Brett Larsen - Executive Vice President of Administration and Chief Financial Officer Craig Gates - President and Chief Executive Officer.

William Dezellem - Tieton Capital Management Sheldon Grodsky - Grodsky Associates George Melas-Kyriazi - MKH Management Company, LLC.

Good day and welcome to the Key Tronic Second Quarter Fiscal 2017 Conference Call. Today’s conference is being recorded. And at this time I would like to turn the conference over to Mr. Brett Larsen. Please go ahead, sir..

Thank you. 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 website. Today we released our results for the second quarter of fiscal 2017.

For the quarter ended December 31, 2016, we reported total revenue of $118.5 million, up from $117.1 million in the previous quarter, and from $116.4 million in the same period of fiscal 2016. For the first six months of fiscal year 2017, total revenue was $235.7 million compared to $242.6 million in the same period of fiscal year 2016.

We saw a slight slowdown in demand from a few customers in the first-half of fiscal 2017, which is consistent with EMS industry-wide experience. As expected, the slowdown is being offset by our new programs that continue to ramp as we continue to diversify our customer base.

For the second quarter of fiscal 2016, gross margin was 8.1% and operating margin was 2.1%, compared to 7.8% and 2.1%, respectively, in the same period of fiscal 2016. Year-over-year improvements in margins were a direct result of production efficiencies and a decrease in material-related costs.

During the second quarter of fiscal 2017, however, our gross margins were so adversely impacted by the costs associated with our new program wins, some of which involve transferring ongoing production from a competitor’s facility to our own. By the fourth quarter, we do expect to see gradually improving gross margins.

While income tax was higher year-over-year, net income for the second quarter of fiscal 2017 was $1.5 million or $0.14 per share compared to $1.8 million, or $0.16 per share for that second quarter of fiscal year 2016. The second quarter of fiscal 2016 included a large one-time tax benefit related to a change in the U.S.

tax law, relating to domestic research and development tax credits. For the first six months of fiscal 2017, net income was $3.3 million or $0.30 per share, up 27% from $2.6 million, or $0.23 per share for the same period of fiscal year 2016. Turning to the balance sheet, we continued to maintain a strong financial position.

We’re pleased to see the results of our efforts to reduce inventory, as inventory decreased approximately $2.1 million in the second quarter from the previous quarter. In coming periods, we expect to see our net inventory levels remain relatively flat as we prepare for the future ramp of new programs.

Our trade receivables were $66.4 million at the end of the second quarter, up $1.7 million from the previous quarter due to timing of sales revenue that occurred within the quarter offset by a slight increase in utilization of our account purchase agreement.

Our consolidated DSOs remained around 45 days, and we expect our DSOs will remain under 50 days in the coming quarters. During the second quarter, we entered into a capital equipment term loan with our primary financing institution, totaling $3.9 million to fund expected future growth.

However, we still reduced our total debt by around $1.5 million compared to the prior quarter. Over the longer-term, we expect to continue to gradually pay down the term loans and the revolving line of credit.

Total capital expenditures for the second quarter of fiscal 2017 were approximately $2.0 million, and we expect the total to be about $9 million for the full-year, as we continue to expand our SMT, sheet metal, and plastic molding capabilities.

Moving into the third quarter of fiscal 2017, we expect more of our new customer programs to ramp to move into production. At the same time, we expect a softness in a few of our longstanding customers.

Taking these factors into consideration, we anticipate that the third quarter of fiscal 2017 will look much like the second quarter with revenue in the range of $115 million to $120 million. We expect that our overall gross margin percentage will also remain flat to recent quarters.

We project gross margin will gradually improve as new customers’ programs ramp and further contribute additional revenues in coming quarters. Taking the factors just mentioned into consideration, we anticipate earnings in the range of $0.11 to $0.16 per share for the third quarter. This expected earnings range assumes an effective tax rate of 20%.

In summary, we’re pleased with our strong financial position and encouraged by the prospects for future growth in revenue and earnings. The overall financial health of the company is strong and we believe that we’re well-positioned to continue to profitably expand our business over the longer-term. That’s it for me.

Craig?.

Well, thanks, Brett. As Brett mentioned, we’re seeing softness this year among a few of our longstanding customers and this appears to be consistent with industry experience. Nevertheless, we’re encouraged that our new programs continue to ramp partially offsetting this modest slowdown in demand.

At the same time, we captured significant new business from competitors, including established programs that will begin generating revenue before the end of fiscal 2017. The recently won new programs involving inventory automation systems and commercial lighting.

Moving into the third quarter, we continue to see a robust pipeline of potential new business and our new programs will continue to ramp. Going forward, our broader and more diversified customer base significantly lowers the potential risk and the impact of a slowdown by any one customer.

Moreover, the returning tide of North American-based customers correctly analyzing the total cost for overseas production continues to help our production in both Mexico and the U.S.

Our steady pipeline of new business continues to be boosted by our level of vertical integration, our multi-country footprint, and the excellence of our manufacturing sites. We believe, we have confirmed a trend we have been tracking over the last three years.

We see an increasing portion of our new business coming from OEM customers who have become dissatisfied with their Tier 1 EMS providers. These OEMs are coming to the realization that the mismatch in the size of their business typically between $5 million to $40 million, and the size of their Tier 1 provider creates insurmountable issues.

We have discussed the issue of this engagement mismatch before, but as a refresher, they include responsiveness, flexibility, and account support. This quarter, most revenue business wins are coming to us from Tier 1 suppliers. This has both the negative and positive implications for our business.

On the negative end of the spectrum, the decision process is much slower for our prospective customer. They are typically surviving their relationship with the Tier 1, but are not happy. So we get into a devil, discussion with people that are suffering from choosing a mismatch.

Then continued on with the Sonos [ph] team, the transfer itself is fraught with risk for the OEMs as the Tier 1’s response to losing the business is hard to predict. On the positive end, once we do get to the actual transfer, the data and information we need to take over the business is typically better.

This is because there has already been vetted and utilized by the Tier 1 in the process of on-boarding the account initially. Another positive for us is that for an OEM with a full product outsourcing project, KTC is the only option that provides a better capabilities of Tier 1.

And finally, as OEMs face an increasingly uncertain geopolitical landscape, KTC has uniquely equipped to offer risk mitigation with our manufacturing facilities located in China, Mexico, and United States of America.

To continue to capitalize on a derisive locations, however, has required significant capital expenditure, training expense and management attention in recent periods. In coming months, we plan to continue to invest in expanding our SMT, sheet metal and plastic molding capabilities in anticipation of increasing demand.

As we move further into fiscal 2017, we expect to see many of our new programs continue to ramp up that continued on-boarding of several new customers and a robust pipeline of potential new business.

Over the long-term, we anticipate our new programs and customers will continue to grow far beyond the revenue levels today, and we’ll continue to invest in increasing our capacity and improving our operations to accommodate a more diversified customer base.

Overall, we feel increasingly encouraged by our growth opportunities and our competitive strengths. This concludes a formal portion of our presentation. Brett and I will now be pleased to answer your questions..

[Operator Instructions] At this time, we’ll take our first question, this will be from Bill Dezellem with Tieton Capital Management..

Yes, thank you. I have a group of questions.

The first one, I guess, my standard question, what’s the size of the new programs that you won, what the rates are?.

$5 million to $50 million..

$5 million to $50 million?.

Yes..

When was the last time that you won a client that was as large as $50 million?.

I couldn’t tell you, it’s been a while though..

Well, congratulations.

What’s the timing that you would anticipate for that to get rolling into the plant and may I assume that it’s longer than the normal ramp time?.

We’ve already built some prototypes. We’re beginning to build the first small order. And hopefully, eight months from now, we’ll begin to see the big orders..

Well, congratulations. Would you talk a little bit about how your – how the interest maybe is changing in your U.S. factories, given the current political environment, and how your U.S.

factories are positioned relative to the competition if OEMs became more interested in having business in the U.S., and I suppose Craig, I’ll pile on with one more tied into that. What if any enhancements, are you making to the U.S.

plants to prepare for any potential change in mindset?.

Okay.

In reverse order, we have been upgrading a pretty decent amount of equipment in two out of the three plants, so maybe the dollar has been spent on automated equipment for those plants both to keep up with capacity and to decrease cost and to improve capability in terms of the size of componentry and the complexity of parts that we can manufacture in those facilities.

We have spent some more money on facilities upgrades and capability upgrades that are not just automation, but in other aspects of the plants. We’re seeing an increased pipeline of business for plants in America, and I have no idea how or what is happening with our government is going to do to our customers both prospective and current.

I know a number of my current customers have called us looking for our take on what’s been rumored, proposed, reported, whatever. And our answer so far is, we don’t know, but we’re better prepared to mostly deal with it for you if something when it does happen..

Thank you very much, I appreciate it..

Yes..

[Operator Instructions] We have one additional or actually now two additional questions in the queue. We’ll now move to Sheldon Grodsky with Grodsky Associates..

Hello, gentlemen, I’m afraid that this conference call is going to be more political than usual. We do have a new President? Donald Trump, our new President in case you missed it, has been extremely negative in his comments towards both China and Mexico, which does happen to be two places where you have important operations.

If a border tax were put in on components from Mexico, would that put your Mexican operations out of business?.

I can’t answer that question. I don’t know what size tariff would go in their border tax over the magnitude, I don’t know if that would be on value add or total value of the products.

If you look at it from a very, very high approach on the world, as I have been doing since 1985, when I moved the first plant from Honeywell to Juarez as a young engineer, you can beat yourself so confused that you can’t come up with the answer, because if you take away the jobs from Mexico and move them back up into the states and people have to pay more for their goods and services, who is going to put that bill, is it going to be yes, is it going to be the OEM we provide, or is it going to be the consumer; in the end of a busy [ph] consumer.

So we will put our factory in Juarez out of business, it depends if he taxes it so much that it’s more expensive than building it in the states, then it would. If he doesn’t go to that extreme, then it won’t. And I have no idea what it’s going to do..

I assume you’re a member of industry groups, or has any lobbying effort begun yet to try to explain that there are Americans jobs that can be lost if Mexican jobs are also lost?.

And the business is speculating who is explaining what to Trump, I would certainly not like..

Okay. Thank you..

Yes..

At this time, we’ll take a question from George Melas with MKH Management..

Hi, guys, good afternoon..

Hi, George..

On the last conference call, you said something that I thought was very interesting. You talked about sort of opportunities for full product manufacturing, where you can provide higher value, which I also imagine potentially higher gross margin for you guys.

And this time you’re talking about capturing business from EMS competitors primarily from Tier 1 that have full product manufacturing capability.

Is that one on the same? Is that – are you – is this full product manufacturing opportunity really coming from Tier 1s?.

Yes, the majority of those full product box builds are coming out of Tier 1s, driven by as we said the mismatch between the project size and the Tier 1s interest level..

Okay.

And what kind of margin – do those kind projects have above average margin, or do they have above average, I mean, are they big projects that I mean, I understand big projects are good, because they require sort of a smaller amount of – on a relative basis, a small amount of resources on your part? What is the real value to you of these big projects from a gross profit dollars or gross margin perspective?.

Well, I can talk in averages and tell you that a typical full product build has a higher gross margin for us than those just a piece that build, because we get to garner some of the margin that would have spread around and spread around three or four providers had it been put together by people who only have one skill set or one capability.

So before on that although I’m sure you understand it. But for the people who are listening, if all we’re doing was manufacturing a PCB and PCA, which has the parts already sided onto it and tested.

And we’re selling that to another contract manufacturer who was then going out and buying more of the plastics from the plastic molder and formed and coated metals from a metal manufacturing site, each of those separate companies would be layering their margin on top of those components.

And then the guy whose finally put it together and shipped to the OEM would be putting his margin on top of all of those. So the margin will be split up amongst three or four different companies.

When we do the entire thing, we get to keep some of that margin that would have been split up or stack, which everybody even look at it by ourselves and some of that margin goes to our customer, as the – I keep pointing a word for picking a fully supplier rather than trying to firm it out amongst three or four.

So that’s why I ended up being a little bit higher margin. It ends up being a lot stickier, and that that’s the basis for why we wanted to be vertically integrated rather than just one or two or the other one or two capabilities or plastics, steel, PCBA’s assembly..

Okay, that’s very helpful.

On the big customer that you signed this quarter, it is a capture from a Tier 1, right?.

That one is not..

Okay..

Yep..

How do you see the ramp of that customer? What – can you help us understand what are the milestone to and for you to sort of track the ramp to its full potential?.

It’s a new product that used to catch phrase, but it’s a disruptive technology. So we’ve been working with these folks for must be two-and-a-half-years now. The Halo types have been installed at the prototype. So first production run has been installed. They work, so that’s milestone number one.

Number two, the customer aggress – our customer is customer agrees that the benefits are as they were anticipated. So that’s driving follow-on orders for a much bigger install, so that’s milestone number three.

And if the bigger install goes off without much of a hitch and continues to work as a small experimental install went, then milestone number three will be – there is a big order for a whole bucket of these will make them..

Okay.

And where are we on that process, Craig?.

So the first production run has been installed. It works and the customer’s customer like it..

Okay. So we have one and two, okay.

Is that fairly – so you have a range – in your new products, you have a range of new products that have a certain kind of risk? And then you have existing products that get transferred from either the customer’s plant, or another EMS to you, and that has – will it be fair to say that has a lower risk?.

There were different types of risks, George..

Yes..

And that should be lower or higher, so….

Okay..

When it’s coming from an OEM, we talked about getting into this, there we have no discussions. So you can have an OEM who is currently a Tier 1 and who is having a horrible time as measurable is missing deliveries to their customer is shipping bad quality products to their customer, can’t get the Tier 1 to pick up the phone.

The Tier 1 is continuing to move people around, so have no continuity on the project team the risk just goes on and on. And yet, our prospective customer is still in business. So even though they’re miserable, they’re still in business.

Typically, the people who tested Tier 1 are being flogged by who is over in-charge and being told, go find me a right match, this can’t be this bad as got to be better. So those people – the people who made the mistake the first time have to go out and make a choice to second time, and so they’re really gun shy.

So it takes somewhat long, long time to make that decision and there’s many fitful starts and stops, because the Tier 1 may find assets, they’re getting ready to lease and promise them to give us one more chance, we’ll fix it for you.

And so the risk in those types of business opportunities for us are that you have a long, long decision process that doesn’t really start until after we’ve spent a lot of time and money on quotes and plant tourists and perhaps resigns for manufacture ability or quality of their products the stresses whether senior management.

So that’s a lot of time gone by and a lot of investment in the sales process of us that may result in our business even though it’s clearly a better decision. It’s the double I don’t know versus the double I do..

Right..

So that kind of risk goes with a cost or extraction out of a competitor versus the design and market acceptance risk that goes with a new company or a new product..

And across your portfolio, it’s not like you are targeting one versus the other.

You have a range of – you have the combination of the different kind of risk in the pipeline?.

That’s true. And as an engineer, I have a soft spot for startups in engineers. So we have to straddle my enthusiasm for small startup. So we typically only do one or two-year, even though I like more than that. So our risk is tending more towards established products than it is startups..

Okay, great. And then few questions on the numbers. I think you guys said that maybe by the end of this fiscal year, which is the June quarter, you could reach 9% gross margin.

So the question, is that still possible, and if it is what would make that possible?.

So, George, I think 9% is still very achievable, let’s kind of make that possible as just how much of the ramp of these programs we can still fit into this fiscal year. If you look at the projections out, sure, it looks like we should be able to get there. But things always take longer than what you first expect.

It really is revenue growth is what’s going to get us to over 9% margin..

Okay.

And that revenue growth comes from not from ramping up the customers that you’ve already signed up?.

Yes, correct..

Yes. Okay, that’s it for me. Thank you very much..

Thank you, George..

[Operator Instructions] Okay. I see no further questions in the queue. I will turn the call back over to Craig Gates for closing remarks..

Okay. I would like to thank everyone again for participating in today’s conference call. Brett and I look forward to speaking with you again and thanks and have a good day..

Once again, this does conclude today’s conference call. Thank you all for your participation..