Good day and welcome to the Q1 Fiscal 2021 Key Tronic Corporation Conference Call. This conference is being recorded. At this time, I would like to hand things over to 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 our Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer.

As always, I would like to remind you that during the course of this call, we might make projections or other forward-looking statements regarding future events or the company's future financial performance. Please remember that such statements are only predictions. Actual events or results may differ materially.

For more information, you may review the risk factors outlined in the documents the company has filed with the SEC, specifically our latest 10-K, quarterly 10-Qs and 8-Ks. Please note that on this call, we will discuss historical financial and other statistical information regarding our business and operations.

Some of this information is included in today's press release, and a recorded version of this call will be available on our website. Today, we released the results for the quarter ended September 25, 2020. For the first quarter of fiscal 2021 we reported total revenue of $123.2 million, up17% from $105.3 million in the same period of fiscal year 2020.

The increase in revenue was due to successful ramp of new customer programs and increased demand from existing customers.

However, partially offsetting the increase in revenue during the first quarter of fiscal year 2021, our revenue was constrained by labor shortages at our facilities in Juarez due to COVID-19 pandemic, and the cost of public health measures implemented as a result of the pandemic.

During the first quarter of fiscal year 2021, we incurred additional cost caused by the COVID-19 crisis totaling approximately $1.4 million or $0.10 per share.

These expenses are related to increased compensation at our Juarez facility in order to attract and retain employees we need to manage our growth, as well as preventative measures and equipment for employees at all of our facilities in the US, Mexico, China and Vietnam. The pandemics adverse impact on revenue expenses also reduced our margin.

For the first quarter of fiscal 2021, gross margin was 8.1% and operating margin was 2.3% compared to gross margin of 8.8% and operating margin of 2.4% in the same period of fiscal 2020.

For the first quarter of fiscal year 2021, net income was $1.7 million or $0.16 per share, compared to $1.6 million or $0.14 per share for the same period of fiscal year 2020. Turning to the balance sheet, we continue to maintain a strong financial position.

As a result of labor shortages in our Juarez facility causing production delays in the first quarter of fiscal 2021 and the continued ramp in transfers in programs, our inventory increased 4% from the prior quarter. In future quarters, we expect to see our net inventory turns increase to be more in line with expected revenue.

At the end of the first quarter trade receivables were up $5.4 million from the prior quarter, reflecting the increased revenue levels and the timing of shipments made in the quarter. Overall, our DSOs increased to be about 64 days. Overall, we have a healthy balance sheet with total working capital of $154 million and a current ratio of 2.5 to one.

Nevertheless, we feel it is prudent to preserve cash where possible should the pandemic again disrupt operations for an extended period. In this light, we increased our total credit facility up to $98 million to manage pandemic risk and give us more flexibility to ramp up pr6oduction in the coming months.

Total capital expenditures in the first quarter of fiscal 2021 were approximately $3.2 million and we expect CapEx to be about $8.5 million for the full fiscal year.

While we are keeping a careful eye on expenditures during fiscal 2021, we plan to continue to invest in our production facilities, SMT equipment and sheet metal and plastic molding capabilities, as well as in efficiency improvements in our facilities as we prepare for growth.

For the second quarter of fiscal year 2021, we currently expect to report revenue of approximately $125 million to $135 million and earnings of approximately $0.15 to $0.25 per diluted share. That said there's a lot of uncertainty surrounding these current estimates.

We're working closely with our customers, key suppliers and employees and minimize the effects of delay attributable to the continued global pandemic.

While our facilities in the US, Mexico, China and Vietnam are currently operating and rigorously following current health guidelines, uncertainty and the possibility of future temporary closures, customer fluctuations in demand and costs and future supply chain disruptions during the rapidly changing COVID-19 environment could significantly impact operations and coming periods.

Due to the heightened risk associated with this pandemic we may issue updated guidance during the upcoming quarter. In summary, while the COVID-19 crisis continues to cause disruptions, during the first quarter and remain a risk in future periods, we are encouraged by our continued growth as we move into the second quarter of fiscal 2021.

And by our prospects for future growth, the overall financial health of the company is strong and we believe that we're increasingly 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. We're pleased with the successful launch of new programs, rebounding customer demand and a strong revenue growth in the first quarter of fiscal 2021.

While some of our customers continue to reduce demand due to the pandemic and related economic slowdown, several customers significantly increased demand in the first quarter of fiscal 2021, including programs for health care, industrial controls and telecommunications.

During the quarter, we also won new programs involving audio and video editing systems, indoor air quality systems, utility meters, warehouse management and automation technologies.

In spite of the trade disputes between US and China, and the worldwide supply and certainty for electronic components, our China facilities are fully operational again, and we saw increased demand from some China based customers.

Uncertainty over trade tensions between US and China, combined with the disruptions caused by the pandemic have further intensified a growing consensus among many of our customers and potential customers, as they see more clearly that the total costs and risks of over reliance on manufacturing in China are actually higher than for a more balanced mix of China and localized supply chains.

Shortened supply chains supported by localized vertical integration are becoming more widely understood and highly desirable. Moreover our customers and potential customers increasingly want their IP maintained in the US where there is more enforceable ownership.

As we discussed before Key Tronic is ideally situated to benefit from these global trends of moving away from over reliance on China manufacturing. We continue to invest in our Mexico and US facilities. Furthermore, our new facility in Vietnam continues to ramp up with new business and new customers.

These new customers are putting their business in our Vietnam facility without the normal prerequisite facility audit, which further demonstrates the demand for supply alternatives to China. A growing number of existing and new customers are transitioning from China facilities to our expanding facilities in Mexico, Vietnam, and the United States.

Facilitated by our centralized command control, we can drastically reduce the time and risk associated with such a transfer. At the very least diversifying the geographies of our customers manufacturing sources allow some flexibility to respond to the rapidly changing political and health landscape.

Moving into the second quarter of fiscal 2021, the COVID-19 crisis continues to present macroeconomic uncertainty and multiple business challenges. But we continue to see the favorable trend of contract manufacturing returning to North America.

Potential customers who were concerned during the trade disputes last year have been further pushed in our direction by delays and uncertainties related to the virus. At the same time, we remain focused on protecting the health of all our employees by adhering to current health guidelines as well as increasing retention of available employees.

As Brett noted, we're incurring increased expenses related to the pandemic, including increased wages and bonuses at the Juarez facility in order to attract and retain employees that we need to meet our growing demand. As well as preventative measures and equipment for employees at all of our facilities in the US, Mexico, China and Vietnam.

While our supply chain remains vulnerable to temporary disruptions caused by a flare up of the virus and associated lockdowns and regulations, we've previously been able to work around temporary disruptions or closures.

We've also managed transportation complexities and disruptions to our supply chain via alternative sourcing, airfreight, product redesigns and alternate component qualifications. We're closely monitoring inventories and will continue to use safety stock as much as possible to ensure minimal interruptions.

Nevertheless, while we've been able to find solutions for most of the COVID related challenges to date, clearly none of us are out of the woods with respect to the global pandemic. In closing, I want to once again thank our great employees for their dedication during these challenging times.

And for adhering to our strict guidelines for social distancing, wearing masks and other recommended precautions during the pandemic. Because of their courage, hard work, and strategic foresight, we expect continued revenue and earnings growth in the second quarter, and we'll continue to invest in new capacity to prepare for long term growth.

Let me assure you that we will continue to make protecting the health of our employees our highest priority. I also want to wish you and your families' good health and safe passage during the pandemic. 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 go to Bill Dezellem, Tieton Capital Management?.

Thank you. Let me start with my normal question.

What is the size of each of the five new program wins that you had in the quarter?.

Six, six, seven, 10 and 11 million..

Six, six, 10 and seven, 10 and 11?.

Six, six, seven, 10 and 11 million..

Excellent, so all of them between five and 11 million?.

Yeah..

Great, thank you.

And would you talk about each of these five in terms of new customer versus an existing customer, adding a new program and any unique insights that any of these particular wins yield?.

Sure. Let me get back on that page. All right, so in order that I read them audio and video editing is new. Indoor air quality systems, is a recently new customer, but a program win. Utility meters, is a customer that left us about two years ago and has returned.

Warehouse management, is an existing customer with a new program and automation technologies, our existing customer with a new program..

And besides the insights to the returning customer what other interesting insightful aspects are there any of these to help us understand you all better?.

So the customer left us for much larger manufacturer and experienced normal problems with that. And that is a mismatch of their program size versus their chosen contract manufacturer. In many cases, very large contract manufacturers do a great job of marketing to a smaller customer.

But once a business relationship begins, things don't work out the way they were intended to work out. And we end up with the business back. This is pretty common for us. It's not all that common that we lose the customer. But it is common that we win a customer who's been unhappy with a relationship with a much bigger contract manufacturer than us.

The other three for the new customer is pretty normal situation coming back from China. The second one is a COVID driven demand that causes a pretty small customer with some pretty cool technology to see significant increase in demand. And we may be obvious choice for them to expand.

So that's about it from insightful reasons as why we have these new customers and programs..

Great, thank you.

And then, in the press release and your opening remarks, you did reference the increased demand from existing customers in healthcare, industrial controls and telecom, would you talk about that increased demand for each of those and, again, insightful perspective, please?.

Well, these are all examples of demand that have increased. Customers have experienced increased demand due to sometimes not expected second or third or effects of the COVID crisis. So for our one side of the equation, we have the gaming customers dropping dramatically.

On the other side of the equation, we have these customers increasing in the demand. And it's strictly due to what people need and want during the COVID crisis. So on the whole, I'd say that while we are profiting, so I guess that makes us a COVID profiteer from some of these customers on the other side we're being harmed in a big way.

I'd say the net effect of COVID is probably neutral on Key Tronic..

And are you able to discuss any of the specific products maybe without customer names, but the products that you are seeing this increased level of demand for?.

I think not..

All right, I'll move on then.

Also your labor constraints, would you please talk through those in terms of what you experienced in the quarter and maybe even more importantly, the view on labor going forward, particularly given that you are talking about an increase in the business, which I suspect means an increase in employees?.

Yes, the labor situation at the end of our fourth quarter and the beginning of the first quarter had started to improve. Previous to that, we had over 550 people that were not allowed to come to work due to pre-existing conditions in Juarez. And so we had a 550-person hole to fill, and that was at our steady state revenue.

And then when you look at trying to add 10 or 20 million on top of that of revenue, we're probably at about a 700 or 800 person shortfall of people out of a 3300 person setup facility at Juarez, so we were quite a way behind eight ball. And then as we got through the quarter, the availability of employees became somewhat better.

And we implemented some bonuses and other pay structures that have helped us the retention of the new employees that we hired. And things improved pretty nicely by the end of the quarter. Unfortunately, in the last month, as I'm sure you know, COVID cases around the world including El Paso and Juarez have spiked again.

So we are unsure as to what's going to happen in the next couple of months or next quarter in terms of availability and cost of employees, mainly in Juarez..

Great, thank you and I'll step back in queue and re-queue up..

[Operator Instructions] We'll go back to you, Mr. Dezellem..

All right, thank you, so you did reference new capacity expansion.

Would you please talk about that?.

Sure. We have some new customers that have products that require different vertical integration technologies than what we currently have in the factory, so we're investing in those technologies. And there are other spots and pinch points in our capacity that are requiring a purchase of an SMT machine, there are stamping machine there.

So those are the type of investments that we're speaking of..

And during the quarter, we also did meet another facility down in the US..

Great, thank you. Thank you both. So there has been some speculation about your new $100 million customer.

What additional insights would you share there with us about that customer?.

I don't think I want to share any insights on that customer..

And how about their ramp, how is that progressing here in this quarter versus Q4 and then in Q2?.

The ramp for that customer started in our Corinth, Mississippi facility, because of the various pieces of timing that had to happen, and concern about the COVID cases that were happening at the beginning of Q4. As we've headed down the past, the ramp in Mississippi was very successful. It's been limited only by the availability of components.

And now we're in the midst of ramping the small introductory lines from Mississippi into large ongoing lines in Juarez, Mexico. So far that ramp is going well and unexpected technical issues and again, the constraint is on some key components that are on high worldwide demand..

And given that - it sounds like those components are not specific to this product.

And if that's the case, how do you navigate that to meet the level of demand the customer is experiencing?.

Well, the degree to which we can navigate that is mainly governed by long lead parts that we're buying ahead of demand. Our customers signing up long-term agreements with suppliers of these components and continue to work in kind of above the Call of Duty effort from our procurement group..

And, Brett, you mentioned the new facility that you leased.

Is there any relationship between this new customer ramping in Juarez and that new facility?.

Yeah, sure is..

All right, thank you and then - so I guess that's - I'm going to stay on that for a moment. So that would be an indication to us that you continue to anticipate that customer to be at a very high revenue run rate as the ramp continues..

Yes..

And I guess as a side, do you have other prospective customers that could be up at that type of a level that you were looking at? Or do they all tend to be more in the six to 11 million as you referenced for your wins this quarter?.

There are a number of very big accounts too that I'd say are high probability of wins both at our - in the 100 million range. But as my dear departed father used to say there's many a slip between the cup and lip, so we'll see where that goes, but it's not just five to 10 million funnel, there are a number of really big possibilities in there..

And are some of those possibilities greater than the 100 million size of this customer?.

Sure..

Congratulations.

Do you have any comments on timing and when those may turn into wins for you?.

Yeah, it's pretty likely that - the answers are pretty short-term and also, we're hopeful by the end of this quarter, we'll know what we're doing..

Look forward to hearing more.

Are those ones that you would press release in the middle of the quarter or that we would anticipate talking about in January if you were successful?.

We would like to press release them, but that depends entirely upon our customers' willingness to get their name out there in conjunction with contract manufacturing. So I cannot answer what we would do if we won this, but it depends on our customers' decision..

Great, okay, thanks. And then let's jump to the guidance for a moment. The low end of the EPS guidance is down from - I want to think a penny down from what you reported this quarter. And yet the low end of the revenue guidance is higher than what you reported this quarter.

Would you talk through what looks to be a bit of a gap there?.

Yes, we're mainly trying to couch our expenses in case COVID gets worse. There is some increase in costs due to the ramp, but mainly we're trying to couch is a half a million or two and a half million due to - try to get employees in whatever happens in Juarez..

So if your COVID costs do not increase as a percentage of revenue, then we would see earnings growing commensurate with the revenue growth, you're just making the conservative build in, if you will, that there will be some extra costs, just in case..

We're just trying to be realistic about what could happen and take a guess. And that's why the range is getting bigger because the uncertainties are getting bigger. We have - this is probably the third quarter in my life, we've had much more demand that we can build.

So our forecasts are now being driven more by our ability to build thereby our customers wishes to buy. That's a new, place where I think for a lot of contract manufacturers to be..

And what is the limitation, is it labor primarily or does it tend to be more on the component side or something else I'm not thinking of?.

Well, there's three major spots that are pinch points for us. The first, I'd say these are in no order of the issue size, so the first one is obviously labor, the second one is parts, components and the third is tooling.

So in cases where customers are suddenly experiencing demand that's 100% or 200% of their original intended demand and they have tools, plastic moulds that we use to make the parts and those plastic moulds take anywhere between 12 and 16 weeks to get up and running.

And our customers themselves are tormented by the question of should they double their capital investment in tooling? Or is COVID driven demand going to once again decrease? Those three things are all limiting our ability to hit what our customers wish we could build..

Well, and you just segue nicely into the question that's been going through my head here, which is to what degree is this demand temporary versus somewhat more than new normal. And then secondarily, your guidance on the revenue front is what 125 to 135.

If you could meet with to your customers wants you to produce, what would that number be?.

If we could meet everything our customers wanted us to produce, it would be around 145 or a little bit above that..

Did you say one, four, five?.

Yeah, I did..

Okay..

Yeah. Yeah. So what was the other part of the question? I forgot it already..

Yeah, transient demand, versus more -.

I forgot it because I answered that already. That's what I was trying to talk about when I said, are we a COVID, profiteer or are we a COVID sufferer? As a company, I'd say it's about a net neutral.

That's what I was trying to say before is the upsides we've seen from existing customers have more or less been offset by the downsides we've seen from existing customers. And the strictly COVID driven demand is not that big compared to the demand that comes from the rebalancing of supply line and minimizing risk.

And so you'd have to parse your question even further, because there's short-term COVID demand, which I would classify as a customer who suddenly wants 10,000 or something, he only thought he needed 5000 before.

And there's long term COVID consequences, which are customers who are suddenly going, oh, my god, I've got my entire supply chain concentrated in one place and as a disaster like COVID or a trade war comes along, I'm completely vulnerable. I need to make a switch. So it's up to you to be able to decide how you want to classify that.

Is that a sea change due to the political landscape? Or is that a sea change that's due to COVID it will be reversed or what? But that's the best I can answer your question..

No. That's fair. Thank you, Craig. And Brett, just so you don't feel left out. The tax rate guidance is being increased to 25% versus your normal guidance of 20%. And this last quarter, I think, was actually closer to 19%.

Why are you expecting that tax rate to go up?.

Yeah Bill, I think that's predominantly the expected growth where we're showing an expected growth in revenue this quarter with an increased profit. Unfortunately, R&D, tax credits and offset are submitted taxes aren't nearly as much as a percentage of total tax, so which is an increase expected profit before tax during the fiscal year..

And Brett, if you end up at the low end of the of the earnings guidance, because your COVID costs are higher, does that imply a lower tax rate, but if you end up with earnings up in that $0.25 range that at that point, you would have a higher tax rate? Is that correct or am I not thinking about that sliding scale correctly?.

Yeah, that's correct. And you have to be - your effective tax rate is based off of what you expect for the full year. So if we had expected a large bump in COVID, produced one quarter, it may not significantly change that effective tax rate. We expect that to be the final three quarters of the year..

So I'm trying to gain some insights here as to how you all have been thinking about the business. So because you guided the first quarter tax rate at 20%, but now you're increasing that guidance to 25%.

Does that infer that you all are looking at the full year as have a higher level of income for the full year now than what you thought you were going to have when you started the first quarter?.

Let's see can hear you..

Moderator, are you there?.

Yes, we can hear you..

Hello, this is the first.

Hello?.

Yes, I'm there Craig..

Okay, okay, good..

You dropped off for a minute there..

Yes Bill, one concern is that we're expecting revenue growth and with that you expect a profit. Now to be able to pinpoint the exact amount for the year, I don't think we feel comfortable in stating that. We're going to be significantly higher, but its own estimate..

[Technical Difficulty] Management..

Hi, guys, good afternoon..

Hi..

Just a few follow up on those wonderful questions. The additional cost of 1.4 this quarter, how do you think about that over the long-term? Is that something that you think will be permanent? Or some of it might go away in the post-COVID world? [Technical Difficulty] to increase retention..

Yeah, the vast majority of it is labor costs related to wages, and hiring costs and training costs..

Okay and is that fair to say that most of that goes into cost of goods sold. So it impacts the gross margin..

Yes, that is correct..

Okay, great.

And then, if I look at the P&L, the product development cost, the R&D and engineering had to step function increase in the June quarter, I think it went from 16, 17 to sort of the low twos right now, is that a reflection of the bidding activity and the work that you're doing that with existing customers and prospective customers to get new business?.

The R&D costs are pretty hard to correlate to the timeframe, quarter or two quarters out, because many times it's funded by our customers, but sometimes it's not.

Sometimes we're doing things on the come because we think if we design something that is revolutionary or cool for a prospective customer that will act as a spur to get them to change to us. Other times, almost the entire department is involved in designs that's being funded by current customers.

So I don't think any of us that in any kind of a barometer for future business size..

Okay, that that number that you have right there now 2.2.

Does that mean that something that you pay, and some of it would you would get reimbursed later through to product sales?.

Yeah, so that is not a net number. So for getting reimbursed by a customer for an engineering contract, that'll actually go up into revenue. So that is both internal and external costs..

Got it, okay, great. And then a follow up on - Craig, you said that there were potentially some very substantial customers, and that you might even hear before the end of this quarter on some potential wins.

It seems like these customers have moved through the pipeline relatively fast, is that correct? Or maybe have you been working on them for a long time and you didn't tell us about it?.

Yeah, every question you guys ask us the answer is both. So one of them we've been working on for over a year, one of them came knocking at our door about a month ago..

Okay, so the one that came knocking at your door months ago, it could happen that fast. It could happen in just a few months..

The award could happen in just a few months. The actual ramp will take quite some time, but the award could happen in just a few months..

Okay, great. Okay, great. Thanks a lot guys..

You bet..

Thanks George..

And at this time, there are no further questions. I'll hand the conference back to our speakers for any additional or closing remarks..

Okay. Well, once again, thank you to everyone for participating in today's call. I wish all of you and your families safe and healthy next three [Technical Difficulty]. Look forward to talking to you again next quarter..

That does conclude today's conference. Thank you all for your participation today. You may now disconnect..