Good day, ladies and gentlemen, and welcome to the First Quarter Fiscal 2023 Key Tronic Corporation Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Brett Larsen. Please go ahead..

Thank you. Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in the Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer.

As always, I would like to remind you that during the course of this call, we might make projections or other forward-looking statements regarding future events and 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 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 quarter ended October 1, 2022.

For the first quarter of fiscal year 2023, we reported total revenue of $137.3 million, up 9% from the previous quarter and up 3% from $132.8 million in the same period of fiscal year 2022. During the first quarter of fiscal year 2023, we ramped up new programs from both longstanding and new customers.

While constraints in the global supply chain continued to limit production, we saw some gradual improvements with respect to lead times of certain key components. During the first quarter of fiscal year 2023, our results were impacted by storm damage to our facilities in Arkansas, which reduced revenue and gross profit.

We have received initial insurance proceeds to repair the plant and replace equipment, which should be completed by the second half of fiscal year 2023. And these initial coverage amounts, net of equipment book value are included in the reported gain on insurance claims during the quarter.

For the first quarter of fiscal year 2023, our gross margin was 7.6% and operating margin was 2.4%, compared to gross margin of 7.6% and an operating margin of 1.6% in the same period of fiscal year 2022.

The gross margin in the first quarter of fiscal year 2023 was adversely impacted by the storm damage to our Arkansas facility and increased labor cost in both the U.S. and Mexico.

While profitability is expected to improve in coming quarters with increasing expected revenue, higher interest rates on our line of credit and increasing wages will limit a portion of that expected improvement.

For the first quarter of fiscal year 2023, net income was $1.2 million or $0.11 per share, up from $0.8 million or $0.07 per share for the same period of fiscal year 2022. Turning to the balance sheet.

We continue to maintain a strong financial position despite the continuing production delays due to supply chain problems and the continued ramp and transfer new programs, we ended the first quarter with total working capital of $185.8 million in a current ratio of 2.1 to 1.

At the end of the first quarter of fiscal year 2023, our inventory increased by approximately $26.2 million or roughly 18% from the same period a year ago, reflecting our preparations for significant growth in coming quarters with much of the inventory increase being associated with the previously announced large outdoor power equipment program.

While the state of the worldwide supply chain still requires that we look out much further in the future than in historical periods, we continue to carefully balance custom – customer demand and the likelihood of successful bringing in parts in time for plant production.

In future quarters, we expect to see our net inventory turns slowly improve to more historical levels.

At the end of the first quarter of fiscal 2023, trade receivables were up about $12.6 million from the same period a year ago, and our DSOs also increased to about 91 days up from 83 days from the same period a year ago, which reflects timing of shipments to customers with extended terms and some delays and payments from customers who have been impacted by pandemic related slowdowns and restarts in their respective markets.

Total capital expenditures were roughly $2.5 million for the first quarter of fiscal year 2023, and we expect total CapEx for the year to be around $9 million.

While we’re keeping a careful eye on capital expenditures, we plan to continue to invest selectively in our production equipment, SMT equipments and plastic molding capabilities, utilizing leasing facilities as well to make efficiency improvements to prepare for growth and add capacity.

Despite the ongoing disruption from the global supply chain that will continue to significantly limit production and adversely impact operating efficiencies, we are expecting significant growth in fiscal year 2023.

For the second quarter of fiscal 2023, we expect to report revenue of approximately $140 million to $150 million and earnings of approximately $0.13 to $0.18 per diluted share.

We’re working closely with our customers, key suppliers and employees to minimize the effects of delays attributable to the supply chain constraints, higher cost of labor and component costs, freight logistics, and limited availability of key components.

While our facilities in the U.S., Mexico, China, and Vietnam are currently operating, uncertainty remains to the possibility of future temporary closures, customer fluctuations and demanding costs, future supply chain disruptions, another potential factors could significantly impact operations in coming periods.

In summary, we continue to grow our pipeline of new sales prospects and continue to increase our customer demand to unprecedented levels for Key Tronic.

The overall financial health of the company appears strong and we believe that we are increasingly well positioned to a new EMS programs and to continue to profitably expand our business over the longer term. That’s it for me, Craig..

Okay. Thanks, Brett. Despite facing continuing business challenges of worldwide component shortages, transportation bottlenecks, and increasing labor costs, we’re pleased with our growing revenue and earnings during the first quarter, driven by a successful ramp of new programs and our expanding customer base.

During the first quarter of fiscal year 2023, we won new programs involving auto – electric vehicles, automation and power distribution equipment. We’re also preparing for a significant ramp in production in our Mexican facilities for the previously announced program with a leading outdoor power equipment company during the second quarter.

Once fully ramped, this program alone could contribute approximately $80 million in annual revenue. Global logistics problems, the war in Europe and China-U.S. geopolitical tensions continue to drive OEMs to examine their traditional outsourcing strategies.

These customers increasingly realize they have become overly dependent on their China based contract manufacturers for not only product, but also for design and logistic services. As time has gone by, the decision to onshore or near shore production has become accepted as a smart long-term strategy rather than a knee-jerk reaction.

As a result, we see opportunities for Key Tronic’s continued growth. As we have discussed in prior calls, we built Key Tronic to be the ideal solution for customers as they move to respond to geopolitical pressures.

As you know, our facilities in Mexico represented campus at 1.1 million square feet in Juarez, most of which is continuously located in nine facilities acquired over time. Our three U.S. based manufacturing sites have also benefited greatly from the macro forces driving business back to North America.

Moreover, our new Vietnam facility continues to increase production levels and the abatement of COVID-related government restrictions in Vietnam is allowing us to travel there and tour the plant with potential customers for the first time.

Our Shanghai plant has added capabilities in management staff and systems that allow it to serve Chinese customers directly.

Shanghai has replaced the business that we moved to Vietnam and our procurement group in Shanghai, which serves the entire corporation is critical for managing as supply issues that crippled many of our competitors without boots on the ground in China.

The combination of our global footprint and our expansive design capabilities is proving to be extremely effective in capturing new business. Many of our large and medium size manufacturing program wins are predicated on Key Tronic’s deep and broad design services.

And once we have completed a design and wrapped it into production, our knowledge of our program specific design challenges makes that business extremely sticky.

We also invested in vertical integration and manufacturing process knowledge, including a wide range of plastic molding, injection blow molding, gas assist multi-shot, as well as PCB assembly, metal forming, painting and coating, complex high volume automated assembly and the design construction and operation of complicated test equipment.

This expertise sets Key Tronic apart from our competitors of a similar size. As a result, a customer looking to leave their contract manufacturer finds a one stop shop in Key Tronic, which makes the transition to our facilities much less risky for them than carving together a group of providers each limited to a portion of the value chain.

In recent years, the pandemic and supply shortages have been restricted both our top and bottom line performance and obscure the amplitude and velocity of the growing wave of new business. Nevertheless, the fact that we are achieving record revenue in the midst of continuing and unprecedented supply issues is an indicator of our growing momentum.

Moving further in the fiscal 2023, the headwinds from the global supply chain continued to present uncertainty and multiple business challenges, but do show some signs of abating, particularly with respect to the recent price stabilization for some commodity components.

At the same time, these price reductions are offset by increasing wages at our North American facilities. We believe global logistic problems, China-U.S.

political tensions can heightened assurance of supply concerns will continue to drive a favorable trend of contract manufacturing returning to North America, as well as to our expanding Vietnam facilities. We see the potential for significant growth in fiscal 2023 and beyond. This concludes a 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. Please go ahead..

Thank you. Nice quarter and nice guidance.

So of the forecast – pardon me?.

Nothing. Go ahead, Bill..

Okay, I’m sorry. I heard a – thought I heard a noise coming through the line.

Of the four new customer wins that you announced, what is the size of each of those?.

The audio equipment is 15, the automation control is 15, commercial electric vehicle charging is five, power distribution is five..

Great. Thank you.

And do we have this correct that if you hit the $40 million low end of your guidance range that that would be a record revenue quarter for you all? Is that right?.

Yes..

Congratulations. Let me shift if I may to the Arkansas flood. Could you walk us through what happened? I guess, I didn’t – haven’t heard about any floods, but maybe that had been overtaken by hurricanes or other big events that took place. And then I have some financial questions..

You bet. That was actually a lightning strike that occurred at our Fayetteville facility that impacted some of our production equipment..

And what was the revenue impact and the earnings impact as you calculate it..

Those somewhere around $2.5 million of revenue. It’s difficult to ascertain the exact bottom line impact, but somewhere between 10% and 20% of that number..

And then let me – let’s see here. If we do that math of 10% to 20% of $2.5 million, that’s going to be up to 500,000. So the plant damage was actually greater than the actual financial impact in here in the first quarter..

Yes. The gain is actually associated with the equipment replacement. Of course, that has an impact on the gross profit as we discussed. We’re still analyzing and working with the insurance carrier on business interruption, but we have no value at this point..

So you do have business interruption insurance, it’s just that the negotiation process is underway..

Correct..

That’s help.

After you, Brett?.

Yes. That can take some time, Bill..

Right. So when we look at the kind of stepping back away from the Arkansas flood, the gross margin declined sequentially from 9.3%. And some of that impact is the Arkansas flood as you pointed out. But then there’s another component that would not be in there.

What besides the Arkansas plant pulled the gross margin down sequentially?.

Couple of things. One, we have increased wages that we’ve discussed during the quarter. The other is some inefficiencies associated with essentially starting up new production for new programs. We are definitely in the ramp phase of a number of those programs.

And that, of course, has a detriment to your overall gross profit until you can stabilize those..

And how long do you anticipate it will be before those are stabilized?.

I think, well, throughout fiscal 2023, we’re going to be introducing new programs. I think a large part of the decrease in gross profit this quarter was related to getting ready for the large $80 million program that starts this quarter. So I don’t know if we’re ever stabilized. That was probably the wrong..

We hope never to be stabilized..

Yes, we always want to be ramping new programs..

And were you ramping new programs last quarter?.

Yes..

Okay. So where I’m going with all this, and maybe I’m over matting this situation.

But if I look at the sequential change in gross margin, assuming that you can go back to 9.3% and still be ramping new production that and you had the Arkansas plant impact, but if we were to add back in the insurance proceeds, I mean, ultimately there’s roughly a $0.10 sequential impact so that what $0.11 number that you reported this quarter would otherwise be somewhere closer to a $0.20 – $0.21 number, and I’m just assuming a 25% tax rate on my incremental dollars.

Is there anything that I’m directionally missing? I may be off by a few pennies, but directionally missing with thinking about this?.

Yes. I think we mentioned in our fourth quarter press release and earnings call that the gross margin was higher than historically – higher than historical numbers and that it would more than likely drop down to more historical levels.

Some of that is mix, some of that is price increases to capture some of the increased costs that were incurred earlier on last year through the first three quarters. So I think that 9.3% gross margin is higher than what I would expect going forward..

Okay. That is helpful. And kind of backing off of the actual math, just qualitatively would you concur with the idea that as you improve efficiencies and as your revenue grows that there is an opportunity for that gross margin to expand from this quarter’s level.

And therefore, there is an opportunity to see some faster earnings growth as a result of the revenue growth?.

Absolutely. Completely concur with that..

Okay, great. Thank you both and again, nice quarter and sounds like a beginning to a good trend. Thank you..

Yes. Thank you..

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

Hello everybody. One of the things I didn’t hear you mention in going over the quarter’s results is the SEC investigation.

So were there no cost associated with that? Has it have – has the SEC said, okay, we’re done? Or is it just at a lower level of activity or something else?.

It was a lower level activity..

It was what?.

It was a lower level activity than in the past few quarters..

Any idea whether it’s going to stay that way?.

I have no comment on the SECs..

Okay. I’ll let someone else ask a question..

[Operator Instructions] We’ll take our next question from George Melas with MKH Management. Please go ahead..

Thank you. Hi. Good afternoon guys. Just as a follow-up to that question, what was the cost associated with the SEC [indiscernible] September quarter..

It was roughly a couple hundred thousand dollars for the whole quarter..

Okay, great.

And Brett, do you have a slightly better crystal ball and Craig on the SEC investigation?.

I will follow my leader. I have no comment..

If you look – George, if you look back on the transcripts for the last year and a quarter, my comment has been no comment and it will remain to me. No comment..

Sorry. I would try to see if we can get something else. Okay. And that’s a question for Brett. The SG&A this quarter was sort of backward used to be, and of course, that was helped hardly by the lower SEC investigation cause, but it’s – even if you normalize for that, it’s no, I guess it’s about a normal level.

Is that what we should expect for the rest of the year?.

Yes..

So essentially you had 5.7% minus 0.2%, like 5.5% would be sort of the ongoing SG&A benefit that we should expect?.

Yes. I’d expect the operating expenses to maintain somewhere near the 6% range, yes..

Okay.

But that of course that includes engineering the 6%, right?.

Yes. Correct. Correct..

Great. And even as you ramp up revenue and programs you think we can still maintain at that level? Well, I guess, it’s the percentage of revenue. Okay. In terms of inventory that went up a bit. I know I remember you had a fair amount of inventory that was in your warehouses but was owned by the customer.

What is the situation there? Is that still at similar levels or maybe is it coming down?.

Actually, the inventory that is in our warehouses that is owned by customers, that amount has grown..

Okay..

And we’ll continue to do so as inventory that we bought with an agreement with our customer that we – if we were to own that for 60 days, 90 days, 120 days, depending on what we negotiated. That inventory would age out and our customer would be forced to pay us for that inventory.

It was a tit for tat agreement, because our customers want product and wanted us to take a chance that we would get that last component that we’re having trouble finding. And so that’s why they agreed to these arrangements.

So as time goes by, we’re in kind of a – I’d say, we’re getting close to an inflection point on that as more and more of this inventory that we bought on the come so to speak, that is eventually covered by the customer ages out and we are paid for it.

So I don’t know trying to predict the trend of your questioning, but the fact that we have more in our warehouse that’s already been paid for is actually a good thing rather than a bad thing..

Because it helped, because it’s not [indiscernible] helps you with production..

Right. So we were able to go procure and secure parts that may have otherwise snapped up by somebody else while we were looking for the one part we couldn’t find. And yet in eventually our customer funded all of that in case we were not successful in finding that last part..

Very good. Okay.

And remind us the major sort of new program, the outdoor power equipment were going, did that come from China? Was it made by other contract manufacturing? Was it in house program [indiscernible] of that and both you expected to be truly ramp?.

So that program we expect to be ramping in a couple of weeks. It came from a company who is in the power equipment business, but is entering a new segment. They have their distribution channel with orders already in place. So this isn’t speculative number that we’re giving out as long as everything goes as per plan.

So this is not an example of something that came back out of China or out of Asia or somewhere else, however, is an example of a – an OEM that was asked by the end customer to enter the business because the product currently available was not up to their standards..

Okay. Was that a new customer for you guys or was it somebody you worked business with..

Yes, that’s a new customer for us..

Yes..

Okay..

So we’ve been – as we’ve talked about in the past, we’ve got a bunch of engineers, including me, you now know how to design a piece of power equipment that we hadn’t known anything about a year ago, which will lead to more opportunities as everything else we’ve designed has done. It’s been fun.

A lot of our stuff is small, sitting on a bench with the source also good, and this stuff has been outside making lots of noise and banging into stuff and breaking things. So it’s been a fun change..

Because you still have your engineering hat from time to time..

Yes. Otherwise, I’d go insane..

Okay. And sort of going back to what the line of question that Bill had at the beginning in terms of the gross margin and the ramp of programs, it seems like this particular program sort of took a hit on your gross margin in September quarter.

Do you expect this quarter to be the bottom for the year in terms of gross margin and to have it progress any equipment after that?.

I’d say probably, there’s a lot of moving parts to gross margin, as you know. And our business is not steady state because we’re adding so many new customers and different facilities are growing so rapidly.

So when you’re trying to ramp an $80 million program at the same time, we’re growing the domestic sites from a $120 million to probably $180 million plus. At the same time, we’ve got buy inflation going on with 10%.

So who the hell knows what’s actually going to happen, when you throw all that into the calculator and try and come up with a number, but in general, more volume, more revenue always turns out good for us..

Okay. Very good. Thank you..

Yes..

We’ll take our next question from Bill Dezellem with Tieton Capital. Please go ahead..

Thank you. I want to circle back to your comment, Craig, that this power equipment company will be $80 million annually. And if we think about that just for linear quarters, which may or may not be correct, that, that you’re not even close to providing a guidance of a $20 million sequential increase at least at the mid-point.

Is there something else going on here that, that we’re not taking into account? Or is it just early enough in the ramp, since you said its not going to start ramping until a couple weeks from now?.

As I said, stuff is still going around and busting. So we’re being cautious about predicting when this ramp hits full speed..

Do they have – you mentioned that they – I’m sorry, Craig. Go ahead..

Actually about a week ago, we keep going around in circles and breaking, so I think the numbers we projected for this quarter are pretty safe, we hope, but they in no way are the same as they would be if we had started on October 1 full speed..

And is this a product that has some seasonal deadline or anything of that nature? Or is it more of a consistent year round nature? And the spirit of where I’m going with this question is give if there is some seasonal deadline, are you tight on that? And therefore, we could see a really big jump from this quarter the Q2 to the March quarter in Q3 as they try to catch up or you try to catch up?.

That’s a nice try, Bill, it get me to predict out more than a quarter and better camouflage than most, but I caught it and the answer is no comment..

Well, thank you for at least acknowledging that it was a nice try. I appreciate that..

Yes..

And shifting, if I may to inventories, there was a discussion earlier about inventories and you did have the inventories up about $13 million sequentially.

Would you discuss kind of what’s happening behind the scenes with that really relative to the conversation you were having before about buying for some customers in advance? I’ll say at risk, but with a limited time period until the customer buys a product?.

Well, the majority of that increase was due to the delay of about a month and a quarter, month and two weeks, month and a week of the power equipment deal. So that inventory is coming in now and we’re just about to start building and shipping that. So that was a bump in inventory levels.

There was about, I don’t know, 3 million or so bump in the domestic sites inventory due to the fact, as I said before, they’re growing very significantly from 120 to 170, 180, 190.

And overall, inventory for the rest of the company was flat or a little bit down, which is basically a win in turn based compared to how many millions of dollars we missed in building that we were hoping to build because a part didn’t show up on time..

Right. Okay. That’s helpful. I’m going to come back to my thinly veiled question about the future. And I’m going to actually in all seriousness, try to make it answerable.

Is there without you answering it and giving me an opportunity just to think it through it – does this product tend to have seasonality to it? And if so, kind of what is at season?.

I’m not commenting on that anymore because we are still under a information lockdown with the customer..

Thank you. And again, really nice quarter and guidance..

Thank you..

Thanks, Bill..

[Operator Instructions] We’ll go next to Sheldon Grodsky with Grodsky Associates. Please go ahead..

Yes. Could you describe….

Sheldon, no comment on the SEC Sheldon..

Could you describe what kind of transportation bottlenecks you’re presently suffering from?.

Yes, they’re still even though the prices are coming down for air freight and boat shipments, containers, there’s still a problem with trains here in the states, pretty bad problem. There’s still problems with getting trucking scheduled. So it’s quite a bit better than it was, but it’s still not the way it needs to be..

Okay. Thank you..

You bet..

We’ll take our next question from George Melas with MKH Management. Please go ahead..

Thank you. Trying to understand a little bit sort of customer mix and customer concentration. Let me pick up my phone here. If I look at the last year, if I look at UK, your top customer had grown very fast in the previous couple of years and then there was a very meaningful time. I think probably they had some COVID-related revenue that came down.

The rest of the business grew incredibly fast. Those kinds of fixed changes, does that create disruption in the operation and the inventory? So kind of the question is how do you manage that? Because over the last few years that’s been pretty extreme, I think..

Well, the shift in customer workload doesn’t really give us difficulties as long as we have a reasonable time, let’s call it a quarter of a year or more to react..

One quarter you said?.

Yes. So there have been – let’s see, there was one customer who we are still arguing with over how much money they owe us in inventory. As inventory burns off, the arguments are getting less heated, but that customer cut their forecasts by two-third inside of a quarter..

Okay..

So, and that was a customer that was running about $6 million a quarter. So the answer to your overall question is all of our inventory issues, not all but 99% of our inventory issues have been caused by unpredictable deliveries of components from our suppliers to us.

And a very, very small percentage of the issues are caused by customers suddenly dropping their forecast and us being stuck with a bunch of parts coming in that we have to hold onto before they have to pay us 60 days or 90 days, 120 days later..

Okay..

The cost of the factory I wish you could go tour the factory, because it’s a point of pride amongst all of us, but all of our factories are almost breathtaking, as you walk through there and see the mix of products that are being built and understand the flexibility within each of those facilities as we can move people and processes up, down, around backwards and sideways to match up with demand.

It’s just – it’s hard to get your mind around 4,000 people in 1,000,001 square feet making so many different products from – they can think of from something that’s worth $0.99 up to something that’s worth $5,000..

Right. Okay. So that’s pretty clear. So in a way, the real issue with the inventory, the volatility of supply, and as that comes down, your life should become a little easier..

Yes, and the thing that’s kind of annoying about that is most of the MRP systems, including ours were never designed to deal effectively with these kinds of surprises of, you get a note one day that says that, yes, those 10,000 parts that were supposed to ship yesterday, we didn’t ship them and we’re not going to ship them for a year.

So as we’ve poured a lot of time and sweat, blood and tears into modifying systems and processes, so that – and actually policy in dealing with our customers, all this work we’ve done to modify this, so that we can drive our inventory down, even with a messed up supply chain, I’d say in about five months as the recession hits, it’s going to go, it’s not going to be needed anymore, will be back to the normal stuff.

But it’s made our systems quite a bit more robust and quite a bit more error proof. So it’ll all be good in the end..

Okay. Okay. Very good. Thank you..

[Operator Instructions] It appears we have no further questions at this time. I would like to turn the conference back to your presenters for any additional or closing remarks..

Okay. Thanks everyone for participating and we’ll talk to you next quarter..

Ladies and gentlemen, this concludes today’s conference. We appreciate your participation. You may now disconnect..