Brett Larsen - CFO Craig Gates - President and CEO.

Bill Dezellem - Tieton Capital Sheldon Grodsky - Grodsky Associates.

Good day and welcome to the Key Tronic Q1 Fiscal 2018 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, sir..

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 the 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 first quarter ended September 30, 2017.

For the first quarter of fiscal 2018, we reported total revenue of $109.2 million, compared to $117.1 million in the same period of fiscal year 2017.

During the first quarter of fiscal 2018, income was impacted by an unexpected approximate 4 million revenue drop, which was the result of delays in shipments due to massive flooding in Houston and an unrelated industry-wide shortage of key electronic components affecting a few larger programs.

In addition, we incurred approximately $0.3 million in statutory severance expense during the quarter in our Juarez facility, as we strove to react to the unexpected change in production requirements.

The unanticipated revenue short falls adversely impacted our margins and bottom line more rapidly than what we could adjust our variable production expenses. For the first quarter of fiscal year 2018, gross margin was 7.2% compared to 8.3% in the same period of fiscal 2017.

In addition, our gross margins continue to be adversely impacted by the ramp up costs associated with our new program wins, some of which have ramped slower than previously anticipated. Many of these new programs involve transferring ongoing production from a competitor's EMS facility to our own.

We expect to see gradually improving gross margins as these new programs move into full production, further utilizing existing production capacity. For the first quarter of fiscal year 2018, our operating margin was 1.1% compared to 2.4% in the same period of fiscal 2017.

Despite the sudden decline in revenue levels and the pressure on margins, we were able to reduce our operating expenses by roughly $0.8 million or 11% compared to the prior quarter. As a result, we offset a portion of the impact of the revenue miss to the bottom line.

Net income for the first quarter of fiscal year 2018 was $0.4 million or $0.04 per share compared to $1.8 million or $0.16 per share for the first quarter of fiscal year 2017.

Turning to the balance sheet, we continue to maintain a strong financial position as a result of ramping new programs and the sudden and unanticipated delays in shipments during the first quarter. Our inventory increased approximately 4% from the previous quarter.

We expect to see our net inventory levels gradually come in line with revenue levels as shipment delays are reduced and eliminated and new program ramps continue in coming periods.

Our trade receivables were $55.6 million at the end of the first quarter, down $9.6 million from the previous quarter, which reflects the decline in sales and improvement in collections during the first quarter. Our consolidated DSOs were around 42 days and we expect that our DSOs will remain under 50 days in coming quarters.

During the first quarter, we reduced our total debt by $1.8 million when compared to the prior quarter. Over the longer term, we expect to continue to pay down the term loans and the revolving line of credit at a more accelerated rate.

Total capital expenditures for the first quarter of fiscal 2018 were approximately $1.3 million and we expect CapEx for the full year to approximate $7 million. We continue to invest in our SMT, sheet metal, and plastic molding capability, but at a more moderated level than our investments in recent years.

Moving into the second quarter of fiscal 2018, we expect more of our new customer programs to ramp and to move into production. Due to planned closures during the Christmas holiday, production will be shortened by one week in most of our facilities and we expect continued softness among a few of our longstanding customers.

Taking these factors into consideration, we anticipate that the second quarter of fiscal 2018 will have revenue in the range of $110 million to $115 million. We expect that our overall gross margin percentage will improve sequentially from the first quarter, as new customer programs ramp and further contribute additional revenue over the longer term.

We anticipate the level of higher legal expenses to continue as we defend the company against a purported offer that we view not as possessing fundamental value to our shareholders. Taking the factors just mentioned into consideration, we anticipate earnings in the range of $0.07 to $0.14 per share for the second 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 are well positioned to win new EMS programs and to continue to profitably expand our business over the longer term.

That's it for me.

Craig?.

Okay. Thanks, Brett. As Brett noted, revenue for the first quarter was unexpectedly impacted by the historic flooding in Houston and by industry wide shortages of key electronic components.

While the anticipated revenue shortfall adversely impacted our margins and bottom line more rapidly than we could fully adjust our variable production expenses, we remain profitable in the first quarter.

At the same time, our new programs are gradually moving forward and we expect new programs we have won to contribute to higher revenue later in fiscal 2018, outpacing some of the weakness in demand from longstanding customers. We continue to see strong results from Key Tronic East, which you will recall, was acquired just over two years ago.

After closing our Kentucky facility and trimming non-profitable programs during the year, we are now seeing growth in revenue from these facilities. We believe that this reflects a growing appetite for US built products.

At the same time, we continued to capture significant new business from EMS competitors across all of our global locations, including established programs that will begin generating revenue in fiscal 2018. We recently won two new programs from EMS competitors, involving HVAC controllers and exercise equipment monitors.

Additionally, we recently signed a manufacturing agreement and began customer funding -- funded tooling related to a consumer security product. This product is already in production at a smaller regional manufacturer, but demand has far surpassed that supplier’s capacity.

We would normally announce this win next quarter as some details of the deal are yet to be finalized. However if the project proceeds as planned, it is expected to have a positive material impact on our results for the remainder of the second quarter and beyond.

If the deal is finalized within the second quarter, we will release further details of the program and update guidance as appropriate. Moving further in to fiscal 2018, we continue to see a strong pipeline of potential new business opportunities.

While there continues to be uncertainty in our market, companies continue to award programs to new suppliers. We have several new customers that have moved business to us, but it often takes time to transfer meaningful revenue from supplier to supplier.

As a result, we already incurred the expense of quoting, winning and transferring new business into our facilities while not yet enjoying the margins that will come as the customers completes the transition to us.

Going forward, a broader and more diversified customer base significantly lowers a potential risk and impact of a slowdown by any one customer.

Moreover, Key Tronic is well positioned for the returning tide of North American based customers as they correctly analyze the total cost for overseas production, pushing production into both Mexico and the US.

Our steady pipeline of new business opportunities continues to be boosted by our unmatched level of vertical integration, our multi-country footprint and the excellence of our manufacturing sites in comparison to other EMS competitors of our size.

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 US.

Moving into the second quarter, we expect to see many of our new programs continuing to ramp up, the continued on-boarding of several new customers and a strong pipeline of potential new business. By the second half of fiscal 2018, we anticipate stronger growth in revenue and improving margins.

Over the long term, we believe our new programs and customers will continue to grow far beyond their revenue levels today with our increased capacity and stronger operations potential to accommodate a more diversified customer base. Overall, we remain optimistic about our growth opportunities and our competitive strengths.

This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions..

[Operator Instructions] We will take our first question from Bill Dezellem with Tieton Capital..

I have a group of questions as always.

Let's start with the traditional one, which is what's the range of sizes of the announced wins?.

HVAC win is probably between 5 and 10. The exercise equipment controller is between 15 and 50..

So that range is so wide, I mean I have to ask, what would lead to the low end and what would lead to the high end, Craig?.

Well, there's a number of factors. I would guess the easiest way to visualize it is it depends on our performance on the first program versus the incumbent's continued performance on the programs he still has..

So the extremes would be that the incumbent does well, you do poorly, you're at the low end, the other extreme is you do well, the incumbent does poorly and you end up winning a lot more business and you end up at the high end..

Yes..

Understood. And then talking a bit more detail about the, I'm going to call it, prospective new customer, but it sounds like there's something more than that, but not quite enough to be listed as a customer.

What more can you tell us about that, about that program?.

We see the volumes that are currently driving demand for this customer and their material, which is why we've taken the extraordinary step of mentioning it at the stage we're at. We've already invested quite a bit of money in the design and engineering work that go with transferring the business.

And we were afraid to not mention it today and then come along a week later and mention this big win without any foreshadowing for the shareholders.

So after a lot of discussion, we decided that we needed to take more or less the middle ground and tell you folks that there's something big out there and we're pretty sure it's going to happen, but we're not to the point where we can officially come up with the press release telling you what it's all about..

And so kind of the two variables that I'm hearing you discuss are number one are how close it is to potentially being an official agreement or customer and secondarily, the other factor is the size and you put those two together and that's why you felt compelled to put in the release..

Yes..

Okay. That's actually quite helpful. Thank you.

And then the 4 million revenue impact, would you talk in a bit more detail about that and the degree to which they were just customer issues not related to components, not related to hurricanes, anything of that nature and the degree to which had those revenues materialized, would your guidance have been the same for the December quarter or would you have been building off of a higher base.

Hope I didn't pack too much in to all that..

I can answer that one Bill. So the $4 million revenue miss in quarter one was really related to two separate events. One was that we had a very large customer in Houston that was unable to process some shipments that we had fully anticipated building and shipping last quarter.

Those were essentially delayed by three months, so first quarter’s anticipated revenue just slides into now our second quarter. The other is some tightening in actually being able to bring in some key electronic components on a couple of other programs. The customers still has demand for those. We're in the midst of trying to expedite those orders.

That too would be a delay as we're hoping to get the components in play to be able to build and ship those during our second quarter. So those are included in the guidance that we have just given of $110 million to $115 million.

Does that answer your question?.

It does. And so just to make sure I'm following this that relative to Houston, they are back now on track and are ordering or taking shipments at their historic level.

Is that correct or is this a new customers that’s ramping I guess that could be part of what's going on?.

It’s actually a newer customer that's in ramp. So, yes, the demand is now where we had anticipated that it would have been a quarter ago..

That's helpful, Brett. Thank you.

And then the component shortages, is this something that -- now that we are this far into the economic cycle that for this customer, you anticipate dealing with kind of on a go forward basis or does this seem to be a bit of a unique situation?.

This is widespread across our industry. It's unique in that since I've been doing this since the 80s, I haven't seen widespread shortages that's projected to last as long as it's going to. So there were a lot of front ends.

This is mainly on silicon based electronic components and there are a lot of front ends, wafer fabs that were decommissioned years ago during the downturn that were never replaced. There have been a number of combinations of semiconductor providers businesses that have decommissioned fabs as a result of that.

And there's been a general reluctance among those companies to increase capacity because they were unsure of what's going to happen.

Meantime, the amount of electronics that go inside of a car, there is multiple PCs worth of electronics in a car now and that is driving demand along with the Internet of things, driving demand and it takes a year and half to two years to build the wafer fab. So this shortage is projected to continue for a year to year and a half from now.

And we have a number of suppliers who are not taking orders. They don't know when they're going to start taking orders again and we have other suppliers with lead times have gone from 15 to 45 weeks. So it's unique in the length that we see.

You remember a while back, I don't know how many years ago, we had this strange capacitor shortage and that lasted about nine months, but this is more widespread and it's going to be longer.

So there's a lot of engineering work and procurement work that’s going in to finding replacement components, retesting with components that aren’t quite replacement, but they'll work, relaying outboards, customers are having to requalify a product with the replacement component. And this is across the industry, it’s not just with our customer base..

I'm going to switch to one more question before I step off and that's the long term obligations or other long term obligations on the balance sheet. What's behind that and I asked the question because it was 7 million or so a year ago and is now 300,000 or so..

A lot of that long term obligation consists of two things.

One is just the classification of deferred tax liabilities, which change over time and the other piece is long term forward hedges that we've discussed in earlier releases that we're burning off those deferred tax liabilities as we get closer to a point in which the forwards match what today's spot rate is..

Thank you. I apologize that I keep forgetting about that and good luck with bringing in the final pieces of this large prospect..

[Operator Instructions] And we will take our next question from Sean Divine with JCAM Investment Company..

Hey. This is actually Vad stepping in for Sean. He just actually had to step out. We've spoken with you guys for multiple years and I have kind of a multiple series of questions over here.

The one, for the quarter, what was the impact of hedges on the P&L and 10-K would appear to be that you guys are going to get hit for another, by about 1 million or so for the next few quarters.

Is that roughly the range that you got hit upon on operating income for the quarter?.

Yes. As disclosed in our footnotes in the 10-K, that did transpire..

So that was roughly what –.

Four contracts are contractually required to settle with our bank. Yes..

So, do you have an exact number in front of you for the quarter, because -- obviously it’s an estimate which you put in 10-K but I’m assuming it was what, I mean, without, it would appear to be somewhere –.

It was over 1 million and less than 1.5 million. Roughly 1.3 million..

So that would and I know you’re not going to necessarily break it out in the press release, but it would be helpful for people to kind of just set the number, real numbers, closer to 2.5 on operating income roughly. That’s one.

Two is how long will those hedges according to 10-K, those will run off or kind of get back to closer to the spot rate and it’s about two quarters, is that correct? So for the next two quarters, assuming the prices did not move according to the 10-K, you’ll have another 1.5 million or so hit for the next two quarters and after that, it becomes slightly positive, right?.

Yeah. I believe the next two quarters are about 1.3 million, down to 1 million and then just less than 400,000..

Okay. And then the next question is, this one is more strategic in nature.

Obviously, you guided the component shortages appear to be industry wide, so it’s not unique to you, since you said it’s mostly related to silicons, so it’s mostly related to semiconductor shortages and that is probably going to last for a little over, for the guidance that you have for the next quarter, does that anticipate continuation with current state, 30 state supply issues or is that baking in any pressure for pricing.

Obviously, the logical thing will be, you assume there was a loss stuff in the previous cycles, when there were supply shortages, the pricing got impacted and are you seeing any of that yet?.

We haven't seen any pricing impacts that have stuck..

But you've seen the most -- delays on timing..

Delays and lead times expanding..

And then obviously the next thing obviously is it’s hard to fault for specific quarter, considering the Houston situation and some supply shortages, but we -- just like any other investors or your quasi suitor, I'm not sure you can really perceive that offer to be real at this point that there is no real filing, obviously, some of the numbers they have quoted and the conversation we had in the past is I could have probably written a press release for you guys, it's usually something like unexpectedly impacted by X, Y and Z and we expect to keep winning programs and things will turn around next quarter, but obviously that’s been going on for about four years.

And now that you have your essentially a target of unsolicited real or not takeover and you have supply shortages which obviously some smaller names, smaller PCB or CMs are having, not necessarily – it’s not necessarily hitting the larger player in the same way, at what point are you actually -- is the board going to consider some other strategic alternatives other than just continuing the status quo of waiting for 18 months from now or whenever the number is to get some impact or actual positive impact to shareholders?.

We have no comment on that..

At some point, I know your hesitancy on that and I wasn't or in the situation you are in right now where this offer is not even concur over a lot of your comments, but necessarily disagree with any of the factual information that you can expedite either.

I mean as a shareholder, when should we be expecting some positive movement in the stock price or some returns for us to shareholders?.

Vad, you called in under a false name. I think we're done answering your questions. We’ll hang up..

We’ll take our next question from Sheldon Grodsky with Grodsky Associates..

I'm calling under my own name. A couple of questions. Is there anything that you can see that is serious about the contracts of activities? I mean it doesn't seem real. The stock market doesn't seem to be taking it seriously. I don't seem to be taking it seriously.

Is there anything -- any elements of reality to it or are these guys just well are from an alternate universe and putting out press releases..

Yeah. So let me read you what my lawyer said I have to say. On that subject, we have nothing to say in addition to what we have already said in our three press releases of 10.26, 9.15 and 9.16, all of which can be found on nasdaq.com. Next question. Sorry. I really am. I wish I could talk about it more..

The next question I might agree a little bit with what the previous call was saying, you haven't had a good year in a long time. I've been sitting here as a shareholder kind of expecting the next quarter or the quarter after that is going to be a breakout quarter and we don't seem to be getting the breakout quarter.

I mean I assume that you would like to see your return on equity in double digits.

That would be a reasonable target rather than where we've been kind of hanging out and I don't know, it sounds like this new deal that isn’t the deal yet maybe something to help accelerate the process, but I knew it’s said earlier, earlier than today and probably again today that you’re expecting better results in the second half of this year, although obviously the first quarter was a setback.

And I think you said that you expected to, paraphrasing, a lot higher volume probably in the next year than you’re doing now.

So am I misinterpreting what you're saying or does it appear that you're -- things are about to come to fruition, about meaning in the next couple of quarters in terms of finally getting out of this negative rot you’ve been in?.

Well, so if we put this all in perspective, you’ve asked an overarching question so you’re getting a pretty long overarching answer..

Good..

About two years ago, our largest customer was almost $90 million in revenue per year. That customer funded the purchase of Ayrshire which has turned out to be a fantastic purchase. That customer then went almost bankrupt and is now dropped off our revenue completely.

So in the past, almost two years, we've been replacing that 90 million of revenue with new customers.

As we've been doing that, we've pretty much been able to tread water in terms of our revenue and our margin, even though it's been a mad scramble to replace that 90 million of one customer of essentially one product, which we’re able just to run down a line pretty much with the lights out, no effort whatsoever in terms of management or oversight.

It just fell together and we shifted. So during that year and a half to two years, we've been scrambling like mad in adding customers and adding revenue and adding programs and adding capital expense to replace that 90 million with more business.

So we keep talking about the fact that we're optimistic because we've been able to add those customers and fill that hole left by, at that point, almost a third of our revenue, while staying positive, while staying in compliance with our bank loan and while adding new customers, which is expensive and costs a lot more effort than just running steady state.

The reason that we keep saying we're optimistic is that soon, hopefully, within a couple of quarters, we're going to replace that 90 and all the business we've been adding is going to show up on growth of the top line.

The reason that we've been delayed by over a half a year, longer than what I thought we're going to be is that there's been a fundamental change in the contract manufacturing market. If you follow it, a couple of years ago, people were still talking about 10%, 12% CAGR. If you look at it now, it's projected to be flat.

And we've experienced that ourselves as some of our current customers have gone away, they haven’t found new suppliers, but their business has softened.

So what has surprised us and why we're not at the point where we're seeing top line growth like we thought we would, instead we’re struggling to maintain the top line is that three of our long term good customers have seen softening in their business.

So, the reason we remain optimistic is that we see all the new customers that are coming in, we see the pipeline of new customers that we're bidding on and we see the products that are ending up in our factory that are kind of like a duck swimming like crazy underneath the water, but all you see above hand is we're basically staying steady with the shoreline.

But in general, unless things turn to crap with the economy, somewhere in the next two quarters, we should climb above that $90 million loss and start to grow at a rate that you'll see rather than just as replacing the loss. So that's a long answer to your question..

So you are expecting that growth, did you say that you have a lot of extra capacity to supply?.

Yeah. So we're running at about 75% capacity right now. So the other point you need to realize is that in this business, once you get above breakeven, revenue starts dropping to the bottom line at a nice rate. So today, we've got a good 25%, 30% growth capacity cooked into a lot of our capital expenses. That was a pretty random sense.

I’m trying to say that we don't have to spend a whole lot more capital until we grow more than 25% of where we are now.

So we've got floor space, we've got capital, we've got people to get there and if we wanted to be a higher margin business right now, we could make cuts across the board and manage our current customers, but that would be a lot more shortsighted than what we think we want to be because with the advantages we've talked about, we continue to win customers.

And we don't understand, we don't see why we can't grow once we replace this hole that got dug for us by our other customer. And when we do grow, the margins will be very, very nice..

We will go back to Bill Dezellem with Tieton Capital..

Craig, you were just talking about winning new business, would you characterize your win rate today versus maybe what it was 18 months ago and three years ago. It seems like in the marketplace, you may be perceived differently than you were in prior years..

Well, for sure, there's a couple or three things going on that are all good. One is the addition of the engineering resources to the east, we call them the East there, the Ayrshire acquisition. So the addition of the Key Tronic engineering resources to the East's prospective and current customer base is having a really nice effect.

As we said in the press release, the East has grown quite well. So their win rate has gone up quite a bit from what it was before we purchased them. The second side of that is there are a number of customers that are just starting with the East that if they hit their projections will end up with us in either Mexico or China as they grow.

So those customers, we never would have seen as we didn't have a US based manufacturing structure to service them. So that's pretty cool in terms of what's going to happen in the next year or so as these new programs take off and grow out of the capacity of the East.

And then the third part of it is that the combination of the East and the West in terms of quoting products has made us much stronger in quoting, so our win rate has gone up, although you haven't yet seen the impact on our top line and bottom line.

For example the products we announced in our press release, the monitor for exercise equipment won't even go into production until middle of this coming summer. And once it does, it will be a nice, sticky engagement we believe as it was a sticky engagement with their former folks.

But it'll take that long to get the new design completed and get it prototyped and get it running, even though we already know what the revenue is going to be and even though we know the timing, it just takes that long..

And kind of continuing down this same path, how about characterizing the type of business that you are bidding on and winning today versus the type of business that you were winning in prior years.

Has that changed at all and if so how?.

Yeah.

There's a -- if you look at the change in the CAGR for contract manufacturing, what it looks like, if you throw it into a classical business analysis, is that the industry has gone almost to maturity in terms of growth and therefore starting to flatten out and people buying each other and the part that's answered your question is that the type of business we’re quoting on today is almost all being stolen or earned, actually, a better word -- being earned away from a current contract manufacturer.

Two or three years ago, we were -- and up until two years ago, a lot of our business came from OEMs who had stayed in production themselves too long and were in desperate need of outsourcing. So that drove the business transfer and the business decision to be much quicker.

Today when we earn a piece of business from a competitor, the process is long because there is no huge driver, there's nobody that's desperate there, just people who are very unhappy.

So along with that maturation of the contract manufacturing industry goes a change in the type of business that we can look at and a change in the time it takes to win it and the change in the time it takes to transfer it. And that's also in part an answer to the previous caller's question on how come this damn thing has taken forever..

And I’m going to take this one step further, if you don't mind, and that is if the existing companies are maturing in this process, there always seems to be a new start up around that 9 of 10 die, but one turns out to be a great thing.

Is there a way to participate in that end of the spectrum of the market or is that simply too risky?.

Well, there's ways to participate with the startups and we -- a couple of our new pieces of business look like they're going to be from, I guess, 2 to 4 year start-ups.

So there are ways to do it and we'll talk about that probably a couple of quarters from now when I hope we can pound on or just and say, oh, this has worked for a while, this satisfaction, but I don't want to talk about it now..

[Operator Instructions] And at this time, we have no further questions. I will turn the conference call back over to Mr. Gates for any closing comments..

Okay. Thank you again for participating in today's conference call. Actually, thank you to everybody except Vad. Vad, don't bother trying to call in again under assumed name. That's not critique. Brett and I will look forward to speaking with the rest of you again. Thank you and have a good day..

Ladies and gentleman, this will conclude today's conference call. We do thank you for your participation and you may disconnect at this time..