Key Tronic Corp (KTCC) 2020 Q1 法說會逐字稿

Good day, and welcome to the Key Tronic Q1 Fiscal 2020 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, sir.

Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is 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 quarter ended September 28, 2019. For the first quarter of fiscal year 2020, we reported total revenue of $105.3 million, sequentially flat compared to the $106 million for the prior quarter, but down from $127.5 million in the first quarter of fiscal year 2019. Despite strong demand from both new and existing customers, a dramatic increase in the demand for sheet metals caused workload balancing challenges. These constraints, which are now largely resolved, resulted in production delays and were the primary reasons for the unexpected shortfall in revenue.

Despite the revenue shortfall, margin percentages improved when compared with the prior year. For the first quarter of fiscal year 2020, gross margin was 8.8%, and operating margin was 2.4% compared to 7.5% and 2-point -- and 2%, respectively, in the same period of fiscal 2019. The improvement in margin percentages was a result of product mix changes having a favorable impact on material costs and some labor efficiencies achieved in production. Despite the lower revenue levels for the first quarter of fiscal year 2020, net income was $1.6 million or $0.14 per share comparable to the same period of fiscal year 2019.

Turning to the balance sheet. We continue to maintain a strong financial position. As a result of the production delays in the first quarter and the continued ramp in transfers of new programs, we did see a sequential increase in our inventory by approximately 17% from the fourth quarter of fiscal year 2019. In the second quarter of fiscal year 2020, we expect to see our net inventory levels declined and come more in line with revenue levels.

At the end of the first quarter, trade receivables were down $2.2 million from a year ago, and DSOs were about 55 days.

Total capital expenditures in the first quarter of fiscal 2020 were approximately $3.1 million. We continue to invest in our production facilities, SMT equipment and sheet metal and plastic molding capabilities as well as improvements in our facilities. We plan to have approximately $10 million in capital expenditures during the fiscal year 2020.

Moving into the second quarter of fiscal 2020. With the addition of new production capacity, we expect more of our new customer programs to ramp and to move into production. The disruptions and delays experienced in recent quarters have been largely resolved, and we expect revenue to increase. Taking these factors into consideration, we expect that the second quarter of fiscal year 2020 will have revenue in the range of $117 million to $122 million.

Our new Vietnam facility successfully began production with the first shipments leaving the new facility in September. For the second quarter of fiscal 2020, we expect to see some drag on gross margin as we continue to invest in enabling and accelerating the successful ramp of our new Vietnam facility. We anticipate earnings in the range of $0.13 to $0.18 per diluted share. This assumes an effective tax rate of approximately 20%.

In summary, while we're disappointed by the disruptions to our revenue in the first quarter, we remain encouraged by our prospects for future growth. The overall financial health of the company is strong, and we believe that we are well positioned to win new EMS programs and continue to profitably expand our business over the longer term.

That's it for me. Craig?

Okay. Thanks, Brett. As we've discussed in recent quarters, concerns about the uncertain tariff situation with China continues to have mixed ramifications for us. On the one hand, the tariffs are causing uncertainty and sudden reactions across EMS market including our own customers. Additionally, tariffs further complicate the supply chain, particularly for our China suppliers importing product back into the United States.

On the other hand, the big story moving into fiscal 2020 is that as a result of concerns over tariffs and trade tensions between the U.S. and China, a number of existing and new customers have accelerated their plans to transition from China facilities to our expanding facilities in the U.S., Mexico and Vietnam. We see this trend as an important and very positive sign over the longer term as customers see the increasing advantages of our North American and Vietnam-based production.

While this transition caused delays in production during the first quarter, many of our current customers are experiencing a seamless transition of their business out of China operations, facilitated by our centralized command and control. This drastically reduces the risk and time associated with the transfer to our North American sites and thus allows some leeway to respond to the rapidly changing tariff landscape. Furthermore, we are seeing that the tariffs on production in China have made our Mexico-based and Vietnam-based production more appealing to potential new customers.

Our North American sites have become extremely competitive for U.S.-bound products subject to the new tariffs. This has resulted in increased interest and request for quotes from prospective customers. On balance, we're increasingly well positioned for the returning tide of North American-based customers as they appropriately analyze the total cost for overseas production, pushing production into both Mexico and the U.S.

While our marketplace remains very competitive, we continue to win significant new business both from EMS competitors and existing customers. During the first quarter of fiscal 2020, we won new programs involving electrical -- electric vehicle charging infrastructure, LED lighting, oil and gas sensors and flight controls for experimental aircraft. Our broader and more diversified customer base lowers the potential future impact of a slowdown by any one customer.

While we are carefully managing our expenses, we have been preparing for growth in coming periods. During fiscal 2019, we made investments in our facilities, SMT, sheet metal and plastic molding capabilities in Mexico and the U.S. We also deployed innovative new manufacturing equipment in each of our facilities which has improved efficiencies and has made our production less labor intensive. The result of this effort was a decrease in manufacturing and operating expenses of approximately $3 million annually. We also added more contiguous space in the U.S. in production equipment for growth. With respect to integrated electronics and sheet metal-centric programs, we see very strong growth and few real competitors of our size in North America.

Moving into the second quarter, we are ramping up production in our new 86,000-square-foot manufacturing facility in Vietnam to augment our Asian footprint and reduce production costs as well as provide an additional hedge against uncertainty in a lingering or future trade war with China. Our steady pipeline of new business opportunities continues to be boosted by our unmatched level of vertical integration, our multi-country footprint and the excellence of our manufacturing sites in comparison to other EMS competitors of our size. As OEMs face an increasingly uncertain geopolitical landscape, we are uniquely equipped to offer risk mitigation with our vertical integration and manufacturing facilities located in Mexico, Vietnam and the U.S. While industry supply chain shortages and uncertainties about tariffs continue to be a factor, we expect revenue growth in the second quarter and remain optimistic about our opportunities for growth in fiscal 2020 and beyond. This concludes the formal portion of our presentation.

Brett and I will now be pleased to answer your questions.

(Operator Instructions) Our first question comes from Bill Dezellem, Tieton Capital.

A couple of questions here to start with, a normal one. What is the value of each of those 4 wins that you had this quarter in terms of revenues as you'd expect on an annual basis?

First 2 should both end up over 10, probably less than 20. Second 2 are around 5 each.

Great. And would you please walk through how each of those 4 new wins was originally identified? And then why the customer in each of those 4 pieces ultimately chose Key Tronic?

Okay. The first one, vehicle charging infrastructure equipment came to us through a partnership we have with a large parts distributor who is acting as a financier for customers who are looking for upfront financing and is acting as kind of like a rep for Key Tronic in matching us up with those customers that they view who have an exciting new product and yet who Key Tronic would not normally be willing to make financial risks on. So that's how we got the first one. And that is the third through that channel or source or playbook, whatever you want to call it.

The second one comes to us from an existing customer who made an acquisition. And along with the acquisition came some factories that they view as being too expensive and also a lot of products that they view as being too complex. So Key Tronic has been hired to redesign those products and to then put them in our factories, and we're quite a way down the road on doing that at this point.

Oil and gas sensors came to us through our sales network as did the flight controls. Flight controls is an interesting deal because this is a small business that was purchased by a very large avionics company, and they are telling us their strategy is to purchase quite a few small, innovative avionics and aircraft control system companies, and they're looking for a partner to manage those transitions on an ongoing basis. And right now, we've got another 3 quotes from that company as they continue on their acquisition path. So that's the story on those new pieces of business, Bill.

I'm going to actually pick up, if I may, on your last answer. Why is it that the air traffic -- aircraft control company, I mean, chose you for this one piece of business? And what is it that they like about you all that's leading them to, if not explicitly, say, infer that you're the one who will manufacture for them going forward?

Well, I don't know if you're familiar with the experimental aircraft market, but most of the innovation in private aviation is coming out of that market. If you were to go try and buy a typical production airplane, today, it would still have an engine in it that was designed in the 1950s. It would still have ignition controls on that engine that were designed in the 1950s. You would have to pay $40,000 or $50,000 up to $200,000 for your avionics for which the engineering and [trickle] components are probably worth about $5,000 or $6,000.

And the reason that's all the case is that, in order to get something approved by the FAA, it's horribly expensive and the market won't bear it. So there is a category of aircraft, experimental aircraft, that you don't have to put FAA-approved parts on. And that category is showing significant growth in volumes as opposed to the normal private aircraft market, which is basically moribund. So this large company that we're working for has realized that if they're going to have revenue growth and volume growth and also as a great way to come to market with innovative solutions, they need to buy up these little guys that are really doing some pretty cool stuff. So if you go up to the Oshkosh air show, you'll just see company after company that's got some pretty cool little gizmo or not so little gizmo that they're being put on experimental aircraft.

The reason we're a good fit is our vast history of doing small company, I guess, not really babysitting, mentoring, small company mentoring, and transferring of production from their startup facilities into an existing -- one of Key Tronic's existing facilities. So that experience along with the cost structure that allows us to do that are what convinced this big new customer that we would be the right guys to hook up with as they head down this path.

That's helpful. And then before I step back into the queue, I'm going to ask about the first one that you mentioned, the parts distributor that -- it sounds like the third, you said, piece of business that they have sent your direction. Talk a little more about that relationship and the implications of what this could mean for the future for you all. It seems like an innovative channel of sales.

Okay. Talk more about it, it's a -- they're a large distributor of parts. They view the start-up market and the near start-up market as the best place for them to get their foot in the door with what hopefully will turn into a longtime customer. They have limited engineering resources, and they have no manufacturing resources. So it's a natural fit between Key Tronic and them to help these start-ups and near start-ups as they grow. And they have access to a lot of financing and are tolerant to more risk than we are. And we have access to all of our excellent engineers and our worldwide manufacturing facilities. And we're not tolerant of start-up inventory risk. So between the two of us, it's a match made in heaven.

So the first 2 that we did with them, one was a -- is still a very big success. And the other one was a -- I guess you'd call it a failure in terms of the business. But in terms of the business model, working to protect Key Tronic from component risk, it worked out exactly as we intended it to.

Congratulations. It does sound interesting.

Our next question comes from Sheldon Grodsky with Grodsky Associates.

When did you realize that you were going to have a revenue shortfall? And when did you realize that it was not really going to be leading to an earnings shortfall?

This business is pretty tough to figure out what's going to happen in the last 2 or 3 weeks of the quarter. And many times, we don't know until the final truck crosses the border. So I can't give you an absolute answer on what day we realized it, but it was -- we thought we were going to get there towards the end. And not until we get done, crunching all the numbers, do we really know for sure where we're going to come out in terms of profit.

In any case, normally, I would not expect that you could do what you did to have a revenue shortfall and then a big bulge in your inventories and still come out with a reasonable profit for the quarter very close to what you were forecasting before. So I congratulate you on that.

Yes, thank you. It was -- I'd hate to say luck because there was a lot of work involved also. But the products that we were able to build were luckily some of our more profitable ones. So that was what carried us through.

Our next question comes from Mike Hughes with SGF Capital.

I think in the first couple of quarters, there's about $24 million -- there's been a $24 million shortfall versus your forecast. Is that revenue lost or just kind of pushed to the right?

I'd say it's 2/3 of a push to the right and a 1/3 lost.

Okay. And the 1/3, when we lost it -- I'm sorry, go ahead.

Go and ask your question. I was being impolite in anticipating what you're going to ask. So go and ask it.

The 1/3 that was lost, did that go to a competitor? Or what happened on that front?

Okay. So I was right. That's what you're going to ask. And the answer is -- the answer is that those were forecasts from our customers, and they did not get the sales that they thought they were going to get. So in no case did we lose a customer. In no case did we lose an order to a competitor. It was that their sales did not come through the way they expected.

Okay. And this is a little bit of an unfair question, but I'll ask it anyways. So I was looking at the last transcript from the last call. And on that call, you said the disruptions, the delays experienced in the June quarter have been largely resolved. You basically made the same statement today. What -- do you have increased confidence now versus on the last call that you can hit the revenue range you put out there? Or is it the same level of confidence?

Yes, I'd like to agree with you that, that is an unfair question, but I think it's actually really fair. So what happened to us is that we saw a big uptick coming in or meant [to come up] that was going to overcome a shortfall we saw due to our ability to get some electrical components. And we weren't able to achieve all of that metals production. We were caught by surprise with the amount of labor that we had to throw at it during the ramp phase. And we were caught by surprise with one of our customer's specs versus reality in terms of building it. So in this quarter, we're done with all that ramp. We're in the midst of just moving steadily. In this quarter, we see front base towards all the electrical components. And in this quarter, we're already pretty far down the road in terms of getting all the POs and forecasts that we need to fill it out. So I'd hate to be embarrassed 3 times in a row, but I'm pretty sure this quarter is going to be okay.

Okay. And then if you look at kind of the midpoint of the guidance, you're looking for about, I think, $15 million in sequential revenue growth. But the earnings number at midpoint is up a couple of pennies so that's a couple of $100,000, which implies incremental margins of 1% to 2%. I think you referenced maybe some start-up costs. Can you quantify that? And then there's that. And then how much of it is just mix was really good in the quarter you just reported?

I'd say about half of it was due to the mix being really good. As we said, we left out and that the products we could build were better, profitable products. But we are investing quite a bit in ramping the folks in Vietnam and also not being all that efficient trying to add product out of China both to America and Vietnam. So it's probably about an even split between the two.

Is the Chinese facility losing money at this point? I think you said it was close to breakeven on the last call, thereabouts.

This last quarter, they were right at breakeven again.

Okay, okay. And then one last question for you. I was listening to the call of another manufacturer early this morning, and they indicated in Vietnam, they were experiencing labor shortages and some stresses on distribution and logistics just because of the influx of foreign direct investment. Do you have any thoughts on that?

So far, our experience in Vietnam has been almost dreamlike in its ease of doing business. So the only thing we've run into so far at -- on our bills of material. They are requiring much more complete descriptions of each part which sounds like a trivial thing. But when you're looking at hundreds of thousand of parts and our need to [have the factories] for each one of our bills of material and at every one of those lines it's not minimal. But on the other hand, we are ramping products at a time instead of entire factories at a time. So it's going to be manageable.

But in terms of getting people, we've had extremely good luck, and we're extremely happy with the quality of people that we've been able to hire. And in terms of getting parts, we haven't had an issue yet. I'm not at all cocky, but I'm just happy.

Okay. So do you think the facility in Vietnam will be a drag on earnings for the next few quarters? Or at what point does it turn profitable?

It's probably 2 to 3 quarters. It's -- when you start something out of scratch, as you know, it takes a while, but it's come along nicely.

And our final question in the queue comes from Bill Dezellem, Tieton Capital.

I'd actually like to circle back to the too much demand-hurting revenues. Can you describe in some detail how that happened? And frankly, if we run the numbers correctly, had you met your revenue expectations, you would have just simply blown the earnings out of the water. And is that a correct way to think about this quarter? Or would you have had some lower-margin product that would have gone through the factory in that case, and so we would not have seen such an extreme on the earnings front?

So it's latter not the former. We would not have blown away our earnings. We probably would have done a little bit better. When we had too much demand, we had to pick and choose over what we're going to build versus what our customers wanted us to build so we had to pick the right product in order to hit our profit numbers. And at the same time, we had a pretty delicate balancing act amongst the new customers and existing customers that were new to the Juárez metal shop. So it was a complex and sweaty process. But you would be incorrect if you drew the conclusion that just adding the revenue would have blown the profit number sky high. It would've helped, but it wouldn't have blown it sky high.

Would it have been a correct calculation to use your historic gross margin and apply that to the revenues? And -- because you just said that the current quarter gross margin would have been too high.

Yes, it's probably a pretty decent model.

Yes, it's reasonable. Yes. Yes.

That's helpful. And then you did mention that you're increasing metal capabilities and capacity. Where are you doing that, which geographies?

It's in Juárez only.

And should we anticipate at some point that you will be adding metal capabilities at places other than Juárez? Or is there some real advantage to keeping it there?

No, the big advantage is for the U.S. market, stamping, forming, welding and painting those big metal pieces and then shipping them into the states is a wonderful thing versus trying to do it in China and put it on a boat and ship it over here. So putting it in the states wouldn't gain us any shipping savings or any time to market savings. All it would do would get us labor cost increases. So I can't imagine putting it into the states. I don't see any time in the next 2 years that we would put it in Vietnam. So I think it's pretty much going to be where it's at.

Great. That's helpful. And you feel as though you have that problem pretty well dialed in now?

For the current level of business that we have, yes. If we see another couple of big wins, we'll be back to struggling again, but it will be a good struggle.

Okay. Well, let me play off of that, because we would like you to have a couple more big wins, maybe even more than a couple. How do you plan for that to alleviate the metal shop being a bottleneck?

Well, we've done a lot of work on our modeling capabilities. As the metal shop got close to capacity. We were used to modeling our capacity with a pretty basic tool. And as we have added customers with widely varying products, we've had to come up with a much better tool that takes into account all the effects of making a pretty simple product one day and the next day making something pretty complex, and one product that requires one pass to the powder coat and another product that requires 100 people with masking tape and 4 passes until you run it through the powder coat line. So the modeling technique is quite a bit better now, and we should be able to anticipate both people requirements and equipment requirements as we win business rather than trying to do it on the fly. Again, I'm not sure how much we could have done it on the fly with the rapidity which the tariffs forced current and new customers to jump up and say, ta-da, we got to move back to Mexico. But if it does happen, we'll be better equipped to deal with the surprise.

Understood. And then lastly, in your annual letter in the annual report, you made reference to efficiencies that you have built into the plant that has led to something in the neighborhood of a $3 million annual cost savings. Is that -- I guess, 2 questions. First of all, would you describe in a bit of detail what it is that you have done on that front? And then secondarily, is that part of what you were describing to an earlier questioner as to why your margins were good here this quarter and the -- being able to reduce labor content on some of the products?

Well, it's certainly a fact that Q1 would not have been -- I don't think we'd have made half of it if we hadn't done all the things we did over the last year in terms of profit. We've added equipment, some pretty big expensive capital equipment that's really fast compared to what we had before both on the SMT side and on the metal side. We've improved our scheduling processes. We've done a lot of work on pseudo automation and process improvement. So that $3 million we talk about is -- those are heads that are no longer on the payroll. There's nothing ephemeral about it. It's real deal.

And we do have another question in queue. (Operator Instructions) And our next question comes from George Melas, MKH Management.

Two quick questions. On the revenue shortfall, can you identify how many customers were impacted by that? And in a way, how do they deal with it on their end? That's the first question. And I have a second one after that.

Okay. There were 3 customers that were impacted. It adds more expense to them as they try to move what inventory they have around to other places. It adds expense to us as we pay for air freight or expedited shipping to make it happen.

Overtime.

We spend a lot of money on overtime, trying to make what we did get built, built. It hasn't caused any of them to leave us. It certainly caused a lot more heightened discussions at the top levels of their management teams and ours to make sure that we are trying together to make the best of a situation that neither of us made, but that's how it affects them.

Okay. And so these 3 customers are they old-time customers that you've had for a while? Or are some of them or is one of them was a new customer?

One of them was a new customer that was coming out of China, a China manufacturer. That always represents some pretty rough challenges because their paperwork and processes were not well known, so we were inventing on the fly. We were negotiating specifications on the fly. And there were some pretty dramatic changes in both of those as we were trying to ramp. So that's one. The other one was a current customer who has three suppliers. And 2 of those suppliers were in China, us and another company. And they're in the midst of pulling out of that other company and moving it all to us in Mexico. So as their production from us didn't meet their requirements, they continued to run the other guy in China longer. And of course, they had to pay tariffs longer, so they weren't happy about it, but we're still the best option they have in terms of moving it quickly. And the third one was a current long-standing customer.

Okay, great. And then the OpEx were a bit light or at least compared to last year. Is that -- is there a particular factor in there? Or is that the run rate we should expect, Brett?

We missed -- you cut out on the first part of that question, sorry.

I'm sorry. It's about the OpEx. Your SG&A is a bit light. Is that -- is there a particular reason for that? Or is that a new run rate?

Hang on. You're saying what Ex? Did you say CapEx?

I'm sorry, let me try it again. Your SG&A, your OpEx was a bit light compared to the last couple of years.

I got it. Yes, yes, yes. I would expect that is a little bit light. I would expect that in future quarters, the percentages will stay fairly constant, the dollars may increase.

Okay. What would be a particular reason for the SG&A to be soft this quarter?

Probably due to the fact that there is not much in bonuses being accrued for commissions and the likes.

Okay. Very good.

To put it bluntly, George, nobody got a bonus. And this year, we're hoping to get one.

Okay. Okay. I hope you do, too, very much. And then sort of your long-term goal of 10% ROI, I guess, it's not long term, it's sort of roughly run rate by the end of this fiscal year. Is that still in sight or...

Yes.

Yes.

Yes.

Yes. So this shortfall has not changed any of that?

No.

And our last question currently in the queue comes from Mike Hughes, SGF Capital.

Yes. I was trying to bridge the revenue from the just reported quarter of the guide. So you need to grow the revenue by about $15 million. And you previously said that you could capture about 2/3 of that revenue that was pushed out of the $24 million. So that's $16 million. So that alone would get you to the $120 million? Or will that $16 million be spread over a couple of quarters? How will that dynamic work?

It's a couple of quarters. It's not all in this quarter.

Yes. So a slide means it moves into the next quarter, it doesn't mean that you get that plus, it's a delay. It's a timing delay.

Okay. And then on last quarter's call, you indicated about $3 million in new revenue would contribute to the growth. Did that happen in the just reported quarter? And what's the comparable number for the current quarter?

I don't have that split off the top of my head, sorry.

Okay. Last question for you. You also said on the last call that new customer revenue would total about $60 million in the fiscal '20 plan. Is that still the case?

It's actually bigger than that. I just did the analysis for our Board meeting, and it's up to about $75 million in the next 12 months.

And the $75 million in the next 12 months. Is that a function of the revenue being pushed to the right or just a bigger pipeline now?

Bigger pipeline.

And speakers, there are no more questions currently in the queue.

Okay. I appreciate everybody's questions. Thanks for joining us on the call. We'll talk to you next quarter.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.