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

Bill Dezellem - Tieton Capital George Melas - MKH Management.

Good day, ladies and gentlemen, and welcome to the Key Tronic Third Quarter Fiscal 2015 Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over to Mr. 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; and Brett Larsen, our Vice President of Finance.

Today, we released our results for the third quarter of fiscal 2015. As anticipated our results were impacted by declines from certain longstanding programs.

At the same time, we are pleased to see increasing revenue from our new programs and in our recent acquisition of Ayrshire continues to make significant contributions to our progress in different ways.

First by acquiring Ayrshire print circuit assembly, or PCA capabilities, we expect to see a shorter average onboarding time for a new customer, which is historically taken as up to 24-months often involving as helping to design a new product.

Second, among Ayrshire's many satisfying customers, we expect to retain more programs with growing volume or transitioning to full products builds. In the past, many of those maturing programs flow to competitors. We've seen Ayrshire customers award us additional business because of our combined capabilities and global logistics.

Third, the combination has expanded our customer diversification. Given Ayrshire's close proximity to customers, its strong working relationships with their design teams and its excellent high mix services, Ayrshire builds an extensive and superb list of very loyal customers.

At the same time, we continue to see a robust pipeline of potential new business. During the third quarter, we won two new programs involving consumer products. Looking ahead our broader and more diversified customer base significantly lowers the potential risk and impact of the slowdown by any one customer.

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

We have many new programs in the process of onboarding and several more are nearing the end of design phase moving towards production stage. While getting all this new business up and running does impact our expense line in advance to revenue, we expect to see continual sequential improvement in our operating efficiencies in the fourth quarter.

However, we also expect to see a significant moderation in the decline of certain longstanding programs that has impacted us in recent periods, while our many new programs continue to ramp up. As a result, we expect overall sequential revenue growth and increased profitability.

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 March 28, 2015, our results were in line with our previous guidance. We reported total revenue of $112.9 million, this is up 47% from $77 million in the same period of fiscal 2014.

Results for the third quarter of fiscal 2015 include approximately $37 million in revenue from Ayrshire Electronics which was acquired on September 3, 2014. For the first nine months of fiscal 2015, total revenue was $313.6 million, this is up from $233.3 million in the same period of fiscal 2014.

As Craig had said, we are pleased to see Ayrshire’s contributions and the continued ramp up of new programs contributing to our growth. During the third quarter of fiscal 2015 our gross margin was 8% compared to 9% in the same period of fiscal 2014. We expect our gross margins to return to 9% in coming periods.

Our total operating expenses were $6.9 million in the third quarter of fiscal 2015, this is up 57% from the same period last year. This increase primarily reflects the addition of Ayrshire operations and our preparation for growth in coming periods.

Our increased operating expenses and slightly lower gross margins than our target range resulted in operating margin of around 2% in the third quarter of fiscal 2015 compared to 3% in the same period of fiscal 2014. However the longer term we expect increasing operating margins and profitability.

Net income for the third quarter of fiscal 2015 was $1.9 million or $0.16 per share, up from $1.4 million or $0.12 per share for the same period of fiscal 2014. For the first nine months of fiscal 2015 net income was $2 million or $0.17 per share compared to $6.2 million or $0.55 per share for the same period of fiscal 2014.

At this point I'll let Brett go over the balance sheet..

Thanks Ron. We have continued to maintain a strong financial position. Our inventory was $78 million, up $6.6 million from the previous quarter reflecting our preparations for growth in the coming period. Our trade receivables were $69.7 million at the end of the third quarter, up $1.2 million from the previous quarter.

Our consolidated DSOs were about 50 days and we would expect that our DSOs will remain at about this level. You will recall that we completed the acquisition of Ayrshire in the first quarter using $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 third quarter, we reduced the balance on our line of credit and term loan by $1.8 million combined. In coming periods, we expect to continue to gradually pay down both the line of credit and the term loan.

Our capital expenditures for the third quarter of fiscal 2015 were approximately $2.4 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 around $7.7 million..

Okay, thanks Brett. Moving into the fourth quarter of fiscal 2015, we anticipated more of our new customer programs moving into production and gradually ramping up, as well as a significant moderation in the recent reductions in production levels by some of our large longstanding customers.

Taking these factors into consideration, we anticipate that the fourth quarter of fiscal 2015 will have revenue in the range of $115 million to $125 million. We expect our gross margin to return to the historical target of around 9% in the fourth quarter. We also expect some increases in operating expenses.

Taking these factors into consideration, we expect earnings in the range of $0.17 to $0.23 per share for the fourth quarter. This expected earnings range assumes an effective tax rate of 35%. In summary, we expect to see stronger growth in the fourth 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. All right, that’s it for me, Craig..

Okay. 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 onboarded 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 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 operation, brings 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. Beyond the level of cost and service we can provide from our Mexican and US-based facilities, we offer an exceptional level of experience and the recent acquisition of Ayrshire has served you increased responsiveness by bringing us four U.S.

based operations with regional capabilities. 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 cost associated with ramping up new programs will continue to be a 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 to Bill Dezellem with Tieton Capital..

Thank you. Let's start with the two new programs that you won.

What business size of each of those and what details can you share relative to existing or new customer, how you came about winning them et cetera?.

I think the smallest is five and the largest is 20. And one of those was that one plus one equals three and one was a peer driven by the processes that were in place before the acquisition..

And so the one plus one equals three is this a case where this was an existing customer of Ayrshire’s and that you won additional business from that customer?.

Yes..

And the other one was a new customer entirely not a new program for an existing customer..

Yes..

Got it.

And then you talked a little bit both in the opening remarks and in the press release about the longstanding customers where you had revenue decline and directionally you’re looking for a shift there, but would you talk a little bit about why you believe that the decline that you have been experiencing that will change?.

Yes. There is two different customers and two different reasons, one of them the customer has come up with a new product that we’re in the midst of ramping right now and it looks as if that product is going to be home run for them. It gets them into a different market space in what they were competing in before.

So even though we see the continued decline of their longstanding business with us, the new product looks to be like it's headed in the right direction and probably will completely balance out the losses we’ve seen over time of revenue on the old product.

And then the other customer has - I can’t really say much more than that, the other customers market it looks to be as stabilized and is perhaps starting to come back a little bit..

And relative to the first customer, when you referenced negating of their - the new product, negating the existing product set decline or offsetting it.

That prior customer if I’m thinking as the correct one, had been very large previously and are you believing that this new product will return that customer revenue with you back to the previous high point or where are you looking at that shaping out?.

Well we’re optimistic but we’re basing everything that we know on their forecast. And their forecast have been very, very wrong in the past. So I hate to bet any serious amount of money on what’s going to happen there..

It is a new product and so it’s helping to market acceptance..

Understood. Let’s shift if we could to Ayrshire, and they did $37 million or so of revenues here in the quarter.

How does that compare to their standalone March quarter a year ago before they were part of Key Tronic?.

I think they were at about 30 a year ago. They are up about 15%, 20% from where they were running a year ago..

Great, congratulations. And I guess I am going to shift now if I could to your guidance, in the revenue range is a little wider than you have given sometimes if I recall correctly.

And I’m hoping you can share with us a little bit about the dynamics behind that wider range?.

Yes. There is really two things that cause us to factor in how much we’re going to plus or minus our revenue forecast. One is if we worry about our customers forecast on what they expect to buy from us versus what we think they’re actually going to buy from us.

And the other is if we’re in the center of a big ramp and the middle of a big ramp and we know we’ve got orders from the customer but we are not sure they’re getting to get their various design and process ramp up issues solved in time for the quarter.

So in the one case, when we give a broad range where we worry about forecast from the customer, that means that if we are at the low end of our range those orders didn’t materialize for our customer and probably are not going to roll over into the next quarter.

In the other case, where we are worried about the ramp of a new product or new customer if that ramp doesn't happen in the quarter we’re hoping for, it usually does roll into the next quarter. So in this case almost all of the variation we’re concerned about is based upon actually three steep ramps that are going on right now in Mexico.

So three different customers, three different new customers that were ramping up now could go one way or the other way.

So we try to pick in the center but the standard deviation of our revenue is bigger than normal based upon those three big ramps, whether or not, hardest getting near the last week of June, or they are not getting the first week of July and whether or not we saw a couple of technical issues for the customer, things like that that are always part of ramp but it just so happens that part of the sequential growth we’re talking about is based on these three big customers and these three big ramps.

So we did broaden both our revenue and our profit range based upon that uncertainty but I guess the point I’m trying to make is a good uncertainty rather than a bad uncertainty where we don’t know if we’re getting orders or not..

And so to some degree there is a little bit of a look into the September quarter for us also because if you hit let's just say you hit the low end of the mid-range of the guidance, well as those customers ramp you will ultimately be at that 125 and beyond because you’re not assuming a full ramp this quarter..

Yes. I always wonder what’s going to happen to the rest of the 200 plus customers we’ve got. So you can’t predict Q1 with any more certainty than we ever can but it feels better than we’re missing orders..

Right understood. And one other things I also would like to understand is, you seem to be having and I sense this last quarter and again this quarter an increasing amount of success, winning new business and just generally things going well for you.

Why is that, what is happening to make everything seemingly come together right now?.

Well there is a number of factors, we talked about it earlier, the big I think the big overarching factor is what’s going on in China and costing in China and what that is doing to the competitiveness of Mexico.

There is no slackening in the - seems like relentless increase in cost in China, labor rates continue to go up and as those rates go up and people start looking at the cost differential between China and Mexico, it’s almost a parity ex-factory now.

And then when you add in the transportation cost, if the product is going to get sold in Americas or in Europe, you add in the cost of sending four or five engineers over there because something does go wrong, you add in the cost of various IP and FDA in fractions that we often see when we take over a business that's a boomerang account from China.

You add in the cost of one air freight event in a given financial year for our customer and by that I mean one point in time where they either had a quality issue or a forecast and had to fly parts from China to the States, anyone of those factors makes a tie on an ex-factory pricing situation swing in the favor of Mexico.

Certainly two years ago, we were selling perspective customers on the situation and asking them if they would like to look at it quote out of our China operations alongside quote out of our Mexican operation.

Today it’s a clear sea change that almost all of our customers don’t even have to be convinced of the type of products that makes more sense in Mexico.

They’re all very open to, we can’t believe you guys are so helpful to show us this quote out of China as well as Mexico in the open book you do it, we appreciate all the work you’ve done on showing us transportation cost and duty cost and it’s just no longer a sales pitch.

So I think it’s become broadly accepted amongst the purchasing intelligence of the OEMs that we serve that China is no longer the D factor I’ll answer. So that’s a big driver.

Second big driver for us is over the years it may have looked like random acquisitions and process changes in Mexico have now added up to company that has every capability of companies that are 10 times, 20 times our size.

So we are almost completely vertically integrate it, which means that we now have a pretty significant cost advantage over a non-vertically integrated competitor, when we’re trying to build an entire product. If we’re just trying to build the PCB then obviously we don’t have much of an advantage against somebody else who did PCBs.

But when it comes time to try and build their printer or a slot machine or any other complete product and we can make all the sheet metal, we can make all the plastics, we can assemble the PCBA, we can do all of the final test, we can do the shipping, we can do the warehousing, we can do the single quantity unit one product shipping to the customer out of our El Paso warehouse.

That’s a pretty big advantage when you compare that to a lot of the people in our size range with whom we compete.

And then the third big advantage now is that we’ve got all of these customers that were with Ayrshire that had a lot of pent-up demand that really didn’t want to take their business somewhere else as their business grew but they had no option because Ayrshire was obviously limited to their State side production, so all those customers are now really happy that they’ve got a easy path to transition a product from Ayrshire say Minneapolis to Key Tronic or as Key Tronic China.

I’m not sure it’s widely recognized but moving a product from one facility to another within the confines of a corporation like Key Tronic is a lot, lot easier than moving it from one facility to another outside of the confines of the corporation.

Because all the paperwork, all the documentation, all the manufacturing processes, all the qualifications can be done much, much easier when you’re staying with in a company even though you’re moving locations that has been a core tenant of Key Tronic’s operations for years is that if you want to move your product from Spokane to Juarez, or from Juarez to China you have to babysit it, you just call us up and we move it for you.

And not only just taking that step and repeat template and laid it on to the Ayrshire facilities and so there has been a steady stream of Ayrshire customers into Juarez and China plants looking and very, very happy to what they see at our capabilities to move their products as they grow.

So those are the three big things that are all working in the right direction with China was you can say it was luck but we doubled down on Mexico years ago because we all thought this was going to happen for sure the acquisitions that created the capability we have was skill or good planning.

And I’d say the capability of one plus one equals three in the way that we can implement is got to lot to do with skill and not just look, but I would rather be lucky than good, so we’ll take it either way..

That is very helpful and I’d like to take that answer and relay it back if we could to the one new win that you referenced in the quarter that came from an existing Ayrshire customer.

Is that an example of something that that you are just describing or are you describing something different where the customer just keeps the business at Ayrshire or at the new Key Tronic and as the revenues grow, it grows under the total corporation whereas the win that’s actually an entirely new product..

In this case, it's a new product but very much like the product that we’re doing in smaller volumes..

That’s very helpful. I’ll let someone else step in. Thank you..

Thank you. [Operator Instructions] George Melas with MKH Management..

Hi, good afternoon guys..

I apologize for you name, I swore to Bill I was going to give with the moderator before had him go over the proper pronunciation of both yours and Bill name but I didn’t do it, we’ll get it right next quarter..

My name is very hard to get right. That’s not a problem. So just two quick lines of questions.

Could you give us a little data on customer concentration and how that compares with maybe both the previous quarter and a year ago in terms of top maybe you don’t want to see your top customer but maybe your top two, top three, top five?.

Yes, so our right now we only have one customer that’s more than 10% of our business, whereas a year ago we had three customers that were right at 20 plus percent. So I think our top five customers last year was about 65%, last year, this year, our top five is about 54%..

Okay.

So if you have just one customer that's over 10% and the top five is 54%, then each one of those top five is near 10% I imagine?.

Yes, we got a couple of them that are right at just a little bit less than 10%, couple at 7%, 8% range..

Okay. Great..

And our largest customer is just under 20%..

Okay, great.

And just to try to understand the gross margin, you had sort of a nice sequential revenue growth but sort of a very meaningful gross margin expansion and I’m just trying to understand how is that possible that you go from 8.4 gross margin to 9.0, would adjust that revenue growth, so maybe you can try to help explain to me how the profitability of the business improves in the next quarter?.

Probably as you know we get - with additional business you get some fixed burden absorption but at 8% this quarter to 9% next quarter gross margins, it grows a little bit but one of the drivers for our growth as Craig talked about one of the new programs was bit pretty tight and typically our material margin runs on average around 30%, 30% to 31% but in this one product our material margin is only about 20%.

So we’re not getting as much incremental benefit of that revenue growth but it’s enough to move the gross margin from the 8% to 9% overall..

Okay. If you just take - if you look at it sequentially, the incremental gross margin on the additional revenue when I just take the mid-point of the guidance, I think it’s 20%..

Yes it’s just about - 20% is about a good rule of thumb to use for incremental margins and so what I’m going forward - got a couple of big drivers in the revenue growth once a little better than 20%, once a little bit less than 20% incremental but 20% is a good rule of thumb to use..

Okay, great. That’s it for me. Thank you very much..

Thank you..

Thank you. [Operator Instructions] We have a follow-up question from Bill..

Okay, Bill go forward..

Thank you very much.

And by the way, I’m more than happy to have my name mispronounced if that means that you’re doing $125 million in more quarter revenue?.

Well, if there is correlation I would be calling you Mary right now..

And I would be happy to be Mary.

You in your opening remarks made referenced to the fact that your capabilities are equal to or exceed anyone in Mexico, your Mexican facility that is, is that - is there an unstated qualification behind that relative to competitors of your size or is that across the board no matter the size of the competitor?.

Well I haven’t toured Flextronics plants and I haven’t toured Foxconn's plants but we have been speaking with customers who are touring those another of much bigger customers and from what we can tell, what we have is as good as what they have and the fact that it’s concentrated in one place and run under one umbrella means that our customers perceive it is better..

\ Interesting..

So nobody of our size has the vertical integration we have and the biggest guys I know of just equal our vertical integration..

Right. That’s helpful, thank you.

And then talk a little bit about your pipeline of potential new business if you would please?.

Well, it's with the two companies combining together it’s much bigger than we’ve ever seen before. We look at our quotes per quarter and they continue to go up. I hate to say exponentially but at least I don’t know a 45 degree angle and we continue to add people and efficiency into our quote department and that we’re having trouble keeping up.

Today we’re trying to have a staff meeting and we looked around and nobody was here because everybody was at our facilities touring perspective customers and audits through the facilities. So from our viewpoint, we’ve ever seen a pipeline as for as healthy as one we’re looking at right now..

And if this - well the pipeline has two components number one is quantity of quotes and the other is size of quotes, how would you characterize each of those asking to break it down list not finally if you would please?.

There is more quotes that are larger size..

So it's kind of hard to not think about it as an exponential increase, isn’t it?.

Yes..

And then I want to circle back to the comment that Brett had made relative to inventory being up roughly 6.5 million sequentially. Presumably that ties to the three large programs that are ramping in the June quarter and preparation for that.

And so we are really looking at raw material is where the inventory increases at or it might not thinking about that correctly..

No that is correct Bill. There is an anticipation of revenue during the quarter..

Great. Thank you all again..

Thank you. And gentlemen, we have no additional questions in the queue. I would like to turn the floor back over to you..

Okay. Thank you again for participating in today's conference call. Ron and Brett and I look forward to speaking with you again. Thanks and have a good day..

Thank you. And again ladies and gentlemen, that does conclude today’s conference. Thank you all again for your participation..