Key Tronic's (KTCC) CEO Craig Gates on Q4 2016 Results - Earnings Call Transcript

| About: Key Tronic (KTCC)

Key Tronic Corporation (NASDAQ:KTCC)

Q4 2016 Earnings Conference Call

July 26, 2016 5:00 PM ET

Executives

Craig Gates - President and Chief Executive Officer

Brett Larsen - Executive Vice President of Administration and Chief Financial Officer

Analysts

William Dezellem - Tieton Capital Management

Herve Francois - B. Riley & Co., LLC.

George Melas - MKH Management Company, LLC.

Operator

Good day and welcome to the Key Tronic Q4 and Year End Fiscal 2016 Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Brett Larsen. Please go ahead.

Brett Larsen

Good afternoon, everyone. I’m Brett Larsen, Chief Financial 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 Craig Gates, our President and Chief Executive Officer.

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 website.

Today, we released our results for the fourth quarter and the full fiscal year 2016. For the quarter ended July 02, 2016, we reported total revenue of $123.9 million, up 5% from a $118.4 million in the previous quarter and up 3% from a $120.4 million in the same period of fiscal year 2015. For the full fiscal year of 2016, total revenue was $485 million, up 12% from $434 million for fiscal 2015. As expected, we saw a sequential improvement in operating efficiencies.

For the fourth quarter of fiscal 2016, our gross margin was 8.7% and our operating margin was 2.8%, up from 8.4% and 2.3% respectively in the prior quarter. We expect margins to continue to gradually improve over the coming quarters.

Net income for the fourth quarter of fiscal 2016 was $2.1 million or $0.20 per share compared to $2.3 million or $0.21 per share for the fourth quarter of fiscal year 2015. For the full fiscal year 2016, net income was $6.5 million or $0.58 per share up 52% from $4.3 million or $0.38 per share for fiscal 2015.

Turning to the balance sheet, we have continued to maintain a strong financial position. As you will recall, our inventories have been abnormally high in recent quarters, and our inventory was essentially flat from previous quarter. In coming periods, we expect to see inventory decrease returning to levels more in line with revenue. Our trade receivables were $61.7 million at the end of the fourth quarter, up $6.1 million from the previous quarter due to increasing revenues and lower utilization of our account purchase agreement.

Our consolidated DSOs returned to approximately 50 days and we expect that our DSOs will remain about at this level during the first quarter. You will recall that we acquired Ayrshire using about $5 million of cash on hand, $35 million from a new term loan, and $9 million from our revolving line of credit to fund the purchase price.

During the fourth quarter, we reduced our long-term debt and the balance on our line of credit by approximately $1.5 million. Over the longer-term we expect to continue to gradually pay down both the term loan and the revolving line of credits.

Total capital expenditures for the fourth quarter of fiscal 2016 was approximately $3.3 million and $11.9 million for the full-year. As we continue to expand, our SMT electrical assembly, plastic injection molding and sheet metal fabrication capacity and capabilities. We currently plan to spend approximately $7 million in capital expenditures during the next fiscal year. We will continue to finance these capital expenses through a variety of means.

Moving into the first quarter of fiscal 2017, we expect more of our new customer programs to ramp and to move into production. At the same time, we expect to see a slight decline in revenue due to the closure of our Kentucky facility which has seen a decrease in revenue as we pruned less profitable programs in transitioning customers to our Mississippi and Minnesota facilities. We also expect the final and complete ramping down of shipping completed product from the longstanding customer that adversely impacted our business throughout the year.

Taking these factors into consideration, we anticipate the first quarter of fiscal 2016; we will have revenue in the range of $117 million to $122 million. While the closure of the Kentucky plant impacts our topline revenue, we anticipate improvements in margin during the first quarter as the remaining Kentucky programs are transferred to other facilities and cost savings begin to be realized.

Over the longer-term, we expect to realize annual savings equal to approximately $0.08 of diluted earnings per share. We expect that our overall gross margin percentage will continue to gradually improve. Taking these factors just mentioned into consideration, we anticipate earnings in the range of $0.16 to $0.21 per share for the first quarter. This expected earnings range assumes an effective tax rate of 25%.

In summary, we are pleased with our strong year-over-year growth in revenue and earnings in fiscal 2016. Moving into fiscal 2017, the overall financial health of the Company is strong and we believe that we are well positioned to continue to profitably expand our business over the longer-term. That’s it for me. Craig?

Craig Gates

Okay. Thanks, Brett. Well fiscal 2016 was a challenging year for us. We are pleased with our business rebounded from a tough first and second quarter resulting in strong revenue and earnings growth for the year. Our growth was driven by the continued ramp of new programs and our investment in improving our operations to accommodate in more diversified customer base.

Our success in the face of significant adversity, this past year helps explain our optimistic view of the future. As you will recall a major portion of our business concentrated with a large customer sharply declined. Throughout the year, we managed a disengagement from that customer as its business became increasingly uncreditworthy.

Our steady pipeline of new business was boosted by the Ayrshire acquisition, our level of vertical integration, our multi-country footprint, and the excellence of our manufacturing sites.

Over the past 12 months, we have replaced approximately $40 million in revenue with this single longstanding customer by winning and ramping six smaller new programs and customers. While the revenue from the new programs and customers was very welcomed replacing one large customer with many smaller and growing customers is a big challenge from a support cost in inventory standpoint.

Our new customer diversity is good. That required a realigning of our Company involving significant retooling of some of our processes, procedures, and training. The big investments that we made in the first half of the year to support our future business has really paid off in the second half of the year. Also our thesis for acquiring Ayrshire to create one plus one equals three opportunities is working. To make this formula work, however, required a much higher concentration of PCA business at the front-end.

In fact, most of the new program is generating revenue now are PCB intensive, which makes sense as many new opportunities tend to start as PCB and then Foster a broader range of services. We now have 13 SMT lines in Juarez up from six a year ago. This is for significant capital expenditure, training expense, and management attention.

We are continuing to invest in expanding our SMT capabilities in anticipation of increasing demand. As a result of our high capital investment in PCA automation equipment, we are seeing more high value opportunities for full product manufacturing. Getting this new business up and running also impacted our expense line in advance of revenues. Several of our new programs were completely new products that we designed prototyped tool and putting into production.

We launched these programs in the factory in the face of sharp ramps driven by customer demand which were far beyond the optimum ramp rate. As a result, we incurred significant excess costs particularly in the first half of the year in terms of scrap, rework, overtime, airfreight, and inventory.

Despite these challenges, we are gradually improving our operating efficiencies and beginning to get inventory levels under control. The dramatic decline of the large customer and the transition to many new customers that we managed this past year is particularly challenging for an EMS company of our size. Going forward however, our broader and more diversified customer base significantly lowers potential risk and impact of a slowdown by any one customer.

Moreover, the tide of returning North American base customers who are now correctly analyzing the total cost of ownership for overseas production continues to benefit our sales efforts in both Mexico and the U.S., indeed we are seeing good growth in many of the U.S. facilities acquired from Ayrshire even as we rationalize some of those assets.

A large number of the larger EMS companies are seeing a softening in their business. We continue to see a robust pipeline of potential new business. During the past year, we won new programs involving telecommunications, security, lighting, building, consumer household automation, and medical equipment.

Moving into fiscal 2017, we expect to see many of our new programs continue to ramp up, the continued on-boarding of several new customers, and a robust pipeline of potential new business. Over the long-term, we anticipate our new programs and customers we will continue to go far beyond the revenue levels today and we continue to invest in increasing our capacity and improving our operations to accommodate a more diversified customer base.

Overall, we feel increasingly encouraged by our growth opportunities in our competitive strengths. 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 valid customers who continue to honor us with their trust, and to our shareholders for your continued support.

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

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we will take our first question from Bill Dezellem with Tieton Capital.

William Dezellem

Thank you. First of all, I'd like to start with my normal question. Couple of programs you referenced that you won here in the quarter. What size were those [indiscernible].

Craig Gates

They’re between $5 million and $20 million in revenue.

William Dezellem

And thinking about the one customer that you're disengaging from would you happen to have the last eight quarters of revenues from that customer, so we can go back and see that $40 million quarter-by-quarter and what the comparison was in the prior year?

Craig Gates

Not off the top of my head Bill, I’m sorry.

William Dezellem

Okay, not a problem. What about last quarter's revenues. I guess when I say last quarter and referring to this quarter that the June quarter, so we can understand what we will not experience in the September quarter?

Craig Gates

That’s about $4 million.

William Dezellem

And that will be going to zero, is that correct?

Craig Gates

Essentially zero, yes.

William Dezellem

Okay. And Kentucky, what's the revenue impact from Kentucky and that closing, and can you parcel out the proportion of business that you are exiting because its lower margin versus that that business that is choosing not to move with you because the facility is closing?

Craig Gates

Now, let's call it about $9 million in annual revenue and let's say approximately $6 million of that is going away and almost all that was pruned rather then left.

William Dezellem

So really that facility – it was only $9 million annually and…

Craig Gates

Give or take.

William Dezellem

Yes. And roughly two-thirds of it was what all this bluntly call bad business?

Brett Larsen

Yes. Low margin.

Craig Gates

Yes. Low margin, high costs required a lot of attention all the things that we don't like.

William Dezellem

And do you have – have you found any of the remaining business that’s not low margin that you're pushing out that is choosing not to move with you?

Craig Gates

Yes, like I said there's somewhat less than a third of it that is choosing not to stay with us.

William Dezellem

So the $9 million that's not the total facility annual revenue that's the portion of revenue that's going away on a full-year basis?

Craig Gates

Let's try it again. $9 million was approximately the annual revenue of the business, $6 million of that was [indiscernible], but bad business. $3 million of that is business we would like to keep a goodly portion of that $3 million we are keeping.

William Dezellem

Excellent. That's exactly what I was trying to get my arms around. Thank you. And your margins have been growing because very consistently as you pointed out in the press release. Where ultimately do you see a normalized margin level for the business?

Craig Gates

Well, we're hoping for somewhere between 9% and 11%.

William Dezellem

And would you like to venture I guess and how quickly you can get to that steady state?

Craig Gates

I sure would not.

Brett Larsen

Well, we're really close to that 9% Bill and we’re expecting some incremental efficiency this coming quarter.

William Dezellem

Right. And so I guess where I should have asked the question is are you feeling is though this September quarter is going to get you near that steady state run rate or is there still additional margin expansion to come beyond that?

Craig Gates

Yes. As I anticipated what’s you're really asking and my answer is that it sure would not like to answer that one.

William Dezellem

Let me switch gears then. How many new revenue producing customers did you bring on this year? Was it the six that you referenced in your opening remarks or was it more than that?

Craig Gates

No, its lot more than that and the six is just ones that are producing enough revenue that we could complement there and say that they replaced our exiting credit risk customer.

William Dezellem

And so as you look out or look back do you have a number that would be meaningful for us on the outside in terms of new revenue producing customers beyond those six?

Craig Gates

No, I don't think so. You and I have long discussions about the meaningfulness of this line of inquiry. Everyone that we land that we talk about tells us they're going to be over five and I'd say 50% of them never get there. So I think trying to dig at more detail of it doesn't really do a whole lot of good in the broad sense replacing the problem customer has been achieved and as we say we're optimistic about going beyond replacing them because of all the new customers we've got on deck or in the plant, but in terms of trying to give you account that you can draw numerical conclusions from I wouldn't want to do that.

William Dezellem

That's fair. And finally, as you look at the business over the course of the next year? What do you see in terms of business at risk? Trying to understand you know what's going out the bottom of the funnel?

Craig Gates

Yes, we've got to stick with your analogy last quarter we used bottom of the leaky bucket I think that's better than the funnel. So coming out of the bottom of the bucket we don't see any programs of significant size that right now are threatening to start leaking.

William Dezellem

Excellent. All right, thank you very much. And I'll turn it over to someone else.

Craig Gates

Okay.

Operator

We’ll take our next question from Herve Francois with B. Riley.

Herve Francois

Hi, good afternoon guys.

Craig Gates

Hey.

Herve Francois

I want to ask too many questions. When you talk about the transferring of programs from the Kentucky facility to some others. Was there anything particular to the Kentucky facility alone that made it more difficult for you I’d guess to keep some of the programs there is just something in the manner that facilities elsewhere some of those programs are going to are running more efficiently than the facility in the Kentucky?

Craig Gates

No, it's the people there were good. I always hate having to lay anybody off and feel bad about having to lay these folks off. They worked hard. They were good people, but the size of the facility versus the number of functions that it had to fund was a mismatch. So I am trying to explain it this way as that there are a lot of jobs that you had to have a whole person filling the job like we did and a complete HR person and yet there were only about 80 people there, so we had to pay a complete HR person for doing about a quarter of an HR person's job.

Herve Francois

Right.

Craig Gates

So there were a number of inefficiencies by filling functions that when we moved the work to the other facilities we didn't have to increase the number of HR people we had at those facilities and this is just an example. I don't have anything against HR people, but that is the main reason why we made the decision to close the facility as it just didn't have enough business nor did it have enough footprints to expand the business to make it as efficient as we could make those businesses in our other larger facilities.

Herve Francois

So has opposed it’s safe to say that that is not the situation in the other facilities in the Minnesota and Mississippi facilities?

Craig Gates

Right. We have a footprint and people, capacity, runway there in both of those facilities and they're both looking like they're going to be growing nicely even before we move this business to them. So we're able to absorb the workload without adding overhead headcount.

Herve Francois

Okay. Do you expect there to be, I guess how do you see the gradual improvement, it expected to be a gradual improvement in margins as some of these programs are transferred from your Kentucky to your Mississippi and Minnesota facilities. Is it going to be gradual? Or is it going to be kind of a sharp improvement considering you've got so many more new programs coming into fill the capacity in those two facilities?

Craig Gates

Well, there is two effects here. One effect is moving the business that we did not prune into the existing facilities from Kentucky and those improvements in margin will be pretty immediate, but you have to remember that's not a whole lot of business that we kept.

Herve Francois

All right.

Craig Gates

And then the other improving margins we talk about will be gradual over time because they are coming from adding new business into the factory and learning how to run those new products over time. So if you look back at our Q1, we had a pretty horrible Q1 and we produced X amount of product A and in Q4 we also produced X amount of product A, but we did it about two-thirds of the cost as we did it in Q1, because it was a new product for us in Q1.

So that's where the overarching improvement in margins will originate from and that just takes time as you become expert in learning a product. And you have to remember for us versus the typical contract manufacturer is that we are not just learning to build a PCB which is pretty commonplace and doesn't require a whole lot of a learning process to become efficient, because it's pretty much the same around the world to put the component down on the PCB in a reflow solder.

Herve Francois

All right.

Craig Gates

In our case a lot of the new products we're bringing on board are complete products. So all of the little tricks of the trade that’s previous factory whether it be our OEM customer or some competing contract manufacture that we won the business away from. All those tricks of the trade that gives you the last 4% or 5% of production efficiency take time to either learn or discover. And so if you multiply it all that time for each one of those businesses, times all the businesses that we're bringing onboard, that's why the gradual improvement of gross margin.

Herve Francois

That’s a gradual improvement. Okay. All right, I understood. Can you talk about [indiscernible] down in a couple of minutes later in promise time again, but did you talk about some of the end markets that are representative by these six customers that are replacing the inefficient customer that you're winding down with?

Craig Gates

What do you want me – what's your question?

Herve Francois

So for example how many of them were I guess in the transportation, or consumer, or industrial so on and so forth those particular end markets if you have it split up that way?

Craig Gates

I think as we talked when you and I met in person we don't really look at it that way, we don't really concentrate on a telecommunication or security or a consumer market per se. In fact when we try to put the list together for bill on, every quarter's new customers we won, we sometimes struggle on coming up for which business they're in.

Herve Francois

Okay.

Craig Gates

So I don't think it's worth a whole lot to try and talk about the growth we're seeing in telecommunications versus the contraction we saw in household automation or any discussions like that.

Herve Francois

All right. That’s helpful. Thank you very much.

Craig Gates

You bet you.

Operator

And we will take our next question from George Melas with MKH Management.

George Melas

Hi, guys. Good afternoon.

Craig Gates

Hi, George.

Brett Larsen

Hey, George.

George Melas

So I’m trying to sort of understand the CapEx that you had this year and also the CapEx guidance that you gave in 2017. And if I look at this year I think on a normalized basis because you bought Ayrshire in early September, almost two years ago. So I see sort of a normalized growth of $20 million, but can you really replace $20 million from that one large customer.

So it's almost an increase of $60 million in new business and you had roughly $30 million in CapEx and I think you're guiding to just seven in the coming year. Can you sort of talk about what the CapEx, I mean I understand you had a whole bunch of new SMT lines, but maybe can you talk a bit about what the implication of this lower CapEx in the coming year?

Craig Gates

Okay. Well, the previous year 2016 fiscal was much higher than normal, because we bought extra SMT lines, we also bought some whole equipment and we also bought some cheap metal lasers and turrets. As we look forward into next year, the departure from our standard balance of PCB versus complete product business is going to start to dissipate to certain extent as those PCB businesses turn into more complete product build.

So we think that we're going to be back down to a more normal level of balanced acquisition of capital equipment when you look at it historically versus last year. So we'll be buying more machines and lasers and turrets and maybe an SMT line here or there, but it won't be this massive investment in SMT equipment which is really expensive stuff.

George Melas

Got it. Okay.

Craig Gates

So and I think what’s you're getting that is can you draw any conclusions from the decrease in capital expenditure we're projecting and that's the reason you can't is because it's a different mix of requirements that we're funding.

George Melas

Okay. And this transition – so we’re focused on PCB to the core product, is that baked in your customer plans with your customer or is that sort of your expectation that or is that already in the plan?

Craig Gates

I’ll try to answer that. We have some customers who've already awarded us the transition from PCA's to full box. We have some customers who have awarded us the business from PCA's to subassemblies and we have some customers who are talking to us about moving from PCA's to full assemblies.

George Melas

Okay, great.

Craig Gates

So I think – okay.

George Melas

Okay. And then just a final question Craig and Brett, what are the margin implications of going from PCA’s to subassemblies --A - Craig Gates

Typically, when you go from PCA's which are commodity based to full assembly which are quite a bit stickier and customized, we've seen improvement in margin.

George Melas

Okay great. Thank you very much.

Craig Gates

You bet.

Operator

We’ll take a follow-up at this time from Bill Dezellem with Tieton Capital Management.

William Dezellem

Thank you. A couple more questions. First of all probably dialing this into finally, but the six customers that replaced the $40 million of revenues. Presumably they are not those six are not at their full revenue run rate with the business that they have already awarded you and I'm trying to avoid the movement to the next level for box builder whatever that may be. So assuming that assumption is correct what would be a full revenue run rate for those six customers when they move the business that they've committed to moving to you is done?

Craig Gates

Well do you want me to give you the answer they tell us when we won the business or some other estimate.

William Dezellem

I'd actually like to hear both because I think it actually - and not because I'm being silly, but I think it might be instructive to understand just the magnitude of the haircut that you often see. So I would like both.

Craig Gates

Okay. So if you lump those six together it be over a $100 million in revenue according to their sales pitch during the bid process.

William Dezellem

And for clarification that would be $60 million more than the $40 million they did last year?

Craig Gates

Yes that's correct.

William Dezellem

Okay. Go ahead.

Craig Gates

And then if I were to guess what’s actually going to happen, I'd probably say there's another [20 years only] and you come out of that group.

William Dezellem

So you find just historically you get a half or maybe a little better than half of what a customer will use to entice you in the bidding process?

Craig Gates

Yes. And that's an average and the standard deviation is probably two or three times at on any given day, but yes, that's a rough average.

William Dezellem

Interesting. Thank you. And then the second question is now that Ayrshire is going to be essentially integrated once the Kentucky facility is closed. To what degree are you thinking about additional acquisitions and if you are – are you thinking Ayrshire type acquisitions or Sabre type acquisitions, what would be your mindset there?

Craig Gates

Well, we need to get our debt down to probably a quarter to a third of what it is today before we would begin to experience a renewed appetite for acquisitions. And once the debt is down to that level, we’ll be looking at adding I would think some more Ayrshire rather then just a sheet metal or just a plastic mold shop.

William Dezellem

That's helpful. Thank you again.

Craig Gates

Yep.

Operator

[Operator Instructions] We’ll take a follow-up from George Melas with MKH Management.

George Melas

Yes. Just a question for Brett, Brett the working capital is still fairly high. Do you expect that? Hello.

Brett Larsen

Yes.

George Melas

Do you expect it to improve somewhat for the working capital cycle in the coming year?

Brett Larsen

Yes. That’s one of our major initiatives and it feels like we are finally getting some tractions. I would think that coming out of this fiscal year with our current planned revenue; we should have less working capital.

George Melas

Can you try to quantify that? Are you going to try to get $1 million out of working capital, but – or more what would be your goal?

Brett Larsen

At this point, George I’d rather not quantify that, but we’re hoping for some substantial improvement.

George Melas

Okay. And these are primarily from inventory or is that also AR?

Brett Larsen

Primarily from inventory, I believe our DSO’s will stay fairly constant, of course we have the account purchase program that we can utilize it anytime, but no – the improvements needs to be done in the inventory side.

George Melas

Okay. Fair enough. Thank you.

Brett Larsen

Thanks.

Operator

And we will take a follow-up from Herve Francois.

Herve Francois

You guys might have mentioned before just a housekeeping, did you mention your debt pay down was it $9 million that you have lowered debt by in the June quarter?

Brett Larsen

In the June quarter we paid off just over $1.5 million.

Herve Francois

All right. And was there an improvement in cash flow in the quarter as well. Cash flow from operation?

Brett Larsen

Not much, our inventory unfortunately did not go down as much as we had hoped, but we are expecting that to gain some traction in the coming year.

Herve Francois

All right. Very well, thank you again.

Brett Larsen

You bet.

Craig Gates

Thank you.

End of Q&A

Operator

[Operator Instructions] And with no further questions at this time, I'd like to turn the call back over to Craig Gates for any additional or closing remarks.

Craig Gates

Okay. Thank you again everyone for participating in today's conference call. Brett and I look forward to speaking with you next quarter. Thanks and have a good day.

Operator

And that does conclude today's conference. Thank you for your participation. You may now disconnect.

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