Earnings Call Transcript
KEY TRONIC CORP (KTCC)
Earnings Call Transcript - KTCC Q2 2023
Brett Larsen, CFO
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 this 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 December 31, 2022. For the second quarter of fiscal 2023, we reported total revenue of $123.7 million compared to $134.5 million in the same period of fiscal 2022. For the first six months of fiscal 2023, our total revenue was $261 million compared to $267.2 million in the same period of fiscal 2022. As previously announced, our revenue for the second quarter of fiscal 2023 was impacted by a six-week delay in starting production for a large program with a leading power equipment company. This delayed revenue by approximately $20 million from the second quarter of fiscal 2023, but production for this program is currently underway and increasing in the third quarter. While constraints in the global supply chain continued to limit production, we saw some gradual improvements with respect to lead times of certain key components. For the second quarter of fiscal 2023, our gross margin was 7.2% and operating margin was 2.9%, compared to a gross margin of 7.3% and an operating margin of 1.2% in the same period of fiscal 2022. The gross margin in the second quarter of fiscal 2023 was adversely impacted by business interruption and other operational losses related to storm damage in our Arkansas facility, as well as by preparations for expected sales growth in the second quarter and increased labor costs in both the U.S. and Mexico. While profitability is expected to improve in coming quarters with expected increases in revenue, higher interest rates on our line of credit and increasing wages will limit a portion of that expected improvement. For the second quarter of fiscal 2023, net income was $1 million or $0.09 per share compared to $0.6 million or $0.05 per share for the same period of fiscal 2022. Our results for the second quarter of fiscal 2023 included a gain on insurance proceeds of $2.7 million or approximately $0.19 per share related to equipment damaged in the storm at our Arkansas facility. We are still determining further business interruption proceeds related to the operational losses incurred in the past two quarters as a result of the storm damage. For the first six months of fiscal 2023, net income was $2.1 million or $0.20 per share compared to $1.4 million or $0.13 per share for the same period of fiscal 2022. Turning to the balance sheet, despite the continuing production delays due to supply chain problems and the continued ramp and transfer of new programs, we ended the second quarter with total working capital of $190.7 million in a current ratio of 2.1 to 1. Compared to the prior quarter, we're encouraged to see our receivables decrease by $4.7 million and DSOs at 78 days, down from 91 days, which we believe reflects some improvement among our customers with respect to disruptions from COVID-19 and supply chain issues. At the end of the second quarter of fiscal 2023, our inventory increased by approximately $2.5 million or by 1.5% from the prior period, reflecting the delayed production for the large outdoor power equipment program and our preparations for expected growth in coming quarters. While the state of the worldwide supply chain still requires that we look out much further in the future than in historical periods, we attempt to carefully balance customer demand and the likelihood of successfully bringing in parts in time for planned production. In future quarters, we expect to see our net inventory turns slowly improve to more historical levels. Total capital expenditures were $1.4 million for the second quarter of fiscal 2023 and we expect total CapEx for the year to be around $9 million. We're also utilizing the $2.7 million gain on insurance proceeds for storm damage to modernize our operations, which should increase efficiencies in our Arkansas facility. While we are keeping a careful eye on capital expenditures, we plan to continue to invest selectively in our production equipment, SMT equipment, and plastic molding capabilities, utilizing leasing facilities as well as making efficiency improvements to prepare for growth and add capacity. Despite the ongoing disruptions from the global supply chain that will continue to limit production and adversely impact operating efficiencies, we are expecting significant growth in fiscal 2023. For the third quarter of fiscal 2023, we expect to report revenue in the range of $160 million to $170 million, and earnings in the range of $0.15 to $0.25 per diluted share. While profitability is expected to improve in coming quarters with increasing expected revenue, higher interest rates on our line of credit and increasing wages will limit a portion of that expected improvement. While our facilities in the U.S., Mexico, China, and Vietnam are currently operating, uncertainty does still remain as to the possibility of future temporary closures. Customer fluctuations and demand costs, future supply chain disruptions, and other potential factors, any of which could significantly impact operations in coming periods. In summary, we continue to grow our pipeline of new sales prospects and continue to increase our customer demand to unprecedented levels for Key Tronic. We believe that we are increasingly well positioned to win new EMS programs and continue to profitably expand our business over the longer term. That's it for me. Craig?
Craig Gates, CEO
Okay. Thanks, Brett. We're pleased with the successful ramp of new programs and our expanding customer base in the second quarter of fiscal 2023 despite a six-week delay for production from the large previously announced power equipment program. Production for that program is now back on track and rapidly ramping up. In essence, the revenue from that program was simply pushed by a quarter. During the second quarter of fiscal year 2023, we continued to see the favorable trend of contract manufacturing returning to North America. Currently awarded new business has created backlog that will support over 65% growth in the U.S. sites over the next fiscal year. We won new programs involving outdoor power equipment, battery management, automated sprinklers, and biometric sensor technology. We move into the third quarter with record backlog and we're seeing improvement in the global supply issues for certain components that have severely limited our production in recent periods. Global logistics problems, the war in Europe, and China-U.S. geopolitical tensions continue to drive OEMs to examine their traditional outsourcing strategies. We believe these customers increasingly realize they have become overly dependent on their China-based contract manufacturers not only for product but also for design and logistic services. Over time, the decision to onshore or nearshore production is becoming more widely accepted as a smart long-term strategy. As a result, we see opportunities for continued growth. As we've discussed in prior calls, we built Key Tronic to offer the ideal solution for customers as they move to respond to geopolitical pressures. Our facilities in Mexico represent a campus of 1.1 million square feet in Juarez, most of which is located in nine facilities acquired over time. Our three U.S.-based manufacturing sites have also benefited greatly from the macro forces driving business back to North America. Moreover, our new Vietnam facility continues to increase production levels and the abatement of COVID-related government restrictions in Vietnam is allowing us to travel there and tour the plant with potential customers. Our Shanghai plant has added capabilities in management staff and systems that allow it to serve Chinese customers directly. Shanghai has replaced the business that we moved to Vietnam and our procurement group in Shanghai, which serves the entire corporation, is important for managing the supply issues that crippled many of our competitors without boots on the ground in China. The combination of our global footprint and our expansive design capabilities is proving to be extremely effective in capturing new business. Many of our large- and medium-size manufacturing program wins are predicated on Key Tronic's deep and broad design services. And, once we have completed a design and ramped it into production, we believe our knowledge of program-specific design challenges makes that business extremely sticky. We also invested in vertical integration and manufacturing process knowledge, including a wide range of plastic molding, injection blow, gas assist, multi-shot, as well as PCB assembly, metal forming, painting and coating, complex high volume automated assembly, and the design construction and operation of complicated test equipment. This expertise may set us apart from our competitors of a similar size. As a result, a customer looking to leave their contract manufacturer will find one-stop shopping in Key Tronic, which is expected to make the transition to our facilities much less risky than cobbling together a group of providers each limited to a portion of the value chain. Moving further into fiscal 2023, the headwinds from the global supply chain continue to present uncertainty and multiple business challenges, but show some signs of gradually abating, particularly with respect to the recent price stabilization for some commodity components. At the same time, these price reductions are offset by increasing wages at our North American facilities. We believe global logistics problems, China-U.S. political tensions, and heightened assurance of supply concerns will continue to drive the favorable trend of contract manufacturing returning to North America, as well as to our expanding Vietnam facilities. The fact that we see record level backlogs and expect record revenue in the third quarter indicates our growing momentum. Along with the records we are setting for backlog and revenue, we see a dramatic improvement in all metrics associated with business development. For example, over the past year, a number of active quotes with prospective customers has increased eightfold. This unprecedented increase in demand for our unique mix of skills, location, and people has powerful implications beyond the obvious revenue growth potential. In particular, we have been able to negotiate more favorable pricing terms and business parameters than in the past, as well as to be much more selective in the new customers we bring on. While this shift in leverage will not manifest in the short term, its effect on our long-term performance should be profound. As the implacable effects of global demographics combine with the unique attributes of the North American economy to drive the re-industrialization of the U.S. and the accelerating industrialization of Mexico, Key Tronic should be uniquely positioned for significant growth in fiscal 2023 and beyond. This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions.
Bill Dezellem, Analyst
Thank you. Let's start, if we could, with the power equipment customer that had the delays and that led to the preannouncement. Walk us through, if you would, what happened there? And what if anything that Key Tronic could have done to influence those revenues coming in sooner?
Craig Gates, CEO
Well, Bill, I'm not sure I can be as specific as you would like about what happened there. I can, in general, only say that it was a brand new program on a brand new product that we shared in the joint design and development thereof. There were delays all across the board. In fact, the final delay was the artwork for the packaging. So, we were six weeks off out of an 11-month design program, which was pretty annoying. But on the other hand, we got it done. And in fact, we mentioned the new programs involving outdoor power equipment, that same customer has just awarded us another piece of business on another product. And before you ask me, it's about $11 million.
Bill Dezellem, Analyst
That's quite helpful. And congratulations on that next piece of business.
Craig Gates, CEO
Yes, thank you.
Bill Dezellem, Analyst
Since I've never been in the position of doing artwork for packaging, a six-week delay sounds like a lot. Can you walk us through that? It seems extreme to me.
Craig Gates, CEO
It is actually more common than you would hope in our business, where we manufacture a product for a customer that sells it to a retail customer. Retail packaging is very critical for sales and product market acceptance. Unfortunately, or probably fortunately given the artistic nature of my engineers and me, we have no say in the artwork. It requires a joint agreement between our customer and their customer, involving several artistic individuals. Therefore, it's fairly common for us to face pressure while trying to get packaging or artwork for packaging approved and produced. In fact, we're currently looking at a significant opportunity for a different product, and once again, the delay stems from our ability to obtain packaging on time to meet the customer's increased demand in a new market.
Bill Dezellem, Analyst
Fascinating. Thank you. And so, with this power equipment customer, just to help us have a perspective of the trend line that's taking place, what was the revenue level in October, then the month of November, the month of December and then in January? What does that look like?
Craig Gates, CEO
Pretty easy, Bill, zero, zero, zero. And then, January...
Bill Dezellem, Analyst
Yes.
Craig Gates, CEO
What?
Bill Dezellem, Analyst
At least one more month of January. Go ahead.
Craig Gates, CEO
Yes. I'm not going to comment on what it was in January, but it was a lot more than zero.
Bill Dezellem, Analyst
And are you able to talk about what the peak level of production will be for this customer?
Craig Gates, CEO
No.
Bill Dezellem, Analyst
And is January, probably not at the full run rate given that they were zero in December, so that will be even higher in coming months?
Craig Gates, CEO
Yes, right now we're at about five-eighths of our required run rate after really about three weeks of full production.
Bill Dezellem, Analyst
Okay. That's helpful. And then, originally, if I have the right customer in mind, I think you had a press release that stated that you anticipated that they would be an annual run rate of about $80 million. Is that still this piece of business is looking like? I'm excluding the new piece of business that you won, but just this original piece of business?
Craig Gates, CEO
This original piece of business, we expect to be somewhat less than that in this first period as far as an annualized run rate. But at the beginning towards the middle of next fiscal year, it should be up to that number for a run rate.
Bill Dezellem, Analyst
Okay. That's quite helpful. Thank you. And then, you did allude to the fact that I asked about the new product wins and the size. Would you talk through the other three in terms of the size? And then, whatever discussion that you have on these four wins would be helpful.
Craig Gates, CEO
The other three were around five million each and will be allocated to the Midwestern facilities. These are quite representative of the impressive success the three sites in the Midwest have been achieving over the past year. We projected over 65% growth, which is remarkable considering they had been relatively stable for about four and a half to five years. As I have mentioned before, we anticipated these developments, and although there was a slight delay, they are now happening to an even greater extent than we expected. The teams in the Midwest are particularly well-equipped to manage programs ranging from one million to ten million. These types of programs continue to come in at an impressive rate, and the process of receiving, organizing, and optimizing them is truly remarkable. It has been an extremely rewarding experience.
Bill Dezellem, Analyst
Even though it might be more exciting for us to discuss a large customer, it seems that the smaller ones, which I consider our mainstay, likely yield higher margins than a significant portion of business.
Craig Gates, CEO
Yes, you can pretty reliably predict that something that's going to be run in the U.S. facilities is lower volume, higher margin, stickier overall, and typically quicker to develop also, unless there's a design program that went with it.
Bill Dezellem, Analyst
Thank you. I don't want to take up more time than necessary, but I would like you to explain the change that has occurred with the U.S. facilities or the Midwest facilities, going from essentially flat for several years to this accelerated growth. What happened? What changed to lead to this?
Craig Gates, CEO
As we mentioned earlier, there's a growing consensus that operating overseas poses significant risks. The size of companies that can attract the necessary attention for successful outsourced business is increasing, while smaller contracts that used to default to Asia are now more often remaining in the U.S. This shift is due to rising costs in Asia, growing uncertainties regarding Asian supply, and an increased recognition of the challenges associated with international business. The landscape is significantly different from five years ago when securing business was a struggle. Now, opportunities are coming our way, and potential clients are no longer just exploring options; they are under directives from their corporate leaders to move operations out of Asia due to associated risks.
Bill Dezellem, Analyst
Thank you. And did we hear correctly that your quotes you said were up eightfold from one year ago?
Brett Larsen, CFO
Yes.
Craig Gates, CEO
Yes, we have been doing this for a while now. About five or six years ago, we would sit around and stress over a few significant quotes that we needed to secure to offset revenue losses and potentially grow. Now, we have numerous single-line quote opportunities that are all legitimate prospects. It's astonishing to consider how much things have changed compared to what we experienced years ago, and it's genuinely exciting.
Sheldon Grodsky, Analyst
Well, good afternoon, everyone. First question I'm going to ask is the Arkansas facility, is it fully up and running, or is it still being repaired or what's the status?
Craig Gates, CEO
It's probably 90% up and running, and that's a bit more down to the weather than it is anything else. We just had the last machine arrive today in the snowstorm and everybody's home, but the General Manager and the VP are out there driving forklift trucks and getting it off of the trailer.
Sheldon Grodsky, Analyst
Okay. Well...
Craig Gates, CEO
Yes, it's about 90% operational, and they had a good couple of weeks recently, so we expect that momentum to continue.
Sheldon Grodsky, Analyst
Okay. And as far as the insurance situation, there may be more money coming in from that as things get determined, or do you expect it to be neutral from here?
Craig Gates, CEO
No, I think there's going to be some more coming in. Our insurance policy was well written and the company has been very forthright and honorable, which has been a pleasant surprise. They've been good people. So, the cool thing about that is that the equipment that we have replaced was aged, but the policy was for replacement. And as we said in the narrative, just to put some flesh on those bones, the stuff we got in there now is five times as fast. And so, that has a very massive impact on capacity and cost out of that Arkansas facility.
Sheldon Grodsky, Analyst
Okay. Now I don't know how to phrase this question, but based on what you're saying, you're seeing probably at least in the short or medium term more demand than you can actually meet in a relatively short period of time. Are we looking forward to a major growth cycle for Key Tronic as far as you can tell?
Craig Gates, CEO
Just from a macro sense of what's happening in the world and as I've gone through the various metrics that we analyze and think are relevant, it certainly seems as if we should be looking at a very nice growth rate for us going forward.
Sheldon Grodsky, Analyst
Well, I've been following your company for a long time and it always seems that something gets in the way of getting to the bottom line. So, I just keep on hoping every quarter that we're finally going to break out of that and get some real sense of what potential you can do here. So, I wish you good luck and that the world hasn't been an easy place to operate. So, let's hope it gets a little bit easier for you and you are able to pick the right contracts, etc. I'll let someone else take the floor with questions.
Craig Gates, CEO
Okay. Thank you.
Brett Larsen, CFO
Thank you.
George Melas, Analyst
Thank you. Hi, Craig. Hi, Brett.
Craig Gates, CEO
Hey, George.
George Melas, Analyst
Sort of I want to follow up on the two previous callers. And sort of want to sort of look into the future, and I think you're saying that quoting is very strong, that has an impact on pricing, on business terms, you can choose your customers better. But then, I guess you have to make some kind of balance between growth and margins. And I'm wondering how you think about that. I'm always thinking about margins and where could those margins go. And is there sort of an idea that maybe the idea would be to grow X percent in order to reach 9% margins or 9.5% margin? Can you sort of elaborate on that? I don't know if it makes sense, but maybe I'd love to have a discussion on that.
Craig Gates, CEO
What I meant to convey is that five or six years ago, from the time we started as a contract manufacturer until about a year ago, we were ahead of the curve in anticipating the changes that are now taking place. In the early days of our contract manufacturing, this awareness diminished over time. There’s no need to comment on the political situation, but the Trump administration definitely accelerated our understanding of these impending changes, and then COVID pushed it even further. The current situation is quite different from what it was back then, before the realization about the risks of overseas operations. Previously, during final negotiations, customers would often say they needed us to lower our margins because we were priced higher than competitors. We would feel pressured to close the deal and would try to maintain our composure, which customers could often see through. We often ended up compromising our margins under that pressure. Now, however, our approach has shifted significantly. When customers initiate negotiations with demands like lowering prices, holding inventory for extended periods, or other unfavorable terms, we can confidently say no and walk away. While I can’t predict exactly how this will impact our gross margin, I am certain it will improve. We don’t have a strict guideline that states we will walk away from anything below a 9% margin. Instead, we evaluate various factors, including potential for growth, customer behavior during negotiations, and overall business attractiveness. We are negotiating from a position of strength instead of desperation. While I understand you're looking for a specific number to use for projections, I can’t provide that right now. What I can say is that I genuinely believe the situation will improve.
George Melas, Analyst
Okay. The improvement is really driven by your design capability and the fact that you are becoming a comprehensive service provider capable of delivering not just components but complete products. It's noteworthy that you're addressing some delays in the artwork and packaging, which means that once your product is packaged, it goes directly to the retailer as a finished product.
Craig Gates, CEO
Yes. For example, one of our new business ventures perfectly illustrates the macroeconomic trends we're observing and anticipated. About 30 years ago, someone developed a new product that required a complex manufacturing process involving welding, vacuum forming, and hydro forming. Twenty years later, that product was relocated to a town in China, and several competitors followed suit by moving their products there as well. This town became the leading location for manufacturing that type of product. Recently, that company and its competitors recognized the need to reduce shipment times, as the extended wait of over 12 weeks from China was not sustainable. They found that a slight price increase could be justified by the higher business volume and profit margins achievable through faster turnaround times. Thus, they selected us to bring manufacturing back to Mexico. The process moved from the West Coast to China and is now returning to our facility in Mexico. We are essentially reverse engineering what the Chinese manufacturers did. This is a significant cyclical trend that's happening across various industries. In some instances, our customers have lost the capability to manufacture, and in others, they've also lost the ability to design and manufacture. This reflects the broader theme of re-industrialization in the U.S. and industrialization in Mexico, which serves as a perfect example.
George Melas, Analyst
I think nobody was keeping track, Craig, but that's great. Okay. Let me push you a little bit more on margins. What are your margin goals for fiscal '24? From a gross margin perspective, since they have fluctuated and we were always aiming for 9% or slightly above, but we fell short. What would be your goal?
Craig Gates, CEO
I can't provide you with a specific number for your equation because I'm not able to. I hope it's better than that. Based on what I’m seeing, if everything goes well, it should be better than that. However, something always tends to go wrong.
George Melas, Analyst
Okay. And then, from a growth perspective, how much growth is too much growth? How much growth would be very difficult to manage? Is 20% growth sort of a good number? I mean, 20% is a lot.
Craig Gates, CEO
If we consider the Midwestern site as a standalone entity, they are projected to achieve over 65% growth in the next six months. I don’t foresee any significant operational issues in reaching that goal. While there might be challenges in sourcing parts, I believe the management aspect will not pose a problem. Each business is unique; some require considerable effort to acquire, while others simply involve transferring a PCB assembly from a competitor to us. All these considerations contribute to my response; I can't predict precisely, but it's certainly feasible to achieve much more than what we've accomplished in the past.
George Melas, Analyst
Okay. Great. Okay. Thanks for those very precise guidelines.
Craig Gates, CEO
Yes. 9.276%, so just plug that in there, we'll be good.
George Melas, Analyst
Exactly. Thank you very much.
Craig Gates, CEO
Okay. Bye.
Brett Larsen, CFO
Thanks, George.
Bill Dezellem, Analyst
Thank you. You mentioned that the outdoor power equipment company had awarded you another $11 million piece of business. Given that they presumably made that decision before you had actually delivered any of the current program for them, what influenced their choice to expand your business before you had completed any work?
Craig Gates, CEO
Well, we've been interacting with them for over a year now. We've had people in their factory and they've had people in our factory for over a year. We've been in the design process for over nine months. We started quoting on this new piece of business while we were still trying to get the current design done. But in fact, it wasn't awarded to us until just last week. So, it wasn't really awarded until they saw the first chunk of product go off the back door.
Bill Dezellem, Analyst
Congratulations. Okay. That does help. And then, let's talk a little bit about Vietnam. You had mentioned that customers or prospective customers can now go and tour the factory. What does the prognosis look like for filling that factory?
Craig Gates, CEO
It looks very hopeful to the point that we have looked at land availability close to the factory.
Bill Dezellem, Analyst
And since I have not been to that factory, what does the availability of land facilities and labor look like in that near area? Is it as convenient as Juarez where literally everything is contiguous?
Craig Gates, CEO
So far, yes.
Bill Dezellem, Analyst
And what level of expansion are you currently considering?
Craig Gates, CEO
We're not currently considering anything. We're just beginning to think it would be wise to have a good understanding of what's close and how fast it's going to get gobbled up by other folks.
Bill Dezellem, Analyst
And then, what about the labor factor, Craig? What...
Craig Gates, CEO
Labor still looks good in the region we're in. Some of the other regions are getting tighter, but where we're at looks very good so far.
Bill Dezellem, Analyst
Okay. That's helpful. Thanks. And then, speaking of labor...
Craig Gates, CEO
Hey, Bill, speaking of labor, maybe we're going to the same place. In the last two months, we've hired 1,000 people in Juarez.
Bill Dezellem, Analyst
And how does that compare to a normal amount of hiring that you would do? Because presumably some of those people are replacing those who have left and just the whole great resignation concept, but talk to us about that.
Craig Gates, CEO
I'd say the normal number over that period would be maybe a couple of hundred.
Bill Dezellem, Analyst
And that period was what again?
Craig Gates, CEO
Couple of months.
Bill Dezellem, Analyst
I thought you said. So, normal run rate of 100 people a month, you'd be hiring and now you're hiring 500.
Craig Gates, CEO
Yes.
Bill Dezellem, Analyst
That might start to answer my next question, which is about wage pressure in Mexico - is it accelerating, decelerating, or what is your perspective on the current situation?
Craig Gates, CEO
Well, it feels to us as if the wage pressure is flattening out.
Bill Dezellem, Analyst
And what do you attribute that to?
Craig Gates, CEO
Too many factors to mention.
Bill Dezellem, Analyst
Okay. And are you a bit surprised that as you're trying to hire five times as many people as you normally would in a period of time that you're sensing the labor pressures or wage pressures are mitigating? I mean that sounds pretty positive.
Craig Gates, CEO
Well, I'm kind of enthralled with the whole demographic situation across the globe. And if you spend some time looking at that Mexico and the States are basically uniquely positioned compared to the rest of the world, and the fact that we aren't about to age ourselves into oblivion. And so, I would expect that even though they may raise prices by law in Mexico, the availability of generally younger people who are looking to start their professional life continues to be good in Mexico and in the States compared to the rest of the world.
Bill Dezellem, Analyst
Right. Yes. Okay. Well, thank you. Appreciate it, and look forward to seeing the coming quarters growth. Thank you.
Craig Gates, CEO
Yes.
Brett Larsen, CFO
Thanks, Bill.
Operator, Operator
This concludes today's question-and-answer session. I will turn the call back to Mr. Gates for any additional or closing remarks.
Craig Gates, CEO
Okay. Thanks again to everybody for participating in today's conference call. Brett and I look forward to talking to you all next quarter.
Operator, Operator
This concludes today's call. Thank you for your participation, and you may now disconnect.