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Key Tronic Corporation (NASDAQ:KTCC)

F2Q13 Earnings Call

January 29, 2013, 5:00 p.m. ET

Executives

Craig Gates - President, CEO

Ronald Klawitter - CFO, EVP - Administration, Treasurer

Analysts

Bill Dezellem - Tieton Capital Management

Operator

Good day, ladies and gentlemen, and welcome to the Key Tronic second quarter fiscal 2013 conference call. At this time, all participants are in a listen-only mode. Following today’s presentation, the conference will be open for questions. (Operator Instructions)

As a reminder, this conference is being recorded today, January 29, 2013.

I would like to turn the conference over to CEO and President, Craig Gates. Please go ahead, Sir.

Craig Gates 

Good afternoon everyone. I am Craig Gates, President and Chief Executive 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 Ron Klawitter, our Chief Financial Officer.

Today, we released our results for the second quarter fiscal 2013. We’re pleased with our strong year-over-year growth in revenue and earnings for the second quarter, and for the first half of fiscal 2013. Our many new customer programs continue to ramp up, and we have an increasingly diverse mix of new customer programs.

At the end of the second quarter of fiscal 2013, we were generating revenue from 169 separate programs, and had 52 distinct customers, up from 149 programs and 40 customers a year ago.

During the second quarter, we continue to extend our customer portfolio across a wide range of industries. We won new programs involving RFID, exercise and security equipment. While many of our new program wins will take many months to move in to production, the outstanding and unique services that we provide our customers during the ramp phase have played a key role in our growth by becoming a powerful differentiator to help us win new programs.

As our business has grown, we’ve continued to overcome many challenges associated with rapid growth, steep program ramps, product mix changes and the addition to new facilities and people. We focused on optimizing product designs, production processes and supply chains, and made changes in our business processes to enable continued profitable growth. As a result, we continue to see increases in our margins and profitability in the second quarter.

While we maintained strong operating efficiencies and further strengthen our balance sheet during the second quarter, our sequential quarter revenue was impacted by a significant slowdown in demand from one customer.

Moving in to the third quarter, we expect to see our revenue reduced by the continued slowdown in demand, from that same customer. In coming periods, however, we expect to see the continued ramp-up of our new programs more than offset this customer’s decrease in demand.

In addition, two other customers decided to change the mix of in-house versus outsource production for portions of certain programs during the second quarter. In examining these particular customers’ decisions, I would like you to keep in mind three important considerations.

First, the decision to outsource is often a difficult one, requiring a company to weigh a long-term profit improvement that comes with outsourcing against a near-term impact on employees, local communities, and in-house factory utilization. As a result, not every management team comes to the same conclusion.

Second, the decision to outsource to China has increasingly proved to be the wrong decision for many North American companies, which was the case with one of these clients.

And third, we have seen that the partial outsource model, usually proves problematic because it often means the customer can’t fund fewer manufacturing hours, must still support the manufacturing burden that goes along with maintaining a factory.

Well our analysis with many customers, the only reason to partially in source, is the highly proprietary or unusually capital-intensive manufacturing process. An overwhelming evidence shows that the long-term trend toward outsourcing continues to gain momentum worldwide. Outsourcing made sense before the China model became popular. All the classic drivers of outsourcing; demand, aggregating, capital utilization, and strategic focus on core capabilities are still as valid today as they were in the 1980s.

Furthermore, an abundance of recent evidence, strongly points to the many costs, logistical, and risk management advantages of North American-based outsourcing versus Asian outsourcing for the North American market.

In other words, broader trend supports the fundamental Key Tronic strategy and the value proposition of our significant investment in capacity and expertise in Mexico and U.S.A.

As a result, we have an increasingly robust pipeline of potential new business, including programs with larger revenue potential than most of our current customer programs. We believe this trend towards larger quote opportunities reflects increased recognition of the competitive advantages of North America-based manufacturing for products sold in the Americas.

Over the long-term, we believe our unique combination of global logistics with world class engineering and production capabilities in the U.S., Mexico, and China will continue to fuel our growth.

Now I’d like to turn the call over to Ron to review our financial performance, then I will come back to discuss our strategy going forward. Ron?

Ronald Klawitter 

All right. Thanks a lot, Craig. 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 for 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.

For the quarter ended, December 29, 2012, we reported total revenue of $94.6 million. This is up 12% from $84.5 million in the same period of fiscal year 2012. The first six months of fiscal 2013, total revenue was 192.1 million, this is up 25% from 154.2 million in the same period of fiscal 2012.

Despite the fact that we have been moving many new programs in to production, we have continued to improve our gross margins. Our gross margin was approximately 10% in the second quarter of 2013, up from 8% in the same period of fiscal 2012. For the third quarter, we expect our gross margin to be around 9%.

Our total operating expenses were $4.2 million in the second quarter of fiscal 2013. This is up just 2% from the second quarter of last fiscal year, which is much less than our year-over-year growth in sales.

Although the new program startups that fueled our revenue growth have required the addition of technical and support headcount, we’ve done a good job of controlling our cost. Our operating margin was 6% in the second quarter of 2013, up from 3% in the same period of fiscal 2012.

Our increased revenue and operating efficiencies had a positive impact on our bottom line. Net income for the second quarter of fiscal 2013 was 3.6 million, or $0.33 per diluted share. This is up 13% from the 3.2 million or $0.30 per diluted share for the same period of fiscal 2012.

The first six months of fiscal 2013, net income was 7.3 million, or $0.67 per share, up 66% from 4.4 million, or $0.42 per share for the same period of fiscal 2012.

Turning to the balance sheet, we have further strengthened our financial position as we expand our business. Our inventory was down $7.8 million, or 14% from the previous quarter, which reflects our planned reductions in line with our expectations for the third quarter revenue.

We also continued to reduce the balance in our line of credit. At quarter-end, the balance in our line of credit was 4.7 million, which is a reduction of around 6.4 million from the previous quarter, and a reduction of $10.3 million from the end of fiscal 2012.

Our trade receivables were 54.8 million at the end of the second quarter, and our DSOs were about 52 days, comparable to recent quarters. Our capital expenditures for the second quarter of fiscal 2013 were approximately $1.5 million, and we still expect our CapEx to be about $5 million for the entire fiscal year of 2013.

Moving in to the third quarter of fiscal year 2013, we anticipate more of our new customer programs moving in to production, and gradually ramping up. At the same time, we anticipate lower overall revenue as a result of the continued slowdown in demand from the same customer that began to reduce its production levels in the second quarter.

Taking these factors in to consideration, we anticipate that the third quarter of fiscal 2013 will have revenue in the range of 83 million to $90 million. In coming periods, however, we expect to see the continued ramp-up of our new programs to more than offset this customer’s decrease of demand.

In the third quarter, we expect our gross margin to be around 9%. They also expect our operating expenses to remain relatively flat in coming periods. Taking these factors in to consideration, we expect earnings in the range of $0.24 to $0.30 per share for the third quarter. This expected earnings range assumes an effective tax rate of 25%, and this reflects the U.S. Government’s recent renewal of the research and development tax credits.

In summary, while we expect a short-term dip in our revenue levels in the third quarter, the financial health of our company is excellent and we believe that we are well positioned to continue to profitably expand our business over the longer term.

All right, that’s it for me, Craig.

Craig Gates

Okay, thanks Ron. Moving in the third quarter of fiscal 2013, we continue to believe our fundamental strategy remains sound. As we’ve discussed before, there are three major competitive advantages behind our continued success.

First, increasing cost in China are driving demand for more localized production; Mexico, for North American end-users and China for Asian end-users. Among EMS providers, we stand alone in the excellence and breadth of our Mexican operations. As more previously outsourced manufacturing business moves back from China, we stand to continue to benefit.

Second, our unique organizational structure, which we have honed over 25 years of experience in running offshore operations, bring significant advantages to OEMs. Our growing portfolio of customers is increasingly desirous of offshore cost savings, but fear IP loss, do not want to manage an offshore relationship, fear of offshore schedule risk and inventory uncertainty, and want U.S. based engineering and prototyping.

While we’ll sometimes be competing against our customers in-house factories, we believe that beyond the level of cost and services we can provide from our Mexican facilities, we do offer an exceptional level of experience with the process of competing with an in-house model.

Third, our size and responsiveness compared to our degree of vertical integration and engineering capabilities become even more attractive as the push for localized production intensifies.

While our growth has moved us in to the Tier 2 category as an EMS provider, we continue to provide the flexibility of a Tier 3 provider and the capabilities of a Tier 1 provider.

With these three competitive advantages powering us, we expect to continue to win market share. While mixed changes in our program portfolio and cost associated with ramping up new programs, will continue to be a part of our business, we expect our sustained focus on controlling cost, augmenting production processes, and enhancing our design capabilities will continue to result in competitive advantage.

Despite the continued macroeconomic uncertainty, and a near-term significant decline in the demand from one customer, we continue to see positive business momentum, and are building an increasingly diversified customer base.

We anticipate more of our new customer programs moving in to production, and our pipeline of new business opportunities is increasingly robust. Over the longer term, the EMS market is expected to see growth, and we believe Key Tronic is increasingly well positioned to continue to capture market share and capitalize on emerging opportunities.

This concludes a formal portion of our presentation. Ron and I, will now be pleased to answer your questions.

Question-and-Answer Session

Operator

(Operator instructions). And our first question comes from Bill Dezellem, Tieton Capital Management. Please go head.

Bill Dezellem - Tieton Capital Management

Thank you. Relative to this quarter, you had the three different customers that you specifically called out, with the one that had the slowdown, and the two that brought some more business in-house. How much of that did you understand and anticipate when you gave your December quarter guidance, versus how much of that was a surprise to you during the quarter?

Craig Gates – President, CEO

I would say that most of what happened during the quarter; we had anticipated when we gave our guidance.

Bill Dezellem – Tieton Capital Management

And then relative to the one customer that had a significant slowdown, are they – or were they running at the end of the December quarter at their new reduced level of run-rate, or are they still decreasing their commitments to you as the weeks progress?

Craig Gates – President, CEO

They are changing their forecast pretty much on a daily basis. So, whether or not there are the bottom, whether or not they’ve started to come back up again, I can’t answer with any degree of clarity.

Ronald Klawitter – CFO, EVP – Administration , Treasurer

But our guidance for revenue for Q3 does anticipate additional reductions and that difference coming from that customer.

Bill Dezellem – Tieton Capital Management

Right.

Craig Gates – President, CEO

We’re always pretty conservative in our guidance, so we’ve expected them to continue to go down, and it maybe that they don’t.

Bill Dezellem – Tieton Capital Management

And if I’m reading between the lines correctly, and maybe I should ask, because it sounds like at times when they are changing their forecast on a daily basis, sometimes it’s actually going up. So, that’s what makes you wonder really directionally where their at?

Craig Gates – President, CEO

That’s correct.

Bill Dezellem – Tieton Capital Management

Okay, thank you. And then, you did make reference to three new winds in the quarter, what were the size of those rascals, and what can you tell us about each one of them beyond what’s in the release?

Ronald Klawitter – CFO, EVP – Administration , Treasurer

They were from 2 to 5 million each, and beyond that I can’t tell you much about them.

Bill Dezellem – Tieton Capital Management

Is there anything special or unique about any one of those three that you have not done in the past, or some extra special capability that you have that kind of made it a done deal for you to win one of those pieces of business?

Craig Gates – President, CEO

Ah, let’s see. A couple of them were based pretty heavily on the fact that we have U.S. prototyping and design services, which has been increasingly attractive over the last couple quarters.

Bill Dezellem – Tieton Capital Management

And why do you suppose that that change is taking place, or that that phenomenon has taken place in the last couple quarters that you’ve noticed?

Craig Gates – President, CEO

I think that the China lending rush to (sea) has stopped. And what people used to put up with, as they were carried along with that rush in terms of the difficulty in getting engineering done, and the difficulty in getting new products launched. Now that the overwhelming pressure to go to China is no longer being brought to bear, the people that used to just kind of squished when they complained or whined or pointed out the fact that it was going to be hard and slow – when they were ignored before, it seems like more and more those people are being listened to.

And so, what was always attractive to the portion of our current and perspective customers is now being weighed more heavily as the savings that result from being in China and shipping to America decreased.

So, the fact that we started to build our engineering capabilities and (NYSE:NPI) capabilities here in Spokane a couple years ago is turning out to be a good idea.

Bill Dezellem – Tieton Capital Management

Congratulations. And then, in the press release, and I think in your opening remarks, you made reference to larger revenue potential new business pipeline. Would you discuss that further, and have you won any of that business?

Craig Gates – President, CEO

First, in reverse order, we’ll tell you about whether we’ve won any of that new business in this call quarter from now.

And second, the quotes, or a portion of the quotes that we’re seeing are quite a bit bigger than the 2 to 10 million that we typically talked about winning. So, we don’t know about the [inaudible] change or not, but it’s been happening for about the last two quarters. And we don’t know if it reflects again the China pricing issue, or if it reflects the localization of drive of folks. We’re not exactly sure, but it may be that it reflects the growing legitimacy that people attach to Key Tronic business today, versus three years ago. Or it could be all of those things together. We’re not sure, but we like it.

Bill Dezellem – Tieton Capital Management

And so I want to push on this just a little bit. So, if you’re seeing something different in the last six months – I mean, can you quantify that in terms of, you know, the number of what I’ll call larger potential that you’ve see in the last six months and how that might compare to prior years?

Craig Gates – President, CEO

We’ve probably seen five or six quote opportunities in the last six months that are all bigger than our – or as big as our current largest customer. And that’s unusual, typically we’d see may be one of those a year.

Bill Dezellem – Tieton Capital Management

Again, trying to read between the lines, but you reference in response to one of my first questions that you would comment more about winds next quarter. That almost gives the impression that may be you’ve won one of these already in the month of January. Or feel like you’re very close to winning.

Craig Gates – President, CEO

Well, I can’t comment to that either way.

Bill Dezellem – Tieton Capital Management

Let me ask this. Assuming that you were to win some of these – some of these prospective customers, is the timing of their ramp any different than the typical 2 to 20 million or 5 to 10 million pieces of business? Does the sheer size either increase the speed or decrease the speed at which they move their ramp process?

Craig Gates – President, CEO

Well, if you accept one of the three theories, in that people are given us these larger quotes because we’re legitimately a $400 million company, part of the reason that they wouldn’t give us that large of a quote opportunity before, is that just because it’s – just using a number here, but just because it’s 75 million opportunity rather than 7.5, doesn’t mean that it can ramp any slower.

So, I think it’s a pretty common belief that if you’re asking a company to ramp a piece of business that’s more than 20% of their current revenue base, you’re going to experience some significant delays.

So, it hasn’t been our experience that these programs that are larger to us, have any less demand in terms of service or speed- to-ramp, or anything else that goes along with our – what we provide to the customers.

So, if I look at the big ones we’re looking at now, some of them are slow ramps and some of them are really fast, just like every other program we win.

Bill Dezellem – Tieton Capital Management

Great, thank you. I’ll step back and let someone else have a turn.

Operator

(Operator Instructions). And we have a follow-up question from the line of Bill Dezellem with Tieton Capital Management. Please go ahead.

Bill Dezellem - Tieton Capital Management

All right, well, it no one else wants a turn then I’m going to continue here.

Craig D. Gates

You know, Bill, from here on out when we get done with this operator, every time I’m going to tell them your name if Bill Dezellem and you work for Tieton Capital. This has gone on for 20 years and it’s time to fix that.

Bill Dezellem - Tieton Capital Management

Tieton Capital Management it is. Thank you.

Craig D. Gates

There you go, Buddy.

Bill Dezellem - Tieton Capital Management

So in the press release, you referenced maybe for the first time that I can recall in the 20 years that you just referenced that you actually made a comment about coming periods and the ramp of new programs offsetting a slowdown in the one customer that had the significant slowdown. That begs the question of when you talk coming periods, that sounds more forward looking than you normally would be, and I know that you’re cautious about being forward looking, which to me implies a sooner quarter rather than farther out quarters; i.e. the June quarter or September quarter is when you’re looking at these new programs ramping in a way that’s noticeable to offset the one significant slowdown. Is that a correct interpretation or what more light can you shed on the phrase, coming periods and that whole thought process that you dangled in front of us?

Craig D. Gates

Well, we’re trying to be very careful, to live with all the rules and guidelines we have for outlook, and at the same time, we want to give everybody a very clear understanding of how we view the future and the fact that we’re seeing a dip for this quarter, this upcoming quarter concerned us that people might be reading into it that this decline is going to continue and we didn’t want people to walk away from anything we’ve said or written today believing that’s what we thought was going to happen. So we have been very, very cautious about saying it’s going to go or it’s going to shrink, but we wanted to make sure people understood that the outlook continues to be bright and up and we view the next quarters to two quarters as a dip rather than a decline.

So that’s why we said it. In terms of being precise on telling you whether it’s going to come back two quarters from now, three quarters from now or half a quarter from now, it depends on a whole lot of moving parts that there’s no way we would be willing to predict. But we did want to make sure that the people that follow us and risk their money on us understood that we were viewing the business as a dip rather than a decline.

Bill Dezellem - Tieton Capital Management

And I would even take that a step further and pose the question of whether, you know, not for the near term because clearly you’re forecasting a dip, but long term you’re almost giving more positive signals about the business than I think we’ve ever heard you give, especially when you start talking about this – it almost sounds like a bit of a seat change in the last six months where you’re having a number of larger opportunities present themselves and that ultimately flows through revenue and could be very, very material to the business unless we’re not hearing you correctly.

Craig D. Gates

Well, to, I think, give the best view I can of that, we’ve always disclosed the fact that our biggest customer is quite a large percent of our business in our mind. At one point they were pushing 30%. So in our view, if you go back four years ago, we won the race against the 2008/2009 recession and were able to bring in enough customers to keep us in the black and get us growing nicely. But one of those customers in the 2010/2011 timeframe included this one big customer that at 30% is pushing the range of where we like to see our biggest customer be in size; it’s too much risk. So we’ve been in that race, a much less desperate race than the one we were running in 2008/2009, but that race has been to shore up our revenue in the case –in case this big customer got a little bit sick on us. And what happened to us is this big customer got sick ahead about two quarters, we think, head of where we could have compensated with the new business and shown a continued growth in revenue even if this new customer declined to a more reasonable percentage of our revenue base.

So that’s about as clear as I can be about it, is we’ve continued to add new business, new customer, new revenue in a very healthy pace. One of the customers that we added a while back that certainly helped us through the bad times following the recession has been a little bit too big for comfort, not only in our own minds, but when we spoke to various analysts, we agreed with them, before we spoke to them, during and after we spoke to them. And so it looks like we have tied rather than won the race this time and we’re just trying to make it clear to everybody that we believe that we’re going to win and the timing is just a little bit off.

Bill Dezellem - Tieton Capital Management

That’s very helpful. Thank you. And then diving into the one specific customer a bit further, often times we have seen where they have a dip, it allows them to clear inventory and get their turns – their inventory turns where they want them and then since they’re actually having you produce at a below-normal run rate level, the business then ramps back up. Is that what you would anticipate at some point in the future with this particular customer, that they will be producing at a higher run rate than where you’re currently at today?

Craig D. Gates

I don’t know that I could say I would anticipate it. It certainly has been, historically, the case with this and other customers that they slow us down below their actual pull-through rate until they burn up inventory and then we come back up. But there’s always a risk that their business will continue to decline, so we’ve been cautious about forecasting any kind of significant recovery in their order patterns with us.

Bill Dezellem - Tieton Capital Management

That’s fair. And a couple of numbers questions. Ron, the revenues were down versus the September quarter by a small amount, but the gross margin percentage was up. How did you accomplish that?

Ronald Klawitter

A better mix of our revenue. Some of the declines that we saw are on lower margin business, so I would have to say the size of the business gets a lot tighter margin and so when some of the largest customers decline it’s actually a more favorable mix of the revenue that we have left.

Bill Dezellem - Tieton Capital Management

Understood. And then your revolver, you’ve paid way down, but given that you’re not ramping revenues in this coming quarter, that, in theory, would imply that you may need less working capital. So would you expect to pay the revolver off as of the end of March when you report next time?

Ronald Klawitter

It’s a very good possibility.

Bill Dezellem - Tieton Capital Management

Great. Thank you both.

Craig D. Gates

Thank you.

Operator

(Operator Instructions). One moment please. Mr. Gates, there are no further questions at this time.

Craig D. Gates

Okay, I’d like to thank all of you again for participating in today’s conference call and Ron and I will look forward to speaking with you again next quarter. Thanks, and have a good day.

Operator

Ladies and gentlemen, this concludes the Key Tronic Corporation second quarter fiscal 2013 conference call. If you would like to listen to a replay of today’s conference call, please dial 1-303-590-3030 or toll free at 1-800-406-7325. Thank you.

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