Craig Gates - President & CEO Brett Larsen - EVP, Administration & CFO.

Bill Dezellem - Tieton Capital Management Sheldon Grodsky - Grodsky Associates Lewis Moser - Mafax Investors George Melas - MKH Management.

Good day, everyone and welcome to the Key Tronic Third Quarter Fiscal Year 2016 Conference Call. As a remainder, today’s call is being recorded. At this time, I would like to turn things over to Mr. Brett Larsen. Please go ahead sir..

Good afternoon, everyone. I’m Brett Larsen, Chief Financial 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 Craig Gates, our President and Chief Executive Officer.

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 or 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 Web site. Today, we released our results for the third quarter of fiscal year 2016.

For the quarter ended April 02, 2016, we reported total revenue of 118.4 million, up 2% from the 116.4 million in the previous quarter and up 5% from the 112.9 million in same period of fiscal year 2015. For the first nine months of fiscal 2016, our total revenue was 361.1 million, up 15% from 313.6 million in the same period of fiscal year 2015.

As expected, we saw a sequential improvement in operating efficiencies. For the third quarter of fiscal 2016, our gross margin was 8.4% and operating margin was 2.3%, up from 7.8% and 2.1% respectively in the prior quarter. We expect margins to continue to gradually improve over coming quarters.

Our total operating expenses were 7.2 million in the third quarter of fiscal 2016, down 7% from the prior quarter and up 4.5% from the third quarter last year. Note that the results of third quarter of fiscal 2016 reflect an extra week of operations due to our 53 week fiscal calendar year this year.

Net income for the third quarter of fiscal 2016 was 1.8 million or $0.16 per share compared to 1.9 million or $0.16 per share for the third quarter of 2015. For the first nine months of fiscal year 2016, net income was 4.4 million or $0.39 per share up 123% from 2 million or $0.17 per share for the same period of fiscal year 2015.

We are beginning to realize incremental earnings improvements as we ramp new customer programs into production. Turning to the balance sheet, we have continued to maintain a strong financial position. As you will recall, our inventories were abnormally high last quarter, reflecting the sudden cancellation of the program that we discussed previously.

In the third quarter of fiscal 2016, we continue to be impacted by this and by the timing of production during the latter part of the quarter as the level of assembled products increased. At the same time we're increasing raw materials in preparation for the ramp of several additional new programs. Our inventory was up 10% from the previous quarter.

In coming periods, we expect to see inventories decrease returning to levels more in line with revenue. Our trade receivables were 55.6 million at the end of the third quarter, down 5.2 million from the previous quarter due to the increased use of our receivables purchase agreement during the quarter.

Our consolidated DSOs declined to approximately 40 days and we expect that our DSOs will remain at about this level during the fourth quarter. You will recall that we acquired Ayrshire using about $5 million from cash on hand, 35 million from a new term loan, and 9 million from our revolving line of credit to fund the purchase price.

During the third quarter, we reduced our long-term debt by over 1.2 million. However, the balance on our line of credit increased 5.9 million reflecting the increase in inventory. Over the longer term we expect to continue to gradually pay down both the term loan and the revolving line of credit.

Total capital purchases for the third quarter of fiscal 2016 were approximately 2.5 million. As we continue to expand, our SMT electrical assembly, plastic injection molding and sheet metal fabrication capacity and capabilities. For the full fiscal year, we expect our capital purchases to be about 12 million.

We will continue to finance these purchases through a variety of means including leasing options. Moving into the fourth quarter of fiscal 2016, we expect more of our new customer ramps to move into production.

Taking these factors into consideration we anticipate that the fourth quarter of fiscal 2016 will have the revenue in the range of $117 million to $122 million.

We recently announced the closing of our manufacturing facility in Harrodsburg, Kentucky which has seen a decrease in demand from its regional customers including those serving the oil and gas industry. We plan to integrate these operations into our Mississippi and Minnesota plants.

As a result we expect to incur about $250,000 in close out expenses which will impact the next few quarters. Over the longer term we expect to realize annual savings equal to approximately $0.08 per diluted share. We expect that our overall gross margin percentage will continue to gradually improve.

Taking these factors into consideration we anticipate earnings in the range of $0.16 to $0.21 per share for the fourth quarter. This expected earnings range assumes an effective tax rate of 25%. In summary we expect to see sequential revenue growth and improving operating efficiencies in the fourth quarter as our new programs continue to ramp.

Overall the financial health of the company is strong and we believe that we are well positioned to continue to profitably expand our business over the longer term. That's it from me Craig..

Okay. Thanks Brett. This has been an eventful year for us so far and I'd like to review some of the major events and put them in context. That context will help explain our outlook for the business and our optimistic view of the future.

Up until about a year ago, our business was concentrated with our largest customer, as its business sharply declined the volume of our work flow accordingly dropped sharply. Fortunately our pipeline of new business was full and generating new business.

This was due to the one plus one equals three effect of the Ayrshire acquisition, our level of vertical integration, our multi-country footprint and the excellence of our manufacturing sites.

Over the past 12 months we've replaced approximately 50 million in revenue with this longstanding customer by winning and ramping seven new programs and customers.

While the revenue from the new programs and customers was very welcomed replacing one large customer with seven smaller and growing customers is a big challenge from a support cost and inventory standpoint, and as required a re-tooling of some of our processes, procedures and training.

For example most of the new programs generating revenue are PCB intensive, which makes sense as many opportunities tend to start as PCBs and then foster a broader range of services. We now have 13 SMT lines in Juarez up from six a year ago. This is for significant capital expenditure, training expense and management attention.

We're continuing to invest in expanding our SMT capabilities in anticipation of increasing demand. Getting this new business up and running also impacts our expense line in the advance of revenue. Three of our new programs were completely new products that we designed, prototyped, tooled and put into production.

All three of these programs launched in the factory in the face of sharp ramps driven by customer demand, and these ramps were far beyond the optimum rate, as a result we incurred significant excess cost throughout this year in terms of scrap rework overtime, airfreight and inventory.

Despite these challenges we're getting our material re-work overtime and airfreight costs under control and are making good headway on inventory.

Our gross margins dropped to 7.1% in quarter one and have since improved to 7.8% in Q2 and 8.4% in Q3 and we see them returning to our historic 9% to 10% range as we optimize our company around a new diverse business base.

This kind of dramatic decline of a large customer and the process of adding many new customers is extremely challenging for an EMS company of our size. The upside is that going forward our broader and more diversified customer base significantly lowers the potential risk and impact of any slowdown by any one customer.

Moreover we continue to see a robust pipeline of potential new business. We recently won new programs involving industrial lighting, equipment, building household controls and medical products.

Moving into the fourth quarter we have many new programs in the process of on-boarding and several more are nearing the end of the design phase and moving towards a production stage. As our new programs continue to ramp, we continue to invest in increasing our capacity and improving our operations to accommodate a more diversified customer base.

Over the long-term we anticipate our new programs and customers will continue to grow far beyond the revenue levels we're at today. We believe Key Tronic is well positioned to grow profitably, capture market share and capitalize on emerging opportunities. This concludes the formal portion of our presentation.

Brett and I will now be pleased to answer your questions..

Thank you. [Operator Instructions] We'll hear first from Bill Dezellem with Tieton Capital Management..

A couple of questions, first of all I want to follow-up on your last comment Craig about the rate now is still to come with the customers that you are in process of pushing in the factory today, if you were to win no additional new business and not ramp any additional products that are not already started in the factory, what would your revenue per quarter kind of move up to and stabilize that?.

Well, I would say it would stabilize where we are right now. If we quit ramping and everything we are doing, we don’t see any big decreases in the future, so I think we would be stable about where we are right now..

Okay.

Craig, I don’t think I asked my question well, do you have a number of customers that are in the early stages of ramping, so I guess what I am trying to grasp is how much additional revenue just from those ramps do you foresee?.

Well we have got a slide that we look at that says there is $50 million to $60 million of revenue coming out of customers that are currently in the ramp phase at some stage. So if that’s what you are asking that is the number..

So we could think of -- I mean if we are talking 50 to 60, that’s pushing 60 million per quarter of additional revenue and that is just if we were to normalize those upfront that are ramping right now?.

Yes that’s correct..

Okay, thank you. And then you hit on another interesting point which was the new, pardon me the existing customers that you’d see declining really the revenues going out of the bottom of the bucket as you bring in the new customers.

Did I hear you say that at this point you really do not see the loss of any business and if so pretty much from this point forward instead of back filling a lost customer like the large customer you have been dealing with the last year pretty much all flaring on top of the business that you have now?.

Well we certainly don’t see any big ones that are going out the bottom of the bucket. There is always some leakage at the bottom as programs go up or down. There is -- that’s basically the bottom-line there is no big ones that we see at risk right now..

Right, interesting, okay thank you, and then the reference in the release that you are seeing improved efficiency as you are ramping good customers, this actually speaks to be in the opposition of each other because generally new customers are additional any efficiency but you are saying it improved efficiencies.

What are you doing to have that success?.

Well, what I was trying to explain in my commentary was the ramps that we just completed over the last year were unusual in both their size and the stress that was on the schedule and the steepness of the ramp.

So the customers that we are adding today, none of those programs have the three deadly sins of, it's a brand new design, it’s got to be up at full production in a month and full production is at the capacity of the factory or above.

And those three characteristics were what drove all the problems we had in the first, two and a half, three quarters of this year and the difference is now, the stuff that we are ramping today does not have all those problems associated with the ramps..

And then I’ll ask my normal question, the new customer that you, or the program that you referenced in the release, what's the size of that?.

Those three are from 3 million to 15 million..

And there are three in the industrial lighting arena?.

No, no I am sorry. The three that are listed, those three are from 3 million to 15 million..

Okay, I am sorry.

I was asking about the reference in the press release to new customer that you won in the quarter?.

Okay, it's all right. I thought you were talking about the three I mentioned in my comments. So the one we mentioned in the press release is one of the ones that should be up over 10..

And then last question for now, did I hear correctly that the closing of the plant will add $0.08 a share to the bottom-line, once you are out of that facility?.

That is correct Bill..

We will take our next question from Sheldon Grodsky of Grodsky Associates..

First question is did I -- did you say that this year, and I know it's not easy to put all the talent together that the loss of business from that big customer was 50 million?.

That’s correct..

I didn’t know you had anyone that big.

And that’s been all absorbed this year?.

It's throughout the year, as we were talking today we have got that pretty much replaced..

So is that customer still with you or they are basically ending their relationship, or ending their product line with you?.

The product line ended and the relationship is ending..

Well I congratulate you on beginning to offset that and maintain profitability for most of the period. It sounds like….

All of the period..

For all of the periods, okay. [Multiple Speakers] I thought you hadn’t lost them maybe that was last year, it was up to 4 [Multiple Speakers]..

Yes that was last year..

Yes..

That is like too long ago.

But it sounds like things are falling into place for a potentially major improvement in both volume and I mean the negative impact of that, the big customer is history at this point, so now it's just getting everybody on stream and hopefully keeping glitches to a minimum I mean we know that there's always a chance of which, which is a part of your business but as you get more coming on the stream, so are you anticipating the possibility that within a couple of years that your profitability might be near record levels?.

Well I would sure not be on record as forecasting anything a couple of years out in this business..

But do you see the -- I mean basically you're talking about frequency is getting better and volume picking up and some cost reduction with the Kentucky plant closing, it seems to me it's an add up to a lot of pennies per share at some point?.

That's what we're hoping..

[Operator Instructions] We'll hear next from Lewis Moser of Mafax Investors..

Good quarter. I'm amazed you can replace that kind of business as you have, so you did a really great job in doing it.

The company seems to be undervalued, underexposed, no one knows about you guys, is there any effort on your part or any thinking that may lead itself to getting some more coverage because I think probably you have a good story to tell and is the price of the stock look to participate in any increase that may become attainable from some new analysts perhaps and/or I don't know kind of presentations you might make to improve the visibility of the company but is there any intensions there at all?.

Yes, so there's a conference being put on in LA by B. Riley who is also our analyst so, Brett and I are heading down there towards the end of this month to make a presentation and then have a bunch of one-on-one meetings.

And then the other side is that the depressed level of stock is one of our long-long time shareholders is so close to the million shares over the last three months and that has obviously had a dampening effect on share price they are about sold out, so we're hoping that once that ends things get back to where they should be based upon earnings per share..

Our next question comes from George Melas with MKH Management..

Can you guys give us some basic numbers on customer concentration, your top-three, top-five, top-10 and how that segways with where you are going?.

Sure. So, George with the replacement of that largest customer we're down to now 40% concentration in our top-five, and just give me one second here and I will figure out where we were a year ago. Not substantially different, 46% last year..

And how many customers and programs do you have now and is that I think that's a relevant metric isn't it?.

Well it's a number for sure, we've got close to 65 customers and I couldn't tell you how many programs we have it's probably over 120. With the addition of Ayrshire there's a number of customers and programs that are not as larger material so really that number, doesn’t mean as much as it used to..

So, with -- I guess a slightly reduced customer concentration is best when it is sort of the large customer who shall not be named sort of exiting your plants.

What is the working capital model of the company right now I think your working capital cycles have I mean as bad as you talked about it at the beginning of the call has increased quite a bit, where could it go or where -- what are your plans about it?.

So, George the biggest I have more working, working capital of course is our inventory.

Inventory is still higher than where we feel comfortable with, as Craig alluded in his comments with the number of programs we're now ramping that base is higher than probably what it has been historically, but we also are doing a concerted effort to reduce inventory at this point. I would like to reduce that by at least 10% in the short, near-term..

Okay.

And then did I hear you guy say that you factored some receivables in the quarter or?.

We did, so continue to use our asset purchase program to help out in some working capital. We will use that depending on the amount that we have outstanding on the revolver at anyone given point in time. The system measure a method of liquidity what -- our expectation is to use additional factoring in, in this quarter of Q4..

Okay.

And does inventory go up this quarter or do you expect it to start coming down?.

We're hoping it should -- it will stay flat and best case start to come down..

Okay, and then just a question on the model on so that you have -- the goal is for it to have 9% to 10% gross margin?.

Yes..

And what would it take to get there?.

Well, we think in Q4 will be there, pretty darn close and when we look out in the next year we don't see an issue with getting there..

Okay and getting there is there a chance that it gets to 10 or we're just talking about 9, I mean maybe that is too early to know I don’t know?.

George actually we're within the 9 to 10 that we are shooting for, we really don't like to give guidance beyond just the one quarter out, but it does look positive..

Okay.

And then the OpEx and that is not -- is that stable functioning on does it -- and what happens to that?.

OpEx should be fairly stable as a percentage of revenue..

And then just to sort of elaborate on to actually to Bill’s question, those customers that you have that are ramping and could add maybe 15 million to quarter’s revenue of the ramp, does that means that if we look at a year from now we should take basically the revenue that we have now minus some other situation plus that first unit.

Just maybe some new stuff that give us that hopefully you would have grant by then.

Or sometime the EMS industry doesn't lend itself to simple math and it is always more complicated?.

Thank you for the second question because we like that one a lot better..

That is not -- that industry thinks, most of the industry still have that characteristic..

So you answered your own question..

No, no what do you think? Tell me what -- how you think about it?.

Well I can't follow-through math but there is no way I am going to say that is what you should count on a year from now because I don't know what's going to happen..

Okay, okay god so maybe just one thing, the top-five customers that you have now that make up 40% of the revenue any of them new in the last three years, well tell us just a little bit about them so we have a little bit more confidence that these guys solid staying with you or that their business is solid?.

Okay. Off those top-five two are new customers within the last three years and one of those was not in the top-five three years ago..

Okay.

So two are new and one again is -- one is -- what is the last one -- one was the customer when they were small?.

Correct..

Two are new and one just grew by organic growth into a top-five customer..

Okay good.

Can you just tell us of course not their names, but what industry they are in or is that too much of me?.

We will do that as part of our Form 10-K in June..

[Operator Instructions] And we'll hear again from Bill Dezellem. Please go ahead..

I am out of the office so I apologize.

I think I missed what you had said Brett in the opening remarks about the increase in inventory did you explain why it was the inventory went up by the next bigger hit any of the commentary please?.

Sure, so we discussed inventory, and mentioned that -- a couple of things, one we had the longstanding customer that abruptly cancelled their inventory, we're still looking to collect on some of that in addition there's quite a few new program ramps any time you start a program you have excess inventory more than you’d like to have.

So those two things coupled have resulted in a higher inventory than what we feel comfortable with..

So that second, just part of that equation is something in -- in one sense we ought to be happy about because it’s a natural component of new business?.

Sure, yes..

Understood, and then how did the extra week affect you, is it an equal number of revenues and expenses and so no real impact on the business or is there some swinging one way or another?.

Our best guess is ratio metrics on both the income and the expense line but what's not ratio metric is the quarter was very backend loaded as we have been working hard to replace the 50 million, we shipped a lot of stuff in that last week, so that had a pretty tough effect on both inventory and receivables so that part of it was not linear but overall I think revenue and expenses were pretty close to linear..

Great, that's helpful.

And then I want to circle back to the 50 million of business you replaced over the last year and I am not sure exactly how to ask this question clearly but as you look at your pipeline of new business today first as the new, the pipeline of new business that you saw in the past, how does the pipeline today look relative to that historic pipeline and what I'm ultimately trying to get at is if the two are similar then coming back to George's question would help frame some perspective on what could develop over the next year, from a revenue standpoint?.

Well I listened very hard to that question and I think all you did was ask George's question over again.

So what you're trying to ask me is -- is the pipeline going to continue to feed us as fast as it has been in the past and are we going to then show 50 million of growth next year and the answer is, the math says yes but I'm sure not going to predict it or commit to it. So there's a lot of stuff that is happened. Go ahead..

No. You've answered more of the question that I asked I was just wondering if the pipeline would be similar to what it has been and then we can figure it out from there, so you did exactly what I hoping to, to understand.

Do you by chance be an acceleration of the pipeline is it in some form greater because of additional traction you're gaining on the sales front or would you characterize it more similar?.

I'd say over the last year it's been about -- been about the same..

We'll take a follow up question from Lewis Moser of Mafax Investors..

Yes I was wondering that whether or not you have any interest in acquisitions and if there are any such type possibilities out there that you've recently considered?.

Well, we have liked what's happened with us with the Ayrshire acquisition. I grew up in the Midwest the child of Depression parents so I hate being in debt so we're going to do more acquisitions I think but not until we get our debt down to where I'm comfortable that really bad times wouldn't cause us a problem..

And the other side of the question would then be would the company put itself up for sale?.

Well it's a public company so it's always for sale but we certainly don't have any intention of, certainly don't have any intention of soliciting bids for the company..

Who're your competitors?.

Well Benchmark, Plexus, Flextronics, J-Bill..

Lewis Moser:.

Our value proposition is that we have the same capabilities if not better but we're only $500 million in revenue, the guys I mentioned are all multibillion dollar companies.

So if you'll look at the customer base we win, our biggest customer's I think about 70 million a year in revenue and typically we're in the five to ten million of customers that we win because that customer can't get the time of day from a multibillion dollar supplier..

And we have no further questions at this time. Mr. Larsen I would like to turn the call back to you for any additional or closing remarks..

Thank you again for participating in today's conference call and we look forward to another call in fiscal year-end in July. Thank you..

Ladies and gentlemen, that does conclude today's conference. Again we thank you all for joining us..