Kimball Electronics, Inc. Q1 FY2021 Earnings Call

Good morning, ladies and gentlemen. My name is Sarah, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball Electronics First Quarter Fiscal 2021 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, November 4, 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, 2020 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, Sarah, and welcome everyone to our first quarter conference call. Our earnings release was issued yesterday afternoon and the results of our first quarter ended September 30, 2020. We have posted a financial summary presentation to accompany this conference call. It 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 turn it over to Mike for the financial overview. After that we will answer any questions that you may have. We are very pleased with the operating results we delivered in the first quarter of fiscal year 2021. We set new quarterly records for sales, operating income, net income, and diluted earnings per share while generating strong cash flow from operations for the second consecutive quarter. Beyond our excellent financial results, we never lost sight of the fact that the health and safety of our employees remains our number one priority. And we continue to make every effort to keep our facilities safe. The number of our employees testing positive for COVID-19 has been capped at a low level and disruptions have been kept to a minimum. Because of the disciplined response and extraordinary effort of our people around the world, we were able to continue to perform our mission as an essential business and support the significant increases from our medical customers for their Respiratory Care and patient monitoring products. In the first quarter of fiscal year 2021, sales in our medical vertical increased 25% compared to the first quarter of fiscal year 2020 and were up 3% sequentially, setting a new quarterly sales record for our medical vertical. We expect the sales in our medical vertical to normalize and begin to approximate pre-COVID-19 run rates during the second quarter of fiscal year 2021. Sales in our automotive vertical continued to gain momentum during the first quarter of fiscal year 2021, increasing 61% from the previous quarter and down just 5% from the first quarter of fiscal year 2020. We expect the sales in our automotive vertical will return to pre-COVID-19 levels in the second quarter and steadily increase throughout fiscal year 2021. October 1, 2020, marked a two-year anniversary of our GES acquisition. GES was slightly accretive to our EPS for the first quarter of fiscal year 2021, which was a significant improvement when compared to the first quarter of fiscal year 2020. 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 the fiscal second quarter being their weakest. However, our backlog of orders for machines to be shipped in the third and fourth quarters of fiscal year 2021 has been growing nicely. Our cash conversion days for the quarter ended September 30, 2020 were 76 days, up from 73 days in the quarter ended September 30, 2019 but were down five days when compared to the fourth 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 actions. We invested $8.5 million in capital expenditures in the first quarter of fiscal year 2021, the majority of these capital investments for capacity expansion and to support the launch and ramp-up of new programs. There were no shares purchased in the first quarter of fiscal year 2021. 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 brought our total to $76.7 million and 5.1 million shares purchased since October 2015, under our Board authorized share repurchase program. And lastly, as I stated earlier, I'm 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 will continue to be keeping our employees healthy and safe. And we'll continue to deliver on our promises to our customers. 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'll turn it over to Mike to discuss our first 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 mentioned which can be found on our Investor Relations website within the events and presentations tab. Or if you're listening via the webcast, you can follow along by advancing the slides on the webcast portal. As shown on Slide 3, our first quarter net sales were $331.7 million, which was a 6% increase and as Don mentioned a new quarterly record compared to net sales of $313.4 million in the prior year first quarter. The increase in net sales compared to the prior year was driven by increases in the medical vertical and to a lesser degree, the industrial vertical partially offset by a decrease in the automotive vertical. Foreign exchange rates favorably impacted our net sales by 1% compared to the first quarter a year ago. Slide 4 represents our net sales mix by vertical market. Our automotive vertical was down 5% compared to the same quarter a year ago. However, the automotive vertical was up 61% sequentially as the automakers began to return to pre-COVID-19 run rates during the quarter. Our medical vertical was up 25% in the current quarter compared to the prior year first quarter to a new quarterly record of $127.1 million, reflecting the continued increase in demand for medical assemblies, specifically that was related to Respiratory Care and patient monitoring products. Our industrial vertical was up 8% from a year ago primarily due to improved sales of automation test and inspection equipment and higher end market demand for climate control products, which were partially offset by decreased demand for smart metering products. Lastly, our public safety vertical sales were $13.3 million, which were down 23% from the prior year first quarter, primarily due to the continued phase-out of certain programs. Our gross margin in the first quarter reflected on Slide 5 was 9.2%, a 210 basis point increase from the first quarter of last fiscal year. Gross margin improvement compared to the first quarter of last fiscal year was driven by a number of factors, including higher volumes and favorable product mix. GES gaining traction with significant improvement and positive contribution as material cost premiums have subsided and more efficient use of our manufacturing capacity and footprint. Adjusted selling and administrative expenses, Slide 6 in the deck were $12.6 million in the first quarter, up $1.5 million in absolute dollars and up 30 basis points compared to the prior year first quarter. The increase in selling and administrative absolute dollars was primarily driven by higher profit sharing bonus expense resulting from our overall strong financial performance in the quarter. Adjusted operating income in the first quarter came in at $18 million, or 5.4% of sales, as shown on Slide 7 in the deck, an improvement from $11.1 million or 3.5% of net sales in the same period a year ago, driven by the increase in gross profit previously mentioned. Adjusted operating income excludes changes in the fair value of our SERP liability, and in the first quarter of fiscal year 2021 excludes $300,000 of income recognized related to proceeds received from a class action lawsuit, of which we were a member. Other income and expense net was income of $2.1 million in the first quarter, which compares to an expense of $2.4 million in the first quarter of fiscal year 2020. Other income net in the current year first quarter includes $2.4 million in net foreign currency gains and $500,000 in gains on the SERP investments, partially offset by $800,000 of interest expense. Other expansion net in the prior year first quarter includes $1.2 million in interest expense and $1.1 million in net foreign currency losses. The effective tax rate for the current year first quarter was approximately 16%. The effective tax rate was favorably impacted by an $800,000 discrete benefit from the reduction of our state tax valuation allowance related to R&D tax credit carryforwards. The mix of earnings within our various tax jurisdictions also favorably impacted the effective tax rate in the quarter. In the prior year first quarter, the effective tax rate was approximately 24% and was unfavorably impacted by a $300,000 discrete excess tax expense related to performance shares granted during the quarter. Slide 8 reflects our adjusted net income trend. Our GAAP net income in the first quarter of fiscal year 2021 came in at $16.8 million, with adjusted net income of $16.6 million after adjusting for the after-tax impacts of the lawsuit settlement proceeds. This compares to GAAP and adjusted net income of $6.6 million in the first quarter of fiscal year 2020. Diluted earnings per share in the current year first quarter was $0.66, with adjusted diluted earnings per share of $0.65. These compared to both diluted EPS and adjusted diluted EPS of $0.26 reported in the same quarter last year. Cash and cash equivalents at September 30, 2020 were $73.4 million. Operating cash flow trends are shown on Slide 11. Our cash flow provided by operating activities during the fiscal first quarter was a strong $20.7 million driven primarily by net income plus non-cash depreciation and amortization. In the prior year first quarter, operating activities provided $39.6 million of cash, largely driven from increased utilization of third-party accounts receivable factoring arrangements. Our cash conversion days or CCD was up three days for the three months ended September 30, 2020, when compared to the same period in the prior year. However, it was down five days from the fourth quarter of fiscal year 2020, compared to the fourth quarter of fiscal 2020, a decrease in PDSOH or production day sales on hand, our inventory metric was partially offset by a decrease in accounts payable days. Slide 12 reflects our capital and depreciation trends, capital investments in the fourth quarter totaled $8.5 million, largely related to manufacturing equipment to increase capacity and to support new production awards. Borrowings on our credit facilities at September 30, 2020 were $111 million, which was down $7 million from June 30, 2020. Our short-term liquidity available represented cash and cash equivalents plus the unused amount of our credit facilities totaled $159 million at September 30, 2020. In conclusion, our financial condition continues to be strong and we're in an excellent position to take advantage of growth opportunities and improve operating margins and return on invested capital, while being able to confront the continued uncertainties caused by the COVID-19 pandemic. With that, I would like to open up today's call to questions from the analysts. Sarah, do we have any analysts with questions in the queue?

First question comes from the line of Anja Soderstrom from Sidoti and Co. You may ask your question.

Congratulations on a very strong quarter. And my first question is going to be around gross margin came in very high, how sustainable are those puts and takes in there and how should we think about that going forward?

Yes, Mike noted that several factors contributed to the gross margin figure, with one notable factor being the favorable mix, which is likely to change in the future. As we mentioned in the release, we are experiencing shifts in both our medical and automotive segments. As we anticipate returning to pre-COVID-19 run rates, we expect automotive to grow as it rebounds, while medical will decline as we fulfill deliveries related to COVID-19 patient care. Therefore, the mix will obviously differ from the previous quarter, and this is the one factor that may not be sustainable moving forward. We will have to monitor how those volumes evolve as we continue to navigate the pandemic and its uncertainties. Additionally, I want to highlight that we have made improvements in several areas, including the utilization of our resources, our global supply chain initiatives, material pricing, and our Lean Six Sigma efforts. We have intensified our focus on productivity in many areas, which we believe will be sustainable as we look ahead.

Okay. And in terms of the supply chain, has that sort of normalized now and that pricing has normalized so what do you see in terms of supply?

It has become more stable, especially in certain component categories that faced shortages and where demand was striving to catch up about a year or five quarters ago. The supply has aligned in those critical areas, such as capacitors that we've previously discussed, and pricing has also returned to more typical levels. We anticipate that this situation will continue to improve as we move forward.

Okay. And then as I think about you ramping new programs and also switching, I guess, programs in medical, how is that going to affect the gross margin?

Well, certainly as we look to ramp new programs, that part of the product life cycle is challenging for us, as we ramp up with, say, a new program and get it to its quoted run rate. But I would say, no different in how we look at the model going forward, because we do have a number of mature programs that are fully ramped. And as you know, especially in the automotive vertical, as we go forward now and get back to pre-COVID-19 run rates. And actually, the other point in the automotive vertical, that's critical to understand that the inventory levels in the industry, especially in the United States are down in terms of finished goods. And so, there will be a desire to not only replenish those inventories back to, let's say, normal levels, especially in the U.S., where we're particularly low on inventory here. There will be two factors, buyers coming back to the market and purchasing new cars, but also replenishing inventory and so we expect several of those mature product lines that have been in volume, especially last quarter and had been recovering this past quarter, I should say, the quarter before that they were down significantly those volumes, on those mature programs will ramp and that will help us and they'll help offset some of those newer programs that are ramping up.

Okay, great. And then in terms of medical what visibility do you have there in terms of sort of COVID related programs tapering off, and then how the electives are coming back?

Yes. That's a really good question and one that is difficult for us to gain a lot of visibility around in our customers as well. What we do know is, the COVID-19 patient care-related products that we supported in Respiratory Care and patient monitoring, we have worked off the backlog that was there over the past couple of quarters and have met the demand for the most part. And so returning to pre-COVID-19 levels will be a decline for those products. What we don't have a good handle on yet are the products that went down as a result of COVID-19, as you mentioned, elective surgery-related products for us were down during this period, and how fast will they come back? And there were other product categories that actually declined during the COVID-19 pandemic period, while we were ramping up other products they were declining. And these would be less critical, but important products and how fast they come back is really the degree of uncertainty, we just don't have the degree of certainty there, not visibility, but we're working very closely with our customers, they expect the demand to come back. It's just really more around when.

Your next question comes from the line of Mike Morales from Walthausen and Co. You may ask your question.

Hey, everyone. Congratulations on your strong performance during the quarter. There are a few points I want to discuss. It's great to hear that we can finally view GES positively. I’d like to explore the opportunities you’re currently seeing there. When I consider this business since the acquisition and moving forward, there were challenges due to the semi-end market, especially in smartphones. However, I haven't heard much about the smartphone market, which appears to be doing quite well when we look ahead a year or two. It seems to have potential for growth as well. Can you elaborate on some of the opportunities in GES that may not have been available before? Additionally, from a financial standpoint, could you share insights on the margin profile of the products you plan to ship later this year?

Sure. You're correct. Currently, the end markets we serve are mainly in the smart mobile device sector, particularly in the manufacturing of smart mobile devices and the semiconductor industry. We've been diligently working on a growth and diversification strategy over the last couple of years and aim to broaden our reach beyond these two markets. We are observing some strength, especially regarding the manufacturing of new smart mobile device releases. The machines we mentioned that have increasing back orders for delivery in the third and fourth quarters are predominantly in that market. We anticipate this strength to persist and are actively pursuing a diversification strategy. Looking at our GES platform, we are well-positioned to leverage many industry 4.0 investments currently occurring in manufacturing. The trends toward automation and replacing human inspection with machine inspection have been significantly intensified by the COVID-19 pandemic. We expect our opportunities to continue to grow, not just within these end markets but also in others that we are actively developing. GES is a technology-driven company, focusing on advanced solutions in our division; we integrate substantial technology to address the challenges our customers face. As we consider our manufacturing processes, the integration of machines is increasing, and the quality expectations for the outputs of these processes are rising towards perfection. This necessitates the products we develop to embody significant engineering expertise. Consequently, we anticipate achieving higher margins in this business. We are still refining our expectations and gaining insights into these end markets and their price tolerance. However, due to the technology component I mentioned, we foresee higher margins in this sector.

Great. So as I'm putting hearing figures about 200 million in 5G handsets going to 400 and potentially 800 after that, that rising tide should continue to benefit GES as capacity dictates?

Yes.

Great. Maybe switching gears a little bit, could you help me understand some of the areas that you're seeing, at least in the new business pipeline now that it sounds like auto demand is coming back a little bit. Medical demand is kind of tapering off? Are there any areas that you can talk about that you're seeing maybe a pronounced return in demand? And is it ahead of what you expected from a timing perspective behind what you were expecting? Just help me understand where you're seeing the most opportunities today.

Yes. Mike, I'm seeing some more than green shoots, if you will, in the automotive vertical. We would actually started to slow down even before the COVID-19 pandemic; we had the GM strike. We had kind of probably 6, 7, 8 quarters, pre-COVID-19 pandemic that were more of a sort of a headwind in our automotive vertical. And, of course, we had to endure the complete shutdown here in the U.S. and for most of Europe, which was all of March half of April. So we endured that and we've come back now and last quarter, we weren't quite at, let's say, a pre-COVID-19 run rate, if you look at our $118 million in revenue for the quarter. If you look at the second quarter of last fiscal year, we were finishing closer to $135 million. So we're not at pre-COVID-19 run rates. And it'll take a while to ramp production back up in the whole value chain. But what I wouldn't want lost on that is not only mature programs ramping back up at some of the new launches that in some cases were delayed, or at least slowed by the pandemic. And so I really believe we're in a great position to see some steady growth in the automotive vertical as buyers come back to the market, which is a great sign. We've actually seen year-over-year growth, car companies reporting growth, each region, China, North America, Europe, there are green shoots of growth coming back with buyers returning to the market. And when you combine that with the inventory levels in the industry, I mean, to me, it's a great story and a great starting point to I think a pretty good run. So that's one area that. And we didn't mention in this script that we did last time, we are well positioned with the applications we support, whether it's a combustion engine-driven car or whether it's a complete electric vehicle. And, one of the real significant growth areas inside of our automotive vertical are the electronic assemblies that we shipped to our customers who shipped to fully electric vehicle manufacturers and that's been a great story for us and we expect it to continue to grow as we are fortunate there to be on one of the most popular electric vehicle brands in the world. So that's a neat story too within the automotive vertical. The medical piece is definitely going to change. I think it's good news for the world, if we don't need to build a lot more COVID-19 patient care products, that means there's less hospitalizations. We're getting the pandemic behind us. And so, we will see that drop back down to normal levels. The question is how fast some of the other products come back that have really been down for a couple of quarters now during the pandemic, as you know, those were not deemed critical to care. And so, things like elective surgeries were being postponed, and other products that we serve in our medical vertical, we saw decreases, and it's really, because they just were not critical to care in this pandemic. But we do believe that business will come back; our customers believe it will come back. And medical has been a great growth story for us and our ambition is to keep it a great growth story for us going forward.

Absolutely. And lastly, for me, just from a capacity standpoint, how are you guys feeling right now and your ability to feel the demand that seems to be coming back? Are you capacity constrained, will there need to be additional CapEx?

Our utilization was a key contributor to the increase in our gross margin. It remains quite high, with certain geographic areas nearing their capacity. We are carefully monitoring this and preparing plans for expansion to support growth. Regarding our facility and square footage, we aim to expand where we already operate as needed, rather than pursuing new country strategies like we did with Romania, which was our last Greenfield project. This will involve some capital expenditure, but it won't entail the extensive ramp-up to breakeven typical of Greenfield developments. Our focus is on enhancing our existing footprint and utilizing our talent in those locations. Currently, some of the areas experiencing high demand include Thailand and Mexico, and Poland is still operating at full capacity since the demand surged during our setup in Romania. We have regions that are quite full and are strategically planning to expand our square footage as required. In terms of growth rates, we've often discussed our aim for organic growth to be around 8% or at least in the upper single digits. When achieving this rate, we expect our capital expenditures for equipment capacity to align with or be around the rate of depreciation. However, expanding our footprint will occur on top of that spending profile.

Next question comes from the line of Richard Greenberg from Donald Smith & Co. You may ask your question.

Don, I just wanted to follow up on the margin issue, previously you would talk about this 8% sales growth. And along with that, in the medium term, you were saying you would hope to get to 4.5% operating margin, you obviously exceeded that this quarter, part of that mix is some other more sustainable item. Are you willing to kind of reset that number now, or I mean, what should we be thinking longer term is your goal, operating margin?

Yes, it's a great question, Richard. We had some favorable conditions this quarter, which Mike highlighted. I believe the improvements we've made and the margin items discussed are sustainable, and we should consistently aim to achieve our long-term goal of 4.5%. We haven't been consistently reaching that target, but this quarter we performed well at 5.4%. We expect to stabilize around 4.5% going forward. Is that our limit? No, we have plans to grow beyond 4.5%. The first step is to consistently achieve 4.5%, but we have strategies in place to move above that and set higher goals. Our focus as a management team is to consistently reach 4.5% before we discuss further growth opportunities.

Okay. And then, regarding capital usage, as you said, you hold off on the buyback, cash is growing, you talked about acquisitions, could we maybe revisit that and in balance foresee your thinking on what we've already talked about capital spending, but balance foresee, buybacks, debt paid down and more what you're thinking in the M&A area.

Yes, it will be on our board meeting agenda next week. We have discussed our desired capital structure and capital allocation in every board meeting. Our main priority continues to be organic growth. As long as we experience success in growing organically, that will remain our focus. Additionally, based on our expected cash flow from operations, we will have surplus capital beyond what is required for organic growth. After that, paying down debt is certainly a priority. We previously paused our share repurchase program to ensure we maintained a strong financial position during the pandemic. As we gain more confidence in our outlook, we may consider restarting our share repurchase program, and that will be part of the discussion next week in the board meeting. Finally, in terms of acquisitions, it's currently a challenging time to identify targets due to the pandemic. However, we do want to pursue strategic acquisitions, particularly in the medical space, similar to our acquisition of Medivative four years ago. Any potential acquisition would need to be carefully assessed based on the pandemic situation and the target itself. Overall, our priorities will focus on the first three points I mentioned.

When you review your previous acquisitions, it appears there have been some successes, but also some short-term disappointments, such as the goodwill impairment taken last year. Has this influenced your strategy at all? While it may be tempting to focus on organic growth since our stock seems undervalued, perhaps we should consider sticking to what we know and pause on taking on more goodwill and intangibles, delaying any new acquisitions.

Well, we talk about that a lot, Richard over the years. And the short answer is yes, we were not happy with the slow start we got with the GES acquisition. But I would go up a little bit higher and look at the acquisitions we've done over the years, they've really been strategic acquisitions that brought key capabilities or a market presence that we were seeking. And so those are really more long-term kinds of payoffs. That the Medivative acquisition we did four years ago got us into a whole different area of capability and market. And as we're doing very well with that, GES, very slow start, but again, the strategic assets that we brought into the company with GES are going to help us in other areas of our core EMS business, even for example. But it's hard not to go through an acquisition like GES, have conducted an impairment study, and find that you are impaired, and have to take that charge. Those are difficult things that yes, they do impact us as management and I would tell you, they impact our Board and in their oversight of what we're doing from a strategic standpoint. Organically, if we can continue to grow like we've grown, these acquisitions that we would look at would be more about bringing a capability that we don't have today or a market access point that we don't have today. Those would be the big drivers behind an acquisition. And so it's not about adding it, using that tool as a tool for growth as much as it is adding capabilities, developing those and then, again, kind of pushing them back towards our organic growth plans with our existing customers.

There are no further questions at this time. I will turn the call back to Mr. Charron.

Thank you, Sarah. 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.

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