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Key Tronic Corporation (NASDAQ:KTCC)

F2Q14 Earnings Conference Call

January 28, 2014 5:00 pm ET

Executives

Craig D. Gates - President and Chief Executive Officer

Ronald F. Klawitter - Executive Vice President of Administration and Chief Financial Officer

Analysts

Anya Shelekhin - Sidoti & Company

Matthew Dhane - Tieton Capital Management

Jeff Mash - Morgan Stanley

Operator

Good day, ladies and gentleman. Thank you for standing by. Welcome to the Key Tronic Corporation's Second Quarter Fiscal 2014 Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today, Tuesday, January 28 of 2014.

I would now like to turn the conference over to Mr. Craig Gates. Please go ahead, sir.

Craig D. 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 of fiscal 2014, and our results were in line with our previous guidance. During the second quarter and moving into the third quarter of fiscal 2014, many of our new programs continue to ramp up, despite greater than anticipated reductions in orders from some of our large long-standing customers. Our recent quarters have been challenging, we currently expect to see sequential growth either during the fourth quarter of fiscal 2014 or the first quarter of fiscal 2015. By then, we anticipate that growing revenue from several new customers should offset and then exceed those revenue reductions in recent periods by some of our large customers.

At the end of the second quarter of fiscal 2014, we were generating revenue from 190 separate programs and had 57 distinct customers, up from 169 programs and 52 customers a year ago. We expect the increase in the number of revenue generating programs and customers to reduce our revenue concentration. During the fourth quarter of the previous fiscal year, our largest customer contributed around 23% of our total revenue and our top three customers contributed around 61% of our total revenue. By the fourth quarter of fiscal 2014, we expect our largest customer to be contributing around 17% of our total revenue and our top three customers to be contributing around 47% of total revenue. We see this trend as a very encouraging sign that we're building a much more stable foundation for our future growth.

During the second quarter, we also continued to see a robust pipeline of potential new business and have further diversified our future revenue base on winning new customer programs involving consumer dental hygiene products and consumer home products. Our success in winning new business continue to be driven by our unique combination of world class engineering and global footprint and by the competitive advantages that result from our vertical integration and expanding production capabilities in Mexico and China.

Furthermore, our continued integration of software manufacturing into our operations is allowing us to begin rapidly expanding our sheet metal fabrication business across our customer base. We're currently investing in the expansion of our new sheet metal fabrication business to capitalize on a growing number of opportunities related to this capability.

Now, I would like to turn the call over to Ron to review our financial performance. Then, I'll come back to discuss our strategy as we move into the second half of fiscal 2014. Ron?

Ronald F. Klawitter

Okay. Thanks 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 web site.

For the quarter ended December 28, 2013, we reported total revenue of $78.3 million, which is comparable to the previous quarter but down from $94.6 million in the same period of fiscal 2013. For the first six months of fiscal 2014, total revenue was $156.2 million, compared to $192.1 million in the same period of fiscal year 2013. As anticipated, the decline reflects the decrease in orders from certain large long-standing customers in recent periods.

Despite the reduction in revenue levels and the fact that we have been moving many new programs into production, we have continued to maintain a strong gross margin. Our gross margin was approximately 9% in the second quarter of 2014, up slightly from the previous quarter and in line with our long-term target of 9%. Our total operating expenses were $4.6 million in the second quarter of fiscal 2014. This is up 10% from the second quarter of 2013, reflecting our expanding operations and preparations for growth that have been delayed by a quarter or two.

Operating margin was 3% in the second quarter of 2014. This is down from 6% in the second quarter of fiscal 2013. This decline primarily reflects our lower revenue levels. By maintaining reasonably good operating efficiencies, our lower revenue did have an impact on our bottom line in the second quarter.

Net income for the second quarter of fiscal 2014 was $3.1 million or $0.28 per diluted share, compared to $3.6 million or $0.33 per share in the same period of fiscal 2013. The results for the second quarter of 2014 include a one-time tax benefit of approximately $1.5 million, or $0.13 per share, due to the changes in Mexico's tax laws which were enacted in December of 2013. For the first six months of fiscal 2014, net income was $4.8 million, or $0.44 per share, compared to $7.3 million or $0.67 per share for the same period of fiscal 2013.

Turning to the balance sheet, we have continued to maintain our strong financial position. Our inventory was up 3% from the previous quarter, which reflects our preparations for previously anticipated growth in the third quarter which we now expect to occur in the fourth quarter or the first quarter of fiscal 2015. Over the longer term, we expect our inventory levels to come back into line with our revenue levels and our cash position to increase.

We've continued to maintain a zero balance on our bank line of credit and our cash position at the end of the second quarter was $1.4 million. This is down from $2 million at the end of the previous quarter. The decrease mainly reflects capital investments in our new sheet metal production facility in Juarez.

Our trade receivables were $51.4 million at the end of the second quarter, and our DSOs were about 53 days, up slightly from recent quarters, reflecting the timing of shipments during the quarter. The capital expenditures for the second quarter of fiscal 2014 were approximately $1.5 million, reflecting our investment in expanding our new sheet metal fabrication capabilities. We expect our CapEx to be about $6 million for the full fiscal year.

Moving into the third quarter of fiscal 2014, we anticipate more of our new customer programs moving into production and gradually ramping up, partially offsetting the continued reductions in production levels by some of our long-standing large customers in recent quarters. Taking these factors into consideration, we anticipate that third quarter revenue for fiscal 2014 will be in the range of $73 million to $78 million.

In the third quarter, we expect our gross margin to remain around 9%. We also expect our operating expenses to remain relatively flat in coming periods. Taking these factors into consideration, we expect earnings in the range of $0.13 to $0.18 per share in the third quarter. This expected earnings range assumes an effective tax rate of 30%.

In summary, we expect our third quarter results to be roughly comparable to 2Q, excluding the one-time tax benefit. As our new customer programs continue to ramp up, we expect to see stronger sequential growth during the fourth quarter or the first quarter of fiscal 2015. Overall, the financial health of the Company is excellent. We believe we are well positioned to continue to profitably expand our business over the longer term.

All right, Craig, that's it for me.

Craig D. Gates

Okay. Thanks Ron. While the slowdown by so6me large customers in recent quarters has masked the production ramps of several new customers, we continue to believe our fundamental strategy remains sound. As we have discussed before, we have three long-term major competitive advantages.

First, increasing costs 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 years of experience in running offshore operations, bring significant advantages to OEMs. Our growing portfolio of customers increasingly want offshore cost savings, yet they fear IP loss, fear offshore schedule risk and inventory uncertainty, do not want to manage an offshore relationship, 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 service we can provide from our Mexican facilities, we offer an exceptional level of experience with the process of competing with an in-house model.

And 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. To this end, we are investing in the expansion of our metal fabrication capabilities in combination with our plastic moulding, PCB assembly, complete product assembly, design engineering and test engineering services. This investment reflects our continued strategic focus on providing all the EMS services available from a much larger company, while still bringing the flexibility and high customer service levels that our clients expect from us.

While periodic fluctuations in large customer demand, mixed changes in our program portfolio and cost associated with ramping up new programs will continue to be a part of our business, we believe our fundamental strategy remains sound and our sustained focus on controlling costs, augmenting production processes and enhancing our capabilities will continue to result in profitable growth and competitive advantage. We see more of our new customer programs moving into production and gradually ramping up and our pipeline of new business opportunities remains robust. Over the longer-term, EMS market is expected to see steady growth and we believe Key Tronic is increasingly well-positioned to continue to capture market share and capitalize on emerging opportunities.

This concludes the formal portion of our presentation. Ron and I will now be pleased to answer any questions you have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Anya Shelekhin with Sidoti & Company. Please go ahead.

Anya Shelekhin - Sidoti & Company

So first of all, the two new program wins, were they related to the sheet metal fabrication business in any way?

Craig D. Gates

The larger of the two relies in part on the sheet metal business, yes.

Anya Shelekhin - Sidoti & Company

Okay, and are there any new opportunities in the pipeline that you're exploring that are related to that, and could you provide some more color on that?

Craig D. Gates

Related to the sheet metal capabilities?

Anya Shelekhin - Sidoti & Company

Yes.

Craig D. Gates

There's around $40 million to $50 million worth of business that we can identify to-date that would not have been available for us to even bid on had we not had our sheet metal capabilities.

Anya Shelekhin - Sidoti & Company

Okay, and finally, the Asia to North America-China thing going on in the EMS industry, what is the possibility of increased competition there? I'm sure you've seen in the news with Foxconn looking to build a factory in the U.S. Have you seen other competitors doing the same, is that a risk?

Craig D. Gates

Foxconn already had a factory in Juarez, about 3 miles from ours, for about five years now. I don't want to [dog-pass] (ph) our competitors but they have certainly had their challenges in bringing that factory up and running. And again, the point that's really selling there is that Foxconn is not really interested in any kind of an account that's under a couple of hundred million dollars. They might say that they are but history has shown that they are not. So, our sweet spot customer, which is somebody with $5 million to $100 million of business, won't get the time of day from somebody like a Foxconn.

So, what we see is that our competitors that are in our size range and match-up with the business at our sweet spot, don't really have the wherewithal to re-create what we've spent 20 years creating in Mexico. So yes, somebody like Flextronics has already got something in Mexico, somebody like Foxconn has already got something in Mexico, both people are beginning to cover their bets by focusing on Mexico, but we don't really compete with them on a day-in-day-out basis. We compete with the next tier down and those folks, even if they wanted to double or cover their bets, are having a rough time with it.

There's a couple of companies in tier two that have tried to go to Mexico over the past three, four years and have failed and actually given up and closed the shop. So, we don't fear that competitive realization that China has become unattractive, as is now official because the front page in The Economist said that this morning, but we don't fear the competition as a result of that.

Anya Shelekhin - Sidoti & Company

Okay, great. That's all for me.

Operator

Thank you. Our next question comes from the line of Matt Dhane with Tieton Capital Management. Please go ahead.

Matthew Dhane - Tieton Capital Management

I was curious, the two customer wins this quarter, what is the size range for those?

Craig D. Gates

So you're standing in for Bill on that question?

Matthew Dhane - Tieton Capital Management

I am.

Craig D. Gates

Good. One was about 3, the other one was somewhere around 20.

Matthew Dhane - Tieton Capital Management

Okay, great. And how's your confidence in the ultimate ramp of these significant new customers that you expect to ramp in Q4 to Q1, has the confidence in the ultimate ramp, has that changed either favorably or unfavorably?

Craig D. Gates

I guess I'd say it stayed about the same. The timing of it is always a mystery to us and I guess our confidence has been shaken a bit in the long-term outlook, or I should say that in our customers' ability to forecast the long-term outlook, the big guys that we've currently got in our catalog. So it's less of a dramatic slowdown or the way in ramping new customers that has caused this flatness for the next quarter and a half or so, and more of a surprise lack of meeting the forecast from a couple of our big guys.

Matthew Dhane - Tieton Capital Management

Okay, that's helpful. Thank you.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Jeff Mash with Morgan Stanley. Please go ahead.

Jeff Mash - Morgan Stanley

You kind of touched on it, but basically the question is, why are you losing orders from the prior long-standing customers?

Craig D. Gates

We aren't losing any business with them. Their demand has dropped. So, I guess to be perfectly clear, we have lost no programs, we have lost no business, we have lost no upcoming programs, it's just that their demand has slipped.

Jeff Mash - Morgan Stanley

All right. I guess can you comment on it further, I mean it's dropped off enough that it's hit earnings pretty good, I mean can you expand on that?

Craig D. Gates

Okay. I can't mention our customers by name, but for example, we had a customer a year ago at this time that was running over $30 million a quarter and today is running about $13 million.

Jeff Mash - Morgan Stanley

So the function of the economy just slowing way down and the core business shrinking?

Craig D. Gates

In their case, it was a function of their market becoming saturated, then failing to recognize it, and then building inventory too long before they realized they had too much.

Jeff Mash - Morgan Stanley

Okay.

Craig D. Gates

There's another large customer that's off probably 40% compared to the year ago, that was in our top three, and that customer's business is down due directly to a recognized market-wide decrease in demand in their market space.

Jeff Mash - Morgan Stanley

Okay.

Operator

Thank you. Gentlemen, I'm showing no additional questions in the queue at this time. Please continue with any further remarks you may have.

Craig D. Gates

Okay, thank you everyone for participating in today’s conference call. Ron and I look forward to speaking with you again. Thanks. Have a good day.

Operator

Thank you. Ladies and gentlemen, this concludes the Key Tronic Corporation second quarter fiscal 2014 conference call. If you would like to listen to a replay of today's conference, you can do so by dialling 303-590-3030 or 1-800-406-7325 and entering the access code of 4660975 followed by the pound sign. We thank you for your participation today and you may now disconnect.

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