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Key Tronic Corporation (NASDAQ:KTCC)

F3Q 2014 Earnings Conference Call

April 29, 2014 5:00 PM ET

Executives

Craig Gates - President and CEO

Ronald Klawitter - EVP of Administration and CFO

Analysts

Anya Shelekhin - Sidoti & Company

Matthew Dhane - Tieton Capital Management

George Melas - MKH Management

Operator

Welcome to the Key Tronic Corporation Third Quarter Fiscal 2014 Earnings 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, the 29th of April, 2014.

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

Craig Gates

Good afternoon everyone. I am Craig Gates, President and Chief Executive Officer of Key Tronic. I'd 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 third quarter of fiscal 2014. Our results were in line with our previous guidance. During the third quarter, many of our new programs continued to ramp up. Our recent quarters have been challenging. We currently expect to see sequential growth during the fourth quarter of fiscal year 2014.

As drawing revenue from several new customers should offset and then exceed revenue reductions in recent periods by certain large customers.

Overall, we continue to enjoy strong customer loyalty, with many of our customers rewarding us with nearly a decade or more of uninterrupted business. At the end of the third quarter of fiscal 2014, we were generating revenue from 192 separate programs, and had 55 distinct customers, compared to 177 programs and 56 customers a year ago. We expect the increase in the number of revenue generating programs to reduce our revenue concentration.

During the first nine months of fiscal 2014, our top three customers contributed 51% of our total revenue, down from 61% in the same period of fiscal 2013. While these results include the year-over-year decline in revenue levels from some of our major customers, we see this trend as a very encouraging sign that we are building a much more stable foundation for our future growth.

During the third quarter, we continue to see an increasingly robust pipeline of potential new business, involving programs with greater revenue potential over the long term. We have further diversified our future revenue base by winning two new programs from new customers involving consumer products and fitness equipment. Our increased competitiveness in the EMS marketplace is being driven by the growing recognition of the advantages of Mexico-based production over China-based production for products consumed in the Americas.

We are also seeing a growing number of opportunities, where we can capitalize on the continued expansion of our new sheet metal fabrication capabilities in concert with our plastic molding, printed circuit and product assembly capabilities.

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

Ronald 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 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 web site.

For the quarter ended March 29, 2014, we have reported total revenue of $77 million, compared to $84.3 million in the same period of fiscal year 2013. For the first nine months of fiscal year 2014, our total revenue was $233.3 million, compared to $276.4 million in the same period of fiscal 2013. As anticipated, the decline reflects the decrease in orders of certain large longstanding 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 third quarter of 2014, comparable to the previous quarter and in line with our long term target of around 9%.

Our total operating expenses were $4.4 million in the third quarter of fiscal 2014, this is down 4% from the previous quarter, but up 3% from the third quarter of 2013, reflecting our expanding operations, and preparations for growth that have been delayed in recent quarters.

Our operating margin was 3% in the third quarter of fiscal 2014, this is down from 4% in the third quarter of fiscal 2013. This decline primarily reflects our lower revenue levels. Despite maintaining reasonably good operating efficiencies, our lower revenue did have an impact on our bottom line in the third quarter.

Net income for the third quarter of fiscal 2014 was $1.4 million, or $0.13 per diluted share compared to $2.9 million or $0.26 per diluted share for the same period of fiscal 2013. For the first nine months of fiscal 2014, net income was $6.2 million or $0.57 per share, compared to $10.2 million or $0.94 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 down 2% in the previous quarter, as we brought inventory levels down, in line with our delayed growth in recent quarters. This growth, we now expect to begin in the fourth quarter. At the same time, our cash position was $2.2 million at the end of the third quarter, this is up 56% than the previous quarter. We have continued to maintain a zero balance on our bank line of credit.

Our trade receivables were $52.6 million at the end of the third quarter, reflecting the back end loaded nature of shipments during the quarter, and our days sales outstanding were about 53 days, which is comparable to recent quarters.

Our capital expenditures for the third quarter of fiscal 2014 were approximately $4.5 million -- for the first three quarters was approximately $4.5 million, reflecting our investment and expanding our new sheet metal fabrication capabilities, which has helped us win substantial new business.

We now expect our CapEx to be about $8 million for the full fiscal year, as we plan to continue to expand our sheet metal fabrication, plastic injection molding, and electrical assembly, to accommodate the new business that we have won.

Moving into the fourth quarter of fiscal 2014, we anticipate more of our new customer programs moving into production and gradually ramping up, more than offsetting the recent reductions in production levels by some of our large, longstanding customers in recent quarters.

Taking these factors into consideration, we anticipate that the fourth quarter of fiscal 2014 will have revenue in the range of $78 million to $85 million. In the fourth 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 $0.17 to $0.23 per share for the fourth quarter. This expected earnings range assumes an effective income tax rate of 32%.

In summary, we expect to see renewed sequential growth in our fourth quarter, and as our new customer programs continue to ramp up, we also expect to see continued growth during fiscal 2015.

Overall, the financial health of the company is excellent, and we believe that we are well positioned to continue to profitably expand our business over the longer term.

Okay, that's it for me Craig.

Craig Gates

All right. Thanks Ron. While the slowdown in a couple of large customers in recent quarters has massed production ramps of several new customers; we continue to believe our fundamental strategy remains sound, and we expect it to be rewarded with a return to growth. 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 at the excellence and the 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 running offshore operations, bring significant advantages to OEMs. Our growing portfolio of customers increasingly wants offshore cost savings. Yet they fear IP loss, fear offshore schedule risks, and inventory uncertainty, and do not want to manage an offshore relationship, and they want U.S. based engineering and prototyping.

While we 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.

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 a plastic molding PCB assembly, complete product assembly, design engineering and test engineering services. This investment reflects our continued strategic focus on providing all the EMS service available for a much larger company, while still bringing the flexibility in high customer service levels that our clients expect from us.

While periodic fluctuations and large customer demand, mixed changes in our program portfolio and costs associated with ramping up new programs will continue to be 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 result in profitable growth and increasing competitive advantage over the long term.

We see more of our new customer programs moving into production and gradually ramping up and our pipeline of new business opportunities looks increasingly robust. Over the longer term, the 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 your questions.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions). Our first question comes from the line of Anya Shelekhin. Please go ahead.

Anya Shelekhin - Sidoti & Company

Good afternoon, and thanks for taking the question.

Craig Gates

Sure.

Anya Shelekhin - Sidoti & Company

So just a couple for me. First, were either of the two new program wins related to the sheet metal fabrication business?

Craig Gates

Yes. One of them was almost entirely dependent upon the fact that we had that capability. That program does combine high line assembly and plastic molding, but over half of the building material is metal parts.

Anya Shelekhin - Sidoti & Company

And are there any new opportunities in the pipeline that are related to sheet metal fabrication?

Craig Gates

Yeah. I'd say over half of the new business that we are quoting on or are close to winning, adds some reliance upon the fact that we have the sheet metal capabilities.

Anya Shelekhin - Sidoti & Company

All right, great. And last question, would you be able to provide any guidance on what percent of revenue you expect the top three customers to make up by the end of the year?

Craig Gates

By the end of the fiscal year?

Anya Shelekhin - Sidoti & Company

By the end of the fiscal year, yeah.

Ronald Klawitter

We expect them to be approximately at the same level, around 50% of our business, and that's just in the fourth quarter.

Anya Shelekhin - Sidoti & Company

Okay. Thanks. That's all for me.

Craig Gates

Okay.

Operator

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

Matthew Dhane - Tieton Capital Management

Thank you. That's Tieton Capital. I was curious, [indiscernible] the typical question. The range of revenues expected from the two new program wins, the ones that ramped, what is that?

Craig Gates

One is about $20 million and one is about $50 million.

Matthew Dhane - Tieton Capital Management

Oh wow. Those definitely are much larger than normal.

Craig Gates

Yup.

Matthew Dhane - Tieton Capital Management

Congratulations.

Craig Gates

Thanks.

Matthew Dhane - Tieton Capital Management

Also, I was just curious, what's leading to the commentary about an increasingly robust pipeline? Add some detail around that if you could Craig?

Craig Gates

Sure. The main driver -- well, there is two main drivers. One is the, as we talked about, the boomerang accounts. These are accounts that went to China, and as the cost has increased in China, they are coming back to North America. So we see really I'd say, the majority of the business that we are looking at, is product that either was in China, or was being at least ported out of China, and now its just becoming more and more feasible to reap the advantages of having built in North America, and it actually can be as cheap or slightly cheaper than what you would pay out of China.

The second driver, is the fact that with the metals capability, it opens the door to an entirely new set expanded market that we can go quote on. So pretty much in the past, anything that we were quoting that had more than 5% or 10% of its bill of materials as a metals part, we become uncompetitive, because we had to pay somebody else's margin, to make that metal for us. Now that we are making our own metals, we can pull opportunities that have up to 100% metals, and be competitive.

So as you can imagine, looking out as you walk through Walmart or whatever, any product you can think of, if you are looking at products that are only plastics and PCBs and assembly, there is a lot less of those, than if you look for products that are plastics, PCBs, assembly and some metal. So essentially, we can make anything now, and that has been a big-big enabler for us to do a lot more board opportunities and win quite a bit more.

Matthew Dhane - Tieton Capital Management

And just help me frame the sheet metal opportunity. Roughly, what would you say increases the potential market opportunity of Key Tronic by having the ability to be competitive on products that have significant sheet metal requirements?

Craig Gates

I don't know how to answer that, other than to say, a whole bunch. If you look at it -- here's an interesting way to look at it, is we have been attracting a number of quotes that we participate in per quarter. I would say that, the last quarter was simply the first quarter that we had and truly realized metal capability. We are still learning how to quote it, but let's call the first quarter the first one -- the last quarter the first one, I should say. And our number of quotes have hit an all time high by probably a factor of about 35% more than we have ever done before, and that's just board opportunities. I think that's going to continue, as more and more people learn Key Tronic has metal capability, and as people discover the price that we can actually quote out of the Mexico facility.

Matthew Dhane - Tieton Capital Management

Well that's helpful. Thank you, Craig.

Craig Gates

Yep.

Operator

Thank you. Our next question is from Shawn Lytle with GBOGH Traders [ph]. Please go ahead.

Unidentified Analyst

Yeah. I was just wondering if we could clarify Ron's comment on growth in 2015. In 2014, I think we targeted -- the bar was set a little lower than it had been in the past. So are we talking the continued sequential growth over Q4 or just growth year-over-year?

Ronald Klawitter

I would say that it should be both. So we should continue to expect to see sequential growth each quarter going forward. At least that we see right now, can't really quantify that beyond the next quarter obviously, because its so uncertain with our customers orders. But from what we have been awarded and what has been forecasted, we expect to see sequential growth each quarter going forward, and also of course, year-over-year growth, because we are starting off at a base that's going to be a little bit lower.

Unidentified Analyst

Excellent. Thanks.

Operator

Thank you. Our next question is from the line of George Melas with MKH Management. Please go ahead.

George Melas - MKH Management

Good afternoon guys, two quick questions. When you have a program that has significant sheet metal involved, how does that impact gross margins?

Craig Gates

Right now, we are finding that it helps them. We see that there is the market for mid-size custom sheet metal out of Mexico looks to be underserved. So we are not seeing nearly the price competitiveness required out of, what you might call commodity PCB assembly, when we are talking about the custom sheet metals that we are quoting.

George Melas - MKH Management

Okay.

Craig Gates

Yeah, the value add, obviously is a little bit higher in sheet metal. But another way of looking at it, we have been averaging around 70% material costs overall on our quotes, 70% of revenue is material costs. Sheet metal tends to be a little bit lower. Somewhere around 50% to 55% material costs to overall revenue.

George Melas - MKH Management

Okay. Just to understand that this is on sort of programs that don't have much sheet metal, typically material costs of 70%. But when they raise a fair amount of sheet metal, the actual overall material costs goes down?

Craig Gates

That overall -- but the sheet metal itself is lower -- its lower at around 50% to 55%. It doesn't bring the overall average down, but the sheet metal itself has got a lower material content.

George Melas - MKH Management

Okay. I am sorry to say, I am not sure I understood really what is the implications of that?

Craig Gates

Okay. Let me see if I can help you with that, because its kind of important. What that means is that, when you have got -- let's say we had a pure sheet metal product, not sheet metal, but metal. So there is nothing in it, but steel, form steel, welded steel, painted steel. If you looked our total cost to our total price to produce it, the actual material portion of that would only be about 50%. So that means the other 50%, that remains between material costs and price, is made up of either margin for us or conversion costs, that means our manufacturing costs.

When you are looking at a -- something at the extreme of the end of that spectrum, which would be a commodity-type simple PCB assembly, then you're looking at something around 80% to 85% of the price is just parts, and so there is only, let's say 15% left for our margin and our cost of conversion. And we find this to be true in just about everything we do. The farther you go towards the commodity product, the higher the material, as a percent of price becomes. Therefore the lower your opportunity for margin and conversion cost is, and so it gets much-much tighter.

We can make money on commodity PCBs and we do. We have been finding more and more success doing that. But it looks like sheet metal is a bit less of a commodity and more of a custom market, and can drive higher gross margins as a result.

George Melas - MKH Management

Okay, great. Thanks for the explanation. Again, I must say it feels kind of intuitive, but its great to hear that answer.

Craig Gates

Yeah. Its one of those things where, gee, that's an amazing discovery.

George Melas - MKH Management

Can you just give us a little bit more color on the top three and the top five, and in particular, on your large Canadian customer?

Craig Gates

What kind of color do you want, because we can't give much?

George Melas - MKH Management

All right. Give us what you can, sort of like -- basically percentage of revenue?

Craig Gates

Well, we talked about the fact that there are 51% to 61% of revenue, so they declined by 10%. The top two which are the vast majority of that, are both in markets that are not doing well. So our customers' share of the market they are in hasn't decreased, but their overall sales have, and as a result, it directly turns into less sales for us to them. So we look at it as, are we failing, are we losing programs that these customers know not at all. In fact, we are gaining programs with these customers. We look at it as -- some of these customers aren't happy with Key Tronic, that's a question. The answer is no, they are very happy with Key Tronic. They actually question, are these customers putting us at risk by bidding us out against other EMS companies, and the answer is, in both cases, no; we have actually just recently won large pieces of business with them.

So there is really nothing we can do about the fact that they are both in markets that aren't doing super great right now.

George Melas - MKH Management

Okay. Very good. One of those customers, you do a 100% of their worldwide manufacturer assembly, is that correct?

Craig Gates

More or less, yeah.

George Melas - MKH Management

More or less. And the other one is still fairly -- and the other -- if you take your top three, one of them -- you are largely their manufacturer. And the other ones, do they have a number of manufacturers plus internal capabilities, or what's the structure there?

Craig Gates

I think the best way to say that is that, [indiscernible], we are in essence, their only manufacturer. The other one, we are their single largest supplier by far.

George Melas - MKH Management

Okay.

Craig Gates

That's the best I can tell you.

George Melas - MKH Management

Great. Great to see. Great to hear that things are ramping up. Congratulations.

Craig Gates

Thank you. We will take your congratulations at the end of the next quarter.

George Melas - MKH Management

Okay. I will [indiscernible] again.

Operator

Thank you. (Operator Instructions). Looks like we have no additional questions at this time. I would like to pass the call back to management for closing remarks.

Craig Gates

Okay. Thank you again for participating in today's conference call. Ron and I look forward to speaking with you at the end of next quarter. Thanks and have a good day.

Operator

Ladies and gentlemen, this does conclude the Key Tronic Corporation third quarter 2014 earnings conference call. If you would like to listen to a replay of today's conference, please dial 1800-406-7325 or internationally 1-303-590-3030 with pass code 4676348. We'd like to thank you for your participation. You may now disconnect.

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