Brett Larsen - CFO, EVP of Administration and Treasurer Craig Gates - CEO, President and Director.

William Dezellem - Tieton Capital Management Sheldon Grodsky - Grodsky Associates.

Welcome to the Key Tronic Third Quarter Fiscal 2017 Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Brett Larsen. Please go ahead..

Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would 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 third quarter fiscal year 2017.

For the quarter ended April 1, 2017, we reported total revenue of $113.6 million compared to $118.4 million in the same period of the fiscal year 2016. For the first 9 months of fiscal year 2017, total revenue was $349.3 million compared to $361.1 million in the same period of fiscal year 2016.

We have seen a slowdown in end customer demand from a few customers that has impacted our business in the first 9 months of fiscal 2017. This slowdown is partially being offset by our new programs that continue to ramp as we continue to diversify our customer base.

For the third quarter of fiscal 2017, gross margin was 8% and operating margin was 1.6% compared to 8.4% and 2.3%, respectively, in the same period of fiscal 2016. The year-over-year decline in margins primarily reflects the lower revenue levels.

During the third quarter of fiscal 2017, our gross margins were still 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.

We expect to see gradually improving gross margins as these new programs move into full production, further utilizing the existing production capacity. Net income for the third quarter of fiscal 2017 was $1 million or $0.09 per share compared to $1.8 million or $0.16 per share for the third quarter of fiscal year 2016.

For the first 9 months of fiscal 2017, net income was $4.3 million or $0.39 per share compared to $4.4 million or $0.39 per share for the same period of fiscal year 2016.

Note that net income for the 9 months of 2017 was adversely impacted by realized losses from the settlement of foreign currency contracts of $4 million or $0.37 per share compared to $2.9 million or $0.26 per share for the same period of 2016.

Foreign currency contracts are used to avoid currency fluctuation risks when quoting manufacturing in our Mexico facilities. The change in current fair value of hedging contracts is reported net of tax in equity and the transactional gains or losses are recognized as they mature in the cost of goods sold. Turning to the balance sheet.

We continue to maintain a strong financial position. As a result, of the lower-than-anticipated revenue levels in the third quarter, our inventory increased slightly from the previous quarter.

In coming quarters, we expect to see our net inventory levels remain relatively flat as the delayed consumption of that inventory will be offset by the ramp of new programs. Our trades receivables were $62.3 million at the end of the third quarter, down $4.1 million from the previous quarter.

Our consolidated DSOs remain around 47 days and we expect that our DSOs will remain under 50 days in coming quarters. During the third quarter, we reduced our total debt by $2.2 million when compared to the prior quarter.

Over the longer term, we expect to continually -- to continue to gradually pay down the term loans and the revolving line of credit.

Total capital expenditures for the third quarter of fiscal 2017 were approximately $2.6 million and we expect the total to be around $9 million for the full year as we continue to invest in our SMT, sheet metal and plastic molding capabilities. Moving into the fourth quarter of fiscal 2017.

We expect more of our new customer programs to ramp and to move into production. At the same time, we expect continued softness among a few of our long-standing customers.

Taking these factors into consideration, we anticipate that the fourth quarter of fiscal 2017 will look much like the third quarter, with revenue in the range of $112 million to $117 million.

We expect that our overall gross margin percentage will also remain essentially flat in the fourth quarter but will gradually improve as new customer programs ramp and further contribute additional revenue over the longer term.

Taking the factors just mentioned into consideration, we anticipate earnings in the range of $0.10 to $0.15 per share for the fourth quarter. This expected earnings range assumes an effective tax rate of 25%. In summary, we're 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?.

Okay. Thanks, Brett. As Brett mentioned, we're continuing to see softness this year among a few of our long-standing customers. Nevertheless, we're encouraged that our new programs continue to ramp, partially offsetting the slowdown in demand.

At the same time, we continue to capture significant new business from competitors, including established programs that will begin generating revenue in fiscal 2018. We recently won two new programs involving electronic scheduling devices and pool controllers.

Moving into the fourth quarter, we continue to see a strong pipeline of potential new business and our programs continue to ramp. Going forward, our broader and more diversified customer base significantly lowers the potential risk and 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 see 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 $5 million to $40 million and the size of their Tier 1 provider creates insurmountable issues which include the lack of responsiveness, flexibility and account support.

As we discussed last quarter, this trend of our gaining more business from OEMs that are leaving Tier 1 EMS suppliers has both negative and positive implications for our business. On the negative end of the spectrum, the decision process is usually slow and risky for our prospective customer.

These customers have typically been engaged with the Tier 1 for some time. As a result, the decision to transfer is fraught with the rest for the OEM customer. This is because the Tier 1 EMS provider's response to losing the business is hard to predict and could be potentially damaging to production.

Moreover, once these OEMs do make the decision to switch to Key Tronic, we typically face the challenge and associated cost of transferring the business from an unhappy Tier 1 supplier. 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 than from other providers.

This is because it has already been embedded and utilized by the Tier 1 provider in their process of on-boarding the account initially.

Additionally, we believe these new customers, having carefully selected Key Tronic over a Tier 1 competitor, will be very sticky customers for us, particularly for an OEM with a full product outsourcing product, Key Tronic is really the only Tier 2 option that provides the breadth of capabilities of a Tier 1.

As OEMs face an increasingly uncertain geopolitical landscape, Key Tronic is uniquely equipped to offer risk mitigation with our manufacturing facilities located in China, Mexico and the U.S.

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

For the fourth quarter of fiscal 2017, we expect to see a continued softness among some of our long-standing customers. At the same time, we also expect many of our new programs to continue to ramp up, the continuing on-boarding of our several new customers and a strong 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 continue to invest in increasing our capacity and in improving our operations to accommodate a more diversified customer base.

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

Operator, could you open the Q&A, please?.

[Operator Instructions]. And we'll take our first question from Bill Dezellem from Tieton Capital Management..

A group of questions. First of all, let's start with the size of the new program wins that you had, please..

$5 million to $10 million, Bill..

Okay. Well, that's not quite as interesting as last quarter's answer..

Sorry..

Me, too. So last quarter, one of the programs, I think, you had mentioned was closer to $50 million in terms of its potential.

What's the update on that program?.

The customer was out here 2 weeks ago, had a very good meeting. They are expecting their first PO. I wouldn't call it the first. It will be the second PO which will be for rollout in a limited region. So we've done a couple installations. Now it will be the rollout for a limited region and then the next one should be the biggie..

And that limited region you are anticipating, does that production schedule -- will look like what? And then what's the time frame for the full-on commercial?.

Well, we think the rollout for the limited region will help to -- and after that, I'd be hard-pressed to tell you how soon they're going to decide on the whole thing..

And Q2 being the December quarter?.

Yes..

Okay. All right. Let's shift, if we could. You, in your last quarter call and in this quarter, referenced this new business from your EMS competitors.

Talk a little bit about the ramp that you have seen from business you have won from competitors or whether that's still in process and has not ramped because they're -- they've dug their claws into it and are holding on to the business..

Well, we have four right now that are in various stages between almost-signed contract to aggressive ramp. And we continue to confirm our thoughts on this. The sales base takes forever. Getting the contract signed is a glacial pace.

And then once we move into production ramp, that goes completely upside down and it's much faster than a normal ramp that we used to think of as normal..

And how many of those types of wins do you have that have now begun production?.

One..

All right. That's helpful. And then, gosh, it was probably a year ago or so, you all had mentioned that when Kentucky was closed, that that would probably add $0.02 a quarter to EPS.

And now that Kentucky is in the rearview mirror, are you feeling like that's still the correct number? Or did that move up or down?.

No, that's....

That's about right..

That's about what we're saving now on a quarterly basis..

Great. And then one additional question.

Brett, would you please repeat your comments relative to the currency impact that impacted the March quarter?.

It actually was year-to-date. So what we've disclosed is -- on the script was that fiscal 2017, for the first 9 months, was adversely impacted by realized losses from the settlement of those foreign currency contracts to the amount of $4 million or $0.37 per share compared to $2.9 million or $0.26 per share last year..

Or an incremental $0.11 negative..

That is correct..

And thought of another way or said another way, your earnings would have been $0.37 higher had you not done any hedging for this year..

That's correct..

And I presume that's largely a function of the election and the commentary that's been somewhat negative towards Mexico that has led to their currency decline and that's why you have these negative impact from your hedging. And had you not been hedged, you just would have benefited from the lower peso..

Yes. I don't want to speculate on why the Mexican peso has weakened, definitely attribute it to many of those facts. But yes, substantial weakness in the peso, we were unable to realize that due to the foreign currency contracts that were already established..

Right. And I'm not trying to direct you one way or another here. True curiosity.

Does the experience in the last couple of years alter your thinking at all relative to how you hedge?.

No. Our intent is to hedge based on forecasting manufacturing costs in foreign locations. We quote based on having those hedges in place. So no, still standard practice. And we've been very effective in the past.

It's unfortunate right now that we're unable to profit from the weakened peso, but at the same point, we're now entering into forwards at a much better rate recently than what we have in the past..

And that's a great segue to my next question before I step out of the queue which is, is there a particular quarter or time frame when -- that we might see a step function change in that currency impact and the hedging impact and see it be beneficial or just much less negative?.

Over the next 18 months, you'll see a gradual reduction of those forward currency losses if the spot rate were to stay the same as it is today..

Right.

And if the spot rate were to see an appreciation of the peso, in that case, you would then see a benefit happen much more quickly?.

Actually, no. We're contracted into a forward rate, so you'd actually see an additional transactional loss if the Mexican peso were to weaken..

And an improvement in your financial position if the peso were to appreciate..

Correct..

[Operator Instructions]. We'll take our next question from Sheldon Grodsky from Grodsky Associates..

It's another disappointing quarter in terms of the bottom line which is what the world really looks at. But hopefully, we'll get out of this slump. I guess the ForEx and the customers have combined to create some disappointment here. Let me ask a question on revenues. You mentioned the ramp-up and you mentioned obvious things.

How much bigger do you think the business is going to be 2 years from now in terms of revenues?.

I would not be at all willing to forecast that at this point and we never have been. Too many things go right and too many things go wrong. You take a guess at it..

I thought I heard you say somewhere in the presentation that you expect revenues to pick up appreciably in the not-too-distant future.

Did I hear that wrong?.

We said that we expect revenues to improve. We didn't talk about some number that we'd be willing to give 2 years out..

How about 1 year?.

We can't..

How about 1 year?.

No, we don't do that based upon policy. There's too many things, too many moving pieces..

Okay. Well, this has been a kind of slow-looking ramp-up as all this ramping up -- the revenues haven't been ramping up. That's just part of the disappointment that we've all been through here. Okay, I'll let somebody else take the floor..

[Operator Instructions] And it appears there are no more telephone questions..

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

This concludes today's call. Thank you for your participation. You may now disconnect..