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Methode Electronics, Inc. (NYSE:MEI)

Q1 2015 Results Earnings Conference Call

September 4, 2014 11:00 AM ET

Executives

Don Duda - President, Chief Executive Officer

Doug Koman - Chief Financial Officer, VP, Corporate Finance

Ron Tsoumas - Treasurer, Controller

Analysts

Christopher Van Horn - FBR Capital Markets

Steve Dyer - Craig Hallum

Joe Vruwink - Robert W. Baird

Jimmy Baker - B. Riley

Operator

Welcome to the Methode Electronics Fiscal 2015 First Quarter Earnings Conference Call. At this time, all participants are in a listen only-mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

This conference call does contain certain forward-looking statements, which reflect Management's expectations regarding future events and operating performance and speak only as of the date hereof. These forward-looking statements are subject to the Safe Harbor protection provided under the securities laws. Methode undertakes no duty to update any forward-looking statements to conform the statements to actual results or changes in Methode's expectations on a quarterly basis or otherwise.

The forward-looking statements in this conference call involve a number of risks and uncertainties. The factors that could cause these actual results to differ materially from our expectations are detailed in Methode's filings with the Securities and Exchange Commission, such as our annual and quarterly reports. Such factors may include, without limitations, the following: dependence on a small number of large customers, including two large automotive customers; investment in programs prior to the recognition of revenue; timing, quality and cost of new program launches; ability to withstand price pressure; dependence on our supply chain; dependence on the availability and price of raw materials; customary risks related to conducting global operations; currency fluctuations; income tax rate fluctuations; fluctuations in our gross margins; the recognition of goodwill impairment charges; ability to keep pace with rapid technological changes; location of a significant amount of cash outside of the U.S.; ability to successfully benefit from acquisitions and divestitures; ability to avoid design or manufacturing defects; ability to protect our intellectual property; ability to compete effectively; ability to withstand business interruptions, a breach of our information technology systems and cost and expenses due to regulations regarding complex minerals.

It is now my pleasure to introduce your host, Don Duda, President and Chief Executive Officer for Methode Electronics.

Don Duda

Thank you, Mannie, and good morning everyone. Thank you for joining us today for our fiscal 2015 first quarter financial results conference call. I am joined today by Doug Koman, Chief Financial Officer; and Ron Tsoumas, Controller. Both Doug and I have comments and afterwards we will take your questions.

We were very pleased this morning to report that year-over-year first quarter sales grew 30% to $218 million, driven mainly by higher North American automotive sales partially offset by decreased sales in interface and the power products. Additionally, consolidated gross margin increased 290 basis points in the first quarter. The largest contributor to this improvement was increased sales but margins were also positively impacted by cost reduction activities on the K2 program in preparation for the contractual price reductions, increased volume at our low-cost manufacturing facility in Egypt, continued vertical integration and a lower R&D spend.

Looking forward, the cost reduction activities we implemented in the first quarter will likely not be additive to gross margins but will offset the contractual price reductions on the truck platform, which began in July and on the [SUV] [ph] platform which will begin in January. We also anticipate increasing our R&D on both the Dabir Surface and 10-gig transceivers in the remaining quarters of this fiscal year. For fiscal 2015, we intend to invest approximately $4 million in additional development costs compared to 2014.

First quarter selling and administrative expenses as a percentage of revenues decreased to 10.2% from 11.3% year-over-year. While we do foresee our legal expense will be higher in the second and third quarters than in the first quarter, selling and administrative expenses should be in the 10% range for the full fiscal year. Our first quarter operating margin was 13% compared to 9% last year as income from operations improved 88% to $28 million. Net income improved 57% to $21 million despite the fact that our effective tax rate moved from 8.7% in the first quarter of last year to 24.6% this year.

With our strong results in the first quarter, we are increasing our fiscal 2015 guidance range to sales of $870 million - $885 million, income from operations of $108 million to $114 million and earnings from $2.10 to $2.20. Based on this guidance range, our fiscal 2015 operating margin is in the mid-12% range which would be in line with our goal to improve our operating margin by approximately 1% every year on average. The expected operating margin increase over fiscal 2014 is an improvement of 300 basis points.

A brief comment on fiscal 2016. Our revenue projection issued in December 2013 included a higher growth rate for our non-automotive businesses than what we are currently seeing. Additionally, you may recall we are anticipating revenues of approximately $15 million from our 10-gig product in fiscal 2016. That program has been pushed out about a year due to the late development of the necessary microchip by a third party shifting those revenues to fiscal 2017.

Now turning to a review of our individual segments. Compared to last year, automotive segment net sales grew 51% in the first quarter due mainly to higher sales of the General Motors K2 program and new program launches in Europe. Automotive revenues in the first quarter exceeded industry forecast and our internal expectations. The July shutdowns had minimal effect on our sales.

First quarter automotive gross margins improved 22.3% from 17.9% last year. As I mentioned a moment ago, higher sales, cost reduction activities on the K2 program, our continued vertical integration as well as increased volume at our low-cost manufacturing facility in Egypt produced the higher margins which will offset the contractual price reductions on the K2 platform. As such, we still anticipate our automotive gross margins will approximate the midpoint of our fiscal 2015 target range of low to mid 20s in the fourth quarter.

During the first quarter Methode was awarded a sensor product with Honda for their Odyssey vehicle. The sensor is located in the vehicle's door handle for a passive entry system. This is a first major award using Methode's HyperTouch product, which addresses common challenges associated with various touch technologies such as sensing touch through a thicker substrate, activating the touch cell with or without gloves, providing water immunity and allowing for greater variances in manufacturing process. The program will launch in our fiscal 2017 with average annual revenues of $5 million for five years.

In Europe, we were awarded entertainment module for a Fiat Alpha platform targeted for Europe, Asia, Japan and the Middle East. It will consist of three rotary control modules located behind the gear lever of the vehicle. The program is expected to launch in our fiscal 2017 with average annual revenue of $6 million for five years. In Asia, we were awarded additional Ford lead frame volume with average annual revenue of $4 million also beginning in fiscal 2017.

Moving to our Interface segment, which has been renamed from Interconnect to better reflect its user interface products. Year-over-year first quarter revenues decreased less than 1% driven mainly by lower European and Asian sales, as well as lower appliance sales than last year. Compared to fiscal 2014, interface's gross margins declined slightly to 27.5% from 27.8% due to sales mix. For margins to improve in this segment, we would need improved sales in Methode's industrial business, which we are diligently working towards as well as continued growth in our Data Solutions segment.

In power products, year-over-year sales declined 6% in the first quarter driven mainly by the conclusion of a high-current bypass switch program in Europe. However, sales on our big data program somewhat offset the lower European sales and caused first quarter power products' revenues to be higher than anticipated. Year-over-year power products gross margins increased slightly in the first quarter to 25.9% due mainly to the big data sales and manufacturing efficiencies. For fiscal 2015 gross margins to meet their goal of mid-20s, we would need to continue the pace of sales we saw in the first quarter to our big data customer throughout the fiscal year.

Finally, an update on Dabir. Dabir team has completed final manufacturing and quality system elements. Successfully listed with UL and we are still anticipating our first sales, albeit minimal, this fall. As I said in the past, our initial product launch will focus on operating room procedures in excess of two hours in duration where our current product offering is optimally designed.

In summary, our performance is a direct reflection of Methode's distinct competitive advantages including, a leading technology, a diverse range of markets, worldwide presence and a lean and flexible cost structure. We will continue to increase our investment in R&D which will enhance our ability to add new technologies and new products and position us for future organic growth. We remain really very excited about our progress and the milestones that we have accomplished as well as those that lie ahead.

Now I will turn the call over to Doug who will give further details regarding our financial results.

Doug Koman

Thank you, Don. Good morning everyone. As Don mentioned earlier, in the first quarter we renamed the Interconnect segment to Interface to describe the user interface nature of those businesses in that segment better. Additionally, we reclassified three of our businesses within our reporting segments as follows. We moved (Detrix) [ph] from Power Products segment to the Other segment. Methode sensing technologies which is our torque sensing business was moved from the Other segment to the Automotive segment. And Dabir Surfaces was moved from the Interface segment to our Other segment. Prior year segment numbers have been reclassified to reflect these changes.

Looking at the effective tax rate based on our updated guidance, the fiscal 2015 effective tax rate should be in the low to mid 20s. This is because we no longer have the net operating loss valuation allowance to shelter domestic book income. For the first quarter the tax rate which included some minor discrete items was 24.6%. As we mentioned on the last call, we still have the tax net operating loss available which we expect will keep U.S. federal cash taxes to a minimum throughout fiscal 2015.

As we mentioned in the guidance factors in the earnings release, the shares used to calculate diluted EPS are expected to increase between 700,000 and 800,000 in fiscal 2015. This is due to the performance-based RSAs issued in fiscal 2011, which vest at the end of fiscal 2015. The accounting rules require that the shares be recognized when the performance threshold is achieved, which we expect will be in the later part of the fiscal year. The diluted shares outstanding for the first quarter were 38.6 million, so we would expect full-year to be between 39.3 million and 39.4 million shares.

Looking at CapEx. In the first quarter of fiscal 2015 we spent $3.3 million and for the full year we expect our capital spending to be somewhere between $22 million and $25 million. Depreciation and amortization expense in the first quarter was $6 million. For fiscal 2015 we expect full-year depreciation and amortization to be between $24 million and $27 million.

Looking at EBITDA. In the quarter it was $34.4 million or nearly 16% of sales. Based on our fiscal 2015 guidance we expect EBITDA to remain in that 16% range and be between the $131 million, maybe $136 million. Free cash flow for the first quarter was $24.1 million and, again, based on our guidance we would expect the full-year free cash flow to be somewhere between $85 million and $89 million. Don, those complete my remarks.

Don Duda

Thank you, Doug. Mannie, we are ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Christopher Van Horn of FBR Capital markets. Please go ahead.

Christopher Van Horn - FBR Capital markets

Good morning, thanks for taking my call and congrats on a great quarter. Could you just give us an update on your conversations with the OEMs around the torque sensing product? I know you guys have been, kind of working with them on that.

Don Duda

We essentially have weekly calls with at least one of the OEMs and then monthly calls with some others. I am hesitant to name the OEM, and it is a domestic OEM. As we continue to work with them to develop the necessary algorithms for the control of the transmission. We know of nothing right now that would impede the implementation of the product but we do not have vehicle approval or approval to be on a vehicle just yet and we are anticipating that after the first of the year. But progress continues. I don’t know if there is much else I can say. We have not had any major technical hurdles that we have overcome. So that proceeds as planned.

Christopher Van Horn - FBR Capital markets

Okay. Great. And then, where is your view on Europe? I know last quarter you were cautiously looking at that region. I just want to see if there is any update on what you are seeing over the past couple of months in that area?

Don Duda

I am just looking for some numbers. I remain cautious. If you look at GDP, it declined in Germany and in Italy and then it was flat in France. We had increased sales in Europe because we had new launches and we were taking some market share but we are not where we -- we still aren't where we anticipated to be a couple of years ago. So I don’t think my view has really changed from the last time we spoke.

Christopher Van Horn - FBR Capital markets

Okay. And then finally on capital deployment. It looks like you have very strong free cash flow this year, maybe you have got a very solid cash balance on the books. How are you guys thinking about use for that cash and how you're going to kind of deploy capital moving forward?

Don Duda

Sure. We, of course, will continue to pay a dividend. We will continue to invest in our businesses. The improvement in gross margin this quarter was a direct result of -- at least a portion of the improvement was a direct result of our investment in vertical integration that remains very key to our performance going forward. So we will deploy capital as that is justified by our divisions. And then, as I said in the past, acquisitions, that is top on my to do list and we continue to engage various entities in looking at acquisitions. And so that is a very, very key focus for us.

Operator

Thank you. The next question is from Steve Dyer of Craig Hallum. Please go ahead.

Steve Dyer - Craig Hallum

Did you book any 31XX revenue in the July quarter? And maybe just a little color beyond that about, sort of how you see the ramp going? I know demand there, at least according to GM, is far in excess of what they had expected. Any color as to how that's impacting things?

Don Duda

Let me answer the second question first. Since we are in launch mode, we need to rely or we need to point you to what GM says. We can't speak for our customers. We did not ship in the quarter, I can say that but we are in launch mode. But, again, I would have to refer you to our customer.

Steve Dyer - Craig Hallum

Okay. Fair enough. Did you book any automotive tooling revenue in the quarter? I know that’s what dinged margins a little bit in the past and nothing seemed to ding in this quarter. And I know you are still, I think you have maintained you will book a decent amount of it this year. Was any of it on Q1?

Doug Koman

We had $4 million in Q1 and that compared to Q4 which was about $9.6 million.

Steve Dyer - Craig Hallum

Okay. And then, I am trying to kind of reconcile the cost reduction steps that you have taken in the auto business with when the price downs occur. Was there any of that in the quarter, given that I don’t think the trucks priced down till July and I think you said the SUVs won't price down until January. Was the quarter a bit of an anomaly from a gross margin standpoint just because you hadn't hit those price downs yet or is that sort of reflective of how we should think about it going forward?

Don Duda

We had one month, July, and that’s why I mentioned in my prepared remarks that, that the team did a very good job of bringing the cost reductions online, I would even say a little bit earlier than we had planned. So kudos to the automotive team. But I would not add that going forward and that's why I reiterated we will be at the midpoint of our goal for automotive going forward. Because we do have the price downs now in effect and then SUV will be in January.

Steve Dyer - Craig Hallum

Okay. And then lastly, I guess, I'm having a little trouble sort of reconciling the guidance and I certainly appreciate that you guys tried to be conservative, not get out ahead of your skews. But July is normally your seasonally worst quarter, generally by a pretty decent margin. And yet, you sort of flowed through the beat for the quarter and really very little else that would -- it sort of implies not a lot of pickup in subsequent quarters, primarily on the revenue line. And yet, you still haven't launched 31XX as of the July quarter etcetera. So maybe just a little bit more color as to how you're thinking about that? Are you just trying to hedge your bets a little bit given Europe and so forth or is there some reason that revenue wouldn't be materially better in the next several quarters?

Don Duda

The July shutdown, probably for the first time that I can remember, had almost no effect. It was almost we went into June full bore, into July, and the shutdowns really did not affect our revenue stream. That is very unusual and I think it's indicative of what's happening in sales and in automotive, which is great. Going forward, we really don't comment from quarter-to-quarter much. 31, we have said in the past, is about 10% of our projected revenues. So it's the smallest of the three launches we are doing. And again, I really can't comment anything more than that.

Steve Dyer - Craig Hallum

No, I just mean that it's incremental to anything you saw in July and yet, it would appear that your guidance for the next three quarters is -- to kind of get to the midpoint is not that much in excess of your July quarter. So I hear you on the shutdowns kind of didn't ding you like it normally does but just wondering if you are trying to be conservative, maybe more so than usual.

Don Duda

More than usual. No, also keep in mind that in our fourth quarter that our Ford center console programs begin to go end-of-life. So we have taken that into account as well.

Operator

Thank you. The next question is from David Leiker of Robert W. Baird. Please go ahead.

Joe Vruwink - Robert W. Baird

This is Joe Vruwink online for David. When thinking about the time between late June when you initially provided guidance for this year and today, what are some of the things that you would say have surprised on the upside. And I think it's notable that you are raising guidance one quarter into the fiscal year, so it would seem like there is probably several things on a better trajectory that give you comfort doing the guidance raise for that.

Don Duda

There is two things. Automotive sales exceeded the industry forecast and our internal expectations. We went back and looked at our model which was based on external forecasts. And last year we hair cutted those forecasts, in this year we didn’t even haircut them and the numbers came in much higher than we anticipated. A nice surprise. We shipped everything. The customer wanted on time with excellent quality and the teams did a great job on the increased volume and we saw that fall to the bottom line. The conversion was quite good. But I -- from an automotive standpoint, this is really sales higher than I think most people anticipated. And then to a lesser extent our big data customer who a quarter ago was -- less than a quarter ago was saying, they were going to -- they were over-inventoried and they were going to probably not require as much product for the next two quarters and they came in very unexpectedly with orders. And again to our power group, great job of meeting the requirements. You know, auto, we planned for a certain volume higher than what normally occurs but in the power group there was, that's kind of build to order and they did a great job of converting those orders in relatively short notice and to profit.

So those would be the two major reasons and, believe me, we have asked the question internally. But it is really to the most part sales driven.

Joe Vruwink - Robert W. Baird

So what would be embedded in the updated outlook just from an end-market demand standpoint. And thinking about you big ones, I would imagine you have expectations around U.S. auto sales, North America appliances, probably your European industrial businesses. And is the growth going forward, it’s still got to be more of what Methode is launching as opposed to just purely the end markets.

Don Duda

Well, the K2 program is a significant driver of that. I mean it is the number one driver. I mean if you look at domestic auto sales, you look at K2 sales, you look at inventory if vehicles which went down, not appreciably, but it did go down and looking at our releases going forward, warranted the increase in guidance. And if you just look at the first quarter and if you were to run rate that and we do have our Christmas quarter coming up and that will be reduced and we do have the Ford program starting to wind down. But that's really the driver of it. It's not appliance. As I said in my remarks, interface was slightly down and power was not down as much as we had anticipated because of our big data customer. I don’t -- Doug, I don't know if there is any more color you would add to that. It's a very robust automotive market.

Doug Koman

It's the primary reason.

Joe Vruwink - Robert W. Baird

Okay. Great. Just as you have got in further into the launch phase of the Dabir product, are you any closer or maybe have a better idea on what the addressable market opportunity would be just in the near term targeting kind of extended OR procedure market?

Don Duda

I always want to answer the questions but on this one I think -- let us get our first sales, which we are anticipating here in the fall, and collect some data from that and then I think we can give a better read on that. At this point I would just be speculating. I have cautioned before that we don't have enough information to say that, I would just like to hold off on that until we get some data from the operating rooms. Which we will have likely, at least preliminary data, after the first of the year. And then we will take a look at what that means for sales and addressable markets going forward. And really the -- I have said this in the past, is this a game changing product that will go in any number of hospitals, that becomes a fairly robust product line for us or will it be just another alternative that a hospital can choose from? We don't know that answer yet. And I don't mean to diminish our enthusiasm for that but I think it would be premature to speculate any further.

Joe Vruwink - Robert W. Baird

That makes sense. And then my last one. When you think about generating $85 million in free cash this year, you already have $136 million on the balance sheet. What size of acquisition do you think is definitely in the range of what Methode is capable of doing? And then it's been a while since a large acquisition, you are obviously a much bigger company since you bought TouchSensor and Hetronic. So maybe, an idea of where the focus would be on in adding capability and what a return threshold might be for the assets you're looking at?

Don Duda

We would, from a return standpoint we want the acquisition to be, if not immediately accretive, accretive within the first year. That's always been our goal when we have done any acquisitions or look at acquisitions. Size wise, if you do the math, $137 million and $85 million, you could be over -- without going in debt you could be $150 million but you could go as high as $250 million, $300 million, if the opportunity presented itself correctly. And Methode is larger and is also a more mature, I don’t mean older, a more mature management team and probably more capable of handling a larger -- managing and acquiring a larger company. And it would be -- and I said in the past, it's going to be something that's complementary to our existing businesses. So industrial, medical, you never say never so I won't rule out automotive if the right acquisition came on there. But we want it to be complementary and maybe add a path to market, bring additional technology. Doug, anything you would add to that?

Doug Koman

No, just that the team, I think has had enough practice with integrating TouchSensor and Hetronic and so we have got the confidence that we can handle something larger and probably even do it better this time.

Joe Vruwink - Robert W. Baird

Would you say you're in active discussions with any potential targets right now, later stage of discussions?

Don Duda

If I was, I wouldn't say.

Operator

Thank you. (Operator Instructions) And the next question is from Jimmy Baker of B. Riley. Please go ahead.

Jimmy Baker - B. Riley

Just on the power products side, can you maybe help us bridge gross margins sequentially there? A really big jump despite the decline in sales. Is that all just a function of mix towards your big data customer? And then I think you mentioned that you'd need to retain this level of big data sales to maintain this level of profitability in that power products business. So can you help us understand how that's looking in Q2? What your visibility is like there?

Don Duda

Sure. Let me answer the last one first. We are expecting similar performance in Q2. Now, it's not likely that we are going to get four quarters of big data business. It's not occurred in the past so we factor that into our guidance. And if you recall, in our remarks at the end of fiscal '14, we weren't anticipating hitting the gross margin targets for power. And for us really great that we would need four quarters of big data and I don't -- and that's why I made the comment on the prepared remarks. The other base business is good margin business but not enough to get it to its target. And then [Mil air] (ph) was still down. And that’s really the main reason that we don’t see the growth in power that we originally had anticipated. That we are just not going to see a recovery anytime soon in that. The military spending would have changed dramatically for that to occur.

Jimmy Baker - B. Riley

Okay. Understood. And I think you mentioned that you're working on improving the Hetronic business. Can you just elaborate on what steps you're taking there? What progress you're making? And then what level of Hetronic improvement is baked into the guide?

Don Duda

What we're doing with Hetronic is essentially going through its product line and applying, I guess, our automotive pedigree to it. Going through and modernizing its PC boards. Hetronic product is a good product but if you look at internally, we feel there is just too many jumpers and we wanted to streamline the product. They cost out of it, make it more robust and we are in the process of doing that. And it's our automotive team coupled with the Hetronic team are doing it. So that’s an important step in that. We want to be able to have as strong a product as we have in, let's say the K2 product as we would in Hetronic. And so we took steps to strengthen that.

Not that there was significant issues, it's just that we thought there was too much rework before the product went out the door, which is not -- you know it's not like Methode. First time pass through is always our goal. And then we are, on some of their handheld product, we are reducing the size of that, reducing the cost on that to market. And we are also adding to sales as well. We think that's a very important -- and not just to sell the radio remotes. I have commented on oil rigs in the past that we have at Methode, we have the capability of doing not only the remote control and the transceiver, we can do the software. And in this instance we are actually doing a hydraulic. So Methode is applying its automotive, full-service supplier to Hetronic. Which is a change for them but it makes the opportunities much greater.

And then as far as in the guide, we had very minimal growth for Hetronic in that. I think that probably, we probably did it flat. It would just take us a while to make any changes.

Jimmy Baker - B. Riley

Okay. That's really helpful. Thanks. And then last for me, just a few questions here on the legal spend. I guess, first, do you still expect roughly that $1.7 million of legal expenses related to Hetronic for the full year? And if so, what was the Q1 impact? And then separately, in your Qs, you continue to call out the SG&A headwind from legal expenses relating to torque sensing. Can you just give us an update on those proceedings? And I guess lastly, overall, is the legal spend increasing sequentially or once we lap this spend, will kind of that headwind go away?

Don Duda

I always think it's going to go away and then something occurs. The legal spend on torque sensing, is a former employee wrote a patent on I guess an application or a derivative of the technology and we expect him to turn that patent over to us because of our -- and I don't want to get too much into it but that's essentially what happened. And so we filed a lawsuit and that’s where the spend is coming there. And Hetronic, that will continue at that pace. In fact, I think we said in the second or third quarter, it will be higher and then we would hopefully would conclude that by our fourth quarter. And then barring nothing else, we would think that would be a one-time or two one-time events, if you can actually have that. But again, I wasn't expecting to have a patent issue.

Jimmy Baker - B. Riley

Sure. What was the Q1 impact though of the combined legal spend?

Doug Koman

I think legal expense in total was $1.8 million in the quarter.

Jimmy Baker - B. Riley

Okay. Thanks a lot.

Don Duda

That's not all litigation, that was our ongoing general.

Operator

Thank you. The next question is from Steve Dyer of Craig Hallum. Please go ahead.

Steve Dyer - Craig Hallum

Hey, guys. Just a follow up. Any further indication on when there may be a cut over to the capacitive screen? Anything you can say about whether the 31XX has it or doesn't have it? And maybe any more on the timing to the extent that you can say when we may get that with the K2?

Don Duda

This must be your day for me not answering your questions. I have to point to the customer. We have the information but until the customer does their announcements, we can't say anything more than we are ready to go.

Steve Dyer - Craig Hallum

But presumably that's embedded in your margin guidance for auto this year, right?

Don Duda

Yes, yes. That's correct.

Operator

Thank you. We have no further questions in queue at this time. I would like to turn the floor back over to management for any closing remarks.

Don Duda

Mannie, thank you very much and we will thank everyone for listening today and now wish everyone a safe and prosperous fall. Thank you.

Operator

Thank you. Ladies and gentlemen this does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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Source: Methode Electronics' (MEI) CEO Don Duda on Q1 2015 Results - Earnings Call Transcript

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