Earnings Call Transcript - KTCC Q2 2021

Operator, Operator

Good day and welcome to the Q2 Fiscal Year 2021 Key Tronic Corporation Conference Call. Today's conference is being recorded. At this time, I’d like to turn the conference over to Brett Larsen. Please go ahead.

Brett Larsen, CFO

Thank you. Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer. As always, I would like to remind you that during the course of this call we might make projections or other forward-looking statements regarding future events or the company's future financial performance. Please remember that such statements are only predictions. Actual events or results may differ materially. For more information you may review the risk factors outlined in the documents the company has filed with the SEC, specifically our latest 10-K, quarterly 10-Qs and 8-Ks. Please note, 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 26, 2020. For the second quarter of the fiscal year 2021, we reported total revenue of $128.3 million, up 10% from the $116.7 million in the same period of fiscal year 2020. For the first six months of fiscal year 2021, total revenue is $251.5 million, up 13% from $222 million in the same period of fiscal year 2020. The revenue increase during the second quarter of fiscal year 2021 was due to the successful ramp of several new customer programs and increased demand from existing customers. At the same time, our revenue continued to be constrained by temporary government-imposed shutdowns and labor shortages at our facilities in Juárez due to the COVID-19 pandemic and associated public health measures. During the second quarter of fiscal year 2021, we again incurred additional costs due to COVID-19, totaling approximately $1.8 million or roughly $0.13 per share. Despite the pandemic's adverse impact on revenues and expenses, our margins improved in the second quarter of fiscal year 2021 due to increased revenue. Our gross margin was 8.3% and operating margin was 2.1%, up from a gross margin of only 7% and an operating margin of 1.3% in the same period of fiscal 2020. For the second quarter of fiscal year 2021, net income was $1.6 million or $0.14 per share, up from $800,000, or $0.08 per share, for the same period of fiscal year 2020. For the first six months of fiscal year 2021, net income was $3.3 million, or $0.30 per share, up from $2.4 million or $0.22 per share for the same period of fiscal year 2020. Turning to the balance sheet. We continue to maintain a strong financial position. As a result of the pandemic-related production delays in the second quarter of fiscal year 2021 and the continued ramp and transfers of new programs, our inventory turns remained flat compared to the prior quarter. In future quarters, we expect to see our net inventory turns increase to be more in line with the expected revenue. At the end of the second quarter, trade receivables were up $8.5 million from the prior quarter reflecting the increased revenue levels and the timing of shipments later in the quarter. Our days sales outstanding increased to about 69 days, which reflects both timing of shipments during the quarter and some typical delay in payments from customers at the calendar year-end. Overall, we have a healthy balance sheet with total working capital of $174 million and a current ratio of 2.9:1. Nevertheless, we feel it is prudent to preserve cash and expand liquidity where possible. In this light, we added an additional credit facility from our bank in Mexico to bring our total credit facility up to $105 million to manage pandemic risk and give us more flexibility to ramp up production in the coming months. Total capital expenditures for the first six months of fiscal 2021 were approximately $7 million. And we have increased our expected CapEx to be roughly about $12 million for the full fiscal year. While we are keeping a careful eye on expenditures during fiscal year 2021, we plan to continue to invest in our production equipment, SMT equipment and plastic molding capabilities as well as in efficiency improvements in our facilities as we prepare for growth and add capacity. For the third quarter of fiscal year 2021, we currently expect to report revenue of approximately $130 million to $140 million and earnings of approximately $0.20 to $0.25 per diluted share. That said, there's a lot of uncertainty surrounding these current estimates. We're working closely with our customers, key suppliers and employees to minimize the effects of delays attributable to the continued global pandemic, increased global freight and logistic demand and the signs of certain commodity constraints that have increased lead times and limited availability of key components. While our facilities in the U.S., Mexico, China and Vietnam are currently operating and rigorously following current health guidelines, uncertainty remains regarding the possibility of future temporary closures, customer fluctuation in demand, costs, and future supply chain disruptions during the rapidly changing COVID-19 environment could significantly impact operations in the coming periods. Due to the heightened risks associated with the pandemic, we may also issue updated guidance during the coming quarter. In summary, while the COVID-19 crisis continues to cause disruptions during the second quarter and remains a risk in future periods, we are encouraged by our continued growth as we move into the third quarter of fiscal 2021 and by our prospects for future growth. The overall financial health of the company is strong and 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. Despite the headwinds presented by the pandemic, we're very pleased with our strong positive momentum in the second quarter. As we've discussed in detail on previous calls, the pressures on our customer base to lessen their supply and China concentration remain very powerful. To date, these tailwinds have driven a significant increase in our business, and that increase has been along multiple vectors. Firstly, current customers with programs in Asia outsourced to other providers have awarded some of that business to us and we are in the midst of ramping it. Secondly, current customers with new programs that were in the process of being awarded have eliminated Asia from their selection process and selected Key Tronic based on our North American footprint. We are in the midst of ramping those programs as well. Thirdly, new customers with both existing and new programs have also selected Key Tronic based upon our footprint and experience. We would not have won several of these new programs without the opportunity to first ramp the programs in our USA plants and subsequently transfer them to our lower-cost plants in Mexico. Another factor in many of our recent wins has been the realization by many companies in our target market that they have lost design control of their products in the process of outsourcing them. Key Tronic's strength in engineering has proven to be a powerful asset as these companies work to regain design control, and several of the new project wins are due in part to our design services. Another factor in many of our recent wins has been our unusually high level of vertical integration. As a customer seeks to recreate an existing supply chain, the risk and effort are multiplied by the number of new suppliers that must be identified, qualified, bid, selected, ramped, and managed. We believe Key Tronic is unique among our Tier II competitors in that we offer a one-stop shop for molding, metals, printed circuit boards, assembly testing, and distribution. Additionally, many of our new customers' products require a manufacturing process that is unique to their product. Key Tronic has a long history of developing and optimizing such processes as we onboard new customers, and this development is aided by our vertical integration. Uncertainty surrounds the continuing impact of the pandemic and the new U.S. administration's stance towards China. Nevertheless, we believe that the lessons learned through the China-U.S. tariffs and the pandemic will continue to drive our current and prospective customers' actions. We believe they will continue to weigh carefully the degree to which they concentrate their supply chain in any one region and relinquish their design control to their outsourced partner. They more fully recognize the significant impacts an elongated supply chain can have on both cost and availability, the risks of IP appropriations, and the attractiveness of doing business with an outsourced partner that could minimize their risk on all of these factors. We structured Key Tronic to be the obvious answer as the market begins to understand and calculate the costs and risks of over-concentrated outsourcing. We were experiencing increased positive effects of our structure before the advent of tariffs and pandemic. When both of these unprecedented situations came along, they served to accelerate the positive results of our strategy. Even if both of these challenges gradually disappear, we expect that our market will still have been fundamentally and permanently tilted in our favor. We are at an unprecedented point in Key Tronic's history. We see demand of over $150 million per quarter within the foreseeable forecast window. Our results for the last two quarters have been dampened by COVID's effects on our workforce, part availability, and industry-wide shipping and logistics issues. These constraints will continue to be the case, but the growing demand from new and existing customers is a far better problem to have than not enough customer demand. At the same time, we remain focused on protecting the health of all of our employees by adhering to current health guidelines as well as increasing retention of available employees. As Brett noted, we are incurring increased expenses related to the pandemic in order to attract and retain the employees we need to meet our growing demand, as well as preventative measures and equipment for employees at all of our facilities in the U.S., Mexico, China, and Vietnam. While our supply chain remains vulnerable to temporary disruptions caused by a flare-up of the virus and associated lockdowns and regulations, we've so far been mainly able to work around temporary disruptions or closures. We've also managed transportation complexities and disruptions to our supply chain via alternative sourcing, airfreight, product redesigns, and alternative component qualifications. We're closely monitoring inventories and we'll continue to use safety stock as much as possible to ensure minimum interruptions to our customers. Nevertheless, while we've been able to find solutions for most of the COVID-related challenges to date, clearly none of us are out of the woods with respect to the global pandemic. In closing, I want to once again thank our great employees for their dedication during these challenging times and for adhering to our strict guidelines for social distancing, masks, and other recommended precautions during the pandemic. Because of their courage, hard work, and strategic foresight, we expect continued revenue and earnings growth in the third quarter and we continue to invest in new capacity to prepare for long-term growth. Let me assure you that we will continue to make protecting the health of our employees our highest priority. I also want to wish you and your families good health and safe passage during the pandemic. This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions.

Operator, Operator

Well, thank you. And our first question will come from Bill Dezellem with Tieton Capital.

Bill Dezellem, Analyst

Thank you. First of all, congratulations on what I think is a record quarter in terms of revenue. I don't believe you called that out, but am I mistaken that that's not the case?

Craig Gates, CEO

Yes. Thank you.

Bill Dezellem, Analyst

Yeah. Congratulations. So let's start with my normal first question please. What is the size of each of the new programs that you won in the quarter?

Craig Gates, CEO

No, those are about $2 million to $8 million a piece.

Bill Dezellem, Analyst

And is it correct that there were three of them, or did you have multiple wins in any of those categories?

Craig Gates, CEO

No, just two.

Bill Dezellem, Analyst

Thank you. Let me start by asking about your comment regarding the $150 million in demand per quarter for the foreseeable future. Can you elaborate on the gap between the approximately $130 million you're currently at and the $150 million target? What do you think about your ability to reach that $150 million demand level?

Craig Gates, CEO

The gap is entirely due to the pandemic. We are experiencing difficulties obtaining parts. A container that previously cost $3,000 to ship parts across the ocean now costs between $10,000 and $12,000, if you can even get one. There are several ships waiting offshore at the ports, struggling to find space to unload, as the teamsters are facing challenges related to the pandemic just like everyone else. We have logistics issues and ongoing risks related to the unavailability of employees needed to manufacture and ship our products. These two factors are what stand between the demand and our actual production capabilities. We are actively working to position ourselves to meet our targets, but this is resulting in our inventory being higher than we would prefer. However, our official forecast is based on our current understanding of parts availability, logistics, and workforce aspects of our operations.

Bill Dezellem, Analyst

Thanks, Craig. And if we look at the $150 million, if the pandemic were to instantaneously disappear and you were to alleviate the shipping and the labor problems, would there be a demand side of the equation that would also pull back? And therefore, you wouldn't have that number to hit, or do you see enough demand without the pandemic that you would be able to move in that direction?

Craig Gates, CEO

That's a tough one to answer. I would say that maybe a little would go away, but quite a bit of it looking forward is based upon new customer ramps.

Bill Dezellem, Analyst

All right. Thank you. And so before we go to new customers, a couple of existing at least one existing customer question, I think in Brett's opening remarks there was a comment that increased demand from existing customers was out there. Would you talk about that increasing demand for that segment of your customer base? And then secondarily you raised the CapEx guidance by about $3.5 million. Talk to that point and where that money is going please.

Craig Gates, CEO

We've been winning new programs from existing customers. We see a trend where our business with them was shared with one, two, or three other suppliers. And as our customers have been exiting those suppliers and redistributing their supply chain, we've been the beneficiary of those decisions. So that means that we are going to need more equipment in order to build and increase volumes. So there's that aspect of it. And then the ramp of new customer programs that we're just beginning to enjoy revenue for those programs also requires that we bring in more capital equipment. We are, in fact, right now outsourcing as not a significant, let's call it a fairly significant portion of our production parts of it anyway because we're concerned about COVID deflation as you're asking the question. But we don't want to have put too much capital in should a couple of customers decline, meaning if COVID whenever goes away fully. So, we're trying to hedge our bets and not go and buy equipment to completely bring all this business completely in-house. But even with doing that we are going to have to spend a little bit more capital on some SMT lines and other things.

Bill Dezellem, Analyst

Okay, great. Thank you very much. And then lastly for now on the last call you'd mentioned a $100 million prospect piece of new business floating around out there. Would you talk to that point and bring us up to speed and an update on what you're seeing on that front?

Craig Gates, CEO

It's still floating around out there and we remain hopeful.

Bill Dezellem, Analyst

What's the next important either decision point or milepost with that situation?

Craig Gates, CEO

It has to go from a verbal handshake award to a contract.

Bill Dezellem, Analyst

So, you already have a verbal award?

Craig Gates, CEO

Yes.

Bill Dezellem, Analyst

Well, congratulations. I'll step back in queue and let someone else ask questions.

Operator, Operator

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

George Melas, Analyst

Good afternoon, Brett and Craig. Hope you guys are well. I have a follow-up on Bill's question. This is a record revenue quarter. And if one were to add back the COVID-related cost to your operating income, this is your best operating margins since 2013. So you're clearly doing something right, and you're getting some scale. You're also improving your gross margin. So maybe can you talk a little bit about the profitability of the business and what has improved the profitability in the last, let's say, couple of years? And where you see that going?

Craig Gates, CEO

Okay. Number one, as we get farther away from breakeven, our profits improve in a non-linear fashion. We've always been in the position where if we wanted to we could cut our overhead and try to go for maximized profit rather than a balance between profit and growth. And we've always chosen the balance. But as we get farther away from breakeven, we see continued improvement in profit because the fixed costs become not linear. But we don't see having to add a lot more fixed costs in the labor and management side of the equation except in steps as we go up. So there's been a lot of work done on efficiencies in the factories. We're very proud of the costs we've been achieving and the productivity that we've been able to improve in all our factories. We are through the purchase – not purchase but the whole setup and start-up of Vietnam, or through the downsizing of our China Shanghai facility. We have been through a number of expensive ramps. So streamlining our domestic operations, domestic operations have changed quite a bit. So there are a lot of really cool slides that I'm pretty proud of that talk about cost per hour and cost per unit and on-time delivery and rolled throughput yield and everything else we measure and through a lot of work by our staff and by all of our employees. Most of those graphs are heading in the right direction. But the overall driver in this business is revenue is just king and new business, although it costs you a bit more than you'd like to get it in the building, has a non-linear impact on profit.

George Melas, Analyst

Okay. Great. Thank you. That's very helpful. And I think you had – I think if I remember right you had two new $100-million prospects floating around. And remind me if that's correct. And what are the characteristics of these two prospects?

Craig Gates, CEO

Well, if we're going to stick with the analogy one of them sank.

George Melas, Analyst

Okay.

Craig Gates, CEO

Yeah. The other one is floating and it's coming up on plane nicely.

George Melas, Analyst

Okay. And what would be the characteristic of this new customer program? Does it require design on your part? Is this one that is very complicated? Maybe can you characterize it for us?

Craig Gates, CEO

Sure. It did require design on our part that played a major role in our win of the handshake agreement. It's another example of a product that you would look at and say, well gee not many people have experience in doing this. Why is it that Key Tronic thinks they can do this? So it's not necessarily complicated, but it is in a different market than where we've been before. And that kind of slots it into our most successful customer relationships, as I said in my comments, where we run into a customer who has a unique product not necessarily a product that you would look at and go, My God, that's really strange, but a product that is not really that easily outsourced because it has some really unusual processes that are not in the wheelhouse of normal contract manufacturers who grew up as board stuffers. We really shine on those. So this is an example. This is actually on top of the one we won previously which also required our design expertise and adopting learning and capitalizing on a new and wonderful process to us. This is the exact twin of that in terms of those characteristics.

George Melas, Analyst

That's very encouraging because that's where your team excels in blending design expertise with complex processes.

Craig Gates, CEO

Yes.

George Melas, Analyst

Great, and nothing else, sounds really good. Thank you very much.

Craig Gates, CEO

Thanks, George.

Operator, Operator

And our next question comes from Bill Dezellem with Tieton Capital.

Bill Dezellem, Analyst

Thank you. So I do want to circle back to that $100 million prospect. What will it take to move from the handshake where you're at now to an actual contract?

Craig Gates, CEO

That's always a beautiful mystery to understand. We've done everything we can and now we're waiting for our customer to finalize a couple of their supply agreements, and I'm told that this is all that's required.

Bill Dezellem, Analyst

And nothing else once they make it through those supply agreements that you all will need to do other than get out of Japan and sign the contract?

Craig Gates, CEO

Sure, that sounds easy, but yes okay.

Bill Dezellem, Analyst

I'll get the pen and hand it to you if that's helpful.

Craig Gates, CEO

Yes, thanks.

Bill Dezellem, Analyst

Let me turn to another part of the press release that we haven't covered yet, which is related to COVID. It mentioned government-imposed shutdowns. I'm familiar with those in regards to restaurants, but that doesn’t seem to apply to your situation, and I’m not very familiar with Mexico. Could you explain what you encountered in terms of shutdowns? Also, how much of the $1.8 million was impacted by the shutdowns you faced?

Craig Gates, CEO

Sure. So we have about 5,000 employees in Juárez right now. Last quarter – it was last quarter or…

Brett Larsen, CFO

Yes, last quarter, the weekends.

Craig Gates, CEO

So last quarter we had – sorry the quarter we're talking about here, we had two weekends that we were forced to shut down. Those are pretty critical weekends to us because we had planned on installing a number of pieces of capital equipment and we weren't able to do that. So as a result, we had to run through the last week of the December quarter, which is really, really hard in Mexico. People really like to observe their Christmas holiday. So overtime and bonuses and all different kinds of costs mount up pretty quickly. So that's what happened in this last quarter. Previous to that, I don't know if you remember but we had our Juárez facility shut down for almost two and a half, three weeks. So those are the kind of things that can happen. The good news is that the infection rate, hospitalization rate, and death rate in Juárez is falling dramatically. So we are hopeful that's going to continue. They have adopted a very intelligent approach to public safety that I'm not going to get into because I sound like I'm preaching on top of the soapbox, but they're doing really well in terms of controlling the pandemic spread. We're really proud of the fact that we've had almost zero transmissions within all of our facilities. And then we're talking about 5,000 people, that's a lot of work to make that happen right? So I'm really proud of our team and what they've done in Juárez. But that's what we're talking about when we're talking about government-imposed closures of our facilities.

Bill Dezellem, Analyst

All right. That's helpful. And this next question I'll just apologize in advance for my ignorance. On the surface, if you were shut down for nearly three weeks in the prior quarter and this quarter you were only shut down for two weekends, it seems like the cost impact would have been less but you called it out as $1.4 million in the prior quarter and $1.8 million in this quarter. Would you reconcile those two for us?

Brett Larsen, CFO

Yes, absolutely, Bill. So during those three weeks we were not required to pay all of the labor and/or overhead during those three weeks, the plant was shut down. Included in this quarter are a number of employees that due to pre-existing conditions are excluded from coming to work. Those are – we are paying to stay at home. In addition to what Craig mentioned is if you are open during that Christmas week in Juárez, you're going to have to pay double, if not two and half times to get people to show up. And you're also going to likely have a bunch of yield issues and inefficiencies. So those all combined into having a little more of an impact in our second quarter than our first quarter.

Bill Dezellem, Analyst

That's helpful. Thank you very much. Let me clarify something else that was mentioned regarding the equipment you planned to install during the weekends when you were not permitted to operate. Presumably, this equipment was intended for business that you had. Did this delay the ramp-up of the business that the equipment was meant for? If that’s the case, what is the current timeline for moving forward?

Craig Gates, CEO

It did indeed delay a ramp, and that's why we're projecting a higher quarter this quarter than last quarter.

Bill Dezellem, Analyst

Understood. Thank you both.

Craig Gates, CEO

Yes.

Operator, Operator

And our next question will come from Scott Bundy with Moors & Cabot.

Scott Bundy, Analyst

Gentlemen, just one question if I may. Have you had to add additional square footage in your Mexican facilities to accommodate some of this new business that you have coming your way?

Craig Gates, CEO

Yes.

Scott Bundy, Analyst

Can you give us an idea of how much square footage you had to add?

Brett Larsen, CFO

I think it's about 100,000 square feet. So we are currently in a five-year lease of that facility. We've done some tenant improvements, which are including CapEx, but that is what we've invested in today.

Scott Bundy, Analyst

And I made that I apologize, what is that as a percentage of what is currently available in Mexico?

Brett Larsen, CFO

That's about a 10% increase.

Scott Bundy, Analyst

That is significant. Thanks, guys. Appreciate your time.

Brett Larsen, CFO

Thank you.

Craig Gates, CEO

Yes.

Operator, Operator

Thank you. And that does conclude the question-and-answer session. I'll now turn the conference back over to you for any additional or closing remarks.

Craig Gates, CEO

Okay. Thank you all again for participating in today's conference call. I hope all of you and your families stay healthy and safe. And that I look forward to speaking with you again next quarter.

Operator, Operator

Thank you. And that does conclude today's conference call. We do thank you for your participation and have an excellent day.