Key Tronic's (KTCC) CEO Craig Gates on Q4 2014 Results - Earnings Call Transcript

Aug.19.14 | About: Key Tronic (KTCC)

Key Tronic Corp. (NASDAQ:KTCC)

Q4 2014 Earnings Conference Call

August 19, 2014 5:00 pm ET

Executives

Craig D. Gates - President and CEO

Ronald F. Klawitter - EVP of Administration and CFO

Analysts

William J. Dezellem - Tieton Capital Management

George Melas - MKH Management

Ethan Steinberg - SG Capital Management

Operator

Good day and welcome to the Key Tronic Fourth Quarter and Year-End Conference Call. Today's conference is being recorded. At this time, I would like to turn the call over to 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'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 fourth quarter and fiscal year-end 2014. These were in line with our previously announced preliminary results. While fiscal 2014 was a challenging year with respect to our total revenue, we continued to make significant progress in ramping up our new programs, expanding our customer base, and extending our capabilities. Throughout the year, our revenue was impacted by slowdowns and delays from certain long-standing customers. At the same time, we saw the continued ramp of our new programs while maintaining operating efficiencies and a strong balance sheet.

We continue to see a robust pipeline of potential new business and have further diversified our future revenue base. During the fourth quarter, we won new customer programs involving healthcare, fitness, HVAC and gaming products. At the end of the fourth quarter of fiscal 2014, we were generating revenue from 196 separate programs and had 59 distinct customers, up from 183 programs and 56 customers a year ago. Moving into fiscal 2015, we expect to see more of our new customer programs moving into production and gradually ramping up and a return to sequential growth in the first quarter.

Now I'd like to turn the call over to Ron to review our financial performance, then I'll come back to discuss our strategy and recent acquisition as we move into fiscal 2015. 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 of 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 June 28, 2014, we reported total revenue of $72.1 million compared to $84.6 million in the same period of fiscal year 2013. As we announced in July, the decline in fourth quarter revenue primarily reflects a temporary reduction in production levels for a long-standing customer and a delay in the commencement of production for a significant new program due to the timing of certain agency approvals. Revenue from this new program is expected to start being recognized in the first quarter of fiscal 2015.

For fiscal year 2014, total revenue was $305.4 million compared to $361 million for fiscal 2013. The year-over-year decline mainly reflects the decrease in orders from two large long-standing customers. Despite the reduction in revenue levels and the fact that we have been moving many new programs into production, we have continued to maintain our strong gross margin. The gross margin was approximately 9% for the fourth quarter and the full year of fiscal 2014, which is in line with our long-term target of 9%.

The total operating expenses were $4.4 million in the fourth quarter of fiscal 2014, comparable to the previous quarter but up 5% from the fourth quarter of 2013. This year-over-year increase reflects our expenditures in connection with expanding operations and preparations for growth that has been delayed in recent quarters. Operating margin was 3% for both the fourth quarter and fiscal year 2014 compared to 4% and 5% respectively in the same period of fiscal year 2013. This decline primarily reflects our lower revenue levels.

Despite maintaining good operating efficiencies, our lower revenue did have an impact on our bottom line in the fourth quarter. Net income for the fourth quarter of fiscal 2014 was $1.4 million or $0.12 per diluted share compared to $2.4 million or $0.21 per diluted share for the same period of fiscal 2013. For fiscal 2014, net income was $7.6 million or $0.67 per share compared to $12.6 million or $1.12 per share for the same period of fiscal year 2013.

Turning to the balance sheet, we have continued to maintain our strong financial position. Our inventory was up 21% in the previous quarter reflecting the unanticipated slowdown and delays in certain programs. We expect to see our inventories decline gradually in coming periods. At the same time, our cash position was $5.8 million at the end of the fourth quarter, up from $2.2 million at the end of the previous quarter, and we've continued to maintain a zero balance on our bank line of credit.

Our trade receivables were $40.7 million at the end of the fourth quarter and our average days sales outstanding were about 38 days, down significantly from over $50 million in receivables and 50 days in recent quarters. This improvement reflects utilization of our new factoring agreements during the quarter which significantly reduced our cost of capital.

The capital expenditures for the fourth quarter of fiscal 2014 were approximately $3.3 million as we continue to expand our sheet metal fabrication, plastic injection molding and electrical assembly capabilities. CapEx for the year was $7.8 million.

Our recently announced intention to acquire CDR Manufacturing, if consummated, is expected to be accretive to our revenue and earnings. CDR has annual revenue of approximately $120 million and comparable margins. We expect to finance the $46.9 million transaction with cash on hand using our revolver and a term loan from Wells Fargo.

We should note that the letter of intent is not binding on either party and the proposed acquisition is subject to our completion of due diligence, negotiation and execution of a definitive agreement relating to the acquisition and final approval of our financing for the transaction, among other things. However, we are moving forward with due diligence and negotiations and anticipate the transaction will be completed during the first quarter of fiscal 2015.

Moving into the first quarter of fiscal 2015, 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 long-standing customers in recent quarters.

Taking these factors into consideration and excluding the potential impact of the planned acquisition of CDR Manufacturing, we anticipate that the first quarter of fiscal 2015 will have revenue in the range of $76 million to $82 million. In the first quarter we expect our gross margins to remain around 9%. We also expect our operating expenses to remain relatively flat in coming periods.

Taking these factors into consideration and again excluding the potential impact of the planned acquisition of CDR Manufacturing, we expect earnings in the range of $0.13 to $0.20 per share in the first quarter. This expected earnings range assumes an effective tax rate of 32%.

In summary, we expect to see renewed sequential growth in our first quarter as our new customer programs continue to ramp up. Overall, the financial health of the Company is excellent and we believe that we're well-positioned to continue to profitably expand our business over the long-term.

Okay, that's it for me, Craig.

Craig D. Gates

Alright, thanks, Ron. From our perspective, the slowdowns by two large customers and a new program delay in the recent quarters while disappointing have masked the 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 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, brings 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 will 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 plastics molding, 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.

Moving into fiscal 2015, we're also excited about the long-term potential of our Sabre acquisition and planned CDR acquisition. Our successful integration of Sabre Manufacturing has generated strong interest in our expanded capabilities across our combined customer base. Furthermore, our planned acquisition of CDR Manufacturing will, if consummated, represent a major step forward for Key Tronic, significantly growing our revenue and extending our capabilities and customer base worldwide.

Doing business under the name of Ayrshire Electronics, CDR provides printed circuit board assembly and other EMS services to a diversified customer base, including a number of large multinational companies, and operates manufacturing facilities in Minnesota, Arkansas, Mississippi, Kentucky and Mexico.

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. While periodic fluctuations in large customer demand, mix 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.

I want to take this opportunity to express my gratitude to our employees for their dedication and hard work during this past year, to our valued customers who continue to honor us with their trust, and to our shareholders for their continuing support.

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

Question-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Bill Dezellem with Tieton Capital Management. Please go ahead.

William J. Dezellem - Tieton Capital Management

I'd like to start with my normal beginning question which is, the new programs that you announced, I believe there were four of them, what is the range of revenue that they represent?

Craig D. Gates

$5 million to $25 million.

William J. Dezellem - Tieton Capital Management

And curiously, this is the first quarter and actually I think a year or so that you have had four new programs that you announced that you won in a particular quarter, and in last quarter you had a very large dollar amount of wins. Is this representative of something meaningful happening or am I trying to draw a pattern out of data and just torturing the information?

Craig D. Gates

I think you're tending towards torturing it.

William J. Dezellem - Tieton Capital Management

I'll shift onto another questions, maybe not so torturous. Your reference in very last part of your commentary was that your prospect pipeline looks increasingly robust. Would you please expand on those comments?

Craig D. Gates

Yes. There is, as we said in the presentation, we continue to see a growing demand for people who are looking at the true cost of doing business in China and growing demand from people who are looking at true costs of their business in China, and a better realization and appreciation of the costs that are pretty hard to quantify yet are real. So now that the ex-factory costs are becoming almost comparable between China and Mexico, there is a lot of demand for people who are looking for quotes out of Mexico. So that's driving, that sea change is driving a lot of quotes to us that we probably wouldn't have seen before.

In addition, the Sabre Manufacturing acquisition has expanded our available market for quotes because a lot of products don't only have plastic and PCBs, they have metal, and previously we were on the edges of being able to compete for a product that had any type of metal content because we had to buy that sheet metal with somebody else's mark up on it. Now that we're providing the sheet metal to ourselves, we don't have to stack margins on top of the sheet metal that we buy, so it has put us in a more competitive situation than we've been in the past.

And then third, we have continued to refine our quote process and our ability to turn quotes around quickly and accurately. We're still not where I want us to be but we're getting better and that is driving more quote opportunities and keeping more opportunities in the funnel. Those three things are working together to drive what we see as a nice robust steady stream of quotes that we can work on.

William J. Dezellem - Tieton Capital Management

And that quicker turnaround of quote, is that allowing you to quote on more business simply because you are taking less time per quote or is that increasing the number of quotes coming to you because there is a recognition that you will get a quote turned around quickly?

Craig D. Gates

It's both. If you ask the sales guys, they would say that it used to take too long to get quotes back and so we wouldn't get a repeat chance at another quote. It often takes 4 to 40 quotes with a large customer before you win a single deal. And so that first quote has to be done quickly in order to get a chance at the second one and the first quote has to be done accurately to get a chance at the second one.

And then as we win more business and have more satisfied customers and have more people who have left a satisfied customer and gone to another prospective customer, the ability to quote quickly and accurately goes with those transplants as they find a home in a new customer. So it's all kind of combined effect of good things that tend to multiply each other as you start making it all happen at once.

William J. Dezellem - Tieton Capital Management

Understood. And changing topics entirely, and then I will jump back in queue, you grew your programs by I believe it was 13 at the end of this quarter versus the year ago quarter, and the customers by three in this fiscal year. How would you expect fiscal 15 to compare when we rolled out year, do you expect similar number of net new programs that you're producing revenue on and customers or more or fewer, what's your current thought?

Craig D. Gates

The word net programs, I'm glad you put 'net' in there because we've been pruning a number of customers as the year went by. We take business with the assumption that it will grow up to $5 million in revenue and some customers' businesses don't succeed, so we have to help them find somebody that's more interested in smaller business. So that is a net number.

Secondly, I've given up predicting what's going to happen year out. I can tell you which direction the arrow is going to point in terms of new business and new customers but I have no chance of being even close on guessing whether it's going to be 3 or 10 or 50.

William J. Dezellem - Tieton Capital Management

I'll just go with the direction here, that's close enough for me.

Operator

(Operator Instructions) We do have a follow-up question from Bill Dezellem. Please go ahead, sir.

William J. Dezellem - Tieton Capital Management

I guess there's no one else, so I'll ask one follow-up. So I believe you were indicating the direction of the arrow for the number of new programs and new customers in fiscal '15 versus fiscal '14, and that will be directionally higher but specific numbers you're wanting to avoid?

Craig D. Gates

Yes.

William J. Dezellem - Tieton Capital Management

Let's shift if we could please to CDR. You referenced, I believe it was in the release, that CDR will expand your capabilities. Would you talk more about what you're referring to there please?

Craig D. Gates

Yes, so CDR is located in middle of America and a lot of their customers are with CDR because of the proximity advantage. So CDR is involved with a lot of customers on programs that are new launches, that are engineering heavy, that benefit from having the engineer be able to drive over and get there in a couple of hours and touch and work with his new products. It also involves a lot of programs that require very high degree of flexibility and responsiveness, which is also enabled by the fact that they are close to the customers.

So that geographic advantage is something we've been missing out of the Midwest as we have no factories there and not a whole lot of sales out of the Midwest. We found by looking at their customer list versus ours that there's almost no overlap, and I mean almost none, there is one customer that's two different divisions. So it's clear that the customers that they have are not folks that we're getting a look at because of the way that we are organized, Mexico, China and Spokane.

So that's the major advantage and capabilities that they bring, the geographic capability and then a quick turn capability. In terms of the manufacturing processes, they are pretty much the same as our SMT capabilities in Mexico, China and Spokane.

William J. Dezellem - Tieton Capital Management

That's helpful. And I believe, Ron, you had referenced an expected close date here in the first quarter. Would you be willing to tie it down a little tighter than that?

Ronald F. Klawitter

No, not when I got dealing with lawyers. The business aspects, we're pretty comfortable that we got to make sure everything is tied down properly and everything is addressed before the acquisition. So it's going slower than what we had hoped but we still expect to close this first quarter.

William J. Dezellem - Tieton Capital Management

Thank you. And then by reference in the release, you're expecting the transaction to be accretive to earnings. What is the EPS accretion that you're currently expecting?

Ronald F. Klawitter

We haven't disclosed that and I'm not going to disclose it until after we close.

William J. Dezellem - Tieton Capital Management

So if I were to tell you that my current guess scratching through the numbers is approximately $0.10, would you be comfortable commenting on that?

Craig D. Gates

We'll comment on it this way, we'll write it down and we'll see who won when it's over.

William J. Dezellem - Tieton Capital Management

And what's your number?

Craig D. Gates

Yes, right. I'm writing that down but I'm not telling you.

William J. Dezellem - Tieton Capital Management

I understand.

Ronald F. Klawitter

We just can't discuss that at this time.

William J. Dezellem - Tieton Capital Management

No, that's fair. Let's put that aside and shift to one additional question relative to the quarter. Your revenues were down $5 million sequentially and yet gross margin actually increased sequentially, and that to me is counterintuitive. Would you discuss that please?

Ronald F. Klawitter

[Indiscernible] I don't want to be a smart [indiscernible], but I guess we can [get rid of enough] (ph) revenue, our profits really go up. But really to be serious about it, it's more of a mix thing, Bill. Some of the revenue that we did miss had more competitive lower margins than our average. So that's why we didn't have as much impact on the overall gross margin percentage with the revenue decline.

William J. Dezellem - Tieton Capital Management

That is helpful. So that is literally not a function of necessarily the new business you're bringing on but far more a function of the business that went away that it was low-margin business?

Ronald F. Klawitter

Lower than our average, that's correct.

William J. Dezellem - Tieton Capital Management

Right, okay. And the reference that Craig made to pruning customers, did that have any impact on the gross margin or were they so small from a revenue standpoint that it didn't impact gross margin?

Craig D. Gates

Those pruning activities mainly allow us to use our overhead more appropriately on new more exciting customers. So there's typically very little revenue in a customer that gets pruned and more the reason they get pruned is they're taking a lot of babysitting and hand-holding to maintain. So you don't directly see the impact on gross margin but over time you will.

William J. Dezellem - Tieton Capital Management

Right, okay, that's helpful. And finally, CDR, I do want to come back to one additional question with that business, what are you thinking or anticipating for integration costs?

Craig D. Gates

We're going to take a pretty cautious approach to that. We're going to mainly focus on our procurement efforts and our sales efforts in the first year as far as integration goes. We've got – they own a number of different systems, not systems but they are kind of separate in the way they run their purchasing now, and then there's us who's obviously separate from theirs. So we're going to try to combine the purchasing efforts of all the entities involved in this and hopefully get some more leverage and some more efficiencies. So we're still trying to figure out exactly how many seats we're going to have to buy of MRP programs and things like that, but I think that will be our major expense in the coming year.

We're going to also focus simultaneously on combining the sales forces so that everybody who's selling the new combined company understands the benefits that the new combined company brings, so we'll spend time flying sales guys down to Mexico and sales guys out to the CDR facilities. But in terms of major integration costs of layout, expenses and things like that, it's not going to happen. So it should be a huge hit.

William J. Dezellem - Tieton Capital Management

And I apologize for continuing on but that just prompted another question, which I think that in the opening remarks, Ron, you had mentioned that the margins for CDR is similar to Key Tronic, but that I presume is with their current purchasing cost structure, and in theory if they're purchasing off multiple systems, they are likely, and I'm just kind of thinking out loud here, they are likely not getting the level of procurement discounts that they should, and so as you bring this purchasing integration into play, their margins should expand relative to what they historically have been and ultimately would lead to even better margins than what they have now. Are we thinking about that right?

Craig D. Gates

I think it will probably go the other way, in that in the due diligence visits we've seen a number of cases where one plus one is probably going to equal 2.7 or 2.8. And by that I mean we're picking up CDR's customer in the current margin that they are enjoying with that customer. In discussions with that customer, we find that there is more business that they would have liked to give CDR had CDR had sheet metal capabilities, had CDR had higher co-capabilities, had CDR had engineering capabilities, had CDR had injection molding capabilities.

So I think rather than trying to drive the margin higher by keeping any savings that we discover in our pocket, we'll probably end up working with I think a pretty significant portion of CDR's customers to drive more business from those customers into new combined company's pockets at the same margin by helping them understand the benefits of working with a bigger company.

William J. Dezellem - Tieton Capital Management

Okay. I can't resist. So as we think about products being produced, the additional capabilities that you're referencing, whether it would be the molding or the sheet metal, that's a significant dollar amount relative to the Board staffing, and so if they're $120 million of revenues, we're looking at potentially a very large number in terms of revenue increase with additional business from their existing customers, if as you say many of their customers are wanting to do more business with them if they had those capabilities.

Craig D. Gates

I would hesitate to say, very much. I best I can do is put an arrow on it. As we guide into this deal, I've talked before about one plus one equalling more than two, and as I've visited with their customers both face-to-face and on the phone, I'm convinced that there is definitely going to be something greater than two come out of this equation, but I would hesitate to say how big that's going to be. If you think about it, every PCB that they manufacture and ship to somebody goes into something, and that something is either got to be plastic or sheet-metal or a die cast, and so the die cast is the only one where we couldn't help.

William J. Dezellem - Tieton Capital Management

That is helpful. And so with your conversations that you had with customers, whether be in person or on the phone as you referenced, that's been part of your due diligence, have you been surprised and found that there was more potential revenue upside than you had originally anticipated or more not necessarily the case but in line with what you were expecting?

Craig D. Gates

I wouldn't say that I was surprised. I'd say more that I was happy that our predictions look like they're probably going to be correct.

William J. Dezellem - Tieton Capital Management

Alright. Thank you and I am a little bit surprised, so I'm going to have to put an arrow directionally up on my $0.10 accretion, so put that down on that piece of paper.

Craig D. Gates

Okay, what do you want, $0.11 or $0.12?

William J. Dezellem - Tieton Capital Management

Just directionally up please.

Craig D. Gates

Okay.

Operator

And we'll take the next question from George Melas with MKH Management. Please go ahead.

George Melas - MKH Management

Maybe looking at a different arrow here, the arrow of concentration, maybe could you tell us what the top three customers were this quarter and would you expect that arrow to trend in the coming fiscal year?

Ronald F. Klawitter

The top three were just over 50% of our revenues in the fourth quarter. And going forward, we expect that – we don't expect that number to grow significantly. If anything, it will probably be diluted even further as we bring on new customers.

George Melas - MKH Management

Okay. And how much was it in the fiscal year?

Ronald F. Klawitter

I don't have that number off the top of my head, George. I'll have to get back to you with that answer.

George Melas - MKH Management

Okay, great. And then just a quick question on the guidance. It seems that – you generally give a fairly wide range of EPS but this range is slightly wider than usual and I'm just, if you have sort of, if you have some confidence about the gross margin and also about the OpEx, I'm just wondering why it's so wide.

Craig D. Gates

George, the reason we've put that in there like that is we've got a couple of programs that are ramping that are big programs and there are steep ramps, and so we're worried about the difference between the margin we'll make on an ongoing basis and the margin we're going to have to chew up as we ramp all this new production through the factory in an imperfect state. The product will be perfect as we ship it, but the manufacturing processes are not perfect, so it's taking more people on the line to get it there. So the reason we gave a little bit broader earnings forecast is because we're not sure how fast we're going to continue to get better.

That product that was delayed last quarter is in full production now but it's probably at 25% to 30% extra people online to run it right now. So, it's how fast we can make them go away and put them on other programs is going to determine to a large part where we are on that range, as well as the revenue range where we are in that depending on how much of this ramp will get done in time.

George Melas - MKH Management

Okay. Was that the program that had some delays then you had to go back to manufacturing sort of the older product, the legacy product and it was difficult to get the parts or I think you explained something like that in the last call?

Ronald F. Klawitter

What we talked about last, it was this new product is replacing an old one, a new version of it, but we did not go back to building the old product because we didn't have the pipeline of parts. So just the new product did not come on as quickly as we hoped and the delay in getting the agency approval ended up delaying the program to start this quarter. And as Craig mentioned, that new program now is in full production and which is why we hope to see our inventories start to decline this quarter as well, because as we mentioned in our conference call, the inventories were up quite high at the end of the fiscal year because of some of these delays in ramping new program and the shortfall in revenue from another customer.

George Melas - MKH Management

Got it, okay. And your very large customer were actually I think you had some – you've had significant reduction in revenues, in orders from that customer, what do you expect that customer to do in the coming fiscal year?

Craig D. Gates

We're hoping they're going to stay flat with where they are today, both of them. So we don't expect to see increases, and our projections are based upon the fact that they stay flat. It's I think to me an important point that both of those customers, if we had only had the programs that we started the year with, would have shrunk even more than they did. In both cases those customers have pulled out of other of our competitors and focused most if not all of their production with us. So it's not that we're losing share within this customer, in fact we're gaining share within both of the customers. The customers themselves are seeing downturns in their end business.

George Melas - MKH Management

Okay, thank you.

Operator

We'll take our next question from Ethan Steinberg with SG Capital. Please go ahead.

Ethan Steinberg - SG Capital Management

Sorry if I missed this earlier on the call, does the guidance you gave for the quarter, is that a GAAP number or would there be any acquisition expenses?

Ronald F. Klawitter

Our projection is without any impact on the acquisition. So we have neither the acquisition expenses nor do we have in it the expected earnings that we expect to get from closing this transaction before the end of the quarter.

Ethan Steinberg - SG Capital Management

Okay, thanks. And you said there are some programs ramping this quarter. Do you think the gross margin goes down sequentially in this quarter from what you just reported?

Ronald F. Klawitter

We expect that our gross margins should remain around the 9% level. So, no, we do not expect it to go down.

Ethan Steinberg - SG Capital Management

Okay, then over time is there leverage opportunity in that margin or is 9% what it should be even at a much higher revenue run rate?

Ronald F. Klawitter

As revenue goes up, we expect to see gradual improvement in overall gross margins. Our incremental gross margin on revenue increases or decreases is somewhere closer to 15% to 20%. So as you bring on new business, as revenue grows, you bring on the additional revenue to 15% to 20% incremental margins, which will have the tendency to bring your overall margins up, not up to that same level but we see that we could be above double-digits gross margins as we get back closer to the $90 million to $100 million in revenue that we were running at a little over a year ago.

Ethan Steinberg - SG Capital Management

Okay. And that 15% to 20%, that's the incremental gross margin or it's…?

Ronald F. Klawitter

Yes, that's incremental gross margin.

Ethan Steinberg - SG Capital Management

You said SG&A flat this quarter. Is that ex the acquisition impact, can SG&A stay pretty flat at higher revenue levels?

Ronald F. Klawitter

So the only impact it's going to have, we think that our SG&A engineering expenses are only about 20% variable. So as revenue is going up, you're going to have some additional expense there, particularly primarily commissions for salesmen, and then as we have to add other support people to handle the additional number of customers like a program manager or engineers, but again probably that SG&A engineering costs, probably 80% of it is fixed.

Ethan Steinberg - SG Capital Management

Okay. And then the two customers you referenced as hoping they are flat, I feel like there's been a history of hoping they were flat and they weren't. Is your conviction level pretty high that that won't be a P&L headwind anymore?

Craig D. Gates

We can only go off with what they tell us. I agree with you that we've been hoping it was flat six months ago, four months ago, and it keeps ending up sloping downwards. So I can't tell you other than that, that's what they are forecasting, that's what we're buying parts to and I hope they're right.

Ethan Steinberg - SG Capital Management

Okay, thanks guys.

Operator

And gentlemen, with no questions remaining, I'll turn the call back over to you for any additional or closing comments.

Craig D. Gates

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

Operator

Once again, that does conclude today's conference call and we thank you for your participation.

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