Good day, everyone, and welcome to Key Tronic Second Quarter Fiscal 2019 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..

relocating to a new facility in Arkansas; providing a better facility and adding new production equipment; leasing additional contiguous space in Minnesota and investing in additional production equipment for growth; and finally, establishing a new production facility in central Vietnam over the coming quarters.

We expect these investments and others will significantly reduce production costs, diversify our global manufacturing base and provide an additional hedge against uncertainty in any lingering or potential future trade wars. Our growing revenue and improving margins had a positive impact on our bottom line.

For the second quarter of fiscal year 2019, we had net income of $1.6 million, or $0.15 per share, compared to a loss of $200,000, or a $0.02 loss per share for the same period of fiscal year 2018.

For the first six months of fiscal year 2019, net income was $3.2 million, or $0.29 per share, up from $200,000, or $0.02 per share for the same period of fiscal year 2018. Turning to the balance sheet. We continue to maintain a strong financial position.

Despite the continued ramp of new programs and delays in shipments due to component shortages, we were still able to decrease our inventory by approximately $18.7 million, a 16.9% reduction during fiscal year 2019. We are very pleased to see our net inventory levels gradually come more in line with revenue levels.

Trade receivables at the end of second quarter were up $14.8 million from a year ago and DSOs were about 53 days. This reflects an increase in sales revenue and a reduction of $5 million in factored receivables during the quarter when compared to the same quarter last year.

Total capital expenditures in the second quarter of fiscal 2019 were approximately $1.9 million. We continue to invest in our production facilities, SMT equipment and sheet metal and plastic molding capabilities, as well as improvements in our facilities in Arkansas, Minnesota and Vietnam.

We plan to have approximately $10 million of – in total capital expenditures during fiscal 2019. Moving into the third quarter of fiscal 2019 and continuing over the following few quarters, we expect more of our new customer programs to ramp and move into production.

However, one of our large longstanding customers is also forecasting less demand for production during the third quarter, as they bring their inventories into balance with their product demand in China. We expect this customer’s demand to recover in the fourth quarter.

Taking these factors into consideration, we expect that the third quarter of fiscal 2019 will have relatively flat revenue when compared to the second quarter in the range of $120 million to $125 million. For the third quarter of fiscal 2019, we also anticipate earnings in the range of $0.13 to $0.18 per diluted share.

This assumes an effective tax rate of 20%. In summary, we’re encouraged by our growth in revenue and earnings this year, new capital investments and by the prospects for future growth.

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?.

Okay. Thanks, Brett. For the second quarter of fiscal 2019, our new programs continue to ramp driving growing revenues, improved margins and increased profitability.

Despite the continued industry-wide shortages for key components, we have made a number of necessary adjustments for improved lead times across our supply chain and have brought inventory levels more in line with revenue levels.

During the second quarter, we benefited from the continued ramp of new programs, including SkyBell Technologies, a global leader in patent and Wi-Fi, video doorbell technology that improves home and neighborhood’s safety.

As we discussed previously, this important new relationship is projected to expand our customer base and contribute to profitable long-term growth.

While our marketplace remains very competitive, we also continue to win significant new business, both from EMS competitors and existing customers, including new programs involving industrial cleaning equipment, express delivery services and industrial monitoring systems.

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

Moreover, the evolving tariffs situation has complex ramifications for Key Tronic. Certainly for our customers in our Shanghai site, the tariffs are a problem for any product imported back to the USA.

For many of our current customers, however, a transition of their business out of our Shanghai site, to or were as as domestic sites can be seamlessly facilitated by a centralized command and control.

This dramatically reduces the risk and time associated with the move back to our North American sites and thus, allow some leeway to respond to the rapidly changing tariff landscape. Furthermore, we believe the tariffs on production in China have made our Mexican-based production much more appealing to potential new customers.

Our North American sites have become extremely competitive for U.S. bound products subject to the new tariffs. This is resulted in increasing inquiries and request for quotes from prospective customers.

On balance, we’re increasingly 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. During the second quarter, we signed a letter of intent to lease a new 86,000 square foot facility in Da Nang, Vietnam.

We expect that commencing operations in Vietnam will significantly augment our Asian footprint and reduce production costs. We expect this new facility to provide an additional hedge against uncertainty in a lingering or future trade war with China.

The Da Nang, Vietnam facility will be strategically located in an established industrial park inside a government-sponsored export zone within five miles of an international port. We expect Vietnam facility to be operational by July of 2019. As we discussed in our recent calls, we continue to see strong results from our domestic facilities.

We believe that this reflects a growing appetite for U.S.-built products and a significant value 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 U.S.

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

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

Our steady pipeline of new business opportunities continues to be boosted our unmatched level of vertical integration, our multicountry 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, we are uniquely equipped to offer risk mitigation with our vertical integration and manufacturing facilities located in China, Mexico, the U.S. and soon in Vietnam. Although we continue to face industry supply chain shortages, we expect growth in revenue and earnings.

In preparation, we plan to continue to invest in new equipment and processes to be more productive in our Mexico facilities, expand and enhance our highly profitable U.S. facilities and establish our new capabilities in Vietnam. We’re optimistic about the opportunities for growth in fiscal 2019 and beyond.

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..

Good afternoon. As usual, I have a group of questions. And let’s start with the three wins that you announced.

What is the size of each of those? And would you walk us through with each of those wins? Why or what the circumstances were surrounding those wins?.

Okay. So they go from $5 million to $15 million per year in annual revenue..

Thank you..

See first one is acquired – we’ve been calling on for must be seven, eight years now..

Yes..

And Craig, just so that I have this right.

Is that the industrial cleaning equipment you’re taking it as listed in the press release?.

You got it..

Okay. Thank you..

Yes. I don’t know for sure, how much more I want to say about that other than that we’ve been calling on them for a long time. And a number of the factors we talked about in general combine to make them decide that they should start with a relatively small program with us and then hopefully, continue to move more and more business to us.

The available piece of business is quite a bit larger than the first piece that we won. The next one is for our domestic sites. That one fell out of the sky and is basically due to the fact that the design team is pretty local to our manufacturing site.

And then the third one is kind of a typical drawn out year-long RFQ, quote, talk, visit, negotiate, win. So it’s pretty much in those three gamut of our world..

And with each of those, what is the timing that you would anticipate before they begin production?.

They’re probably, all three of them are going to start towards the end of Q4 – our Q4, which would be towards the end of June..

And this seems faster than the tip what you have trained me to understand just the typical timeframe of 12 to 18 months.

Why are each of these a little bit faster or was I not trained correctly?.

You were trained correctly. But I think, we’re seeing perhaps a sea change in the speed with which these come on. I’m hoping it’s the case, but I’m beginning to feel like our 12 to 18 might move down to maybe eight to 12, we’ll see..

And what do you believe that sea change is all about?.

I really don’t know. I think it is, in fact, due to – I think, it’s due to less and less of the, what we used to call, the China Google Eyes, where everybody thought everything had to go to China. And so there was a long run on argument within our customers as to where they were going.

I really can’t tell you other than that’s my guess and that’s what we see..

Great, thank you. And then let’s shift to CapEx. Brett, you had mentioned $10 million for the year.

What did you do in the first-half? So what are the implications for the second-half CapEx?.

We have started out fairly light here today. I don’t have that number right in front of me, but I believe we’re approximately $4 million, six months in. So the majority of our CapEx going forward will be to get our Minnesota extra space and some additional production equipment, along with setting up shop in Vietnam over the next two quarters..

Great. Thank you. And then mentioning Vietnam, would you all discuss that Vietnam facility initial customer reaction, and since this is the first conference call since you announced that location, I think, on the last one you alluded to India, Indonesia, Vietnam.

Since you’ve settled on this location, kind of what was the thought process? And I guess the – share with us much detail as you can? And then, again, what was the initial or so far the customer reaction now that you’ve brought this plant into the public domain?.

The overall customer reaction has been extremely positive. We have a number of people who want to go tour the facility right now even as it sits as an empty building.

The really nice part about this move is that one of our largest customers on our Shanghai plant wants to be our first customer in our Vietnam plant, and they’re large enough that they will make Vietnam plant self-sustaining as far as profitability goes.

So we basically have a – if we build that they will come, situation already set up, which is really nice when you’re trying to get something new started. The – almost all of our existing customers are interested in getting quotes out of the Vietnam facility, which is actually pretty easy for us to do since we have the centralized model.

All we have to do is change once – one block in the spreadsheet and we can already create a quote for the Vietnam operation..

And relative to [Multiple Speakers], I’m sorry, I interrupted….

Go ahead..

…please go ahead..

No, no, I don’t remember if I answered all your questions or not. So go ahead, please..

No, you did.

But to follow-on, how does the cost in Vietnam compare to the cost in China, excluding the tariff – the extra tariff component? And then I guess, at this point, we would add an additional 10% to the Chinese cost, is that correct?.

Yes, for most of the products that we make in China. So if you were to remove the tariffs and just compare baseline, it looks like Vietnam is going to be 10% less expensive than China on average. Shanghai has gotten more expensive than China on average.

So Vietnam, if it were up and running and mature, we would expect to see even more than a 10% differential in cost comparing our current Shanghai facility to what we expect out of Vietnam. We had been on the horns of a dilemma for the last three, four years, because Shanghai continued to increase in cost as did all of China.

And we had actually looked at Vietnam a number of years ago, because we really didn’t want to move into Southern China or deeper into China. And that’s what has made this move a little bit more efficient and speedy for us compared to other folks since we’ve already done quite a bit of the groundwork years ago.

But that’s how they kind of compare to each other. So we think it’s a good move. It is a good move for Key Tronic tariff or no tariff. If the tariffs persist, it’s a fantastic move..

And….

What we’re also seeing is that, there seems to be a more generalized willingness to accept that having all of your production eggs in China, perhaps not – is not that wise of an idea. So we have a number of customers coming to us and say, we don’t care if the tariffs go away. This has been a wakeup call for us.

Tariff terrified us and we realize how fragile we are our supply chain is. So we would like to investigate moving with you to both Mexico, Vietnam and maybe the states. So we’ve got a lot of people who are kind of in wakeup mode, I would say, to what we’ve been preaching for a number of years now..

And do you at all get the indication that some of this could simply be a reaction to tariffs? And as soon as tariff card goes away – if it does go away that, then it will feel like a chicken-level situation and I’ll just go back to the way things were?.

Yes, that’s why I anticipated your question by saying that this has been a wakeup call for people, who a lot of them say, we don’t care if the tariffs go away or not. We still need to diversify our supply chain..

All right. Thank you..

Yes..

And then one other question relative to Vietnam.

The transportation cost or shipping cost from that facility versus Shanghai, was that incorporated into your answer that Vietnam is 10% less expensive?.

Yes..

Yes..

Great, thank you. And then – go ahead..

We found that the infrastructure within Vietnam has improved significantly since we looked at them three or four years ago..

In that short of a time period, you’ve noticed the difference?.

Absolutely..

Great, thank you. And then lastly, you did reference one of your longtime customers that is making some adjustments in the March quarter.

Would you talk through that in a bit more detail, please?.

Well, a market, a consumer product and their demand has been impacted by the economic situation in China. So they decided to pullback on their inventory levels, run at a lower level, so let’s say, hopefully a one-time drop in their demand from us..

And so basically, it’s simply an inventory adjustment?.

Yes, we hope so. We hope that things don’t get worse in China..

Right.

And so this doesn’t have anything to do with the China tariffs directly? I mean, if the China tariffs have impacted Chinese economic activity then maybe, but not directly, that’s not what you’re referring to here?.

Right. I’d call it a second order effect..

Yes, great. Thank you, both..

Yes, thanks..

[Operator Instructions] We’ll go next to Mike Hughes with SGF capital..

Good afternoon, and thanks for taking my questions. Just first, a follow-up on the last question. It looks like normally the normal seasonality from December into March quarter from a revenue perspective is flat to down modestly. And that’s kind of what you’re guiding this year even with this Chinese customer issue.

So can you just kind of quantify how much of a headwind that’s going to be in the March quarter? And has the customer given you any visibility into the June quarter to give you confidence that that business will come back in June?.

The customer has given us all we ever get from them, which is here’s what we think is going to happen with no guarantee behind it. So that’s what we’re basing our statement on that they believe the demand will come back to a more normalized level.

I guess, I don’t want to give you the extra dollar figure that impacted our – or is going to impact our revenue growth, our revenue in Q3. It’s actually the reason we’re flat is because of the new programs that are coming on in Q3.

So we are able to absorb, so to speak, the loss of this chunk of business as they fix their inventory and replace it with new business that’s ramping..

Okay. And then this question was asked a few years ago and I wasn’t clear on the answer. The question was just a normal attrition of the business, meaning, you have end-of-life programs and you on occasion, I assume have some competitive losses.

So if you weren’t winning new business, how much would your core business that you have right now, the $125 million a quarter roughly in revenue, how much would that decline by on an annual basis?.

Yes. So I understand why you didn’t understand the question and the answer last two years ago, I should say, because it’s a really hard one to answer. Our business is so lumpy and is made up by individual events that the only way I could answer would be to go back over a 10-year period and look at everything and trying average it up.

And even then it would just be an average. It wouldn’t be what to expect. So there have been years where we look ahead 12 months and we’re shaking in our boots, because we know that we’re in danger of losing a customer due to some competitive situation.

We’ve been able to look ahead and realize that a certain product is nearing end-of-life and we can no longer depend on it. We can look ahead and see that a customer is about to be bought or just was bought by a larger OEM, who we know is going to move the business to a large CM.

And there are other known events like that that we can see on the horizon that have profound impacts on our revenue when they happen. And then there’s the normal churn or aging out of customer relationships that I guess in the natural order of things, go sour or management turns over and they want to bring in a trusted CM or whatever.

And that’s a much smaller percentage of the impact that we see on a year in, year out basis on our revenue. So out of interest, I’ll go back before our next quarterly call and look at the average and try and give you in those two categories an average over the 10 years of the leakage at the bottom of the bucket.

But with the provider, you have to understand that this is an average and it’s got a massive distribution of error in it depending on what’s going to happen that year. I can tell you that right now, looking out, we don’t see any of those terrifying changes that we’re scrambling to try to either backfill or prevent..

Okay. That 10-year average would be really helpful, and then your second comment about the – your current visibility is even more helpful. So what I’m going to drive – driving at is, on the August call, the year-end call, you said you had 11 major new wins and the average size was $5 million to $15 million.

So if we use $10 million per program, that’s $110 million in revenue that you’re going to layer on over time. And you’re saying that some of those programs are ramping more quickly than in the past.

So I’m trying to figure out when are we going to hit that inflection point where those new programs overwhelm stuff that’s running off and maybe this Chinese customer issues? It sounds like that’s maybe the June or September quarter?.

Well, I think it’s already happened. If you look back the year ago to today, there’s already been some nice growth even if you take out the $7 million that was due to the accounting changes, there’s still over 10% growth. And that’s the combination of business dying and leaving and new business coming on.

I don’t think there’s going to be – I think, we’ve already passed the inflection point, if you want to call it that where we return to growth….

Right..

…on an annualized basis every quarters. God knows what’s going to happen. But I think we’ve passed that inflection point. If you’ve been around for years, you know that we lost the one massive customer in – can I say their name yet? I still can’t? That’s not fair, should be able to.

Anyway, we lost that one major customer and it’s taken us three years to basically replace them. And now that’s replaced, everything we layer on should be growth after you take out the natural shrinkage that occurs or leakage at the bottom of the bucket. So I guess, that’s a long answer to your question. I think, we’ve already hit the inflection point.

It looks to me like it’s going to continue to accelerate certainly our funnel….

Yes..

…of new business from the top of the funnel all the way down to where dollars drain up the bottom is in much better shape than I’ve ever seen it..

Okay. And then on….

And that’s….

Sorry, go ahead..

…go ahead..

No, no….

I’m going to say that, yes, that’s due to a number of factors, all of which – not all of which, but a good chunk of which are in our control. So we’ve added dramatically to our sales team over the last six months. We’ve added dramatically to our quoting abilities over the last six months.

We’ve integrated the acquired Ayrshire more fully into the former existing Key Tronic, much more in the last year than we’ve done before. And then we’ve got a couple of nice tailwinds. One is the tariffs situation and that’s layered on top of, People is beginning to understand that the cost out of China has been going up even before that.

So there are a number of things that are all pushing in the right direction that make it seem like not only have we crossed the point of inflection, the slope of the curve should continue to increase also..

Okay. I think on the last call or the prior call, you said that SkyBell was at $4 million in revenue.

Was that a quarterly number? And would you be willing to say where that number is now as it continue to ramp?.

That was, I think, our first quarter of building them. And I’m not sure, we are supposed to be sharing our revenue with SkyBell. So I’m not going to, and if I did the first time, I’m probably in trouble..

It is growing substantially since that first quarter..

Is there an opportunity to still grow that business as significantly, or is it kind of plateaued at this point?.

No, it’s nowhere near a plateau..

And that business was especially exposed to the components issue, right? And it sounds like in some respects, at least, you rectify that situation.

So will that business ramp more quickly now?.

We are still limited by component availability. We could probably be selling twice as many as we are today if we could manage to get a hold the parts. So we continue to – and it’s kind of a ratcheting situation. We need to have commitments from SkyBell’s customers for increased volume in order to go up by parts.

SkyBell’s customers have to be convinced that the Key Tronic manufacturing capabilities are the real deal and we can actually get parts before they want to make commitments to us for parts. So we’re kind of rationing along here in a pretty steep upward curve.

But what we’re making today is basically only for one customer of SkyBell and there are a number currently in the wings. There are a number who are working – we’re working with on design changes to fully integrate the doorbell with SkyBell’s customers products.

So this has got a lot more potential than what we’re seeing today limited mainly by still parts availability..

Okay. And then two other quick questions. The move to Vietnam seems very important strategically. I guess, the negative flip side is naturally, if you’re going to take a large customer from China and move them to Vietnam, now we have under absorption in China.

That plant presumably is going to be less profitable, or is there a way to backfill it with Chinese-based customers or customers that aren’t exposed to the tariffs.

So just how are you going to address that issue in China?.

Well, we’re going to hope and we’re trying to backfill. But if we can’t backfill, we’ll have to scale. And that’s part of the life of being with CM as you have to scale and you have to have the ability to scale. So we do and we will if that’s our only option..

Okay. And then last question on Vietnam. I had read, I’m not sure if they’ve committed at this point or not, but Foxconn was looking at building capacity in Vietnam.

Do you happen to know is it in the area that you’re located? If so, was there any concern about wage pressures from their presence?.

I don’t know if it’s in our area, but they came in or as in we were a little bit concerned at first, but we haven’t seen any kind of an issue there. So I don’t expect any issue in Vietnam either.

One piece of data I can share is that, to me, our biggest risk in Vietnam was the majority of the workforce and particularly in the management and technical staff. And we’re far enough down the road with our hiring efforts that I can be pretty confident that that’s not going to be an issue. And….

Okay, great..

…if you’ve done as many – yes, if you’ve done as many greenfields as I have that the people are really what matters, the rest of its kind all overcome a little bit, if you can’t get good people, you’re in big trouble. So that was my biggest concern about Vietnam and you never really know until you go out and start trying to hire folks.

But it’s looking very encouraging so far..

Oh, and you’ve made me think of one last question, I promise.

Are there any start-up costs that we should think about in either the March quarter or June quarter or following quarters related to Vietnam?.

We’ve got all of those baked into our projections..

Would the start-up cost increase in June? So I’m just trying to build out my model, I’m just trying to think how I could build the EPS?.

It’s nothing or shattering in the amount that we’re going to have to invest until we get into production into the first part of our next year fiscal first quarter. But there will be some escalating expenses in Vietnam, of course, during our first quarter..

That was a couple of hundred thousand dollars a quarter?.

That’s about what it is..

Okay. Thank you very much..

You bet..

[Operator Instructions] We’ll go next to George Melas with MKH Management..

Hi, guys, good afternoon..

Hi, George..

Good afternoon, George..

I’m just trying to find my questions, I’m sorry. Okay. Last quarter, we talked a little bit about the shortage of components and how that may be impacted revenue by $10 million or $15 million, not just in that quarter, but as a matter of pent-up demand.

Is that still about the case now, or do you feel like the pent-up demand has declined? And I understand that with the SkyBell situation, for example, it’s very hard to know what the pent-up demand is, but maybe you can still give us some color there?.

Yes, if we were to take the SkyBell situation out of it, it’s probably about a $5 million to $10 million impact this time around..

Okay.

And do you have the sense whether that’s a one-time thing or if it’s just pent-up demand and then we just go back to what we had before?.

I think it’s more a case of a – well, I don’t know how to answer your question. I don’t know what you meant. But what I believe it to be is that if we had those parts, we would have got a one-time increase and then it would have settled back to the steady state..

Okay, great. Okay. I’m going to try to ask, I mean, the same question that Bill and Mike asked earlier, but maybe you can answer them slightly differently. If you look at the ramp of new customers, just the contribution of the new programs, should that honest and I’m looking at sequentially quarter-over-quarter understanding the lumpiness of things.

But should that add $3 million, $4 million, $5 million on a sequential basis? And by that, I mean, March over June or June over September.

Would that be a way to look at how these customers ramp? And that does not exclude the churn that – that’s a different dynamic?.

I think that’s a reasonable guess somewhere between $3 to $5 million a quarter extra. But that’s really averaged out, because I know all the ones that are ramping and some big ones are going slow and some big ones are going fast.

And so everything that happens here, you guys and I too would like to be able to put a line on the chart and say that’s what’s going to happen, but it won’t. But that $3 million to $5 million quarters a quarter, it’s a reasonable number the way we see it right now..

Okay..

…excluding SkyBell..

Excluding SkyBell, okay, because I would – then I was going to ask how does that sort of reconcile with those 11 new customers last year that were between $5 million and $15 million in revenue that Mike talked about?.

Yes.

And that’s part of the nomenclature that we get in debates with Bill about all the time is, do we quote the number that relates to that particular SKU that we’ve just started to ramp? Do we quote the number that relates to the family of products that we’ve begun to ramp, or do we quote the number that relates to the size of the overall business that the customer and we have discussed as having been one..

Okay..

So we’re always a bit confused on what we ought to be doing. And it’s hard to tell when you actually win the piece of business, what’s the right number is to give you guys..

Right, right.

Which number do you tend to give for instance?.

We tend to go towards the high-end of the middle. So we don’t just give you the SKU, we give you the family and maybe a little bit of belief in the overall size that they’ve told us the business is going to be..

Got it, okay. I actually have a question for Brett. You talked about the Mexican utility cost. I think the last quarter, there was a bump in cost of roughly $400,000.

Are we on a steady-state basis now in Mexico utility costs, or did it get worse?.

We think we’ve got that mitigated by contracting that, we don’t know when that’s going to kick in. But the cost themselves have actually gone down a little bit, I think, as they realize that competition is coming.

So we actually did see a rate reduction during the month of December, doesn’t get us back to where we were nor what we’re targeting through a different contract, but there was a bit of release..

Okay, great. Okay, that’s it for me. Thank you..

Thank you..

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

All right. Thanks, again, for participating in today’s conference call. Brett and I look forward to speaking with you next quarter. Thanks and have a good day..

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