand to win the accounts instead of Ayrshire losing them to competitors.

Second, we expect the combination to reduce our average onboard time. Third, the combination expands and diversifies our customer base, which significantly lowers the potential risk and impact of a slowdown by any one customer. And fourth, our combination with Ayrshire is already increasing our revenue base and opening up new opportunities for growth.

Over the longer term, the EMS market is expected to see growth, and we believe Key Tronic is increasingly well-positioned to continue to capture market share and capitalize on emerging opportunities.

While periodic fluctuations in large customer demand and mix changes in our program portfolio and cost associated with ramping up new programs will continue to be part of our business, we believe our fundamental strategy remains sound, and are staying focused on controlling costs, augmenting production processes, and enhancing our capabilities will result in profitable growth and increasing competitive advantage over the long term.

We see more of our new customer programs moving into production and gradually ramping up, and our pipeline of new business opportunities continues to look increasingly robust. This concludes the formal portion of our presentation. Ron and I will now be pleased to answer your questions. .

[Operator instructions.] Our first question is from Bill Dezellem with Tieton Capital Management. .

First of all, the two medical device wins that you had, what are the size of those wins?.

They should both be over $5 million..

And the press release implied that they were both new customers, as opposed to new programs with existing customers.

Did I read that correctly?.

Yep, you did..

And if I also recall correctly, you did not have any medical device business a few years ago, and now you’ve won these, and there’s other medical business that you have discussed.

Would you talk to kind of that point, and that change, and whether that’s even relevant? I guess I just think of medical has having a little higher standard or hurdles that they have to get over..

Well, we’ve had medical device for four or five years now for sure. There is a higher standard that goes along with medical devices. For sure, there are a lot of people who are talking to us about moving medical and pseudo-medical devices back from China or Mexico to the States.

In terms of us having a specific focus on medical accounts, we don’t, but it’s part of our competitive advantage that being headquartered and U.S. owned, we are looked upon more favorably by a medical company than if we were offshore..

And then let me shift to what seems to be a new problem, that you had business ramping too fast this quarter, leading to inefficiencies.

Historically, business has been ramping slowly, and has created a little frustration that we haven’t seen more revenue growth more quickly from some of those new customers, or from new programs, whereas now with this ramp happening too fast, that ends up working against us in the short term.

Could you talk a little bit about that ramp and how that came about that that was too fast? On the surface, that sounds like a great problem to have, and yet it turns out to be a bit of a problem..

It can be a bit of a problem because when you do have a faster than planned ramp, you have to absorb quite a bit of inefficiencies as you are tuning your processes. So if you’re forced to make a lot of product, even though the processes aren’t running as well as they should be, you’re going to end up spending more money per product that you ship.

Typically, we like to see a nice smooth ramp, where we get a chance to build a few, tweak the processes, train some people, maybe tweak a mold or two, and then build some more, do a little bit more tweaking, and work our way up the production output, without spending a whole bunch of money from day one on processes that aren’t quite optimal yet.

In this case, the launch of a new product, this is a new design of an existing product for an existing customer. In this case, the product launch was delayed. At the same time, the customer saw a dramatically increased demand for the product.

So existing inventory that we had planned to cover the launch was suddenly used in the marketplace and in order to keep our customer from going out of stock, we had to ramp up much faster than we had planned or wanted to.

So we spent a lot of money on overtime, on training, on rework, and all the things that we normally like to minimize as we can smoothly come up the curve. We just had to eat that to keep our customer in stock and not hurt any of his sales.

It’s a decision that we could have made the other direction, and told our customer, well, tough luck, we’re going to maintain our profitability, we’re a public company, we can’t show a loss.

But in looking at what that damage would have been to the relationship with that customer and the future we have with the customer and the history we’ve had with the customer, that decision wasn’t even close to being considered. So we just had to go all out and make these things as fast as we could. And we did, and we kept our customer healthy. .

And when you make reference to future with the customer, maybe I’m reading too much into this, but that almost implies that you believe you have a line of sight on incremental business from them..

No, but they’re one of our largest customers, and we continue to have new program wins with them, design wins, and we’ve had a long successful history with them. So we couldn’t see how it made any sense to create damage to the relationship for one quarter of diminished losses on our part..

The new wins from Ayrshire customers, are those the same or different than the two medical devices that you specifically called out in the release?.

They’re different..

And can you talk a little bit more about those wins and this one plus one equals three and how you see that progressing and the opportunities that are still in front of you? Because in your opening remarks, it seemed as though you were talking pretty favorably about new business that could be coming from that relationship..

Sure. So those two are perfect examples of what we think and what we thought when we looked at acquiring Ayrshire, what happened for both of us. I’ll take one in particular. The Minnesota facility is a really good low-volume, high- mix prototype, and early design manufacturing facility for PCAs only.

So they had a customer that came to them and said, hey, we’ve got this new product. We’ve never made this thing before.

Can you guys prototype and manufacture our first 3,000 of these? There’s going to be much higher volume, but we need to work with somebody who’s local, because we need to understand all the problems that we’re going to get into with this new product.

So the Ayrshire guys in Minnesota said, sure, that’s what we’re here for, and off they went to the races. Builds a great relationship, did a great job. We’re partway through the first prototype run when the acquisition took place.

In the meantime, this customer has become more and more convinced that their product is going to be a significant volume, and started talking with the Ayrshire folks in Minnesota about the fact that they were going to need to pull this and go somewhere that had lower costs, that had plastic molding and high volume assembly capabilities, and that high volume PCA capabilities.

And so it was very clear that the guys at Minnesota, after doing all their work that they were normally so good at, were going to see the program migrate away from them as it just started to get really interesting from a revenue standpoint.

So in the past, that was a reasonably common occurrence for Ayrshire, and indeed for many regional contract manufacturers who are beloved by their customers, because they can jump in their car and drive next door and put their hands on the prototypes as they’re being built, and solve problems.

But then you have to pull the business and put it with somebody big and lower cost, as the volume gets interesting.

So in this case, instead of losing the business to some big competitor, he tried, and Ayrshire, now that we were combined, were able to take the customer to our Juarez facility, show him all of the vertical integration that we can bring to bear on his product, prepare a new quote for the product in high volume using our molding, our metal stamping, and our assembly and test, and win the program, which would have been lost, had it only been Ayrshire, and which would probably never have been seen if it was only Key Tronic.

So that’s why I would think one plus one equals three. The other program was out of Mississippi, and same type of story, but doesn’t include any plastic molding. It’s just medium volume PCAs that are going to high volume builds without much of a chance to smooth production loads.

These orders are going to be lumpy and Mississippi didn’t have two things that were needed in order to make that succeed. One is the cost structure of Mexico, and two is excess capacity that they could move around as big orders came in for this product.

So, again, this is another situation where Ayrshire probably would have lost the business and it’s another situation where Key Tronic probably never would have seen the business, and instead of that, we are going to be awarded the high volume portion of the business.

So those are two really good test cases of what we thought when we were looking at acquiring Ayrshire, and indeed that we had been thinking about when we looked at acquiring all the other folks we looked at previous to Ayrshire.

We have looked at a company with facilities in California, also to act as our feeder, but we found there that the management structure was such that as soon as we bought them, we probably would have lost all the contacts with their current customers, so we backed out. And this is three or four years ago.

So Ayrshire fulfils a strategic wish that we’ve had for quite some time and we believe we found the perfect fit for that wish in the acquisition of them..

Now, Ayrshire, you said in a release, has 104 customers. You just detailed two of them, where you’ve got incremental revenue.

I suspect you don’t have time to discuss the other 102, but is that something that you think is very prevalent in terms of opportunities over those additional 102 customers? What I’m trying to, in my mind, is to scale up whether that’s a truly very large opportunity to repeat those two examples, or whether it’s a good opportunity, but not necessarily huge..

Well, as a percentage, it’s not very exciting, but when you look at the fact it only takes one or two to dramatically alter our revenue base, it is pretty exciting..

When you say it’s not exciting as a percentage, meaning a percentage of those 100 or so customers?.

Yeah. So let’s say it’s 10% of that. So think of how long it takes us to go find somebody, to woo them, to do all the quoting, to do a new product design, and to finally get them onboard. To do 10 of those a year is pushing our capabilities and our history.

So if you say that 10 of these guys that Ayrshire has already know Ayrshire, they already trust Ayrshire, they already know what Ayrshire can do, so the honeymoon, the first date, the marriage, has already taken place, and so all we have to do is step in with the remainder of a good strong marriage. And ten customers is pretty exciting.

When you look at their customer list, and this is another part that was attractive about Ayrshire, it’s for a smallish company with regional customers that have an amazing number of Fortune 100, Fortune 500 customers on the list.

So it appears to us that it’s going to be a target rich environment and so far, one of the top 10 things that we’ve got on our list of things to do with the new company Key Tronic Ayrshire, one of the top 10 is to go mine all of the good, existing relationships that Ayrshire has and find out how many are interested in what Key Tronic Ayrshire brings.

Part of the due diligence was to talk to as big a percentage as we could of their top customers, and in the due diligence discussions, which I conducted, the majority of the customers I talked to were very interested in Key Tronic Ayrshire, and what the combination would bring.

I think I know I’ve lost track of how many of their customers have been to Juarez in the past three weeks, but it’s a pretty big number already. It’s pretty encouraging..

And our next question is from George Melas with MKH Management. .

I have a few very precise, very sort of specific questions.

The two operating expense items that you singled out on the press release, the $1.8 million and the $0.7, is the first one in cost of goods sold and the second one in SG&A?.

For the most part, yes..

I have a question about the model. About a couple of years ago, when those two customers were roughly 50% of your revenue, you were able to produce gross margin of 9% to 10%. I think you did exceed 10%. And then you had EBIT north of 5%.

Now, with a much less concentrated customer base, what do you think your model can look like?.

George, we still think that target of 9% gross margins is what we’re targeting. And we’re going to keep our operating expenses, will probably remain around the 4% to 5% of revenue. That’s based upon where we see the next couple of quarters. That what we expect it, to get to that level at some point during hopefully this fiscal year.

As we grow beyond this $115 million to $120 million a quarter, that incremental revenue above that level will yield additional incremental profits above that 9% gross margins.

So we still think that a little bit further out long term, that the 9% could improve even faster, but I think a good target for model to build for us is around 9% gross margins and the 4% to 5% operating margins, at least at the current level of revenue that we’re at. .

So you think that the 4% to 5% EBIT margin, you might be able to achieve that this year? In the later quarters of this fiscal year as your gross margin….

That would be how I built my model long term. I’m not going to commit to say that we’re going to hit that number this fiscal year, or we could be coming close. We do have obviously visibility into the second quarter, and we do see improvements going forward. But not enough that we can put numbers to it and commit to them at this point..

And then a question on the revenue and the revenue guidance. Of course, we’ll assume three months of Ayrshire, as they’re built into the coming quarter. And I think we can, based on the numbers that you gave, we can see a little bit what your top two are, the customers that used to be your top two customers might be doing.

There’s still not a lot of growth from the core customers, from your core Key Tronic customers.

Do you expect sort of a revenue ramp in the second half of this fiscal year as these programs that you’re working on kind of come into production?.

We’re hoping that, I don’t know if I’d call them core customers. I’d call them the new programs which are a mix of current customers and new customers. We’re hoping that we see those do exactly what you say, and start contributing to our growth.

As we said, it takes 24 months and it’s been about a year and a half since we got Sabre going the way we want it to go. It’s only been a month since we got Ayrshire. So that timeframe is where we see the winds starting to contribute to revenue and starting to swap out the reduction from the two big guys. .

And then maybe one final question. You said you have 13 programs that are sort of in progress or that you are ramping up, sort of onboarding.

What has historically been the number of programs that you onboard, and how does that compare to historical numbers?.

Typically we’ve been working on bringing two or three on at a given time. .

I guess it’s good sales, but how did it jump from two or three to 13?.

Well, when we’re talking about all vectors that are pointing in the right direction for us, if you look back at our conference calls, you’ll see that the last two pages of script that I read every time have been exactly the same for I think the last five, six quarters.

And so those to me are the vectors that have all been pointing in the right direction for a couple of years. It’s everything we’ve talked about, the push to get out of China, the reemphasis on local manufacturing, the fact that we got our quoting and onboarding process put together, the increasing amount of engineering design work that we’re doing.

All those things added together are what’s been driving the addition of new customers. It’s just been very frustrating that all this stuff takes two years before it starts to hit the top line and the bottom line. .

And these programs, I imagine they have taken longer to onboard.

Is that because they are more complex and they involve plastic molding, metal stamping, and other aspects? Why would they take longer to onboard?.

Many of them, because of where they’re originating, take longer because our customers have lost control of the product in China. So I’m going to talk about one. I’m not going to ever mention the name, but just an example. This customer is the third in their market in the States. They’ve been growing at double digit amounts per year.

They’ve, up until now, they started, I think, about six, seven years ago, they followed a traditional, we’re starting this company, we need to get everything built out of China, approach. And that’s what they did.

And over the years, they’ve lost control of their documentation and in fact their entire product design is pretty much a closed book to them. So as they discover that they can no longer afford China prices, they come looking for somebody like Key Tronic.

They’re not big enough that they feel that they can warrant the attention of a tier one like a Flextronics or Benchmark, but they’re plenty big for Key Tronic. And so they start talking with us, we start looking at their product.

They’re asking us if we can unspool the design that’s been done in China, or modified in China without their consent, and redesign it so that we can build it in Mexico with confidence and redesign it so that we can get their bill of materials and their approved vendor list under control so that they no longer walk around quaking in fear that they’re going to have a massive recall because somebody in China has substituted a component that nobody knew where it came from.

So that process takes a long time. It’s a voyage of discovery for a customer when they wake up to the fact that, holy moly, we don’t even know what it is that we’re buying.

We’ve lost the ability to design what we’re buying, plus all of the molds that are over in China, it’s not clear who owns them, because as time has gone by, people build tools that are being used on our product, and we never paid for them up front.

So all those things are horrible things to realize when you’re an OEM, and your future depends on getting a product out of a supplier who either don’t have any control of, and who is not subject to the rules and regulations of American business. So that whole process is long.

It’s a very powerful process, and it drives people to us like we said, with a lot of stickiness. But it’s not something that happens overnight.

And there are many customers in that exact same boat that we are currently in painful processes of redesigning their products and helping them through the discovery process of the fact that they don’t know what they’re buying. And that’s a political hot potato within the customer.

If you think about that for a while, it’s not a great thing for the VP of materials to walk in and see you and say, yeah, I know you told me get out of China, but we don’t know what the hell we’re buying, and I can’t even guarantee what we’re buying even matches what we say we’re selling. And I don’t know how I let this happen, but I did.

So it’s not an easy path for us to navigate as we go through the various functions, and they have to hold up their hand and say yeah, we don’t know what we’re doing anymore. .

[Operator instructions.] And we do have a question from [Avad Yazinski] from Jordan Capital..

The guidance you gave for the next quarter, does that number include any adjustments for the Ayrshire for amortization of intangibles, or anything related to the acquisition, or is it just basically a clean operating number?.

It’s a clean operating number. We don’t anticipate having to take any additional charges in Q2 for the integration of Ayrshire..

But you will have some amortization of intangibles. It would appear the intangibles are much smaller, than probably a lot of people anticipated, but there still should be some number that is sort of, call it an adjusted number..

Right, so it’s going to have approximately $350,000 a quarter in additional amortization that we’re going to have going forward per quarter related to the write up of intangible assets for the acquisition..

That’s very helpful. I think you guys, just from the standpoint of making sure all investors know, you guys should… It would be helpful if you broke it out separately. I think anything related to the intangibles, etc., that are related to the acquisition.

Because I think some people might be scared by the guidance without really understanding the details behind this..

When we file our 10-Q, we will be breaking out a lot of that information for investors to be able to see what the Ayrshire acquisition brought to us and what the adjustments are going forward. We will also be filing an 8-K in approximately two and a half weeks that, again, will further disclose a lot of that information you’re looking for.

In addition, obviously, to the intangibles, amortization going forward, we’re also going to have, obviously with all that additional debt, a lot of additional interest expense that’s going to be attributable to the acquisition. .

The guidance you have now is including all that?.

Yes, includes all that..

All right, perfect. It was a tough quarter, but I think you’ve given a lot of good color on what the future looks like. Now you just need to execute on it, because the last few quarters have been a little bit of a letdown from the standpoint of the growth that will come in the future, and it has just not yet showed up..

Yes, we understand. We’re infinitely more frustrated than you are. .

Today, that might be the case, but the day when the stock’s flying 25%, I would ….

You need to remember that I’m a significant owner myself..

No, I understand. I wish you good luck in the next quarter..

Our next question comes from Chris Sansone with Sansone Capital. .

Quick question regarding the debt on the Ayrshire acquisition. Can you just remind us what the covenants are on that? And if you could [unintelligible] and sell that I guess with your capex expectations for the next year or so. .

The two main covenants, we’ve got a leverage ratio, total debt divided by our last 12 months EBITDA, and the leverage ratio accounts receivable divided by our debt, basically. Working capital divided by debt. So those are the two main ratios that we’ve got to look at.

Of course, we’re right at the edge on the day of the acquisition, and we see that getting better as we go out through the year..

And I guess if you could just … Thank you for the qualitative explanation.

If you could just quantitative, help me calculate what that number is?.

The leverage ratio is 3x, so debt cannot be more than 3 times the last 12 months EBITDA. And the ratio of our receivables to earnings is approximately, or the letter of credit, is 1.3x AR. So our line of credit, which is not the term debt but on the line of credit, 1.3x accounts receivable. .

As we have no further questions, we’ll turn the call back over to our speakers for any closing comments..

Craig Gates:.

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