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 Inc. Bobby Nouredini - BBN Management, LLC George Melas - MKH Management Company, LLC.

Good day, everyone, and welcome to the Key Tronic Q4 2018 Conference Call. Today's call 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 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 website. Today, we released our results for the fourth quarter and year ended June 30, 2018. For the fourth quarter of fiscal 2018, we reported total revenue of $117 million up 8% from $108.3 million in the prior quarter.

We saw increasing demand from a number of our long-standing customers, and most of our new programs continued to ramp. Once again, our overall revenue and productivity would – was adversely impacted by industry-wide shortages in key electronic component.

For fiscal 2018, total revenue was $446.3 million compared to $467.8 million for the fiscal year 2017. For the fourth quarter of fiscal 2018, our gross margin was 8% and operating margin was 1.8% compared to 8.3% and 2%, respectively, for fiscal 2017.

Our gross margin continued to be adversely impacted by the component shortages, coupled with the 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 increased the length of time it has taken to get full production volumes.

We expect to see gradually improving gross margins 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 reduced our operating cost in Mexico substantially during fiscal 2017, and we plan to further invest in new sheet metal production equipment that will also reduce labor requirements on new programs 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 continuing to be profitable, and we expect to see further growth in these locations.

In support of future domestic growth, we're investing in a new replacement Arkansas facility along with new SMT equipment and will increase our leased square footage and capacity in our Minnesota facility in the coming quarters.

For the fourth quarter of fiscal year 2018, we had net income of approximately $1.3 million or $0.12 per share compared to $1.3 million or $0.12 per share for the same period of fiscal 2017. For the fourth quarter of 2018, the anticipated expenses, in connection with binding arbitration hearing, totaled $0.03 per diluted share.

For fiscal 2018, net income was $2.1 million or $0.19 per share compared to $5.6 million or $0.51 per share for the fiscal year 2017. As previously discussed, net income for the fiscal year 2018 includes $1.1 million of discrete tax expense that resulted mainly from the U.S. tax reform earlier in the calendar year. Turning to the balance sheet.

We continued 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 4% from the previous quarters.

Trade receivables at the end of the fourth quarter were also up 6.5% from the previous quarter as a direct result of sequential revenue growth. Note that all the results of the fourth quarter of fiscal 2018 presented today do not reflect any gains or losses associated with the recent arbitration hearing relating to collecting from a former customer.

We expect the award of the arbitrator to be made in the coming weeks. You will recall that our inventory receivable levels in recent quarters have included roughly $10 million of purchased and paid inventory and receivables due from the former customer.

In addition to the inventory issue and the arbitration, we are 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 associated gains or losses are unknown and could have a material effect on the consolidated financial position, results of operations and cash flows for the fourth quarter of fiscal 2018 and/or future expected results.

Nevertheless, we spent approximately $2 million during the year on legal fees associated with this arbitration, which are now behind us.

Irrespective of the outcome of the arbitration, we expect to see our net inventory levels gradually come more in line with 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 the coming quarters.

By carefully managing payables during the year, we reduced our total debt by $8 million compared to the prior year-end. We hope to accelerate our reduction of debt in coming quarters. Over the longer term, we expect to continue to pay down term loans and the revolving line of credit.

Total capital expenditures through the fourth quarter of fiscal 2018 were approximately $1 million, and were $5 million for the full fiscal year. We continue to invest in our production facilities, SMT equipment and sheet metal and plastic molding capabilities.

We plan to spend approximately $8 million in capital expenditures in fiscal 2019 to keep up with recent new program wins and to invest in future growth. Moving into the first quarter of fiscal 2019, we expect more of our new customer programs to ramp and move into production.

In addition, we see increased forecast demand from some of our largest long-standing customers. Taking these factors into consideration, we expect that the first quarter of fiscal 2019 to have continued sequential revenue growth, with revenue in the ranges of $118 million to $122 million.

For the first quarter of fiscal 2019, we also anticipate sequential earnings growth, with earnings in the range of $0.12 to $0.17 per diluted share. This assumes an effective tax rate of 20%. In summary, we are 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 continue to profitably expand our business over the longer term. That's it for me.

Craig?.

Thanks, Brett. While 2018 was a challenging year, we replaced the revenue shortfall caused by the large former customer, significantly diversified our customer base, reduced our debt and returned to growth. During the year, our business was adversely impacted by several unrelated events, the massive flooding in Houston, changes in U.S.

corporate tax laws, new tariffs, severance costs associated with efficiency gains in Mexico, unexpected reductions in delays from a few large customers, substantial legal expenses in the collection and arbitration effort and the industry-wide shortages of key electronic components.

Despite these challenges, our total revenue grew 8% sequentially in the fourth quarter. In the fourth quarter of fiscal 2018, we saw increasing demand from a number of our long-standing customers, and most of our new programs continued to ramp.

During the fourth quarter, we began the ramp of product for SkyBell Technologies, a global leader in padded Wi-Fi video doorbell technology that improves home and neighborhood safety. As we discussed last quarter, this important new relationship is projected to expand our customer base and contribute to profitable long-term growth.

Once fully ramped over the next few quarters, we expect SkyBell could become one of our largest customers. During the fourth quarter, we also continued to win significant new business from both EMS competitors and also from existing customers.

During the fiscal year, we won 11 major new programs, involving HVAC controllers, exercise equipment monitors, Internet of Things for consumers and consumer applications, gaming equipment, medical devices, home security, distribution services and electronics signage.

Our broader and more diversified customer base significantly lowers the potential future impact of a slowdown by any one, single customer. At the same time, our productivity continued to be adversely impacted by industry-wide shortages in key electronic components, resulting in delays in delivery, expanding inventory and increased costs.

Moreover, we are seeing the impact of new tariffs in the cost of manufacturing in China, and the threat of trade wars is raising uncertainty in the market.

Nevertheless, we're increasingly well positioned for the returning tide of North America-based customers as they correctly analyze the total cost for overseas production, pushing production into both Mexico and the U.S. As we discussed in our recent calls, we see continued strong results from our domestic facilities.

We believe that this reflects a growing appetite for U.S.-built products and the significant value of having highly efficient domestic production facilities. While we are carefully managing our expenses, we are making investments in our facilities, SMT, sheet metal and plastic molding capabilities in both Mexico and the States.

With respect to sheet-metal-centric programs, we see very strong growth and a few real competitors in North America. We're also deploying innovative new manufacturing equipment in each of our facilities, which make our production less labor-insensitive and more efficient.

These investments are expected to enable planned future growth with lower costs and the more efficient production of existing business.

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 OEM space increasingly uncertain geopolitical landscape, Key Tronic is uniquely equipped to offer risk mitigation with our manufacturing facilities located in China, Mexico and the States. Moving into the first quarter of fiscal 2018 although we continue to face industry supply chain issues, we expect growth in revenue and earnings.

In preparation throughout fiscal 2019, we plan to invest in new equipment and processes to be more productive in our Mexico facilities, and we're expanding and enhancing our highly profitable U.S. facilities. We're optimistic about our opportunities for growth in fiscal 2019 and beyond.

In closing, I want to take this opportunity to express my gratitude to our employees for their dedication and hard work during this past year, to our valued customers who continue to honor us with their trust and to our shareholders for your continuing support. This concludes the formal portion of our presentation.

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

Thank you. [Operator Instructions] We’ll take our first question from Bill Dezellem with Tieton Capital Management..

Thank you. I'd like to start with each of your new wins.

Kind of what's the size of these? And how do we think about them going forward?.

Well, I think they all fall within the $5 million to $15 million range..

And Craig, would you discuss each of them, particularly the distribution services? That sounds a little bit different, if it really is a service agreement rather than a product that you're building..

No. That's – that is a product that – what? Oh, yes. That's – Brett was trying to pass me notes..

Once it carefully….

Yes. That's a product that is used by people in the distribution business..

Understood.

And the medical product what can you tell us about that?.

It's pretty cool. It is intended to help people who have had dramatic brain injuries. And it's – I've never actually used it myself, but from what I've seen, it may help me in my skiing and golf game because it's really cool in helping people's coordination in recovering from both brain injuries and from MS and things like that..

Sounds interesting.

And the electronic signage is there anything particularly interesting or unique that's story-worthy?.

It's part of the overall demand we're seeing for metal-centric products. This has a lot of steel in it in addition to displace and input devices..

Thank you.

And then relative to SkyBell, would you, please, discuss demand that you are seeing for their products? And what the bottleneck is for their ramp? And that question is not asked in the spirit of why is it not happening faster, but just trying to understand what's the governor on growing that – ramping that faster than you already are?.

Well, we have talked and are, unfortunately, going to continue to talk about the shortages in the electronics components market, and that is the limiter on how fast we can ramp this business. The demand remains exceedingly strong.

We have customers who have actually prepaid for product in the attempt to get to the front of the queue, and yet we can't get parts. So that is the limiter. The factory is ready to go. The factory has demonstrated capacity well in excess of what we can get parts to feed it..

And presumably, there will be a point you will start to have parts come in.

And at that point, I guess, when would you anticipate that to be? And what's the magnitude of the increase in revenue that could come from that? I mean, is it a massive step function? Or would you anticipate something more gradual?.

From what we can see in the parts marketplace, it's going to, unfortunately, be gradual..

And is there any timing for that to begin that gradual ramp? Or is it just every single day it's that's headed that way?.

This morning, we had 56 parts out of 240 that were on shortage or not coming in when we needed them, and that's down from the day before, and tomorrow, it'll probably go up.

So we're in a constant mode, actually, across our business, as is everybody else in electronics business, of trying to find components that we can replace the component on the bill of material with.

That involves testing components, assembling them running and through T&H, making sure that we haven't run a file with any of the regulatory agencies by switching the manufacturer of a component part.

So it's just an ongoing drag on our business, unfortunately, caused by the fact that nobody in the electronics industry, it appears, trusts that this demand is going to continue. So we don't see a lot of people investing in increasing their capacity to build resistors, capacitors, integrated circuits and the like..

Thank you. And then continuing down this line of questioning, if I may, I believe that Amazon has purchased SkyBell's major competitor, Ring. And we have seen Ring in places like Walmart or Costco, which probably don't want to buy from Amazon would be our supposition.

And so, I guess, the question ultimately is, are you seeing any demand benefit from that? Granted, I understand you're not able to produce it without the components, but can you address that aspect of prospective demand, please?.

Yes. There is a significant demand from the retail market right now as a result of the Ring purchase. And as you said, unfortunately, we can’t get after it in a big way. But as you suppose, no retailer wants to buy product from their largest competitor..

Thank you. And then one additional question, shifting to the arbitration.

Would you, please, provide a bit more commentary around that beyond what was said in the opening remarks, please?.

I have so much that I could comment on. I'm going to ask you to narrow it down.

What are you looking for?.

Well, the timing that you're anticipating, I think it was referenced as weeks.

And have you had any indications from – this is a judge, right and not a jury, if I remember right, that gives you some indication or hint one way or another?.

So we have recently had communication from the arbitrator. It's not a judge, it's not a jury, it's an arbitrator. Yes, we've had a recent communication from him that leads us to believe we're looking somewhere around four weeks from now. And there is no indication from him on which way he is leaning..

Great. Thank you for allowing all the questions..

You bet..

We will go next to Sheldon Grodsky with Grodsky Associates..

You touched upon some of what I was going to ask, but are there counter claims on that arbitration? Is the other party seeking money from you as well as you seeking money from them?.

I think by the time we got done, the answer to that was no..

So you have upside potential and no downside risk other than what's already been expensed as far as the outcome is concerned? The expenses have happened….

No, that's not true. So we have all the inventory that is still in our inventory that if we were to be judged to have bought that incorrectly, that would hit our balance sheet as scrap. So there is the downside of $10 million if the judge – I'm sorry, if the arbitrator was to come back and say, you – Key Tronic, you did all this wrong.

On the other hand, if we were to get what we hope for and believe is fair, we would get our inventory paid for so that would zero out that roughly $10 million of inventory.

And then we would get another between – well, we think we should get another $7 million to cover all the cancellation and carrying expenses that we've had to deal within the last three years while we waited to be paid. So that could be a substantial upside. So the swing is $10 million negative to probably $7 million positive..

And any award would be cash flow positive as that inventory has already been paid for..

Okay.

Can you say anything about the tariff? Does your China operations mostly serve Asia?.

Say that again. I can say a lot about the tariff, but what was your specific question..

Okay.

The specific question was, does your China operation primarily serve the Asian market?.

Probably two thirds of what our China operation makes today comes back to the States..

It does come back to the States, okay. So this is – okay..

These are exciting and troubling times. We’ve seen both positives and negatives. And at this point, I can't tell you which way it's going to end up. And the prediction from our President changes every day on what he's actually going to do. So I really can't tell you what's going to happen next.

Certainly, the way that they're going about it doesn't make any sense when you compare it to the stated goals.

So for example, if you're trying to move manufacturing back to the States and yet you tariff steel coming into the states but you don't tariff finished goods coming into the States, all that does is pressure more OEMs to take their manufacturing to China because they can buy the steel in China untariffed, put it into finished goods and ship it here untariffed.

So the first step in this was exactly counter in result to the stated purpose. But who knows what's going to happen next..

Has your Company communicated directly to the White House? Or do you work through trade organizations…?.

Yes, we work through trade organizations, and I have no comment on the upside or downside of communicating with the White House..

Okay. Thank you..

Okay..

[Operator Instructions] We’ll go next to Bobby Nouredini with BBN Management..

Hey, guys. Question on the severance related to the Mexico operations.

What was that for the year in total?.

It was roughly USD 600,000..

So help me figure this out. My notes say that they're about $500,000 in Q3 and $300,000 in Q1.

Am I just totally off? Or is there something I'm missing here?.

I may be doing the math wrong. I don't recall the $300,000..

Okay. So let’s go with $600,000 for the year. And then I did miss a little bit of the call earlier. I recall you saying that there were about $2 million in expenses associated with the arbitration, and that's over the last couple of years.

Did I hear that right?.

That’s within the last year..

Within the last year, okay. So $2 million within the last year and then $600,000 on the severance, okay..

Well, I'm going to help you with a little math I think you may be heading towards, if you look at the previous year to this year, we had a little bit over $2 million in legal expenses that weren't in the previous year. We had about $1.1 million of the tax surprise. So there's $3.2 million to $3.3 million. Add another $600,000 to $700,000 in severance.

So that ends up saying that this year could have been a better profitability year than the previous year on about, what $25 million less in revenue. If that's the numbers you were going for..

Yes, so that $600,000 to $700,000 in severances is that – just want to make sure we're on the same page, is that pre or post-tax?.

That is a pre….

That’s pretax..

Okay. Thanks guys. Appreciate it..

You bet..

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

Hi, guys. Good afternoon..

Hey, George..

On SkyBell, can you give us a little bit of a sense of how big that customer could be for you guys if it's fully ramped?.

I think we have already stated that it could be up to 10% of our revenue..

Okay.

And right now, based on demand – on the demand that you have and that you probably cannot fulfill, are we at 10% of revenue? Is that – was that something that should – you should get there over time?.

We are in no way close to 10% of revenue..

Yes, it was only – it was way less than that. And we hopefully, can get there over time if we can get enough parts to catch up to the market demand..

If you were able to get the parts, would it jump up to 10% now?.

Yes..

It would probably beat it..

Okay.

And is that for one product? Or is it a family of products?.

It’s a family..

Okay. And then a question on, and I missed a little, on the profitability in the quarter. I think your revenue exceeded guidance, but it seems that the profitability was a bit lower. And what would be the main culprit? I think you sort of knew that there was a part shortage.

Did it get worse during the quarter? What is it that made you – I just want to say, I like the progression of revenue and of profits, so I want to commend you on that.

But I just want to see, this particular quarter, I think you missed your own internal expectations, and I'm wondering what it might have been?.

It was – the parts are continuing to get worse, and so we're paying more expedite fees in order to get parts in here. Customers, as you can imagine, are loathe to agree immediately to expedite fee, so you end up having big arguments with them. And meanwhile, you have to get the products shipped.

So you're buying stuff at a higher price than what you intended to buy it for. And then we spent quite a bit of money on – what's the right word I can say here, we spent quite a bit of money on moving an immature manufacturing process on SkyBell into our factory and making it mature..

Okay. And is it pretty mature right now then? Or….

Yes, it's – we have the capacity to run thousands and thousands per week, and the routings are now matching up pretty close to what we had thought they should be in terms of man-hours per unit. And the scrap is down to a reasonable level at the same time..

Okay. And are you manufacturing SkyBell in the U.S.

and in Mexico? Or just in Mexico?.

Just in Mexico..

Thank you. Can you give us a little bit of a sense of what is the revenue contribution from the product plants in Mexico and from China so roughly..

Did you – I have you pretty muffled. Did you ask us what the revenue from China versus Mexico.

On the three geographies, yes. Craig..

I didn't get – something about geographies. I couldn't hear you..

I am so sorry. It's from the three geographies that is the revenue..

Got three geographies..

Yes, so we're roughly 60% Mexico, just rough numbers, 25% U.S., and 15% China..

Okay.

And how does that look next year? Does Mexico keep growing? Or the U.S.?.

You're closer to the White House, why don't you go ask them?.

Okay. Thanks for that. Craig, I appreciate..

Thank you..

We will take a follow-up question from Bill Dezellem with Tieton Capital Management..

Thank you. I actually want to follow-up on the guidance, given your comments about the extra expenses moving the SkyBell business into the factory.

The low end of your revenue range is basically matching what you did this quarter and the low end of the earnings range is matching what you did this quarter, but it seems as though, if we heard correctly, that you should be – you should have lower costs because you won't have SkyBell expenses with the ramp, unless maybe since we're half way through the quarter, that already happened here in the first half of the quarter.

Would you just address this issue for me, please?.

Sure. So a, it already happened during the first half of this quarter; and b, we're having to spend a ton of money getting parts for SkyBell. So whatever we build is going to cost us more than it should in the first months or so of trying to ramp it with the starts and stops.

And when you have strong demand from Fortune 500 companies and the parts come in, it's not like you can say, yes, I've got a skeleton crew on. We're going to spend the next four weeks building it.

You have to say, yes, I'm going to put all three ships on it and crank your stuff out in the next three days, and then the factory is going go down and sit for another week. So all those people forget how to build it and then they got to come back again and get retrained. Yes, I hate to sound like a whiner, but between our friend Mr.

Trump and the parts, we feel like we've won the war but the battle is not going so good for us..

Thank you. Let me hit on a couple of other questions and actually continuing down just that component issue. In the June quarter, what did the component shortages cost you? And just in terms of dollars.

And what do you anticipate that number will be in the September quarter?.

It's hard for me to put a number on that, Bill, because it costs us in so many different ways. A really expensive but insidious way is that all contract manufacturers bank on getting some PPV as they go through the year, through the quarter, purchase price variance.

So all of us are not getting that these days because you have to at least pay a list price to get a component, you can't negotiate from any position of strength, so all that's gone. And then you have to add that to the expedite fee and the airfreight fees and the engineering time.

So I haven't calculated it, and I wouldn't feel comfortable giving you a guess at the number..

Do you have an expedite expense – the unusual expedite expense in the quarter number handy?.

No..

And so let me ask you qualitatively.

Would you expect that component shortage cost from all aspects, expedite and otherwise, to hold the same or increase in the September quarter, and if it is an increase, does that – is that solely because of SkyBell? Or is it more than that?.

No, it’s across the board and we expect it to continue to at least stay as bad and maybe get worse. For an example, we just spent the last week and a half with our engineers qualifying a replacement diode.

We had to find some stuff, some parts that were actually 10 years old in the market, and then bring them in and assemble them to parts and run through a whole suite of tests to prove that they were still usable, and that's just going on all the time. It's amazing. None of us have seen anything like this..

Interesting? And that’s of course built into your guidance, correct?.

Yes..

Great, thank you. And then I did want to come back to this issue of trade conversation.

And are you seeing any either acceleration or deceleration in movement of manufacturing from China to whether it be Mexico or elsewhere?.

Most, which is a bizarre artifact of the way the tariffs are being introduced, as I discussed earlier..

Right.

And so you are seeing cases where manufacturing – the movement of manufacturing is happening more quickly than otherwise would have? And in other cases where it's happening more slowly?.

We have examples where we're actually moving production out of Mexico to China and out of the States to China because of the tariffs. We have other examples of existing customers moving production from other suppliers in China to us in Mexico.

So it's just really from an engineering standpoint and from a logical standpoint, it's really annoying to see what is being done. I agree with the whole concept that it should be a level playing field, but I just can't understand how we can't do it in a logical fashion that makes sense..

Thank you. And I guess it’s kind of hard to answer the question with a lot more detail, when you see going both directions. So thanks for providing those examples. End of Q&A.

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

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

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