Craig Gates – President and CEO Ronald Klawitter – CFO Brett Larsen – VP of Finance.

Bill Dezellem – Tieton Capital Management George Melas – MKH Management Vad Yazvinski - Jordan Capital.

Good day, and welcome to the Key Tronic second 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..

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 are Ron Klawitter, our Chief Financial Officer; and Brett Larsen, our Vice President of Finance.

Today, we released our results for the second quarter of fiscal 2015. We’re pleased to see our recent acquisition of Ayrshire continue to make significant contributions to our progress by expanding our capabilities, revenue and customer base.

As we discussed on previous calls, less than 30% of our business was print circuit assembly, or PCA prior to acquiring Ayrshire. This was much less than for most of our competitors. Typically, a PCA account can be transferred in six months and entails relatively low risk and much less cost for the OEM compared to a full product transfer.

In contrast, onboarding a new customer has historically taken us up to 24 months, often involving us designing or helping to design a new product.

The upside, our unique non-PCA centric business model has been that once we have won and transferred an account in this very sticky business, we lose very few accounts and programs over time and we typically gain market share within our accounts.

In many cases, we’ve seen that OEMs with a complete product to source like to start the relationship with a PCA transfer, then after the relationship has been established, start to transfer complex product. In the national progression of Ayrshire’s PCA programs, some become high volume.

In order to gain the economics of higher volume production and outsource more of the full production, Ayrshire’s many satisfied customers no longer need to move the program offshore to create, to a new supplier. This lowers the risk and cost for the OEM, and creates new opportunities for an expanded Key Tronic.

By acquiring Ayrshire we believe that many of these programs would grow in volume and programs transitioning to full product builds will now flow nationally to Key Tronic instead of competitors. We also expect to reduce our average onboard time for many new product programs.

During the first and second quarters, we’ve seen Ayrshire customers continue to award us additional business because of our combined capabilities and global logistics. Another positive aspect of the Ayrshire Key Tronic combination is our expanded customer diversification.

Given Ayrshire’s close proximity to, and strong working relationship with customers design teams and the excellent job they did in providing low volume, high mix services to these customers, Ayrshire built an extensive and superb list of very loyal customers.

At the end of the second quarter of fiscal year 2015, we were generating revenue from 164 distinct customers, up from 57 customers a year ago. At the same time we continue to see a robust pipeline of potential business.

We further diversified our future revenue base during the second quarter by winning new customer programs involving consumer products, commercial printers and gaming equipment. Looking ahead, our broader and more diversified customer base significantly lowers potential risk and impact of a slowdown by any one customer.

While our revenue and earnings in the second quarter continue to be impacted by declining orders from certain longstanding customers, our new programs continue to gradually ramp up. As we deal with the longer term decline of certain large customers, we are also managing the challenges of our success in the short-term.

We currently have over 27 new programs in the process of onboarding and several nearing the end of the design phase and moving towards the production stage.

While getting all this new business up and running does impact our expense line in advance of revenue, we do not expect those costs to be of unusually higher levels as they were in the first quarter. As anticipated, we saw a strong sequential rebound in our operating efficiencies in the second quarter and a return to profitability.

Moving into the third quarter, we expect to see increased operating efficiencies and profitability as our new programs continue to grow and our product mix and margins return to normal patterns. In short, we are more encouraged than ever about our long-term potential.

Now I would like to turn the call over to Ron to review our financial performance, then I’ll come back to discuss our strategy going forward.

Ron?.

Okay, 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 December 27, 2014, our results were in line with our previous guidance. We reported total revenue of $114.3 million, which was up 46% from $78.3 million in the same period of fiscal 2014.

Results for the second quarter of fiscal 2015 include approximately $39 million in revenue from Ayrshire Electronics which was acquired on September 3rd, 2014. For the first six months of fiscal 2015, total revenue was $200.7 million, up 28%, from $156.2 million in the same period of fiscal 2014.

Our revenue continued to be impacted by anticipated reductions in production levels from some of our longstanding customers, we are pleased to see Ayrshire’s contributions and the continued ramp of new programs contributing to our growth. As expected, we saw a strong sequential improvement in our operating efficiencies.

You will recall that during the first quarter we had an unfavorable product mix that caused higher material cost and 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 margin was 5% which is considerably lower than historic levels. For the second quarter of fiscal 2015, our gross margin increased to 8% and we expect it to return to 9% or more in coming periods. Total operating expenses were $6.7 million in the second quarter of fiscal 2015. This is up 47% from the same period last year.

This increase primarily reflects the addition of Ayrshire operations. Despite our increased operating expenses, our high revenue levels in the second quarter, combined with operating efficiencies, resulted in an operating margin of around 2%. This is up from a negative 2% in the first quarter of fiscal 2015.

Net income for the second quarter of 2015 was $1.6 million or $0.14 cents per share, which included an R&D tax benefit of approximately $0.02 per share. This compares to $3.1 million or $0.27 cents per share for the second quarter of fiscal 2014, which included a benefit of $1.5 million or $0.13 cents per share due to a change in Mexican tax law.

Now I’ll let Brett go over our balance sheet..

Thanks Ron. On the balance sheet, we have continued to maintain a strong financial position even after the full consolidation of Ayrshire’s operations. Our inventory was down to $71.4 million, down $3.3 million from the previous quarter.

Our trade receivables were $68.5 million at the end of the second quarter, down $6.2 million from the previous quarter. Our consolidated DSOs were about 52 days and we would expect that our DSOs will remain at this level.

You will recall that we completed the acquisition of Ayrshire in the first quarter using about $5 million from cash on hand, $35 million from a new term loan and $9 million from our line of credit to fund the purchase price.

During the second quarter, we reduced our balance on our line of credit by $5.9 million and reduced the term loan by $1.3 million. In coming periods, we expect to continually pay down the line of credit and term loan.

Our capital expenditures for the second quarter of fiscal 2015 were approximately, $2.5 million as we continued to expand our sheet metal fabrication, plastic injection molding, and electrical assembly capabilities. We expect our CapEx for the fiscal year to be around $6.7 million. .

Okay, thanks Brett. Moving into the third 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.

Taking these factors into consideration, we anticipate that the third quarter of fiscal 2015 will have revenue in the range of $108 million to $116 million. We expect our gross margin to return to the historic target of around 9% in the third quarter.

We also expect some increases in operating expense as a result of rationalizing our support groups to match the opportunities before us. Taking these factors into consideration, we expect earnings in the range of $0.13 cents to $0.18 cents a share for the third quarter. This expected earnings range assumes an effective tax rate of 35%.

In summary, we expect to see stronger growth in the third quarter as our new customer programs continue to ramp up. Overall, the financial health of the company is excellent and we believe that we’re well-positioned to continue to profitably expand our business over the longer term. Okay, that’s it for me, Craig..

All right. Thanks, Ron. From our perspective, slowdowns by a certain large, longstanding customers have masked the production ramps of several new customers. However, we are very encouraged by the potential of our many new programs being on boarded and the positive impact of our recent acquisitions.

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

First, increasing costs in China are driving demand for more localized production; Mexico and America for North American end 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 geographically diverse 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 they want US-based engineering, prototyping and higher mix production.

Beyond the level of cost and service we can 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.

Over the longer term, the EMS market is expected to see steady 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, mix changes in our program portfolio and the cost associated with ramping up new programs will continue to be part of our business, we believe our fundamental strategy remains sound, and our sustained focus 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 looks increasingly robust. This concludes the formal portion of our presentation. Ron and I will now be pleased to answer your questions. .

[Operator instructions.] We’ll go first to Bill Dezellem with Tieton Capital Management. .

Thank you. A group of questions.

First of all, the three new wins that you put into the press release this quarter, what is the range of size behind each of those please?.

$5 to $15 million..

And do you have any interesting anecdotes or stories behind winning any of those or all of those programs?.

I don’t think anybody would find them interesting except us, so I guess not..

All right.

And how many of those are existing customers versus new customers?.

Those are all new..

And then I think in your opening remarks, you’d mentioned that you are onboarding 27 new programs and I believe that, and this is what I would like to make sure I heard you say correctly, last quarter that you were onboarding 13 new programs..

Yeah. It’s quite a jump..

Okay, so we are not hearing that incorrectly, that you are literally, you have doubled the number of new programs that are ramping now versus last quarter?.

Yeah. If you look back over our history, we’ve typically been running anywhere from three to nine programs at any given time that we are trying to put in the factory. So it’s doing what we said it was going to do..

So, said another way, last quarter, this quarter is double last quarter and last quarter is double what you would consider normal if I just pick a mid-point between three and nine?.

Yeah, that’s right..

Okay, thank you. A couple of additional questions. I guess two of them they really kind of relate. Number one, can you qualitatively discuss how you see revenues progressing over the course of the remainder of this calendar year.

And I recognize that you are not in the business of giving guidance out future quarters, but given this very strong ramp in new programs, it seems as though you might have a little bit better perspective than normal as to qualitatively how things might be progressing?.

Well, I guess the easiest way to say it without violating our longstanding policy is to say that the trend arrow is strong enough upwards that I'm willing to say that we are pretty optimistic..

Well, I think I'm going to push back a little bit on that because I think in your opening remarks you also mentioned that you are more encouraged than ever about the long-term potential of the business. That even sounds like a stronger statement than what you just said and maybe I can get you to expand on that statement.

How about that?.

You’re talking to Bill [indiscernible].

The balls were flinging to 12 PSI. I guess qualitatively rather than trying to dodge around giving you numbers, from a qualitative standpoint, we expected that one plus one should equal three when we bought Ayrshire instead of two. And from what we see today, maybe one plus one can equal four, four and a half.

We are excited about that and we are very encouraged about it. The other thing that surprised me is how quickly it’s happening. I thought we would see maybe more one or two programs from customers that had some pent up demand that they couldn’t really give to Ayrshire.

And instead we are seeing a lot, like probably seven, eight, or nine existing customers of Ayrshire who have already travelled down to Juarez, who have already gone deep in the courting process with us, who have already been working with our design engineers on new designs, or modifying current designs.

And that’s in the space of a quarter and a month. This is pretty cool and surprising in a good way. It’s always nice to say that you had a brilliant idea and things are working out exactly as expected, but this is better than what we thought..

Does it in any way take away -- that’s not the right phrase, pull in what you ultimately would have thought would have been happening? It’s happening more quickly but it’s just because it’s happening in the first four months rather than nine months from now?.

Yeah. If you are asking if we are just pulling revenue out of a year and getting it now instead of then, it’s going to be a peck of demand of flow and then nothing after that short burst.

Is that what you are trying to say?.

Well, to some degree and just to some degree that there was the pent up demand for the Ayrshire customers looking for that alternative, which they’ve now found with you to award more business to.

And yes, you may have been thinking that you would get some, this pent up demand business over the course of the year, but it’s just happening much more quickly but the total isn’t any greater than what you were originally anticipating..

The total was greater and the speed is greater for both..

Okay, I'm going to absorb that, step back in queue and let someone else ask a question. Thank you..

[Operator instructions.] And we’ll go back to Mr. Dezellem..

Okay. Sorry for that pause. So continuing on the discussion with the Ayrshire customers, one of the things that you made clear in the press release, if one does the general math, they had more customers than you did and therefore their revenue per customer was smaller.

Yet I think when you first did the acquisition, there was a reference to the fact that they had larger customers and more of the Fortune 500 type customers than Key Tronic did.

So it seems as though on the surface that what you are saying is that their average customer is smaller than you or than yours in terms of revenues with you, yet the potential that they could bring to you is substantially larger than what many of your customers would have the ability to bring to you.

Are we thinking about that right or is there an aspect of this that I'm missing?.

Well, to be really precise about it, their average revenue per customer is much smaller than ours. And they have a number of very large Fortune 500, Fortune 100 companies in their customer base for which they’re doing a very small piece of revenue.

A number of those large Fortune 100, whatever companies, have pent up demand for a company like the new Key Tronic that is manifesting itself as quotes and visits and wins for us. I'm not sure that you can make all of the -- draw the conclusions that you listed there, but that’s the precise situation..

Great. That’s helpful. And the old Key Tronic, your largest customers had given you some challenges in the last couple of years.

How would you characterize the health of those customers now?.

Stable and that’s quite a bit better than it was before. And in fact, one of the big customers appears to be actually improving so that’s optimistic outlook there also for us..

Congratulations. And then also, as I think about your comments here, it’s been long time since we’ve heard you sound this favorable and enthusiastic about what you see coming.

And so not to splash cold water on it, but what do you see as your biggest challenges facing you right now?.

Biggest challenges. Well, I would say the biggest challenge is to continue to turn in a nice profit while getting all this new business on board and living up to our potential. It’s a balancing act between how fast we bring it on and how much we spend to bring it on. That’s probably our biggest challenge.

And another big one is, some of our customers’ ability to transfer the programs to us is limited by how much control they’ve had of their business prior to trying to bring it back from some other vendor.

So we’ve got a number of customers who were offshore with a supplier and our customers lost control of the documentation, lost control of the design, lost control of the supply chain and we are having to recreate that for our customers as we bring the product back home so to speak. So that’s adding to our burden of growing as fast as we could grow.

Those are our two biggest challenges..

Thank you for not saying answering shareholder questions..

Oh no, I love talking to you, Bill..

So, one additional question. the number of new programs that you are ramping, given that it is significantly greater than what it historically has been and over the cause of the last couple of years, you have referenced how you’ve had new programs that have been delayed coming into that onboarding process.

How much of this is that pent up ice dam if you will, breaking versus just programs that you have been winning and are just coming on as you anticipated. It just so happens that there's a whole bunch of them..

I’d say the majority is new programs that we’ve won recently. There’s maybe three that seem to have taken forever that have finally started to hit production, but the rest of them are all pretty much where we thought they would be in terms of timing..

Congratulations. Sounds fantastic. Thank you for taking all the questions..

Operator:.

Then we’ll go next to :.

Good morning guys. I’m sorry, good afternoon.

Can you explain a little bit how you went from 13 programs last quarter to 27 this quarter? Just trying to understand where these programs came from?.

Well, they were all programs that were, not all of them, but the vast majority were in various stages of the bid or award process and the business got awarded to us. .

I think over the last -- if you’ve listened to all of our conference calls, we’re picking up about two to three new customers a quarter and it takes about 12 to 24 months in some cases to get that, unless you have won the business to actually get into production.

It just seems like a lot of these are hitting right now for all these customers that we won over the last 12 to 18 months are now finally hitting and moving into production to our source. Kind of, part of it is a pent up demand I guess, but it’s just the timing of when those programs actually reach the point where they are manufacturable. .

That standard I guess flow rate you would think of with a little bit of a lot of traveling through the snake and then on top of that, you layer all the stuff we’ve won because we’re the new Key Tronic instead of the old Key Tronic. And so the two add and that’s how the number got so big..

Can you assume then that most of these new programs that you’ve -- most sort of the increase in the new -- the program that are sort of close to getting to production have come from the Ayrshire side of the business?.

No. I'd say it's probably a 50-50 split. There’s some a little ….

Okay. So I’m trying to understand. You had 13 programs that you were getting close to production three months ago.

You’ve won three new programs and now you’re at 27?.

We don’t necessarily tell you about every program we’ve won because if they are not sizable we don’t go into a bunch of detail about them. I tell you there is some argument here that says we are probably going to quit doing it because we are doing to lose track of them as we try to track all of Ayrshire’s programs and Key Tronic.

I think we are probably going to revert to just telling you the number of customers because it’s getting to be really hard to figure out what’s the program and what’s just a new listing and it's pretty big..

The way to look at this George is the trend as opposed to the absolute what’s happened here and what does this mean. Just the trend low bursting and going forward. .

Okay, very good. If we take these 27 programs that you have now, you are generating very minimal revenue at this point.

Probably no production revenue, but are you getting some engineering revenue from them?.

We are definitely getting engineering revenue from them. For example one program has been in design phase for two and a half years and we’ve been paid over $2 million of engineering costs for our work on that program. That product just went into production last quarter. So that gives you an idea of how long these things take.

Other products are just ramping and we’ll make – not make, but we’ll get about $100,000 of revenue off of them this quarter and others of them are just ramping. We will not get any revenue off of them..

Is there any way to, if you take all these programs, these 27 programs and they are at your expected run rate, production run rate, is there -- can you tell us what kind of revenue, annual revenue they would contribute?.

Yeah but I'm not going to because it scares me and I can’t believe it would actually happen and it hasn’t happened in the past. If you take everybody’s work ….

Can you take that number, Craig and cut it in half so it’s just doing the math?.

That still scares me..

It scares you because it just has not happened in the past or it scares you because that number seems very large?.

It seems very large and we have been enthused in the past and we’ve ended up being not so enthused in reality. But the process we used to look at these 27 is the same process we’ve used for 20 years and the revenue projections that our customers have given us we’ve hacked down quite a bit. So we don’t get disappointed.

And when you look at all the slips and hiccups that happed between today, somebody awards you a piece of business and when you actually start to make revenue off of it, we try to factor that in there and it's still a pretty big number. And then you need to look at what happens to all the businesses we had today.

Is there something else going to go wrong with one of our big customers? But I can tell you that it's easy to get over encouraged.

And that’s why when I was asked earlier what our biggest challenges are, we don’t want to get over encouraged and start spending money like crazy trying to pull all these programs in faster than their national rate because we may end up being disappointed in the end.

But there is kind of a national rate that programs transfer and it's like pushing on a swing. If you push on a swing out of sequence with the swing, it just smacks you in the face, but if you wait till it’s at the top of swinging, give a little bitty shove, it goes right back down again.

We are trying to say in the national frequency of these programs rather than getting over excited and hiring extra engineers and program managers to shove them through the factory because our customers can’t keep up. For example -- okay, good enough..

No, tell me more. I'm sorry I interrupted you..

I was just going to say for example one customer working on right now should be a $25 million customer. And we thought we have it all transferred in here by now, but instead we found out that they had lost their design. Their supplier and modified the design so much that they didn’t even know what it was.

We had to go back and recreate part of the supply chain because they didn’t know where their supplier was buying parts and we’ve had to actually redesign part of it because it really wouldn’t pass specifications the way it was being sold today.

That’s pretty common for the type of business, the boomerang accounts that we are getting, it’s very, very common for our customer to have really lost control and the capability to design and maintain control of the design of a product.

One of the -- we’ve had an opportunity that’s very interesting to us because the customer is highly sophisticated and called us out of the blue and said that they have been running a process for over a year and they had decided that they wanted a supplier that was between $500 million and $2 billion in annual revenue and they haven’t been able to find as many people as the wanted and now that Key Tronic had passed over or close to pass into at least the $500 million range, they were going to open it up and talk to us about the account.

And when we went out there to visit with them, we spent probably an hour answering questions from around 25, 30 people mainly focused on have you ever moved back from China before our program? Do you have Chinese speaking people that can help us decipher these prints? Do know how to move tools out of china because we bought these guys and we have no idea where the tools are? Have you had any experience in rebuilding tools that have been allowed to go to rack and ruined? All that stuff that falls right into what we’ve been doing is becoming more and more common and it’s migrating further up the size of the corporation that faces the issue.

10 years ago we would see that kind of a situation with a pretty small company who’s being run on a shoestring and mum and pop shop and they just shoved it over to China and let it go and live off of the profits. Now we are seeing it with big Fortune 500 companies that are waking up and going Holy Moses, we can’t build this.

We don’t even know what's going on over there and we are getting more and more concerned that we don’t. It's been pretty interesting to watch this whole progression as the boomerang accounts getting bigger and more prevalent..

It’s very, very interesting. Quick question about the numbers.

Can you give us some concentration, some customer concentrations whether it’s your top three, top five?.

Yeah. George, last quarter we only had one customer that was over 10% of our revenue and that customer was about 19% of our revenue. The top three were 34% of our revenue. Top five was about 40% of our revenue..

How much is top five, I'm sorry?.

Top five is little over 40% of our revenue.

Okay. So a big change in that of course..

Yes..

A few quarters ago we were able to hit operating margin in the 4%, 5%.

If we get back to gross margin at 9%, I think that this coming quarter you said that you are going to take probably some cost for some kind of, I'm not sure some restricting or some re-organizing?.

George, what we are trying to allude to there is what I've been talking about is we are going to have to spend some extra money on more engineers, more program managers to on-board all these programs. It's not restructuring. It’s adding people to deal with increased opportunities..

Okay.

This is sort of a front loaded cost that you will hopefully get back later, but at first it hits your margin?.

Yeah. You have to pay guys to get in here before you can start building it..

What would it take for you guys to get back to operating margins in the five?.

We have to be, our gross margins would have to hit double digits, George. And that will happen as our revue continues to increase and we absorb more of our fixed manufacturing costs and that’s when that will happen. That’s part of what's scary -- that scary, but scary exciting about the future is that we don’t have a linear response to revenue.

It's more of an exponential response. As we see revue more away from where we were last quarter, it's not a straight line improvement. It's got a curve to it..

Okay.

Can you then give us some help with trying to understand the components of the growth of the cost of goods sold and how much of that is material cost versus more fixed overheads?.

Okay. I think we’ve talked in the past about incremental margins. We expect as revenue grows our incremental gross margins to increase in the range of 15% to 20%. So the incremental margins are about double what our gross margins are running. That should give you an idea, George of how to look at it.

Components, our materials that their margins component of it and materials are representing about 70% of our cost or 70% of revenue is materials. And then our gross margin is 9% or 10%, which leaves about 20% for manufacturing costs. And it’s part of --it's about 50-50. Manufacturing costs are about 50% variable, 50% fixed. Rough numbers to use..

Okay, great. And then one more question on my part.

As the revenue grows, what kind of capacity do you have right now and do you need to add the capacity?.

We’ve got as far as brick and mortar goes, we don’t see any constrains there even if we were to run out of capacity in what we currently own and lease. We would just look at an aerial photo of the Juarez campus and within three or four blocks there’s probably another 350,000, 400,000 square feet available for lease. We are not worried about that.

In terms of capital expenditure required, these things don’t require multi-million dollar wafer fab lines to put in place. We may have to buy some molding machines, some SMP equipment, but it's not the kind of thing that’s going to strain our fiscal facility to fund it..

Okay. And then I have one more question. The mid-point of the guidance for the March quarter is slightly below the current quarter.

Is that because of some loss from some customers or is it just seasonality?.

Actually the mid-point in our current guidance is actually above our current quarter, George..

My math is pretty bad, huh?.

Yeah. And our current quarter we call included $0.02, almost $0.03 of the R&D ….

Oh no. I was talking about the revenue. I was asking about the revenue. I'm sorry..

Yeah, okay. On the revue side, our Q2 Ayrshire did have, the Ayrshire side of the business did have some unexpected drop in orders that allowed theirs -- that it was above their normal run rate.

Some of their forecast or our forecast include some drop in their revenue, but new programs coming in from the western division as we call it going up and replacing that. As far as the improvement in margin, it’s about a 1% improvement overall gross margin.

Some of that is just additional operating efficiencies that we are picking up in addition to some product mix..

Great. Thanks for taking my questions..

We’ll go to Vad Yazvinski with Jordan Capital..

Good afternoon gentlemen. First of all as a New England fan I want to drop in a Belichick reference I think as with anything, until it's proven -- in this country it’s until proven guilty, okay? I did it ….

That’s how you always know. .

Yeah, I know. I'm with you and same thing for you guys. But actually a lot of my questions have been asked in the follow up over the last 10, 15 minutes. But I want to continue a little bit on that.

One, it does appear you guys had $39 million from Ayrshire this quarter and the run rate was assumed to be, or at least based on the filings for Ayrshire was about 120. And now obviously I guess your answer is that some of the revenue got pulled into this quarter that really could have been spread over the next few quarters.

Is there seasonality in that business at all in general?.

Not really since it's so widely diverse. They just had a couple of blue birds come in through the window and land in their revenue base..

Got you.

So that explains -- you still view it as a -- as far as the annualized run rate, roughly $120 million?.

Yeah, they were there. The 120 that we put in our filing, that was their trailing 12 months at the time we bought them, but they were showing increasing revenues on a per quarter basis. So I think that ….

It was not ….

That actually caused difficulties as we were negotiating the price because we had set the price and then the revenue started to go up. So things got a little dicey for a while..

But their normal run rate right now is at around about $135 million to $140 million. .

I got you. And then obviously then continuing the line of thought is on the guidance. Considering everything, this is probably the most optimistic I've heard you be on any of the conference calls over the last few years. And’s that encouraging obviously considering the last few quarters everybody was a bit cautious.

And on the guidance you guys put out, even if you assume that some of the revenue got pulled into this quarter on the Ayrshire side, it still would appear that the guidance is relatively conservative, at least a little bit. I'm just curious if you guys can comment on that..

Yeah, I'd be happy to. There is -- the down side of being a public company is this. We are looking at the quarter and we’ve got some issues with one account and we’ve forecasted it aggressively to the market.

We can spend a bunch of time running around trying to pull in some revenues so we hit our forecast number, or we can spend a bunch of time ruining around trying to land new business and get it in the factory.

We are forecasting what we think is a nice, safe conservative number because I don’t want to spend a bunch of time chasing around trying to make that number because it was risky..

I understand that. Actually I get to hear because over the last few quarters I think the biggest thing as with patriots and delicate you guys -- the burden of proof is on you guys. So we’ll hopefully just deliver it with the numbers.

Then the second, the next question is obviously there was it would appear that on the balance sheet, you guys had a little bit more fall through on the comprehensive income you guys. I guess it's all currency related.

Are you having -- what kind of impact is the currency movements are causing on the business side in addition to on the balance sheet I guess which is for all intents and purposes the real one, but ….

The currency hasn’t had much impact on us. The reasons that other comprehensive income change so much is because the peso, the value of the peso depreciated. The peso depreciated by about 10% over the last quarter. And we’ve taken out hedge contracts on the peso going out about three years.

Our average rate that we’ve locked in on these hedge contracts is between 14 and 15 pesos to the dollar, in today’s spot rates of about 14.6.

But as those contracts, since they go out three years, the value of those in the marketplace goes up and down and that’s what changes in the other comprehensive income is just the value of what those contracts would sell if we had to liquidate them today.

But our intention is obviously not to liquidate them, but to take advantage of them and use them to pay our peso costs as they come due..

No, I get that. What I meant was more of a -- I understand the accounting side.

I was talking more on the business side if the currency depreciated 10% I’m assuming your contract – are most of your contracts denominated in dollars or in -- I mean I’m assuming they’re all in dollars which would assume you should be getting some -- the costs are in pesos and you should be getting a little additional benefit on the margin side if the contracts are in dollars or even in pesos obviously then since we need to wash..

No because we’ve hedged most of that money. So it’s not given us any benefit because the hedging is already included in that price..

At what revenue levels have you guys hedged? You haven’t hedged at the increasing run rates?.

Our revenue is primarily in US dollar denominated. There’s no currency impact on that. And then our cost in Juarez is primarily in pesos and that’s what we are hedging is the peso denominated costs in our Juarez facility.

And so those contracts that we’ve taken out as I mentioned, those contracts have exchange rates anywhere from 14 to 15 pesos to the dollar, which is about what the current exchange rate is.

That’s why it’s really not having much impact on our costs because we’ve taken out that swing and ups and downs in the peso because we’ve already taken out the contracts..

Okay, I understand that. And that more as you guys grow, obviously there’s a lot of -- I'm assuming the growth will be pretty substantial over the next few quarters.

It’s not like you are going to keep adding contracts even if you get more costs in pesos, which would mean you will have a little bit more improvement on the margin side as the cost will be a little lower. But I understand. .

Okay. What you’re saying now, you are saying the marginal growth is going to happen in Juarez and we would not have contracts against that marginal growth that you expect. You are correct..

Precisely, and that’s why as I said – go ahead..

On the other end, you’ve got to realize that our customers aren’t dumb and they understand when they’re negotiating their price, that ….

That’s why I asked about what the contract is denominated in. But overall in the long run as the currency depreciates, the Chinese RMBs is pegged to dollar more or less. And so you should get -- the Mexican pricing should get more and more advantageous going forward..

That’s what driving. That’s a good half of the boomerang effect..

Okay, understood.

Then the second part you guys touched on it obviously, consider the number of programs you are rolling out right now, would it be correct to assume that the number -- the average size per program is a lot lower than it would have been in the past and that part of it is because you’re rolling things from Ayrshire and some of it is just the title programs or is that not a correct assumption?.

That’s why the number I gave you is scary because it's not a correct assumption. A lot of these programs are not just a small transfer of what something that was in Ayrshire to Mexico. A lot of these programs are things that were never in Ayrshire’s bailiwick and were being built by somebody else.

They are much larger than a typical Ayrshire program and they are new to us..

That’s great to hear. And then obviously on the balance sheet side, you guys paid down some debt.

But are you guys still well within your covenants -- on the covenant side?.

Yeah. We are well within our convents and we‘ve got a great relationship with our bank and we want to keep it that way..

Undertook. Okay. I think that’s pretty much it and so go Patriots. .

We’ll take a follow up from Mr. Dezellem..

Thank you. My question was answered..

There are no further questions at this time. I'll turn the conference back over for closing remarks.

Okay. I want to thank everybody for participating in today’s conference call. Ronald and I look forward to speaking with you again along with Brett. Thank you and have a good day..

This does conclude today’s conference. Thank you for your participation..