Kimball Electronics, Inc. Q4 FY2020 Earnings Call

Good morning, ladies and gentlemen. My name is Demetrius, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball Electronics Fourth Quarter Fiscal 2020 Financial Results Conference Call. All lines have been placed on listen-only mode to prevent any background noise. After the Kimball speakers' opening remarks, there will be a question-and-answer period, where Kimball will respond to questions from analysts. Today's call, August 19, 2020, will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Risk factors that may influence the outcome of forward-looking statements can be seen in Kimball's annual report on Form 10-K for the year ended June 30, 2019 and in today's release. The panel for today's call is Don Charron, Chairman of the Board and Chief Executive Officer and Mike Sergesketter, Vice President and Chief Financial Officer of Kimball Electronics. I would now like to turn today's call over to Don Charron. Mr. Charron, you may begin.

Thank you, Demetrius. Welcome everyone to our fourth quarter conference call. Our earnings release was issued yesterday afternoon on the results of our fourth quarter and fiscal year ended June 30, 2020. We have posted a financial summary presentation to accompany this conference call, which can be found on our Investor Relations website within the Events and Presentations tab. Or if you are listening via the webcast, you can follow along by advancing the slides or download them from the Downloads tab on the webcast portal. I will begin by making a few remarks on the quarter, and then I'll turn it over to Mike for the financial overview. After that, we will answer any questions that you may have. We are pleased with the operating results we delivered in the fourth quarter of fiscal year 2020, despite the global interruptions and challenges caused by the COVID-19 pandemic. The health and safety of our employees remains our number one priority. And we continue to make every effort to keep our facilities safe, utilizing protective shields, face masks, body temperature scanning, social distancing and proper hygiene. Of our 6,400 employees around the world, approximately 1% have tested positive for the virus. And in each positive case, our response has followed our procedures for communication to our employees, contact tracing, self-quarantining, testing and sanitization of the affected work areas. Because of the disciplined response and extraordinary effort of our people around the world, we were able to perform our mission as an essential business and, among many things, completed the first phase of our ramp-up to support the significant increase in demand from our medical customers for their respiratory care and patient monitoring products. In the fourth quarter of fiscal year 2020, sales from our medical vertical were up 23% compared to the fourth quarter of fiscal year 2019 and up 42% sequentially. We are currently on track with the second phase of our ramp-up to meet the continued demand for respiratory care and patient monitoring products and expect this momentum in our medical vertical to continue through the first half of fiscal year 2021. I feel honored and privileged that our company can play such an important role to help in the recovery of those infected by the virus. In our automotive vertical, fourth quarter fiscal year 2020 sales were down 43% year over year and down 41% sequentially. The decline in sales in our automotive vertical was disappointing but not a surprise, given the extensive automotive plant shutdowns in North America and Europe during the months of April and May. Fortunately, we were able to redirect machine capacity and manufacturing associates from certain automotive production lines to medical production lines where we were experiencing COVID-19-related increases. This helped us on multiple fronts, including employee morale, as well as capacity utilization. While the automotive industry restart has been slower than expected, we were encouraged to see our June ending run rate start to approach pre-COVID-19 levels. In addition, we continue the ramp up of several new automotive programs, including a large program for an existing customer who supports a vehicle OEM that specializes in fully electric vehicles. We anticipate our overall run rates for our automotive vertical will return to a new normal, and when added to the ramp up of these new programs, will return us to pre-COVID-19 levels by the middle of fiscal year 2021. While we recognized the goodwill impairment charge in the quarter related to our GES reporting unit, we continue to make nice progress on our integration and diversification plan. GES realized their strongest net sales and operating performance during the quarter since our acquisition of GES in October 2018. On an adjusted basis, excluding the goodwill impairment and a one-time non-operating charge related to the net working capital adjustment on the purchase of GES after the measurement period, GES was accretive to our EPS for the fourth quarter, the impairment charges and adjustment that does not affect the company's cash position, cash flow from operations or debt covenants. It is important to note that while we continue to gain traction with the new business pipeline for GES, we do have a degree of seasonality in that business with fiscal fourth quarter being their strongest. We also remain excited about the role GES is playing in our Industry 4.0 strategy as we work to roll out EM tab, which is a GES developed AI-driven manufacturing management software solution in all our global facilities in the calendar year 2020. We are working diligently to respond to the volatility in demand and the change in mix of our overall business, and continue our relentless pursuit to achieve our operating margin and return on invested capital goals. We are doubling down on execution across all of our units as we continue to drive Lean Six Sigma projects and global supply initiatives to improve yield and throughput to drive improvement in our margins. Margin expansion and capital efficiency will continue to be priorities of focus for us. Our cash conversion days for the quarter ended June 30, 2020 were 81 days, up from 77 days in the quarter ended June 30, 2019 and flat when compared to the third quarter of fiscal year 2020. While the volatility in demand has made it difficult for us to achieve our inventory objectives and thus our cash conversion days objectives, we remain committed to our inventory reduction goals and action. We invested $11 million in capital expenditures in the fourth quarter of fiscal year 2020. The majority of these capital investments were for capacity expansion and to support the launch and ramp up of new programs. There were no shares purchased in the fourth quarter of fiscal year 2020 as a result of the COVID-19 environment. Our plan has been temporarily suspended until further determination by our board. For fiscal year 2020, a total of $8.8 million was returned to our shareholders by purchasing 623,000 shares of our common stock, which brings our total to $76.7 million and 5.1 million shares purchased since October 2015 under our board authorized share repurchase program. Lastly, as I stated earlier, I am so proud of our people around the world and our collective response to the COVID-19 pandemic. Our strong company culture and core values have and will continue to help us get through this together. Our number one priority continues to be keeping our employees healthy and safe. We will continue to deliver on our promises to our customers. And with our strong cash flow and balance sheet, the company is in a solid position, and we are committed to build success in the future. Now I will turn it over to Mike to discuss our fourth quarter results in more detail. We will then open the call to your questions.

Thanks, Don. During my comments, I will be referring to the slide deck Don mentioned, which can be found on our Investor Relations website within the Events and Presentations tab, or if you are listening via the webcast you can follow along by advancing the slides on the webcast portal. As shown on Slide 3, our fourth quarter net sales were $286.2 million, which was a 10% decrease compared to net sales of $318.6 million in the prior year fourth quarter. The decline in net sales compared to the prior year was largely the result of the impact from COVID-19 in the automotive vertical. As Don mentioned, the domestic automakers shutdown for a period of time during the quarter. However, partially offsetting the automotive decline were increases in our medical and industrial verticals. Also contributing to the decrease in net sales for the quarter were unfavorable foreign exchange rates, which reduced our net sales by 1% compared to the fourth quarter a year ago. Slide 4 represents our net sales mix by vertical market. Our automotive vertical was down 43% compared to the same quarter a year ago, as our fourth quarter results reflect the severe impacts of COVID-19 on current quarter demand in the automotive industry. Our medical vertical was up 23% in the current quarter compared to the prior year fourth quarter to a new quarterly record of $123.7 million, reflecting a significant increase in demand for medical assemblies, specifically those related to respiratory care and patient monitoring products, as a direct result of the COVID-19 pandemic and global shortage of respirator equipment. Our industrial vertical was up 9% from a year ago as GES experienced strong revenue growth, with the increase in delivery of test and measurement equipment. GES's increase more than offset declines due to lower demand in climate control products and program exits. Lastly, our public safety vertical sales were $12 million, which were down 26% from the prior year fourth quarter as a result of the continued phase-out of certain programs and lower overall demand. Our gross margin in the fourth quarter, reflected on Slide 5, was 7.3% unchanged from the fourth quarter of last fiscal year. Favorable margin increases related to respiratory care and patient monitoring products in our medical vertical, along with increased margins for GES, were offset by declines across our customer base, most notably in the automotive vertical on lower volumes. Additional direct costs incurred as a result of the COVID-19 pandemic and higher depreciation expense were largely offset by governmental COVID-19 related benefits in certain countries and lower profit sharing bonus expense. Selling and administrative expenses, Slide 6 in the deck, were $11.4 million in the fourth quarter, which were down $1.7 million in absolute dollars and down 20 basis points compared to the prior year fourth quarter. The decrease in selling and administrative absolute dollars was driven by reduced incentive compensation costs, warranty, travel expenses due to the COVID-19 restrictions and other administrative expenses. This was partially offset by a $1.1 million increase in the fair value of the supplemental employee retirement plan or SERP liability, which accounted for a 30 basis point increase compared to the prior year fourth quarter. The revaluation of the SERP liability is exactly offset by gains or losses recorded on the SERP investments during the quarter, which is recorded in other income and expense net and, as a result, has no impact on net income. Operating income for the fourth quarter came in at $1.6 million or 0.6% of sales, as shown on Slide 7 in the deck. Adjusted operating income was $9.5 million or 3.3% of net sales. This compares to operating income of $10.3 million and adjusted operating income of $10.1 million, both 3.2% of net sales in the same period a year ago. The 2019 fourth quarter operating income was adjusted for $200,000 income recognized related to proceeds received from class action lawsuits of which we were members. Fiscal 2020 fourth quarter operating income was adjusted to exclude a $7.9 million impairment charge on our GES reporting unit as a result of identifying an indicator of impairment related to future anticipated revenues. Our GES forecast was updated to reflect the adjusted anticipated revenues, aligning with the current economic environment and to update the impairment analysis. The updated analysis indicated that the fair value of discounted cash flows was lower than our carrying value, resulting in the impairment charge. While the contract nature of the GES business limits our future forecast visibility, our team is making good progress on new opportunities to achieve our growth and diversification goals. We continue to be excited about the capabilities and technologies acquired with GES as we leverage those capabilities, both within the company and across our target market verticals. This impairment charge is an adjustment that does not affect the company's cash position, cash flow from operations or debt covenants, and is excluded for the non-GAAP measures. Other income expense net was an expense of $2.7 million in the fourth quarter, which compares to an expense of $1.6 million in the fourth quarter of fiscal year 2019. Other expense net in the current year fourth quarter included a $3.8 million pre-tax charge related to the final net working capital adjustment on the GES acquisition after the end of the measurement period, which was determined through the dispute resolution procedure provided under the terms of the asset purchase agreement. The net working capital adjustment along with $900,000 of interest expense were partially offset by $1.3 million in gains on the SERP investments and $600,000 in net foreign currency gains. The effective tax rate for the current year fourth quarter was approximately a negative 18%. The impairment charge had a negative 35% impact on the effective tax rate. The effective tax rate was also impacted by a favorable mix of earnings in our various tax jurisdictions, as well as state and federal R&D tax credits and adjustments. In the prior year fourth quarter, the effective tax rate was approximately 14% and was favorably impacted by state tax credits and adjustments and federal R&D tax credit adjustments. Slide 8 reflects our adjusted net income trend. Our GAAP net loss in the fourth quarter of fiscal year 2020 came in at $1.3 million. And we had adjusted net income of $8.5 million after adjusting for the after-tax impacts of the GES goodwill impairment charge and the net working capital adjustments. This compares to GAAP net income of $7.5 million and adjusted net income of $7.4 million in the fourth quarter of fiscal 2019. The prior year non-GAAP adjusted net income excluded adjustments related to lawsuit settlement proceeds. Loss per share in the current year fourth quarter was $0.05 with adjusted diluted earnings per share of $0.34. These compared to both diluted EPS and adjusted diluted EPS of $0.29 reported for the same quarter of last year. Cash and cash equivalents at June 30, 2020 were $65 million. Operating cash flow trends are shown on Slide 11. Our cash flow provided by operating activities during the fourth fiscal quarter was $21.5 million compared to $12.2 million in the prior year quarter. This increase was driven primarily by net income plus non-cash items, a decline in receivables and an increase in accounts payable. Partially offsetting these was an increase in inventories largely to support the increase in medical order volumes. Our Cash Conversion Days or CCD was up four days for the three months ended June 30, 2020, when compared to the same period in the prior year, and flat sequentially through the third quarter of fiscal 2020. Compared to the third quarter of fiscal 2020, an increase in PDSOH, our Production Day Sales on Hand, our inventory metric, was offset by a decrease in days sales outstanding and an increase in accounts payable date. Slide 12 reflects our capital and depreciation trend. Capital investments in the fourth quarter totaled $11 million, largely related to manufacturing equipment to increase capacity and support new production awards. Borrowings on our credit facilities at June 30, 2020 were $118 million, which is down $8 million from June 30, 2019. Our short-term liquidity available represents cash and cash equivalents plus the unused amount of our credit facilities totaled $142.5 million at June 30, 2020, which includes a $30 million secondary short-term credit facility agreement entered into on May 19, 2020. Our working capital and general corporate purposes to provide additional domestic liquidity to support the increased demand in medical assemblies attributed due to the COVID-19 pandemic. In conclusion, our financial condition continues to be strong and we believe we're in a solid position to continue to be able to support the increased demand in the medical market related to the COVID-19 pandemic, and to do our part to help solve the shortage of critical medical devices necessary to help save lives. As Don mentioned, we're very proud of the work our teams are doing to support the efforts to combat this disease on a global scale. With that, I would like to open up today's call to questions from analysts. Demetrius, do we have any analysts with questions in the queue?

Was the strength in the medical sector a result of pulling in demand from the first half, or did you see an increase in demand during the quarter? Additionally, do you anticipate maintaining this demand at the same level from the fourth quarter into the first half of 2021?

So the demand itself started to move up really as the COVID-19 pandemic has spread and gained, let’s say, the pace of the spread in the US and Europe. So really the first phase of the demand was presented to us in the March, April timeframe. And as I mentioned in the script, it was pretty significant demand and you could really look at it in two distinct phases. And so phase one, in completing phase one, you saw that increase that we reported here in the fourth quarter of fiscal year 2020. And the second phase then will need to be executed now here in the first quarter of fiscal year 2021, that's about the extent of the visibility that we have at this point. So, you can expect that we'll give you an update at the end of next quarter on where we're at with the sort of COVID-19 related surge. But one important note there is that we have obviously a significant increase in those respiratory care and patient monitoring products, but there has also been, let's say, a negative offset or a decrease in sales to customers that we support that have products that are supporting elective procedures, for example, that are actually down in the same period. So if we put all that together for our medical vertical, we reported a 23% increase in sales for the quarter. If you took out the COVID-19 related increases and decreases the net number would still be growth in the upper, let's say, single-digit range. So that's the numbers we'd want you to understand or to know about in terms of how our medical vertical is progressing through this period of time.

You mentioned earlier that there is a significant contract that is being postponed, which you believe will offset the increase in production related to COVID in fiscal '21. How is that situation developing?

Well, we do see primarily program delays right now with our customer base, that's some of the volatility that I mentioned in the webcast script. We're not seeing the pull ins that we're seeing or the increases in demand are really related to the respiratory care and patient monitoring products that we support, customers that we support for those products. I would say in general we're seeing more push outs in some of the larger programs, whether it’d be in medical, or automotive, or elsewhere. And so we expect that when the pandemic starts to subside that those programs will then get back on track, and again, we'll have better visibility. But that may be a quarter or two out at least. So Anja, I would say that current run rate levels and focusing on the COVID-19 impact is what's on our mind these days.

And then for the automotive segment, will you be able to sort of catch up in the first half on the lower production in the fourth quarter, or how should we think about the cadence there?

It's hard to get a good view of that. But I think if you go back to our quarter-ending March 31, which should be our fiscal year 2020 third quarter, that's a pretty good benchmark for us to have in front of us because we feel like that's a good of a pre-COVID-19 sort of number that we have to look at. And yes, it was obviously a big impact to Q4. The good news is in June, we started to get to that sort of pre-COVID-19 run-rate. So yes, we're hoping that the automotive car makers in North America and Europe can get back to their run-rate. We hope the demand is there from consumers or buyers of those cars. And obviously, what we felt this past quarter was not only the shutdown but it took a little while to crank up production again, whether it was the car makers of the tier ones or even us as a tier two, the whole value chains had to get cranked back up. So yes, I think June was encouraging to us because we started to see some of those pre-COVID-19 run rates starting to appear again in June for North America and Europe.

You mentioned that there is some seasonality with the GES, with the fourth quarter being the strongest. I assume you were referring to the fiscal fourth quarter. How should we anticipate that as we move into fiscal 2021? Should we expect it to be a bit softer, and what factors contribute to that seasonality?

Well, first of all, we're working hard on a growth and diversification strategy that will diversify the business and eventually flatten out some of that seasonality. But GES primarily today still serves the value chain that supports smart mobile device assembly and semiconductor manufacturing. And so those are the two biggest areas. And so our seasonality sort of follows their needs, if you will, in those two areas. We are working hard on the growth and diversification strategy. I don't think we will be there by Q4 of fiscal year 2021, so there will be some seasonality still in the business during fiscal year 2021, at least that’s our expectation. But it will be dampened somewhat, I think, with the work we're doing to diversify the business.

In terms of the semiconductor capital, has that significantly contributed to the GES in the fourth quarter if it is returning?

There is no doubt that we are seeing some recovery which is beneficial. Additionally, we are succeeding in securing projects within the value chain that supports smart mobile device manufacturing.

And then, the goodwill write down for the GES. Can you just explain a little bit why you took that now and what you're seeing there?

It was scheduled. The impairment study itself was scheduled for the fourth quarter of fiscal year 2020. We completed the study in the quarter. And yes, at this point in time, in this economic environment with the current projected outlook for the business, we were technically impaired and that's the charge that we took in the quarter. But I will say that the strategic assets that we gained in the GES acquisition are very much at work in our business today and they’re helping make us a better manufacturing company and opening up new doors for new growth opportunities for us. So we remain optimistic about how these assets will continue to add to our capabilities and add to our strategy for becoming an even more multi-faceted manufacturing solutions company. And of course, with their operating performance in Q4, we were very pleased. So it’s a little bit ironic that we have the two non-operating charges in the same quarter. We had our best operating quarter since we've owned the company over the last seven quarters. But that's I guess just adding a little more color to that, Anja.

And our next question comes from Mike Morales with Walthausen and Company.

Folks, first of all, really great job at posting the year-over-year earnings growth despite how significant auto is to your business and again, really great with maneuvering to achieve everything that you have and supporting the medical end markets with everything going on. Really great to see that.

Thank you.

Longer term, I think, if I think back about a year ago, you guys had talked about certain top line targets, margin targets and the ROIC targets that hovered around the 12.5% level. Can you guys just talk about how you're thinking about the ROIC targets that you might have set out a year ago versus how you're thinking about that over the next 12 months and beyond and getting that up a little bit?

So Mike, first of all, those remain our medium and long-term targets. Clearly, during this whole pandemic over the past couple of quarters, we are responding as best as we can to the environment in which we’re operating. However, when we consider the fundamentals of the business, we believe those targets are still appropriate in the medium and long term. I would note that ROIC is more aligned with the long-term side of that, given our current capital deployment. We will need a strong recovery in automotive. We will work diligently on that aspect, but it may lean more towards the long-term part of our strategy. In the medium term, we’re aiming for an operating income of 4.5%, a figure we mentioned about a year ago. The fundamentals of the business and the segments we are excelling in still suggest that this target is achievable, so we are focused on reaching it. We were pleased with how the quarter ended up. If we exclude those two non-operating adjustments, we reached 3.3 for the quarter. If you reintroduce the SERP number, that would slightly enhance the operating income by around 30 basis points or so. Even with automotive being down 43%, we are getting closer to that 4.5%. That encourages us that we can achieve our goals. Therefore, we are putting in the effort to reach the 4.5% target in the medium term, which we aim for in the next four to five quarters. As for the long term, we feel confident that the ROIC number is also attainable.

And really thinking about fiscal '21 as you guys head into it. In my mind, it seems like the first half of fiscal '21 and the world was still going to be focusing on the medical needs and those products and by enlarge going to drive a lot of the growth or revenue generation in the company. Maybe thinking about the second half. Is it reasonable to think that auto might start to be a more meaningful contributor, at least from where you guys sit today so that even if that medical piece does fall off a little bit as we going to the back half the year, as the auto might make some of that up? Am I thinking about that correctly, or?

That’s definitely a possibility that we hope will materialize. Clearly, car manufacturers have experienced significant production losses. For instance, General Motors lost production time during their strike back in December 2019, which was followed closely by the impact of COVID-19, resulting in further production setbacks. Consequently, they will be keen to increase production and restock inventories. The focus will then shift to actual consumer demand. In Europe, demand appears to be gaining momentum, while China has already returned to pre-COVID-19 levels much earlier. Our outlook for the automotive sector suggests it could rebound, as mentioned in our script. Considering our existing contracts and their performance prior to COVID-19, along with the upcoming program ramp-ups, it seems plausible that we could reach pre-COVID-19 levels by the middle of the fiscal year. From there, we'll monitor how consumer demand influences those figures as we approach the end of fiscal year 2021.

Lastly from me, you guys mentioned some of the new programs that you're winning, maybe just in a broader sense. Has any of the work that you guys have been doing in that medical vertical related to COVID, has that served to open up more opportunities to speak with those customers and maybe talk about winning non-COVID business in a more normal environment? And has that opened up any conversations that maybe you haven't been able to have in the past, or are those conversations happening more frequently? How are you thinking about growth beyond those?

The short answer is yes. Our response and efforts for the customers we support have been well received. These are long-standing customers who value us as a partner, and we were already in a strong position to secure new programs. With our actions in response to the COVID-19 surge in respiratory care and patient monitoring, our position has improved significantly. We are well positioned to continue winning business even after the pandemic, in these areas and others. It's interesting to consider which respiratory care and patient monitoring products will be crucial for future patient care. Initially, the focus was primarily on ventilators, but as we've had to evolve care for infected patients, we've seen the importance of other breathing assistance products. This evolution has been valuable for us, and we are eager to be the ones selected to produce these products as they enter the market.

Great. Thanks for the color, folks, appreciate it. And stay safe and well. That’s all from me.

Same to you, Mike. Thank you.

And pardon me, we currently do not have any further questions in the queue. I’d like to turn the call back over to Mr. Don Charron for any closing remarks.

Thank you, Demetrius. Thank you, everyone. That brings us to the end of today's call. We appreciate your interest and look forward to speaking with you on our next call. Thank you and have a great day.

At this time, listeners may simply hang up to disconnect from the call. Thank you, and have a nice day.