Brett R. Larsen - EVP of Administration and CFO Craig D. Gates - President and CEO.

Matthew Dhane - Tieton Capital Management George Melas - MKH Management Eric Landry - BML Capital.

Good day everyone and welcome to the Key Tronic Third Quarter of Fiscal 2018 Conference Call. Today's call is being recorded. At this time, I would like to turn the call 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 that 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 ended March 31, 2018. For the third quarter of fiscal 2018, we reported total revenue of $108.4 million, compared to $113.6 million in the same period of fiscal 2017.

Most of our new programs continued to ramp steadily during the third quarter of fiscal 2018, though overall revenue and productivity was adversely impacted by industry-wide shortages in key electronic components and unexpected delays from one large new customer.

For the first nine months of fiscal 2018, our total revenue was $329.3 million, compared to $349.3 million in the same period of fiscal 2017. For the third quarter of fiscal 2018, gross margin was 7.5% and operating margin was 0.7%, compared to 8% and 1.6% respectively in the same period of fiscal 2017.

Our gross margin was impacted during the quarter with severance costs of approximately $500,000 associated with reducing headcounts within our Juarez operation. Gross margin also continued to be adversely impacted by the component shortages coupled with ramp-up costs associated with our new program wins.

Many of these new programs involve transferring ongoing production from a competitor's EMS facility to our own, which has exacerbated the length of time it has taken to get to full production volumes. We expect to see gradually improving gross margin as our new programs move into full production, further utilizing existing production capacity.

We also continue to expect that new programs will fit into existing production equipment capacity and require less labor content. As a result of capital investments and streamlining efforts, we expect the total cost in Mexico will be reduced by approximately 9% in the coming quarters.

Our China facility continues to be profitable, supporting current programs and provides a competitive manufacturing option in Asia for locally sourced programs. Moreover, our U.S. facilities are proving to be increasingly profitable and we expect to see further growth in these locations.

In support of future domestic growth, we are investing in a newer leased Fayetteville, Arkansas facility that will gradually replace the current location in the coming months. In addition, we have increased our footprint in our Oakdale, Minnesota facility by leasing additional space contiguous to current operations.

For the third quarter of 2018, we had net income of approximately $0.6 million or $0.06 per share compared to $1 million or $0.09 per share for the third quarter of fiscal 2017.

For the third quarter of fiscal 2018, the expected expenses in connection with a binding arbitration hearing and the severance expenses related to streamlining the Company's facilities in Mexico reduced our earnings by approximately $0.10 per diluted share.

For the first nine months of fiscal year 2018, net income was $0.9 million or $0.08 per share, compared to $4.3 million or $0.39 per share for the same period of fiscal year 2017. As previously discussed, year-to-date net income for fiscal year 2018 includes a $1.1 million discrete tax expense that resulted mainly from the U.S.

tax reform earlier in the calendar year. Turning to the balance sheet, we continue to maintain a strong financial position.

As a result of ramping new programs and delays in shipments due to component shortages, our inventory increased approximately 6% from the previous quarter and our trade receivables at the end of the third quarter were also up 6% from the previous quarter.

You will recall that our inventory and receivables levels in recent quarters have included approximately $10 million of purchased and paid inventory and receivables due from a former customer.

We just completed the binding arbitration hearing concerning this matter during the third quarter of fiscal 2018 and expect to receive the arbitrator's ruling during the fourth quarter.

In addition to the inventory at issue in the arbitration, we are also pursuing reimbursement for certain cancellation fees and other carrying costs already expensed but believed to be contractually due from the former customer. We have not accrued for any outcomes related to this claim, which could result in a one-time gain or loss.

Legal costs are being expensed as incurred. The ultimate disposition of this matter and any gains or losses are unknown and could have a material effect on the consolidated financial position, results of operations, and cash flows.

Irrespective of the outcome of the arbitration, we expect to see our net inventory levels gradually come more in line with the increasing revenue levels as component delays are addressed and new program ramps continue in coming periods. We expect our consolidated DSOs to remain around 40 days in coming quarters.

By carefully managing payables during the third quarter, we reduced our total debt by $2.1 million compared to the prior quarter. Over the longer term, we expect to continue to pay down the term loan and revolving line of credit.

Total expenditures through the third quarter of fiscal 2018 were approximately $4 million and we now expect CapEx for the full fiscal year to approximate $5 million. We continue to invest in our SMT, sheet metal, and plastic molding capabilities, but at a more moderated level than our investment in recent years.

Moving into the fourth quarter of fiscal 2018, we expect more of our new customer programs to ramp and move into production, including the potentially large program for consumer security devices announced today. In addition, we see increased forecast demand from two of our largest long-standing customers.

Taking these factors into consideration, we anticipate that the fourth quarter of fiscal 2018 will have renewed sequential revenue growth with revenue in the range of $112 million to $117 million. During the fourth quarter, we anticipate renewed sequential earnings growth with earnings in the range of $0.11 to $0.16 per diluted share.

This assumes an effective tax rate of 20%. In summary, we're encouraged by the prospects for future growth in revenue and earnings. We also look forward to resolution in the arbitration.

The overall financial health of the Company is strong and we believe that we are well positioned to win new EMS programs and continue to profitably expand our business over the longer term. That's it for me, Craig..

[Indiscernible] We continue to see a strong pipeline of potential new business. We were very pleased to announce today that Key Tronic began manufacturing for SkyBell Technologies, a global leader in patented Wi-Fi video doorbell technology that improves home and neighborhood safety.

SkyBell views us as an important strategic partner to increase product availability to fulfil demand in its new distribution channels. SkyBell also plans to leverage our expertise in manufacturing capabilities to help accelerate the introduction of its expanding line of Wi-Fi video doorbell products and accessories.

This important new relationship is projected to expand our customer base and is expected to contribute to profitable long-term growth. Once fully ramped over the next few quarters, we expect SkyBell could become 10% or more of our total revenue.

As we discussed on our last call, we see continued strong results from [Key Tronic East] [ph], which you will recall was acquired over two years ago. We believe that this reflects a growing appetite for U.S.-built products and the significant value of having highly efficient domestic production facilities.

At the same time, while we are carefully managing our expenses, we are making investments in SMT, sheet metal and plastic molding capabilities in both Mexico and the U.S. These investments are expected to enable planned future growth with lower labor cost.

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 U.S.

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 site, 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 U.S. Moving into the fourth quarter, in spite of continued significant supply-chain issues, we expect renewed sequential growth in our revenue and earnings.

Two longstanding customers are significantly increasing their forecast demand, our new programs continue to ramp, and we have a strong pipeline of potential new business.

In preparation for future growth, we continue to invest in new equipment and processes to be more productive with less labor content in our Mexico facilities, and we are expanding and enhancing our highly profitable U.S. facilities. Overall, we are efficiently 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'll take our first question from Matt Dhane with Tieton Capital Management..

In the press release discussing the SkyBell win, you referenced that there is additional channels that are waiting to sell SkyBell's products. I was just curious if you could add some color around that, how significant are these channels and how quickly they could ramp up, and in there the potential impact to you folks..

The SkyBell product competes with Ring, and as you know Ring was purchased by Amazon. So, the retailers in the world do not want to be buying a product from their worst and most vicious competitor. So, the impact on SkyBell's sales from that development looks to be very positive..

So it's really primarily through the retail channel, that's the real focus with this product thing, Craig?.

No, that's just the new channels that are opening up. The existing channels are more Fortune 500 and very large home security and home controls type companies..

Okay.

And so, that's what you'd initially be manufacturing product for, is their existing channels, and then they have expectations of having success in current Ring customers, since Amazon purchased Ring for I guess was it $1 billion or more not that long ago?.

I don't remember the number, but it was big. Actually SkyBell has already seen success in some of those channels. So, it looks pretty probable..

That's great. It sounds like a great win for you folks. I'm very excited to see the results. I wanted to also touch on Mexico and the streamlining of the facilities there in Mexico.

Where are you at in that process and when do we really start seeing the financial ramifications of that?.

So, our severance occurred during the third quarter where we were able to reduce a number of headcounts. That is now complete. We are expecting to now reap the benefits of that moving into our fourth quarter..

Okay. Gross margin, wanted to also ask a question around that if I could, I believe in the past you have talked about a 9% plus goal for that with the increase in revenue.

I was curious if that's still a reasonable expectation and if you see the pieces in place now within your revenue base to generate that here within the next six months or a year, or just help add some color around that if you could?.

I don't think that that has changed as far as a goal. The pieces are in place now, provided that the supply-chain starts to [indiscernible] itself up with more capacity in the electronic components market. With the customers we have and the cost structure we now have in place, I think that 9% is still achievable..

And talking about the component shortages and the challenges that's creating, do you see changes taking place within the component electronic manufacturers that may facilitate that taking care of itself?.

The issues are pretty widely acknowledged amongst all of the EMS competitors and there is a pretty strong consensus that it's probably going to get worse before it gets better. The timeline still looks like it should get better within the next 12 months but no more sooner than that, and it's kind of shifting.

It started off with the higher end integrated circuit components and it's actually now spread like a virus into the very simple passive, so capacitors, resistors and things that you can't believe they never run out of, the world is running out of..

Interesting. I appreciate the help, gentleman, and good luck with the shortages and all the best as you ramp up SkyBell..

We'll go next to George Melas with MKH Management..

Just a follow up on your previous question regarding the component shortages, how is that really affecting you on the revenue line and on the gross margin [indiscernible]? I imagine some of the higher cost of components you can pass through [indiscernible] impact on your [indiscernible] productivity..

It's kind of insidious. It gets everywhere, George. So, first of all, we can in many cases pass along PPV, purchase price variance, on to our customers. That's getting easier as it's more widely acknowledged that it's a market condition.

But it certainly takes away any opportunities for negotiated cost reductions when we have no [indiscernible] threat in our negotiations. It's pretty tough to drive prices down. So you are lucky to hold prices steady. At the same time, suppliers will not ship parts that they have committed to ship and give us manufacturers zero warning of that.

So, we can have an entire line worth of people, 300 or 400 people, show up on a Monday and Monday afternoon the shipment of capacitors that was supposed to be there for Tuesday doesn't show up. So, everybody stands around getting paid making no product.

And then finally, when you have all the parts there except for one part and you can't build products for a week or a month or six months, your inventory gets impacted because you've got everything else except for maybe one capacitor. So, that drives our capital requirements and cost of capital level. So, it has a pretty broad effect..

Okay. [Indiscernible] what is sort of the history of that because it took longer than probably you thought to close that deal.

Is there any way you can give us some color about sort of [indiscernible] that process and how long it took you, and why was it sort of [indiscernible]?.

It's a pretty complex transfer around the current contract manufacturer, it's complicated, much worse than an ongoing piece of business is by the lack of materials. And when you handoff from one contract manufacturer to another, that's never pretty.

And when you handoff between one manufacturer to another in the midst of a massive component shortage, it's even uglier. So, the demand that we see for the product remains incredibly strong.

Our issues have been with securing and guaranteeing the supply-chain and we didn't want to announce that the project had started until we were reasonably confident that we could get parts to actually build it. So that's been the majority of the delays from when we thought we were going to announce it to today when we did announce it..

Got it, okay, great.

And just in case, [indiscernible], can you give us a bit of a range on the size of the deal that you closed during the quarter?.

Yes. So, in the order in which they are listed, let's call it [5, 10, 5, 3, 5] [ph], and very big..

[Indiscernible] And then just [indiscernible] my question in a way, how long do you expect to get to these levels of [10, 5, 2 and 5] [ph], is it going to be 12 months, is it 24 months?.

Actually for once it seems like the last two years everything we say is going to take forever. In this case, the first two are actually lapping today. It should be in full production by the end of this quarter.

And then the second two are probably six months and then the last one we are producing SkyBell now but at nowhere near the rate that we hope to see once we get all the supply-chain figured out..

[Indiscernible].

I couldn't hear you. You kind of garbled, George..

I'm sorry.

How come those [indiscernible] accelerated compared to I think what we have seen in the past?.

There is kind of a – this is a theory not a fact, but what I believe has happened is that probably 2.5 to 3 years our metal shop capabilities and integration capabilities in Mexico have allowed us to bid programs at prices that were below what most of our competitors could bid.

And what I expected to happen which is that our competitors would throw in the towel pretty quickly, didn't happened and instead for 2.5 years they tried to continue to compete and priced it below where I think they could do a good job of providing the product.

And just in the last four or five months, we have seen a number of those competitors try to impose significant price increases on our customers, at the same time that they were providing pretty poor service and quality. And so, those customers have now switched in kind of a sea-tide to us. When the demand used to be split, it's no longer split.

It's all mainly coming to us.

The other thing we see is that in a couple of our big customers, they had been managing through kind of a consistent downturn of their business, so over the past three to five years, and their teams had never lived through an unexpected upside and didn't really understand the value of short cycles in terms of supply chains and product [indiscernible] and upside capacity.

And now that those customers have actually seen a blip in demand, they have been unable to meet that blip. And so, performance that was once really exciting before where they saved $5 or $10 on a product by moving it somewhere along their way, that $5 or $10 is now insignificant when it's compared to being unable to ship a $2,000 or $5,000 product.

So, it's a couple of things that have combined to make some of these programs much quicker than our normal, and I hope that my theory is right and it keeps happening that may..

It's an interesting one because you've been really working for the last two years [indiscernible] to provide all these integrated [indiscernible] and you are suggesting that [indiscernible]..

Yes, it's easy to get too encouraged but six months ago we were laying off people in our sheet metal shop and today we are hiring as fast as we can and looking at buying more laser [indiscernible] and everything else. So, I'm thinking it has turned on us the right way..

Okay. Good luck..

We'll take a follow-up question from Matt Dhane with Tieton Capital Management..

I did want to circle back around and ask another question or a question I should say about your U.S. facilities. You sounded more optimistic about the prospects for the U.S.

facilities and I have heard in quite some time, and I know you covered some of the details on the call, but I was just hoping to have a little bit more color on what's driving the capacity expansions and how long until it starts having an obvious benefit to us as outsiders, with revenues and so forth?.

I think you are probably looking at maybe six months before you see an obvious benefit from where the East is running today. Programs that they have won are in the ramp phase right now and that's what's driving capacity expansion.

Particularly our Minneapolis facility was full and they were continually being just bombarded with customer visits and customers like to see if they get the space [indiscernible] out-square on the floor where their product is going to go, and Minneapolis facility was full. So, that has driven that expansion.

It's almost a doubling in size for them and it looks like that market, Minneapolis market in that area is really strong.

So, we continue to win new programs up there and the Fayetteville, Arkansas facility was a move out of a very old and dilapidated facility with old equipment that showed really poorly to customers and yet they had retained the majority of their customers and were continuing to win more.

So, we also believe that moving them out to a new facility is going to be a very positive, is going to have a very positive effect on their ability to win new programs above and beyond what they have already won.

The final, as we talked earlier about the fact that the OEM business had become more and more commoditized over the past three years and that we had reacted by focusing more and more on sales, so at this point we have increased our field sales force by almost 80%, we have almost doubled the number of reps that we have onboard, and we have put a lot of effort into our quoting processes and manpower.

So, we are creating more times at that and we are getting a better sling and we do get up to the plate..

That's great to hear. And the pipeline that you spoke about, you said there is a really good pipeline of opportunities that you have out there.

Are those more heavily weighted then to domestic opportunities than in the past as well?.

Certainly in the past before we bought Ayrshire, definitely.

I would say after we bought Ayrshire, there was probably a year to year and a half where the Eastern division guys were kind of seduced by the pricing available out of Juarez and we took our eye a little bit off the ball, are continuing to drive the U.S.-based facility as far as they could be driven for pipeline and new business.

So, we corrected that as probably a year and a half ago, almost two years ago, and we're seeing the fruits of that too. So, it's not necessarily that we have more in the U.S. than we used to.

It's just that we have more period and we're doing a better job of having the old sales guys – when I say the old, not the guys that are over 50, I mean the long-term employees, selling the East as they understand their capabilities better and the East traditional sales guys now understand Juarez and China better and the capabilities here in Spokane.

And then the new guys we brought on are more industry-specific who have a lot more ties into certain industries and have actually resulted in RFQs in record time compared to when we used to bring a sales guy on five or six years ago..

Great, that's really helpful and I appreciate the time..

Let's take a follow-up from George Melas with MKH Management..

Quick follow-up on the balance sheet, Brett, if the arbitration goes your way, which I think it will, [indiscernible] what could the balance sheet look like at the end of this fiscal year?.

I know that we have disclosed that the total amount owed from this former customer is just over $10 million. Predominantly that is inventory..

That's not the total amount owed. That's the total amount of [indiscernible]..

So we have got approximately $10 million of inventory on the books related to this arbitration..

And there is perhaps we believe quite a bit more than that due in interest and storage expenses and cancellation fees and things that we have already expensed. It would be really nice if we were to get awarded more than the $10 million, like we hope, but it could go the other way too..

So, with that in mind, George, my hope and intent is that we get back to four turns of inventory a year..

That's the goal..

It's going to take us a while to get there..

Okay.

What would it take to get there besides of course reducing inventory for that arbitration ruling?.

I think as well as what Craig mentioned, the effects of shortages in some of the electronic components has also added to the inventory on balance sheet as well as bringing in inventory early for production ramps..

Okay, great. Okay, very good. Thank you..

We'll go next to Eric Landry with BML Capital..

You mentioned four wins during the quarter, a 10, a 5, a 3, and a 5, is that an annual run rate that you're quoting?.

Yes..

Okay. And then I think that the prior quarter you quoted one was 5, one was 15.

Are those different than these that you just quoted this quarter?.

Yes, every quarter we try to only talk about the wins as those that occurred within the quarter.

We always have a hard time, we have to sit down around the table and say, what are we considering win, we have a handshake agreement, we have a signed contract, we have a signed contract and we have POs, we have signed contract, we have POs, we are beginning production but we can't get any goddamn parts.

So, it's hard to figure out win but we don't double-count anything. So that I can tell you, we never double count it..

So these are POs, is that what these are?.

These are, these range from PO, PO contract, contract in negotiation, and production has already started..

Okay, so the contract come before a PO or is it [indiscernible]?.

The wonderful thing about this business is it happens every which way you can think of..

Okay, I got you.

All right, so just if my math is correct here, it's somewhere perhaps approaching $100 million in new business you talked about over the past couple of quarters, correct?.

That's what the customers have told us. They have disappointed us before..

Any reason to believe they will disappoint you going forward?.

History would suggest..

Okay, great. Thank you..

And with no further questions in the queue, I would like to turn the call back over to Craig Gates for any additional or closing remarks..

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

This does conclude today's conference. We thank you for your participation. You may now disconnect..