KTCC 10-Q
Key Tronic Corp (KTCC)
10-Q
2022-05-11
For: 2022-04-02
View Original
Added on
April 06, 2026
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________________________________________
FORM 10-Q
____________________________________________________________
FOR THE QUARTERLY PERIOD ENDED APRIL 2, 2022
OR
FOR THE PERIOD FROM TO .
Commission File Number 0-11559
____________________________________________________________
(Exact name of registrant as specified in its charter)
____________________________________________________________
| (State of Incorporation) | (I.R.S. Employer Identification No.) | ||||
(509 ) 928-8000
(Address of principal executive offices and registrant’s telephone number)
____________________________________________________________
Securities registered pursuant to Section 12(b) of the Act:
| Title of each class | Trading Symbol | Name of each exchange on which registered | ||||||
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements during the past 90 days. Yes ☒ No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulations S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
| Large accelerated Filer | ☐ | ☒ | ||||||||||||||||||
| Non-accelerated Filer | ☐ | Smaller reporting company | ||||||||||||||||||
| Emerging growth company | ||||||||||||||||||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
As of May 9, 2022, 10,761,871 shares of common stock, no par value (the only class of common stock), were outstanding.
KEY TRONIC CORPORATION
Index
| Page No. | ||||||||
| PART I. | ||||||||
| Item 1. | ||||||||
| Item 2. | ||||||||
| Item 3. | ||||||||
| Item 4. | ||||||||
| PART II. | ||||||||
| Item 1. | ||||||||
| Item 1A. | ||||||||
| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds* | |||||||
| Item 3. | Defaults upon Senior Securities* | |||||||
| Item 4. | Mine Safety Disclosures* | |||||||
| Item 5. | Other Information* | |||||||
| Item 6. | ||||||||
* Items are not applicable
“We,” “us,” “our,” “Company,” and “Key Tronic,” unless the context otherwise requires, means Key Tronic Corporation and its subsidiaries.
PART I: FINANCIAL INFORMATION
Item 1: Financial Statements
KEY TRONIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands; except share data)
| April 2, 2022 | July 3, 2021 | ||||||||||
| ASSETS | |||||||||||
| Current assets: | |||||||||||
| Cash and cash equivalents | $ | $ | |||||||||
| Trade receivables, net of allowance for doubtful accounts of $219 and $275 | |||||||||||
| Contract assets | |||||||||||
| Inventories, net | |||||||||||
| Other | |||||||||||
| Total current assets | |||||||||||
| Property, plant and equipment, net | |||||||||||
| Operating lease right-of-use assets, net | |||||||||||
| Other assets: | |||||||||||
| Deferred income tax asset | |||||||||||
| Other | |||||||||||
| Total other assets | |||||||||||
| Total assets | $ | $ | |||||||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | |||||||||||
| Current liabilities: | |||||||||||
| Accounts payable | $ | $ | |||||||||
| Accrued compensation and vacation | |||||||||||
| Current portion of debt, net | |||||||||||
| Other | |||||||||||
| Total current liabilities | |||||||||||
| Long-term liabilities: | |||||||||||
| Term loans | |||||||||||
| Revolving loan | |||||||||||
| Operating lease liabilities | |||||||||||
| Deferred income tax liability | |||||||||||
| Other long-term obligations | |||||||||||
| Total long-term liabilities | |||||||||||
| Total liabilities | |||||||||||
| Commitments and contingencies (Note 8) | |||||||||||
| Shareholders’ equity: | |||||||||||
| Common stock, no par value—shares authorized 25,000; issued and outstanding 10,762 and 10,762 shares, respectively | |||||||||||
| Retained earnings | |||||||||||
| Accumulated other comprehensive income (loss) | ( | ||||||||||
| Total shareholders’ equity | |||||||||||
| Total liabilities and shareholders’ equity | $ | $ | |||||||||
See accompanying notes to consolidated financial statements.
3
KEY TRONIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited, in thousands, except share and per share amounts)
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| April 2, 2022 | April 3, 2021 | April 2, 2022 | April 3, 2021 | ||||||||||||||||||||
| Net sales | $ | $ | $ | $ | |||||||||||||||||||
| Cost of sales | |||||||||||||||||||||||
| Gross profit | |||||||||||||||||||||||
| Research, development and engineering expenses | |||||||||||||||||||||||
| Selling, general and administrative expenses | |||||||||||||||||||||||
| Total operating expenses | |||||||||||||||||||||||
| Operating income | |||||||||||||||||||||||
| Interest expense, net | |||||||||||||||||||||||
| Income before income taxes | |||||||||||||||||||||||
| Income tax provision | |||||||||||||||||||||||
| Net income | $ | $ | $ | $ | |||||||||||||||||||
| Net income per share — Basic | $ | $ | $ | $ | |||||||||||||||||||
| Weighted average shares outstanding — Basic | |||||||||||||||||||||||
| Net income per share — Diluted | $ | $ | $ | $ | |||||||||||||||||||
| Weighted average shares outstanding — Diluted | |||||||||||||||||||||||
See accompanying notes to consolidated financial statements.
4
KEY TRONIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited, in thousands)
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| April 2, 2022 | April 3, 2021 | April 2, 2022 | April 3, 2021 | ||||||||||||||||||||
| Comprehensive income: | |||||||||||||||||||||||
| Net income | $ | $ | $ | $ | |||||||||||||||||||
| Other comprehensive income (loss): | |||||||||||||||||||||||
| Unrealized gain (loss) on hedging instruments, net of tax | ( | ( | |||||||||||||||||||||
| Comprehensive income | $ | $ | $ | $ | |||||||||||||||||||
Other comprehensive income for the three months ended April 2, 2022 and April 3, 2021, is reflected net of tax expense (benefit) of approximately $0.1 million and $(0.2 ) million, respectively. Other comprehensive income for the nine months ended April 2, 2022 and April 3, 2021, is reflected net of tax expense (benefit) of approximately $(0.7 ) million and $1.3 million, respectively.
See accompanying notes to consolidated financial statements.
5
KEY TRONIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(Unaudited, in thousands)
| Nine Months Ended | |||||||||||
| April 2, 2022 | April 3, 2021 | ||||||||||
| Operating activities: | |||||||||||
| Net income | $ | $ | |||||||||
| Adjustments to reconcile net income to cash used in operating activities: | |||||||||||
| Depreciation and amortization | |||||||||||
| Amortization of interest rate swap | |||||||||||
| Amortization of deferred loan costs | |||||||||||
| Provision for obsolete inventory | |||||||||||
| Provision for warranty | |||||||||||
| Provision for doubtful accounts | |||||||||||
| Share-based compensation expense | |||||||||||
| Deferred income taxes | ( | ||||||||||
| Changes in operating assets and liabilities: | |||||||||||
| Trade receivables | ( | ( | |||||||||
| Contract assets | |||||||||||
| Inventories | ( | ( | |||||||||
| Other assets | ( | ||||||||||
| Accounts payable | |||||||||||
| Accrued compensation and vacation | ( | ( | |||||||||
| Other liabilities | ( | ||||||||||
| Cash used in operating activities | ( | ( | |||||||||
| Investing activities: | |||||||||||
| Purchase of property and equipment | ( | ( | |||||||||
| Proceeds from sale of fixed assets | |||||||||||
| Cash used in investing activities | ( | ( | |||||||||
| Financing activities: | |||||||||||
| Payment of financing costs | ( | ( | |||||||||
| Proceeds from issuance of long term debt | |||||||||||
| Interest rate swap termination fee | ( | ||||||||||
| Repayments of long term debt | ( | ( | |||||||||
| Borrowings under revolving credit agreement | |||||||||||
| Repayments of revolving credit agreement | ( | ( | |||||||||
| Principal payments on finance leases | ( | ||||||||||
| Cash provided by financing activities | |||||||||||
| Net (decrease) increase in cash and cash equivalents | ( | ||||||||||
| Cash and cash equivalents, beginning of period | |||||||||||
| Cash and cash equivalents, end of period | $ | $ | |||||||||
| Supplemental cash flow information: | |||||||||||
| Interest payments | $ | $ | |||||||||
| Income tax payments, net of refunds | $ | $ | |||||||||
| Recognition of operating lease liabilities and right-of-use assets | $ | $ | |||||||||
| Recognition of financing lease liabilities and right-of-use assets | $ | $ | |||||||||
See accompanying notes to consolidated financial statements.
6
KEY TRONIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Unaudited, in thousands; except share data)
| Three Months Ended | Nine Months Ended | |||||||||||||||||||||||||
| April 2, 2022 | April 3, 2021 | April 2, 2022 | April 3, 2021 | |||||||||||||||||||||||
| Total shareholders’ equity, beginning balances | $ | $ | $ | $ | ||||||||||||||||||||||
| Common stock (shares): | ||||||||||||||||||||||||||
| Beginning balances | ||||||||||||||||||||||||||
| Exercise of stock appreciation rights | ||||||||||||||||||||||||||
| Ending balances | ||||||||||||||||||||||||||
| Common stock: | ||||||||||||||||||||||||||
| Beginning balances | $ | $ | $ | $ | ||||||||||||||||||||||
| Share-based compensation | ||||||||||||||||||||||||||
| Exercise of stock options | ||||||||||||||||||||||||||
| Ending balances | ||||||||||||||||||||||||||
| Retained Earnings: | ||||||||||||||||||||||||||
| Beginning balances | $ | $ | $ | $ | ||||||||||||||||||||||
| Net income | ||||||||||||||||||||||||||
| Ending balances | ||||||||||||||||||||||||||
| Accumulated other comprehensive income: | ||||||||||||||||||||||||||
| Beginning balances | $ | ( | $ | $ | $ | ( | ||||||||||||||||||||
| Unrealized gain (loss) on hedging instruments, net | ( | ( | ||||||||||||||||||||||||
| Ending balances | ( | ( | ||||||||||||||||||||||||
| Total shareholders’ equity, ending balances | $ | $ | $ | $ | ||||||||||||||||||||||
See accompanying notes to consolidated financial statements.
7
KEY TRONIC CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1.Basis of Presentation
The Company’s reporting period is a 52/53 week fiscal year ending on the Saturday closest to June 30. The three month period ended April 2, 2022 was a 13 week period whereas the three month period ended April 3, 2021 was a 14 week period. Fiscal year 2022 will end on July 2, 2022, which is a 52 week year. Fiscal year 2021 which ended on July 3, 2021, was a 53 week year.
Certain Significant Risks and Uncertainties Related to Outbreak of Coronavirus Disease 2019 (“COVID-19”)
Due to the COVID-19 pandemic, the Company has seen extreme shifts in demand from its customer base, and shifts in supply chain and logistics risks. The possibility of future temporary closures, as well as adverse fluctuations in customer demand, freight and expedite costs, precautionary safety expenses and labor shortages, collectability of accounts, and future supply chain disruptions during the rapidly changing COVID-19 environment can materially impact operating results. Additionally, continued adverse macroeconomic conditions and significant currency exchange fluctuations can also materially impact operating results.
2.Significant Accounting Policies
Reclassifications
Certain prior period reclassifications were made to conform with the current period presentation. These reclassifications had no effect on reported income, comprehensive income, cash flows, total assets, or shareholders' equity as previously reported.
Earnings Per Common Share
Basic earnings per common share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the combination of other potentially dilutive weighted average common shares and the weighted average number of common shares outstanding during the period using the treasury stock method. The computation assumes the proceeds from the exercise of equity awards were used to repurchase common shares at the average market price during the period. The computation of diluted EPS does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an anti-dilutive effect on EPS.
Derivative Instruments and Hedging Activities
The Company has entered into foreign currency forward contracts that are accounted for as cash flow hedges. The effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI) and is reclassified into earnings in the same period in which the underlying hedged transaction affects earnings. The derivative’s effectiveness represents the change in fair value of the hedge that offsets the change in fair value of the hedged item.
The Company uses derivatives to manage the variability of foreign currency fluctuations of expenses in our Mexico facilities. The foreign currency forward contracts have terms that are matched to the underlying transactions being hedged. As a result, these transactions fully offset the hedged risk and no ineffectiveness has been recorded.
8
Income Taxes
We compute our interim income tax provision through the use of an estimated annual effective tax rate (ETR) applied to year-to-date operating results and specific events that are discretely recognized as they occur. In determining the estimated annual ETR, we analyze various factors, including projections of our annual earnings, taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and available tax planning alternatives. Discrete items, including the effect of changes in tax laws, tax rates, and certain circumstances with respect to valuation allowances or other unusual or non-recurring tax adjustments, are reflected in the period in which they occur as an addition to, or reduction from, the income tax provision, rather than included in the estimated annual ETR.
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences and benefits attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as tax credit and net operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized.
We utilize a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50 % likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments based on new assessments and changes in estimates and which may not accurately forecast actual outcomes. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense. The tax years 2004 through the present remain open to examination by the major U.S. taxing jurisdictions to which we are subject. Refer to Note 5 for further discussions.
Recently Issued Accounting Standards
In January 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2021-01, Reference Rate Reform (Topic 848) to identify alternative reference rates that are more observable or transaction based and less susceptible to manipulation. The Company is currently assessing the effects on its consolidated financial statements, and if it will elect this optional standard.
In March of 2020, the FASB issued ASU 2020-03, Codification Improvements to Financial Instruments, which clarifies specific issues raised by stakeholders. Specifically, the ASU clarifies the following: 1) that all entities are required to provide the fair value option disclosures in ASC 825, Financial Instruments 2) clarifies that the portfolio exception in ASC 820, Fair Value Measurement, applies to nonfinancial items accounted for as derivatives under ASC 815, Derivatives and Hedging; 3) clarifies that for purposes of measuring expected credit losses on a net investment in a lease in accordance with ASC 326, Financial Instruments - Credit Losses, the lease term determined in accordance with ASC 842, Leases, should be used as the contractual term; 4) clarifies that when an entity regains control of financial assets sold, it should recognize an allowance for credit losses in accordance with ASC 326; and 5) aligns the disclosure requirements for debt securities in ASC 320, Investments - Debt Securities, with the corresponding requirements for depository and lending institutions in ASC 942, Financial Services - Depository and Lending. The amendments in the ASU have various effective dates and transition requirements which are dependent on timing of adoption of ASU 2016-13. The Company is currently assessing the effects on its consolidated financial statements, and it intends to adopt the guidance as they become effective.
In June 2016, the FASB issued ASU 2016-13 “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” and also issued subsequent amendments to the initial guidance: ASU 2018-19, ASU 2019-04 and ASU 2019-05, which replaces the existing incurred loss impairment model with an expected credit loss model and requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected. The guidance is effective for the Company beginning in the first quarter of fiscal year 2024 with early adoption permitted. The Company is currently assessing the impact on its consolidated financial statements, and it intends to adopt the guidance when it becomes effective in the first quarter of fiscal year 2024.
9
3.Inventories
4.Long-Term Debt
On September 3, 2021, the Company entered into an amendment to the Company’s current loan agreement with Bank of America. The amendment increases the Company’s current credit facility of $93 million to $120 million, subject to the Company’s borrowing base, maturing on September 3, 2026. As of April 2, 2022, the Company had an outstanding balance under the asset-based revolving credit facility of $99.7 million, $0.3 million in outstanding letters of credit and $15.8 million available for future borrowings.
As of July 3, 2021, the Company had an outstanding balance under the credit facility with Bank of America of $90.9 million, $0.3 million in outstanding letters of credit and $2.1 million available for future borrowings.
Generally, the interest rate applicable to loans under the Bank of America loan agreement will be, at the Company’s option: (i)(A) the base rate which is the highest of (1) the prime rate for the applicable day (as such rate is determined from time to time by the Bank), (2) the federal funds rate for the applicable day plus 0.50%, and (3) LIBOR for a 30-day interest period as of the applicable day plus 1.00% (provided that in no event shall the base rate be less than zero), plus the applicable interest margin for base rate loans; and (B) LIBOR rate for an applicable interest period (provided that in no event shall the LIBOR rate be less than 0.50%), plus the applicable interest margin for LIBOR rate loans. Depending on average daily excess borrowing availability over applicable periods under the Credit Facility, applicable interest margins on: (x) base rate loans will be 1.25-1.75%; and (y) LIBOR rate loans will be 2.25-2.75%, resetting on a quarterly basis beginning in early 2021. If there is an event of default under the loan agreement, all loans and other obligations will bear interest at a rate of an additional 2.00% on the otherwise applicable interest rates. In addition to interest charges, the Company is required to pay a fee of 0.25% per annum on the unused portion of the Credit Facility, monthly in arrears.
Under the new loan agreement with Bank of America, the asset-based revolving credit facility bears interest at LIBOR plus 2.5%, as elected by the Company.
On August 14, 2020, the Company also entered into a $5.0 million equipment financing facility relating to the Company’s existing U.S. manufacturing equipment that bears interest at 4.85 % and matures on August 14, 2025. Under this loan agreement, equal monthly payments of approximately $94,000 commenced on September 14, 2020 and will continue through the maturity of the equipment financing facility on August 14, 2025. As of April 2, 2022, the Company had an outstanding balance of $3.5 million. As of July 3, 2021, the Company had an outstanding balance of $4.2 million under the Bank of America equipment term loan agreement.
On November 24, 2020, the Company entered into a $6.0 million equipment financing facility related to the Company’s existing manufacturing equipment that bears interest at 5.52 % and matures on April 24, 2026. Under this loan agreement, equal monthly payments of $100,000 commenced on May 24, 2021 and will continue through the maturity of the equipment financing facility on April 24, 2026. As of April 2, 2022, the Company had an outstanding balance of $4.9 million. As of July 3, 2021, the Company had an outstanding balance of $5.8 million.
The interest rates on outstanding debt as of April 2, 2022 range from 3.25 % - 5.52 % compared to 3.25 % - 5.52 % as of July 3, 2021.
10
Debt maturities as of April 2, 2022 for the next five years and thereafter are as follows (in thousands):
| Fiscal Years Ending | Amount | ||||
2022 (1) | $ | ||||
| 2023 | |||||
| 2024 | |||||
| 2025 | |||||
| 2026 | |||||
| Thereafter | |||||
| Total debt | $ | ||||
| Unamortized debt issuance costs | ( | ||||
| Long-term debt, net of debt issuance costs | $ | ||||
(1) Represents scheduled payments for the remaining three-month period ending July 2, 2022.
The Company must comply with certain financial covenants, including a fixed charge coverage ratio and a cash flow leverage ratio. The Company was in compliance with all financial covenants as of April 2, 2022.
5.Income Taxes
The Company expects to repatriate a portion of its foreign earnings based on increased net sales growth driving additional capital requirements domestically, cash requirements for potential acquisitions and to implement certain tax strategies. The Company currently expects to repatriate approximately $7.5 million of foreign earnings in the future. All other unremitted foreign earnings are expected to remain permanently reinvested for planned fixed assets purchases and improvements in foreign locations.
Repatriations of cash will generally be tax-free in the U.S. However, withholding taxes in China may still apply to any such future repatriations. Management has not changed its indefinite investment assertions with regard to the portion of accumulated earnings and profits in China that may be repatriated in the future. Accordingly, management estimates that future repatriations of cash from China may result in approximately $0.8 million of withholding tax. We do not anticipate there would be any offsetting foreign tax credits in the U.S. and as such, this potential liability is a direct cost associated with actual repatriations. Withholding taxes would not apply to future repatriations from Mexico or Vietnam.
The Company has available approximately $7.0 million of gross federal research and development tax credits as of April 2, 2022. ASC 740 requires the Company to recognize in its financial statements uncertainties in tax positions taken that may not be sustained upon examination by the taxing authorities. Accordingly, as of April 2, 2022, the Company has recorded $2.7 million of unrecognized tax benefits associated with these federal tax credits, resulting in a net deferred tax benefit of approximately $4.3 million.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted in response to the COVID-19 pandemic. The CARES Act is not expected to have a material impact on the provision or timing of cash payments for income taxes. However, under the CARES Act, AMT credits not previously refunded for the 2018 tax year became refundable in the 2019 taxable year rather than in years 2019-2021, and taxpayers could elect to claim 100% of the AMT credits in the first taxable year beginning in 2018 by applying for a tentative refund claim on or before December 31, 2020. The Company made this election by applying for a tentative refund claim in the fourth quarter of fiscal year 2020. The Company is continuing to evaluate the impacts of other aspects of the CARES Act, and at this time the Company does not believe they will have a material impact on our consolidated financial position, results of operations, or cash flows.
The Company is evaluating tax law changes and regulatory guidance issued through the quarter. Such changes and regulations include guidance under Sec. 162(m), Sec. 245A, Sec. 951A, foreign tax credits, and rules relating to consolidated NOL carryback claims. The Company is still evaluating the ongoing impact of these law and regulatory changes, and does not expect them to have a material impact on its provision for income taxes.
6.Earnings Per Share
11
The following table presents a reconciliation of the denominator in the basic and diluted EPS calculation and the number of antidilutive common share awards that were not included in the diluted earnings per share calculation. These antidilutive securities occur when equity awards outstanding have an option price greater than the average market price for the period.
| Three Months Ended | |||||||||||
| (in thousands, except share and per share information) | |||||||||||
| April 2, 2022 | April 3, 2021 | ||||||||||
| Net income | $ | $ | |||||||||
| Weighted average shares outstanding—basic | |||||||||||
| Effect of dilutive common stock awards | |||||||||||
| Weighted average shares outstanding—diluted | |||||||||||
| Net income per share—basic | $ | $ | |||||||||
| Net income per share—diluted | $ | $ | |||||||||
| Antidilutive SARs not included in diluted earnings per share | |||||||||||
| Nine Months Ended | |||||||||||
| (in thousands, except share and per share information) | |||||||||||
| April 2, 2022 | April 3, 2021 | ||||||||||
| Net income | $ | $ | |||||||||
| Weighted average shares outstanding—basic | |||||||||||
| Effect of dilutive common stock awards | |||||||||||
| Weighted average shares outstanding—diluted | |||||||||||
| Net income per share—basic | $ | $ | |||||||||
| Net income per share—diluted | $ | $ | |||||||||
| Antidilutive SARs not included in diluted earnings per share | |||||||||||
7. Share-based Compensation
The Company’s incentive plan provides for equity and liability awards to employees and non-employee directors in the form of stock options, stock appreciation rights (SARs), restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based or cash-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is recorded as employee compensation expense in cost of goods sold, research, development and engineering, and selling, general and administrative expenses. Share-based compensation is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on historical experience and future expectations.
In addition to service conditions, SARs contain a performance condition. The additional performance condition is based upon the achievement of Return on Invested Capital (ROIC) goals relative to a peer group. All awards with performance conditions are evaluated quarterly to determine the likelihood that performance metrics will be achieved during the performance period. These awards are charged to compensation expense over the requisite service period based on the number of shares expected to vest. The SARs cliff vest after a three-year period from date of grant and expire five years from date of grant.
The grant date fair value for the awards granted below were estimated using the Black Scholes option valuation method:
| August 9, 2021 | July 23, 2020 | ||||||||||
| SARs Granted | |||||||||||
| Strike Price | $ | $ | |||||||||
| Fair Value | $ | $ | |||||||||
Total share-based compensation expense recognized during the three months ended April 2, 2022 and April 3, 2021 was approximately $75,000 and $18,000 , respectively. Total share-based compensation expense recognized during the nine months ended April 2, 2022 and April 3, 2021 was approximately $218,000 and $132,000 , respectively.
12
8.Commitments and Contingencies
Litigation and Other Matters
The Company is party to certain lawsuits or claims in the ordinary course of business. The Company does not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on the financial position, results of operations or cash flow of the Company.
Warranties
The Company provides warranties on certain product sales. Allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. If actual return rates and/or repair and replacement costs differ significantly from management’s estimates, adjustments to recognize additional cost of sales may be required in future periods. The Company’s warranty reserve was approximately $28,000 as of April 2, 2022 and $25,000 as of July 3, 2021, respectively.
9.Derivative Financial Instruments
As of April 2, 2022, the Company had outstanding foreign currency forward contracts with a total notional amount of $6.7 million. The maturity dates for these contracts extend through June 2022. For the three months ended April 2, 2022, the Company did not enter into any foreign currency forward contracts and settled $7.2 million of contracts. During the same period of the previous year, the Company did not enter into any foreign currency forward contracts and settled $7.0 million of contracts.
For the nine months ended April 2, 2022, the Company entered into $13.9 million of foreign currency forward contracts and settled $17.8 million of such contracts. During the same period of the previous year, the Company did not enter into any foreign currency forward contracts and settled $19.9 million of such contracts.
As of April 2, 2022, the aggregate notional amount of the Company’s outstanding foreign currency contracts along with their unrealized gains (losses) are expected to mature as summarized below (in thousands):
| Quarter Ending | Notional Contracts in MXN | Notional Contracts in USD | Estimated Fair Value | |||||||||||||||||
| July 2, 2022 | $ | $ | $ | |||||||||||||||||
On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of September 30, 2022, related to the borrowings outstanding under the term loan with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. On the date of termination this interest rate swap was in a liability position of $148,400 , which will be amortized to interest expense over the original term of the swap.
On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of November 1, 2023, related to the borrowings outstanding under the line of credit with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. On the date of termination this interest rate swap was in a liability position of $776,500 , which will be amortized to interest expense over the original term of the swap.
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The following table summarizes the fair value of derivative instruments in the Consolidated Balance Sheet as of April 2, 2022 and July 3, 2021 (in thousands):
| April 2, 2022 | July 3, 2021 | ||||||||||||||||
| Derivatives Designated as Hedging Instruments | Balance Sheet Location | Fair Value | Fair Value | ||||||||||||||
| Foreign currency forward contracts | Other current assets | $ | $ | ||||||||||||||
The following tables summarize the gain (loss) on derivative instruments, net of tax, on the Consolidated Statements of Income for the three months ended April 2, 2022 and April 3, 2021, respectively (in thousands):
| Derivatives Designated as Hedging Instruments | Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) | AOCI Balance as of January 1, 2022 | Effective Portion Recorded In AOCI | Effective Portion Reclassified From AOCI Into Income | AOCI Balance as of April 2, 2022 | ||||||||||||||||||||||||
| Forward contracts | Cost of sales | $ | ( | $ | $ | ( | $ | ||||||||||||||||||||||
| Interest rate swap | Interest expense | ( | ( | ||||||||||||||||||||||||||
| Total | $ | ( | $ | $ | $ | ( | |||||||||||||||||||||||
| Derivatives Designated as Hedging Instruments | Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) | AOCI Balance as of December 26, 2020 | Effective Portion Recorded In AOCI | Effective Portion Reclassified From AOCI Into Income | AOCI Balance as of April 3, 2021 | ||||||||||||||||||||||||
| Forward contracts | Cost of sales | $ | $ | ( | $ | ( | $ | ||||||||||||||||||||||
| Interest rate swap | Interest expense | ( | ( | ||||||||||||||||||||||||||
| Total | $ | $ | ( | $ | ( | $ | |||||||||||||||||||||||
The following tables summarize the gain (loss) on derivative instruments, net of tax, on the Consolidated Statements of Income for the nine months ended April 2, 2022 and April 3, 2021, respectively (in thousands):
| Derivatives Designated as Hedging Instruments | Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) | AOCI Balance as of July 3, 2021 | Effective Portion Recorded In AOCI | Effective Portion Reclassified From AOCI Into Income | AOCI Balance as of April 2, 2022 | ||||||||||||||||||||||||
| Forward contracts | Cost of sales | $ | $ | $ | ( | $ | |||||||||||||||||||||||
| Interest rate swap | Interest expense | ( | ( | ||||||||||||||||||||||||||
| Total | $ | $ | $ | ( | $ | ( | |||||||||||||||||||||||
| Derivatives Designated as Hedging Instruments | Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) | AOCI Balance as of June 27, 2020 | Effective Portion Recorded In AOCI | Effective Portion Reclassified From AOCI Into Income | AOCI Balance as of April 3, 2021 | ||||||||||||||||||||||||
| Forward contracts | Cost of sales | $ | ( | $ | $ | ( | $ | ||||||||||||||||||||||
| Interest rate swap | Interest expense | ( | ( | ( | |||||||||||||||||||||||||
| Total | $ | ( | $ | $ | ( | $ | |||||||||||||||||||||||
As of April 2, 2022, the net amount of unrealized gain expected to be reclassified into earnings within the next 12 months is approximately $267,000 . As of April 2, 2022, the Company does not have any foreign exchange contracts with credit-risk-related contingent features.
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10.Fair Value Measurements
The Company currently has forward contracts to hedge known future cash outflows for expenses denominated in the Mexican peso. These contracts are measured on a recurring basis based on the foreign currency spot rates and forward rates quoted by banks or foreign currency dealers. There are three levels of fair value hierarchy inputs used to value assets and liabilities which include: Level 1 – inputs are quoted market prices for identical assets or liabilities; Level 2 – inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3 – inputs are unobservable inputs for the asset or liability. These contracts are marked to market using level 2 input criteria every quarter with the unrealized gain or loss, net of tax, reported as a component of shareholders’ equity in accumulated other comprehensive gain (loss), as they qualify for hedge accounting.
The following table summarizes the fair value of assets (liabilities) of the Company’s derivatives that are required to be measured on a recurring basis as of April 2, 2022 and July 3, 2021 (in thousands):
| April 2, 2022 | |||||||||||||||||||||||
| Level 1 | Level 2 | Level 3 | Total Fair Value | ||||||||||||||||||||
| Financial Assets: | |||||||||||||||||||||||
| Foreign currency forward contracts | $ | $ | $ | $ | |||||||||||||||||||
| July 3, 2021 | |||||||||||||||||||||||
| Level 1 | Level 2 | Level 3 | Total Fair Value | ||||||||||||||||||||
| Financial Assets: | |||||||||||||||||||||||
| Foreign currency forward contracts | $ | $ | $ | $ | |||||||||||||||||||
The carrying values of cash and cash equivalents, accounts receivable and current liabilities reflected on the balance sheets at April 2, 2022 and July 3, 2021, reasonably approximate their fair value. The Company’s long-term debt, which is measured at amortized cost, primarily consists of an asset-based revolving credit facility, lease liability, and an equipment loan. These borrowings bear interest at LIBOR plus 2.5 % per the loan agreement. Each of these rates is a variable floating rate dependent upon current market conditions and the Company’s current credit risk as discussed in Note 4.
11.Revenue
Revenue Recognition
The Company specializes in services ranging from product manufacturing to engineering and tooling services. The first step in its process for revenue recognition is to identify the contract with a customer. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied. The Company generally enters into manufacturing service agreements (“MSA”) with its customers that outline the terms of the business relationship between the customer and the Company. This includes matters such as warranty, indemnification, transfer of title and risk of loss, liability for excess and obsolete inventory, pricing, payment terms, etc. The Company will also bid on a program-by-program basis for customers in which an executed MSA may not be in place. In these instances, as well as when we have an MSA in place, we receive customer purchase orders for specific quantities and timing of products. As a result, the Company considers its contract with a customer to be the combination of the MSA and the purchase order. The transaction price is fixed and set forth in each purchase order. In the Company's normal course of business, there are no variable pricing components, or material amounts refunded to customers in the form of refunds or rebates.
15
The Company assesses whether control of the product or services promised under the contract is transferred to the customer at a point in time (shipment) or over time (as we manufacture the product). The Company is first required to evaluate whether its contracts meet the criteria for 'over-time' or 'point-in-time' recognition. The Company has determined that for the majority of its contracts the Company is manufacturing products for which there is no alternative use due to the unique nature of the customer-specific product, IP and other contract restrictions. The Company has an enforceable right to payment including a reasonable profit for performance completed to date with respect to these contracts. As a result, revenue is recognized under these contracts 'over-time' based on the input cost-to-cost method as it better depicts the transfer of control. This input method is based on the ratio of costs incurred to date as compared to the total estimated costs at completion of the performance obligation. For all other contracts that do not meet these criteria, such as manufacturing contracts for which the terms do not provide an enforceable right to payment for performance completed to date, the Company recognizes revenue when it has transferred control of the related manufactured products which generally occurs upon shipment to the customer. Revenue from engineering services is recognized over time as the services are performed.
The Company’s sales arrangements do not contain any significant financing component for its customers.
The Company generally provides a warranty for workmanship on its manufacturing contracts. Historically, the amount of returns for workmanship issues has been de minimis under the Company’s warranties.
The Company elected to not disclose information about remaining performance obligations as they are part of contracts that that have expected durations of one year or less.
During the first nine months of fiscal year 2022, no revenues were recognized from performance obligations satisfied or partially satisfied in previous periods.
Contract Balances
A contract asset is recognized when the Company has recognized revenue, but has not issued an invoice for payment. Contract assets are classified separately on the condensed consolidated balance sheet and transferred to receivables when the right to payment becomes unconditional. The following table summarizes the activity in the Company’s contract assets during the nine months ended April 2, 2022 (in thousands):
| Contract Assets | |||||
| Beginning balance, July 3, 2021 | $ | ||||
| Revenue recognized | |||||
| Amounts collected or invoiced | ( | ||||
Ending balance, April 2, 2022 | $ | ||||
Disaggregation of Revenue
The following table presents the Company’s revenue disaggregated for the three and nine months ended April 2, 2022 and April 3, 2021 (in thousands):
| Revenue | ||||||||||||||||||||||||||
| Recognition | Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||
| April 2, 2022 | April 3, 2021 | April 2, 2022 | April 3, 2021 | |||||||||||||||||||||||
| Over-Time | $ | $ | $ | $ | ||||||||||||||||||||||
| Point-in-Time | ||||||||||||||||||||||||||
| Total | $ | $ | $ | $ | ||||||||||||||||||||||
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12.Leases
The Company has several commitments under operating and financing leases for warehouses, manufacturing facilities, office buildings, and equipment with initial terms that expire at various dates during the next 1 year to 10 years.
The components of lease cost for the three and nine months ended April 2, 2022 were (in thousands):
| Lease cost | Classification | Three Months Ended | Nine Months Ended | |||||||||||
| Operating lease cost | Cost of sales | $ | $ | |||||||||||
| Operating lease cost | Selling, general and administrative expenses | $ | ||||||||||||
| Financing lease cost | Cost of sales | $ | $ | |||||||||||
| Financing lease cost | Selling, general and administrative expenses | $ | $ | |||||||||||
| Total lease cost | $ | $ | ||||||||||||
| Fixed lease cost | $ | $ | ||||||||||||
| Short-term lease cost | $ | $ | ||||||||||||
| Total lease cost | $ | $ | ||||||||||||
Amounts reported in the Consolidated Balance Sheet as of April 2, 2022 were (in thousands, except weighted average lease term and discount rate):
| April 2, 2022 | ||||||||
| Operating Leases: | ||||||||
| Operating lease right of use assets | $ | |||||||
Operating lease liabilities (1) | $ | |||||||
| Weighted-average remaining lease term (in years) | ||||||||
| Operating leases | ||||||||
| Weighted-average discount rate | ||||||||
| Operating leases | % | |||||||
Financing Leases (2): | ||||||||
| Financing lease right of use assets | $ | |||||||
| Financing lease liabilities | $ | |||||||
| Weighted-average remaining lease term (in years) | ||||||||
| Financing leases | ||||||||
| Weighted-average discount rate | ||||||||
| Financing leases | % | |||||||
(1) The current portion of the total operating lease liabilities of $5.4 million is classified under Other Current Liabilities, resulting in $12.4 million classified under Operating Lease Liabilities in the Long-term Liabilities section of the condensed consolidated balance sheet.
(2) The total finance lease right of use assets of $9.7 million is classified under Other Long-term Assets. The current portion of the total finance lease liabilities of $3.9 million is classified under Current portion of debt, net, resulting in $4.8 million classified in Other Long-term Liabilities section of the condensed consolidated balance sheet.
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Other information related to leases was as follows (in thousands):
| Three Months Ended | Nine Months Ended | |||||||||||||
| April 2, 2022 | ||||||||||||||
| Cash paid for amounts included in the measurement of lease liabilities: | ||||||||||||||
| Operating cash flows from operating leases | $ | $ | ||||||||||||
| Financing cash flows used in financing leases | $ | $ | ||||||||||||
Future lease payments under non-cancellable leases as of April 2, 2022 are as follows (in thousands):
| Fiscal Years Ending | Operating Leases | Finance Leases | ||||||||||||
2022 (1) | $ | $ | ||||||||||||
| 2023 | ||||||||||||||
| 2024 | ||||||||||||||
| 2025 | ||||||||||||||
| 2026 | ||||||||||||||
| Thereafter | ||||||||||||||
| Total undiscounted lease payments | ||||||||||||||
| Less: present value discount | ( | ( | ||||||||||||
| Total lease liabilities | $ | $ | ||||||||||||
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
FORWARD-LOOKING STATEMENTS
References in this report to “the Company,” “Key Tronic,” “we,” “our,” or “us” mean Key Tronic Corporation together with its subsidiaries, except where the context otherwise requires.
This Quarterly Report contains forward-looking statements in addition to historical information. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Risks and uncertainties that might cause such differences include, but are not limited to those outlined in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risks and Uncertainties that May Affect Future Results.” Readers are cautioned not to place undue reliance on forward-looking statements, which reflect management’s opinions only as of the date hereof. The Company undertakes no obligation to update forward-looking statements to reflect developments or information obtained after the date hereof and disclaims any obligation to do so. Readers should carefully review the risk factors described in this report and other periodic reports the Company files from time to time with the Securities and Exchange Commission, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
Overview
Key Tronic is a leading contract manufacturer offering value-added design and manufacturing services from its facilities in the United States, Mexico, China and Vietnam. The Company provides its customers full engineering services, materials management, worldwide manufacturing facilities, assembly services, in-house testing, and worldwide distribution. Its customers include some of the world’s leading original equipment manufacturers. Our combined capabilities and vertical integration are proving to be a desirable offering to our expanded customer base.
Our international production capability provides our customers with benefits of improved supply-chain management, reduced inventories, lower transportation costs, and reduced product fulfillment time. We continue to make investments in all of our operating facilities to give us the production capacity, capabilities and logistical advantages to continue to win new business. The following information should be read in conjunction with the consolidated financial statements included herein and with Part II Item 1A, Risk Factors included as part of this filing.
Our mission is to provide our customers with superior manufacturing and engineering services at the lowest total cost for the highest quality products, and create long-term mutually beneficial business relationships by employing our “Trust, Commitment, Results” philosophy.
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Executive Summary
For the third quarter of fiscal year 2022, the Company reported total revenue of $138.4 million, up 2.8% from $134.6 million in the same period of fiscal year 2021. While year-over-year sales have increased, customer demand has been even higher but production continues to be limited by global supply chain and transportation issues. In the coming quarters, the Company expects to ramp a number of new programs, including the previously announced program with a leading power equipment company in its Mexico facility in the first part of the next fiscal year.
As new customer programs ramp the concentration of our top three customers’ net sales decreased to 34.4 percent of total sales in the third quarter of fiscal year 2022 from 37.9 percent in the same period of the prior fiscal year.
Net sales to our largest customers may vary significantly from quarter to quarter depending on the size and timing of customer program commencement, forecasts, delays, and design modifications. We remain dependent on continued net sales to our significant customers and most contracts with customers are not firm long-term purchase commitments. We seek to maintain flexibility in production capacity by employing skilled temporary and short-term labor and by utilizing short-term leases on equipment and manufacturing facilities. In addition, our capacity and core competencies for printed circuit board assemblies, precision molding, sheet metal fabrication, tool making, assembly, and engineering can be applied to a wide variety of products.
Gross profit as a percent of net sales was 8.3 percent for the third quarter of fiscal year 2022 as compared to 8.2 percent for the same quarter of the prior fiscal year. The global supply chain and transportation issues continued to disrupt production, including a mandated COVID shutdown in the Company’s facilities in Shanghai, China, intermittent parts supply, factory downtime and overtime expenses.
Operating income as a percentage of net sales was 2.0 percent for the third quarter of fiscal year 2022 compared to 1.9 percent of operating income as a percentage of net sales for the third quarter of fiscal year 2021. The increase in operating income as a percentage of net sales was primarily driven by the increase in gross profit as discussed above.
Net income for the third quarter of fiscal year 2022 was $1.0 million or $0.09 per diluted share, as compared to net income of $0.9 million or $0.08 per diluted share for the third quarter of fiscal year 2021. Net income for the third quarter of fiscal 2022 was also impacted by legal costs related specifically to the Securities and Exchange Commission’s (the “SEC”) review of last year’s whistleblower complaint, which totaled approximately $0.06 per diluted share during the quarter and we expect legal costs to potentially continue at a similar pace in coming periods.
During the third quarter of fiscal year 2022, we won new programs involving outdoor recreation, RFID, industrial connectivity and electric mobility products. While the global supply chain and COVID-19 crises continue to present uncertainty and multiple business challenges in the fourth quarter, we see the potential for significant growth in fiscal 2023 and beyond.
Moving into the fourth quarter of fiscal 2022, the war in Ukraine, China’s COVID lockdown and global logistics problems continue to drive the favorable trend of contract manufacturing returning to North America. We believe we are well positioned to benefit from this growing demand.
To protect the health of its employees, the Company has implemented the recommendations of WHO and the CDC including wearing of face masks and shields, workstation arrangements to provide social distancing, temperature monitoring, enhanced worksite disinfection, spacing in cafeterias and break areas, contact management and other precautions. The Company is also in compliance with government regulations related to COVID-19.
We have experienced shortages in electronic components used in our products. These shortages can result from strong demand for those components or from problems experienced by suppliers, such as shortages of raw materials. We have also experienced, and expect to continue to experience, such shortages and shutdowns due to the effects of the COVID-19 pandemic. These unanticipated component shortages have resulted and could continue to result in curtailed production or delays in production, which may prevent us from timely satisfying our performance obligations with our customers. Our inability to satisfy these performance obligations could cause us to experience a reduction in sales, increase in inventory levels and costs, and could adversely affect our operating results. We are carefully monitoring potential supply chain disruptions due to ongoing tightness in the overall component environment and are working to mitigate supply chain constraint risks.
We maintain a strong balance sheet with a current ratio of 2.1 and a debt to equity ratio of 0.9 as of April 2, 2022. Total cash used in operating activities as defined on our cash flow statement was $11.6 million for the nine months ended April 2, 2022. We maintain sufficient liquidity for our expected future operations and had $99.7 million in borrowings on our revolving credit facility and $15.8 million remained available at April 2, 2022.
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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. These estimates and assumptions are based on historical results as well as future expectations. Actual results could vary from our estimates and assumptions.
The accounting policies and estimates listed below are those that we believe are the most critical to our consolidated financial condition and results of operations. They are also the accounting policies that typically require our most difficult, subjective and complex judgments and estimates, often for matters that are inherently uncertain.
•Revenue Recognition
•Inactive, Obsolete, and Surplus Inventory Reserve
•Allowance for Doubtful Accounts
•Accrued Warranty
•Income Taxes
•Share-Based Compensation
•Impairment of Long-Lived Assets
•Derivatives and Hedging Activity
•Long-Term Incentive Compensation Accrual
Please refer to the discussion of critical accounting policies in our most recent Annual Report on Form 10-K for the fiscal year ended July 3, 2021, for further details.
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RESULTS OF OPERATIONS
Comparison of the Three Months Ended April 2, 2022 with the Three Months Ended April 3, 2021
The financial information and discussion below should be read in conjunction with the Consolidated Financial Statements and Notes.
The following table sets forth certain information regarding the components of our condensed consolidated statements of income for the three months ended April 2, 2022 as compared to the three months ended April 3, 2021. It is provided to assist in assessing differences in our overall performance (in thousands):
| Three Months Ended | |||||||||||||||||||||||||||||||||||
| April 2, 2022 | % of net sales | April 3, 2021 | % of net sales | $ change | % point change | ||||||||||||||||||||||||||||||
| Net sales | $ | 138,391 | 100.0 | % | $ | 134,600 | 100.0 | % | $ | 3,791 | — | % | |||||||||||||||||||||||
| Cost of sales | 126,883 | 91.7 | % | 123,504 | 91.8 | % | 3,379 | (0.1) | % | ||||||||||||||||||||||||||
| Gross profit | 11,508 | 8.3 | % | 11,096 | 8.2 | % | 412 | 0.1 | % | ||||||||||||||||||||||||||
| Research, development and engineering | 2,526 | 1.8 | % | 2,655 | 2.0 | % | (129) | (0.2) | % | ||||||||||||||||||||||||||
| Selling, general and administrative | 6,193 | 4.5 | % | 5,865 | 4.4 | % | 328 | 0.1 | % | ||||||||||||||||||||||||||
| Total operating expenses | 8,719 | 6.3 | % | 8,520 | 6.4 | % | 199 | (0.1) | % | ||||||||||||||||||||||||||
| Operating income | 2,789 | 2.0 | % | 2,576 | 1.9 | % | 213 | 0.1 | % | ||||||||||||||||||||||||||
| Interest expense, net | 1,551 | 1.1 | % | 1,020 | 0.8 | % | 531 | 0.3 | % | ||||||||||||||||||||||||||
| Income before income taxes | 1,238 | 0.9 | % | 1,556 | 1.2 | % | (318) | (0.3) | % | ||||||||||||||||||||||||||
| Income tax provision | 231 | 0.2 | % | 689 | 0.5 | % | (458) | (0.3) | % | ||||||||||||||||||||||||||
| Net income | $ | 1,007 | 0.7 | % | $ | 867 | 0.6 | % | $ | 140 | 0.1 | % | |||||||||||||||||||||||
Net Sales
Net sales of $138.4 million for the third quarter of fiscal year 2022 increased by 2.8 percent as compared to net sales of $134.6 million for the third quarter of fiscal year 2021.
The $3.8 million increase in net sales from the prior year period was primarily due to the successful ramp of new customer programs and increased demand from existing customers. However, the Company’s revenue was constrained by tightening worldwide supply chain and transportation and logistics issues which delayed the arrival of key components, causing factory downtime and overtime expenses.
Gross Profit
Gross profit as a percentage of net sales for the three months ended April 2, 2022 was 8.3 percent compared to 8.2 percent for the three months ended April 3, 2021. This 0.1 percentage point increase was primarily a result of increased sales offset in part by supply chain constraints and continued but lessening expenses related to COVID-19.
The level of gross margin is impacted by facility utilization, product mix, timing, severity and steepness of new program ramps, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.
Included in gross profit are charges related to reductions in the carrying value of our inventory due to obsolescence. We recorded a provision of approximately $155,000 and $12,000 for obsolete inventory during the three months ended April 2, 2022 and April 3, 2021, respectively. We adjust the carrying value for estimated obsolescence as necessary in an amount equal to the difference between the cost of inventory and its net realizable value based on assumptions as to future demand and market conditions. The provisions are established for inventory that we have determined customers are not contractually responsible for and for inventory that we believe customers will be unable to purchase.
21
Operating Expenses
Total research, development, and engineering (RD&E) expenses were $2.5 million during the three months ended April 2, 2022 and $2.7 million during the three months ended April 3, 2021, respectively. The decrease in RD&E expenses relate to a decrease in engineering payroll expenses. Total RD&E expenses as a percent of net sales were 1.8 percent during the three months ended April 2, 2022 and 2.0 percent during the three months ended April 3, 2021.
Total selling, general and administrative (SG&A) expenses were $6.2 million during the three months ended April 2, 2022 compared to $5.9 million for the three months ended April 3, 2021. The increase in SG&A expenses relate to an increase in legal expenses related to the subject of the previously disclosed internal investigation and related matters, partially offset by a decrease in payroll related expenses. Total SG&A expenses as a percentage of net sales were 4.5 percent for the three months ended April 2, 2022 and 4.4 percent for the three months ended April 3, 2021.
Interest
Interest expense was $1.6 million during the three months ended April 2, 2022 and $1.0 million during the three months ended April 3, 2021. The increase in interest expense is primarily related to an increase in the average balance outstanding on our line of credit and increased interest rates.
Income Taxes
The effective tax rate for the three months ended April 2, 2022 was 18.7 percent compared to 44.3 percent for the three months ended April 3, 2021. The decrease was primarily due to the recording of a valuation allowance against Vietnam’s net operating loss deferred tax asset and a true up of federal research and development tax credits in the third quarter of fiscal year 2021. For further information on taxes see Note 5 of the “Notes to Consolidated Financial Statements.”
Our judgments regarding deferred tax assets and liabilities may change due to changes in market conditions, changes in estimates, changes in tax laws or other factors. If assumptions and estimates change in the future the deferred tax assets and liability will be adjusted accordingly and any increase or decrease will result in an additional deferred income tax expense or benefit in subsequent periods.
RESULTS OF OPERATIONS
Comparison of the Nine Months Ended April 2, 2022 with the Nine Months Ended April 3, 2021
The financial information and discussion below should be read in conjunction with the Consolidated Financial Statements and Notes.
The following table sets forth certain information regarding the components of our condensed consolidated statements of income for the nine months ended April 2, 2022 as compared to the nine months ended April 3, 2021. It is provided to assist in assessing differences in our overall performance (in thousands):
| Nine Months Ended | |||||||||||||||||||||||||||||||||||
| April 2, 2022 | % of net sales | April 3, 2021 | % of net sales | $ change | % point change | ||||||||||||||||||||||||||||||
| Net sales | $ | 405,609 | 100.0 | % | $ | 386,069 | 100.0 | % | $ | 19,540 | — | % | |||||||||||||||||||||||
| Cost of sales | 374,155 | 92.2 | % | 354,336 | 91.8 | % | 19,819 | 0.4 | % | ||||||||||||||||||||||||||
| Gross profit | 31,454 | 7.8 | % | 31,733 | 8.2 | % | (279) | (0.4) | % | ||||||||||||||||||||||||||
| Research, development and engineering | 7,473 | 1.8 | % | 7,292 | 1.9 | % | 181 | (0.1) | % | ||||||||||||||||||||||||||
| Selling, general and administrative | 17,447 | 4.3 | % | 16,349 | 4.2 | % | 1,098 | 0.1 | % | ||||||||||||||||||||||||||
| Total operating expenses | 24,920 | 6.1 | % | 23,641 | 6.1 | % | 1,279 | — | % | ||||||||||||||||||||||||||
| Operating income | 6,534 | 1.6 | % | 8,092 | 2.1 | % | (1,558) | (0.5) | % | ||||||||||||||||||||||||||
| Interest expense, net | 3,638 | 0.9 | % | 2,549 | 0.7 | % | 1,089 | 0.2 | % | ||||||||||||||||||||||||||
| Income before income taxes | 2,896 | 0.7 | % | 5,543 | 1.4 | % | (2,647) | (0.7) | % | ||||||||||||||||||||||||||
| Income tax provision | 487 | 0.1 | % | 1,377 | 0.4 | % | (890) | (0.3) | % | ||||||||||||||||||||||||||
| Net income | $ | 2,409 | 0.6 | % | $ | 4,166 | 1.1 | % | $ | (1,757) | (0.5) | % | |||||||||||||||||||||||
| Effective income tax rate | 16.8 | % | 24.8 | % | |||||||||||||||||||||||||||||||
22
Net Sales
Net sales of $405.6 million for the nine months ended April 2, 2022 increased by 5.1 percent as compared to net sales of $386.1 million for the nine months ended April 3, 2021.
The $19.5 million increase in net sales from the prior year period was due to the successful ramp of new customer programs and increased demand from existing customers. At the same time, the Company’s revenue was constrained by tightening worldwide supply chain and transportation and logistics issues which delayed the arrival of key components, causing factory downtime.
Gross Profit
Gross profit as a percentage of net sales for the nine months ended April 2, 2022 was 7.8 percent compared to 8.2 percent for the nine months ended April 3, 2021. This 0.4 percentage point decrease was primarily a result of supply chain constraints and continued but lessening expenses related to COVID-19. The level of gross margin is impacted by facility utilization, product mix, timing, severity and steepness of new program ramps, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.
Included in gross profit are charges related to reductions in the carrying value of our inventory due to obsolescence. We recorded a provision of approximately $520,000 and $458,000 for obsolete inventory during the nine months ended April 2, 2022 and nine months ended April 3, 2021, respectively. We adjust the carrying value for estimated obsolescence as necessary in an amount equal to the difference between the cost of inventory and its net realizable value based on assumptions as to future demand and market conditions. The provisions are established for inventory that we have determined customers are not contractually responsible for and for inventory that we believe customers will be unable to purchase.
Operating Expenses
Total research, development, and engineering (RD&E) expenses were $7.5 million and $7.3 million during the nine months ended April 2, 2022 and nine months ended April 3, 2021, respectively. The increase in RD&E expenses relate to an increase in engineering payroll expenses. Total RD&E expenses as a percent of net sales were 1.8 percent during the nine months ended April 2, 2022 and 1.9 percent during the nine months ended April 3, 2021.
Total selling, general and administrative (SG&A) expenses were $17.4 million during the nine months ended April 2, 2022 compared to $16.3 million for the nine months ended April 2, 2022. The increase in SG&A expenses relate to an increase in legal expenses related to the subject of the previously disclosed internal investigation and related matters, partially offset by a decrease in payroll related expenses. The increase in SG&A expenses relate to an increase in legal expenses related to the subject of the previously disclosed internal investigation and related matters. Total SG&A expenses as a percentage of net sales were 4.3 percent during the nine months ended April 2, 2022 compared to 4.2 percent during the nine months ended April 3, 2021.
Interest
Interest expense was $3.6 million during the nine months ended April 2, 2022 compared to $2.5 million during the nine months ended April 3, 2021. The increase in interest expense is primarily related to an increase in the average balance outstanding on our line of credit and increased interest rates.
Income Taxes
The effective tax rate for the nine months ended April 2, 2022 was 16.8 percent compared to 24.8 percent for the same period in fiscal year 2021. The effective tax rate decreased from the prior year primarily due to the recording of a valuation allowance against Vietnam’s net operating loss deferred tax asset and a true up of federal research and development tax credits in the third quarter of fiscal year 2021. For further information on taxes see Note 5 of the “Notes to Consolidated Financial Statements.”
Our judgments regarding deferred tax assets and liabilities may change due to changes in market conditions, changes in estimates, changes in tax laws or other factors. If assumptions and estimates change in the future the deferred tax assets and liability will be adjusted accordingly and any increase or decrease will result in an additional deferred income tax expense or benefit in subsequent periods. Considering the ongoing economic impacts of the COVID-19 pandemic, management assessed the realizability of all deferred tax assets at April 2, 2022, and determined that it is more likely than not that the deferred tax assets will be realized, other than the Vietnam net operating loss carryover. Due to the Tax Holiday and net operating loss utilization ordering rules, we expect our Vietnam net operating losses will be used against Tax Holiday qualified income subject to tax at a zero rate, resulting in no benefit for these net operating losses. Therefore, we have established a valuation allowance against the full amount of the Vietnam net operating loss carryover at January 1, 2022. For further information, see Note 5 of the “Notes to Consolidated Financial Statements.”
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BACKLOG
On April 2, 2022, we had an order backlog of approximately $384.1 million. This compares with a backlog of approximately $236.6 million on April 3, 2021. The increase in order backlog is related to increases in demand and increasing supply chain issues that have delayed production. Order backlog consists of purchase orders received for products expected to be shipped within the next 12 months, although shipment dates are subject to change due to design modifications or changes in other customer requirements. Order backlog should not be considered an accurate measure of future net sales.
CAPITAL RESOURCES AND LIQUIDITY
Operating Cash Flow
Net cash used in operating activities for the nine months ended April 2, 2022 was $11.6 million, compared to $17.7 million during the same period of the prior fiscal year.
The $11.6 million of net cash used in operating activities for the nine months ended April 2, 2022 is primarily related to $2.4 million in net income for the period adjusted for $3.9 million of depreciation and amortization, a $27.6 million increase in accounts receivable, a $18.3 million increase in inventory, a $2.8 million decrease in accrued compensation and vacation, a $1.6 million increase in other assets, partially offset by a $32.4 million increase in accounts payable, a $1.9 million increase in other liabilities and a $1.3 million decrease in contract assets.
The $17.7 million of net cash used in operating activities for the nine months ended April 3, 2021 is primarily related to $4.2 million in net income for the period adjusted for $5.0 million of depreciation and amortization, a $26.9 million increase in accounts receivable, a $15.8 million increase in inventory, a $1.1 million decrease in accrued compensation and vacation partially offset by a $2.9 million increase in accounts payable, and a $4.3 million decrease in contract assets.
Accounts receivable fluctuates based on the timing of shipments, terms offered and collections that occurred during the quarter. While overall net sales are not typically seasonal in nature, we ship the majority of our product during the latter half of the quarter. We purchase inventory based on customer forecasts and orders, and when those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable fluctuates with changes in inventory levels, volume of inventory purchases, negotiated supplier terms and taking advantage of early pay discounts.
Investing Cash Flow
Cash used in investing activities was $4.1 million during the nine months ended April 2, 2022 as compared to $9.7 million during the nine months ended April 3, 2021. Our primary investing activity during the nine months ended April 2, 2022 and April 3, 2021, was purchasing equipment to support increased production levels for new programs.
Leases are often utilized when potential technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds as well as our revolving line of credit facility and equipment term loan.
Financing Cash Flow
Cash provided by financing activities was $14.0 million during the nine months ended April 2, 2022 as compared to $28.1 million in the same period of the previous fiscal year. Our primary financing activities during the nine months ended April 2, 2022 and nine months ended April 3, 2021, were borrowings and repayments under our revolving line of credit facility and term loans.
As of April 2, 2022, approximately $15.8 million was available under the asset-based revolving credit facility.
Our cash requirements are affected by the level of current operations and new programs. We believe that projected cash from operations, funds available under the revolving credit facility and leasing capabilities will be sufficient to meet our working and fixed capital requirements for the foreseeable future. The Company further notes projected cash from operations from increased demand from certain customers will be partially offset by an anticipated slowdown in collections from other customers and increasing inventory levels in efforts to mitigate supply chain constraint risks. As of April 2, 2022, we had approximately $1.7 million of cash held by foreign subsidiaries. If cash is to be repatriated in the future from these foreign subsidiaries, the Company would be subject to certain withholding taxes in the foreign jurisdictions. The total amount of tax payments required for the amount of foreign subsidiary cash on hand as of April 2, 2022 would approximate $43,000. We have accrued withholding taxes for expected future repatriation of foreign earnings as discussed in Note 6 of the “Notes to Consolidated Financial Statements.”
OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS
We have included a summary of our Contractual Obligations in our annual report on Form 10-K for the fiscal year ended July 3, 2021. There have been no material changes in contractual obligations outside the ordinary course of business since July 3, 2021.
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RISKS AND UNCERTAINTIES THAT MAY AFFECT FUTURE RESULTS
The following risks and uncertainties could affect our actual results and could cause results to differ materially from past results or those contemplated by our forward-looking statements. When used herein, the words “expects,” “believes,” “anticipates” and other similar expressions are intended to identify forward-looking statements.
RISKS RELATED TO OUR BUSINESS AND STRATEGY
Our operations may be subject to certain risks.
We manufacture product in facilities located in Mexico, China, Vietnam and the United States. These operations may be subject to a number of risks, including:
•difficulties in staffing, turnover and managing onshore and offshore operations;
•political and economic instability (including acts of terrorism, pandemics, civil unrest, forms of violence and outbreaks of war), which could impact our ability to ship, manufacture, and/or receive product;
•unexpected changes in regulatory requirements and laws;
•longer customer payment cycles and difficulty collecting accounts receivable;
•export duties, import controls and trade barriers (including quotas);
•governmental restrictions on the transfer of funds;
•burdens of complying with a wide variety of foreign laws and labor practices; subject to trade wars and tariffs;
•our locations may be impacted by hurricanes, tornadoes, earthquakes, water shortages, tsunamis, floods, typhoons, fires, extreme weather conditions and other natural or man-made disasters; and
•our locations may also be impacted by future temporary closures and labor constraints as a result of COVID-19.
Our operations in certain foreign locations receive favorable income tax treatment in the form of tax credits or other incentives. In the event that such tax incentives are not extended, are repealed, or we no longer qualify for such programs, our taxes may increase, which would reduce our net income.
Additionally, certain foreign jurisdictions restrict the amount of cash that can be transferred to the U.S or impose taxes and penalties on such transfers of cash. To the extent we have excess cash in foreign locations that could be used in, or is needed by, our operations in the United States, we may incur significant penalties and/or taxes to repatriate these funds.
We may experience fluctuations in quarterly results of operations.
Our quarterly operating results have varied in the past and may vary in the future due to a variety of factors, including adverse changes in the U.S. and global macroeconomic environment, volatility in overall demand for our customers’ products, success of customers’ programs, timing of new programs, new product introductions or technological advances by us, our customers and our competitors, and changes in pricing policies by us, our customers, our suppliers, and our competitors. Our customer base is diverse in the markets they serve, however, decreases in demand, particularly from customers in certain industries could affect future quarterly results. Additionally, our customers could be adversely impacted by illiquidity in the credit markets which could directly impact our operating results.
Component procurement, production schedules, personnel and other resource requirements are based on estimates of customer requirements. Occasionally, our customers may request accelerated production that can stress resources and reduce operating margins. Conversely, our customers may abruptly lower or cancel production which may lead to a sudden, unexpected increase in inventory or accounts receivable for which we may not be reimbursed even when under contract with customers. In addition, because many of our operating expenses are relatively fixed, a reduction in customer demand can harm our gross profit and operating results. The products which we manufacture for our customers have relatively short product lifecycles. Therefore, our business, operating results and financial condition are dependent in a significant way on our ability to obtain orders from new customers and new product programs from existing customers.
Operating results can also fluctuate if changes are made to significant estimates and assumptions. Significant estimates and assumptions include the allowance for doubtful receivables, provision for obsolete and non-saleable inventory, stock-based compensation, the valuation allowance on deferred tax assets, impairment of long-lived assets, long-term incentive compensation accrual, the provision for warranty costs, and the impact of hedging activities.
Due to the COVID-19 pandemic, we have seen extreme shifts in demand from our customer base. The possibility of future temporary closures and labor constraints, as well as the inability to predict customer demand, costs, and future supply chain disruptions during the rapidly changing COVID-19 environment can materially impact operating results.
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We are exposed to general economic conditions, which could have a material adverse impact on our business, operating results and financial condition.
Adverse economic conditions and uncertainty in the global economy such as unstable global financial and credit markets, inflation, and recession can negatively impact our business. Unfavorable economic conditions could affect the demand for our customers’ products by triggering a reduction in orders as well as a decline in forecasts which could adversely affect our sales in future periods. Additionally, the financial strength of our customers and suppliers and their ability to obtain and rely on credit financing may affect their ability to fulfill their obligations to us and have an adverse effect on our financial results.
Adverse macroeconomic conditions as a result of COVID-19 have and may continue to affect our business. The conditions affect the Company’s ability to predict and plan for future supply chain disruptions, fluctuations in customer demand and costs, and the ability to operate as there is uncertainty over future temporary closures.
The majority of our sales come from a small number of customers and a decline in sales to any of these customers could adversely affect our business.
At present, our customer base is concentrated and could become more or less concentrated. There can be no assurance that our principal customers will continue to purchase products from us at current levels. Moreover, we typically do not enter into long-term volume purchase contracts with our customers, and our customers have certain rights to extend or delay the shipment of their orders. We, however, typically require that our customers contractually agree to buy back inventory purchased within specified lead times to build their products if not used.
The loss of one or more of our major customers, or the reduction, delay or cancellation of orders from such customers, due to economic conditions or other forces, could materially and adversely affect our business, operating results and financial condition. The contraction in demand from certain industries could impact our customer orders and have a negative impact on our operations over the foreseeable future. Additionally, if one or more of our customers were to become insolvent or otherwise unable to pay for the manufacturing services provided by us, our operating results and financial condition would be adversely affected.
We depend on a limited number of suppliers for certain components that are critical to our manufacturing processes. A shortage of these components or an increase in their price could interrupt our operations and result in a significant change in our results of operations.
We are dependent on many suppliers, including sole source suppliers, to provide key components and raw materials used in manufacturing customers’ products. We have seen supply shortages in certain electronic components. In addition, our suppliers' facilities may also experience earthquakes, tsunamis and other natural disasters which may cause a shortage of components. This can result in longer lead times and the inability to meet our customers request for flexible production and extended shipment dates. If demand for components outpaces supply, capacity delays could affect future operations. Delays in deliveries from suppliers or the inability to obtain sufficient quantities of components and raw materials have and may continue to cause delays or reductions in shipment of products to our customers which could adversely affect our operating results and damage customer relationships.
Key Tronic continues to work closely with its employees and key suppliers to ascertain delays attributable to the COVID-19 pandemic. Delays in production and extended transit times of critical parts have and may continue to cause a shortage of components.
We operate in a highly competitive industry; if we are not able to compete effectively in the contract manufacturing industry, our business could be adversely affected.
Competitors may offer customers lower prices on certain high volume programs. This could result in price reductions, reduced margins and loss of market share, all of which would materially and adversely affect our business, operating results, and financial condition. If we were unable to provide comparable or better manufacturing services at a lower cost than our competitors, it could cause sales to decline. In addition, competitors can copy our non-proprietary designs and processes after we have invested in development of products for customers, thereby enabling such competitors to offer lower prices on such products due to savings in development costs.
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Fluctuations in foreign currency exchange rates could increase our operating costs.
We have manufacturing operations located in Mexico and China. A significant portion of our operations are denominated in the Mexican peso and the Chinese currency, the renminbi ("RMB"). Currency exchange rates fluctuate daily as a result of a number of factors, including changes in a country's political and economic policies. Volatility in the currencies of our entities and the United States dollar could seriously harm our business, operating results and financial condition. The primary impact of currency exchange fluctuations is on the cash, receivables, payables and expenses of our operating entities. As part of our hedging strategy, we currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. We currently do not hedge expenses denominated in RMB. Unexpected losses could occur from increases in the value of these currencies relative to the United States dollar.
As a result of COVID-19, significant currency exchange fluctuations can occur causing unexpected losses. Future temporary closures of production facilities in Mexico could also cause significant changes in our ability to qualify for hedge accounting treatment of our forward contracts to hedge foreign currency fluctuations. However, given the unprecedented nature of the pandemic the FASB staff believes that an entity may apply the exception in paragraph 815-30-40-4 for rare cases caused by extenuating circumstances that are related to the nature of the forecasted transaction and are outside the control or influence of an entity to delays in the timing of the forecasted transactions if those delays are related to the effects of the COVID-19 pandemic and are considered probable to still occur. In addition, the FASB staff believes that it would be acceptable for an entity to determine that missed forecasts related to the effects of the COVID-19 pandemic need not be considered when determining whether it has exhibited a pattern of missing forecasts that would call into question its ability to accurately predict forecasted transactions and the propriety of using cash flow hedge accounting in the future for similar transactions.
Our success will continue to depend to a significant extent on our key personnel.
Our future success depends in large part on the continued service of our key technical, marketing and management personnel and on our ability to continue to attract and retain qualified production employees. There can be no assurance that we will be successful in attracting and retaining such personnel, particularly in our manufacturing locales that may be experiencing high demand for similar key personnel. The loss of key employees could have a material adverse effect on our business, operating results and financial condition.
Start-up costs and inefficiencies related to new or transferred programs can adversely affect our operating results and such costs may not be recoverable if such new programs or transferred programs are canceled or don’t meet expected sales volumes.
Start-up costs, the management of labor and equipment resources in connection with the establishment of new programs and new customer relationships, and the need to obtain required resources in advance can adversely affect our gross margins and operating results. These factors are particularly evident in the ramping stages of new programs. These factors also affect our ability to efficiently use labor and equipment. We are currently managing a number of new programs. Consequently, our exposure to these factors has increased. In addition, if any of these new programs or new customer relationships were terminated, our operating results could be harmed, particularly in the short term. We may not be able to recoup these start-up costs or replace anticipated new program revenues.
Customers may change production timing and demand schedules which makes it difficult for us to schedule production and capital expenditures and to maximize the efficiency of our manufacturing capacity.
Changes in demand for customer products reduce our ability to accurately estimate the future requirements of our customers. This makes it difficult to schedule production and maximize utilization of our manufacturing capacity. We must determine the levels of business that we will seek and accept from customers, set production schedules, commit to procuring inventory, and allocate personnel and resources, based on our estimates of our customers' requirements. Customers can require sudden increases and decreases in production which can put added stress on resources and reduce margins. Sudden decreases in production can lead to excess inventory on hand which may or may not be reimbursed by our customers even when under contract.
Continued growth could further lead to capacity constraints. We may need to transfer production to other facilities, acquire new facilities, or outsource production which could negatively impact gross margin. The Company has been able to manage the arrival of components in an effort to control inventory levels of customers that have seen sharp decreases in demand, as a result of COVID-19.
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Compliance or the failure to comply with current and future environmental and health laws or regulations could cause us significant expense.
We are subject to a variety of domestic and foreign environmental regulations relating to the use, storage, and disposal of materials used in our manufacturing processes. In addition, increasing governmental focus on climate change may result in new environmental regulations that may negatively affect us, our vendors or our customers. As a result, we may incur additional costs or obligations in complying with any new environmental and reporting requirements, as well as increased indirect costs resulting from our vendors or customers that get passed on to us.
If we fail to comply with any present or future regulations, we could be subject to future liabilities or the suspension of current manufacturing operations. In addition, such regulations could restrict our ability to expand our operations or could require us to acquire costly equipment, substitute materials, or incur other significant expenses to comply with government regulations.
If our manufacturing processes and services do not comply with applicable statutory and regulatory requirements, or if we manufacture products containing design or manufacturing defects, demand for our services may decline and we may be subject to liability claims.
We manufacture and design products to our customers’ specifications, and, in some cases, our manufacturing processes and facilities may need to comply with applicable statutory and regulatory requirements. For example, medical devices that we manufacture or design, as well as the facilities and manufacturing processes that we use to produce them, are regulated by the Food and Drug Administration and non-U.S. counterparts of this agency. In addition, our customers’ products and the manufacturing processes that we use to produce them often are highly complex. As a result, products that we manufacture may at times contain manufacturing or design defects, and our manufacturing processes may be subject to errors or not be in compliance with applicable statutory and regulatory requirements. Defects in the products we manufacture or design, whether caused by a design, manufacturing or component failure or error, or deficiencies in our manufacturing processes, may result in delayed shipments to customers or reduced or canceled customer orders. If these defects or deficiencies are significant, our business reputation may also be damaged. The failure of the products that we manufacture or our manufacturing processes and facilities to comply with applicable statutory and regulatory requirements may subject us to legal fines or penalties and, in some cases, require us to shut down or incur considerable expense to correct a manufacturing process or facility. Our customers are required to indemnify us against liability associated with designing products to meet their specifications. However, if our customers are responsible for the defects, they may not, or may not have resources to, assume responsibility for any costs or liabilities arising from these defects, which could expose us to additional liability claims.
If we do not manage our growth effectively, our profitability could decline.
Our business is experiencing growth which can place considerable additional demands upon our management team and our operational, financial and management information systems. Our ability to manage growth effectively requires us to continue to implement and improve these systems; avoid cost overruns; maintain customer, supplier and other favorable business relationships during possible transition periods; continue to develop the management skills of our managers and supervisors; and continue to train, motivate and manage our employees. Our failure to effectively manage growth could have a material adverse effect on our results of operations.
Energy price increases may negatively impact our results of operations.
Certain components that we use in our manufacturing process are petroleum-based. In addition, we, along with our suppliers and customers, rely on various energy sources in our transportation activities. While significant uncertainty currently exists about the future levels of energy prices, a significant increase is possible. Increased energy prices could cause an increase to our raw material costs and transportation costs. In addition, increased transportation costs related to certain suppliers and customers could be passed along to us. We may not be able to increase our product prices enough to offset these increased costs. In addition, any increase in our product prices may reduce our future customer orders and profitability.
TECHNOLOGY RISKS
Our operations are subject to cyberattacks that could have a material adverse effect on our business.
We are increasingly dependent on digital technologies and services to conduct our operations. We use these technologies for internal purposes, including data storage, processing and transmissions, as well as in our interactions with vendors and customers. Digital technologies and services are subject to the risk of cybersecurity incidents and some incidents can remain undetected for a period of time.
We routinely monitor our systems for cyber threats and have processes in place to detect and remediate vulnerabilities. Nevertheless, we have experienced attempted security breaches, such as phishing emails and other targeted attacks. We expect that our operations will continue to be subject to cyber threats, and any future cybersecurity incident could significantly disrupt our operations.
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Cybersecurity incidents could also result in the misappropriation of proprietary or confidential information of the Company or that of its customers, employees, vendors or customers. We expect to incur costs in the future to mitigate against cybersecurity incidents as threats are expected to continue to become more persistent and sophisticated. If our systems for protecting against cybersecurity incidents prove not to be sufficient, we could be adversely affected by, among other things, loss of or damage to intellectual property, proprietary or confidential information, or employee, vendor or customer data; interruption of our business operations; and increased costs to prevent, respond to or mitigate cybersecurity incidents. These risks could harm our reputation and our relationships with employees, vendors and customers and may result in claims or enforcement actions and investigations against us.
Disruptions to our information systems, including losses of data or outages, could adversely affect our operations.
We rely on information technology networks and systems to process, transmit and store electronic information. In particular, we depend on our information technology infrastructure for a variety of functions, including worldwide financial reporting, inventory management, procurement, invoicing and email communications. Any of these systems may be susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and similar events. If we or our vendors are unable to prevent such outages, our operations could be disrupted.
If we are unable to maintain our technological and manufacturing process expertise, our business could be adversely affected.
The markets for our customers’ products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and short product life cycles. The introduction of products embodying new technologies or the emergence of new industry standards can render existing products obsolete or unmarketable. Our success will depend upon our customers’ ability to enhance existing products and to develop and introduce, on a timely and cost-effective basis, new products that keep pace with technological developments and emerging industry standards and address evolving and increasingly sophisticated customer requirements. Failure of our customers to do so could substantially harm our customers’ competitive positions. There can be no assurance that our customers will be successful in identifying, developing and marketing products that respond to technological change, emerging industry standards or evolving customer requirements.
RISKS RELATED TO CAPITAL AND FINANCING
Cash and cash equivalents are exposed to concentrations of credit risk.
We place our cash with high credit quality institutions. At times, such balances may be in excess of the federal depository insurance limit or may be on deposit at institutions which are not covered by insurance. If such institutions were to become insolvent during which time it held our cash and cash equivalents in excess of the insurance limit, it could be necessary to obtain other credit financing to operate our facilities.
Our ability to secure and maintain sufficient credit arrangements is key to our continued operations.
There is no assurance that we will be able to retain or renew our credit agreements in the future. In the event the business grows rapidly or there is uncertainty in the macroeconomic climate, additional financing resources could be necessary in the current or future fiscal years. There is no assurance that we will be able to obtain equity or debt financing at acceptable terms, or at all in the future. In addition, we have restrictive covenants with our financial institution which could impact how we manage our business. If we cannot meet our financial covenants, our borrowings could become immediately payable which could have a material adverse impact on our financial statements. For a summary of our banking arrangements, see Note 4 Long-Term Debt of the “Notes to Consolidated Financial Statements.”
An adverse change in the interest rates for our borrowings could adversely affect our financial condition.
We are exposed to interest rate risk under our revolving line of credit and term loan. We have not historically hedged the interest rate on our credit facility; therefore, unless we do so, significant changes in interest rates could adversely affect our results of operations. For a summary of our debt obligations, see Note 4 Long-Term Debt of the “Notes to Consolidated Financial Statements.”
In addition, the U.K.’s Financial Conduct Authority, which regulates LIBOR, has formally announced that the publication of LIBOR is ending and confirmed that LIBOR-indexed rates will cease after June 30, 2023, with the remaining IBOR-indexed rates ceasing on December 31, 2021. The Federal Reserve Board and the Federal Reserve Bank of New York identified the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative rate for LIBOR for debt and derivative financial instruments.
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Our credit facility and debt agreements contains provisions that contemplate alternative methods to determine the base rate applicable to our LIBOR-indexed debt to the extent LIBOR-indexed rates are not available. However, if our loan agreement is not transitioned to SOFR and LIBOR-indexed rates are discontinued, or if the methods of calculating the rates change, interest rates on our current or future borrowings may be adversely affected. While we currently expect LIBOR-indexed rates to be available until June 30, 2023, it is possible that they will become unavailable prior to that time.
Our stock price is volatile.
Our stock price has and may continue to be subject to wide fluctuations and possible rapid increases or declines over a short time period. These fluctuations may be due to factors specific to us such as our stock's thinly traded nature, variations in quarterly operating results, changes in earnings estimates, or the Audit Committee's internal investigation, or to factors relating to the contract manufacturing industry or to the securities markets in general, which, in recent years, have experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stocks are traded. In addition, holders of our common stock will suffer immediate dilution to the extent outstanding equity awards are exercised to purchase common stock.
RISKS RELATED TO OUR CONTROLS AND PROCEDURES AND THE INTERNAL INVESTIGATION
We identified a material weakness in our internal control over financial reporting and concluded that our disclosure controls and procedures were not effective as of December 26, 2020 and April 3, 2021. If we fail to properly remediate any future deficiencies or material weaknesses or to maintain proper and effective internal controls, our business and financial condition could be materially adversely impacted.
As previously disclosed, we concluded that our disclosure controls and procedures were not effective as of December 26, 2020 and April 3, 2021, due to the existence of a material weakness in our internal control over financial reporting. While we have undertaken remediation efforts to address the identified deficiencies and have concluded that the material weakness was remediated as of July 3, 2021, we cannot provide assurance that we will be able to conclude that our controls will be effective in the future. We also cannot assure you that additional significant deficiencies or material weaknesses in our internal control over financial reporting will not arise or be identified in the future. We intend to continue our control remediation activities. In doing so, we will continue to incur expenses and expend management time on compliance-related issues.
If additional deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results. Moreover, because of the inherent limitations of any control system, material misstatements due to error or fraud may not be prevented or detected on a timely basis, or at all. If we are unable to provide reliable and timely financial reports in the future, our business and reputation may be further harmed. Restated financial statements and failures in internal controls may also cause us to fail to meet additional reporting obligations, negatively affect investor confidence in our management and the accuracy of our financial statements and disclosures, or result in adverse publicity and concerns from investors, any of which could have a negative effect on the price of our common stock, subject us to regulatory investigations and penalties or stockholder litigation, and materially adversely impact our business, financial condition, results of operations and cash flows.
Matters relating to or arising from the subject of the Audit Committee’s internal investigation, including expenses and diversion of personnel and resources, regulatory investigations, and proceedings and litigation matters, could have an adverse effect on our business, results of operations and financial condition.
We have incurred, and may continue to incur, significant expenses related to legal, accounting and other professional services in connection with matters relating to or arising from the subject of the Audit Committee’s internal investigation. As a result of the internal investigation, we have taken and continue to take a number of steps in order to remediate identified deficiencies in our internal control over financial reporting and attempt to reduce the risk of future recurrence. The validation of the efficacy of these remedial steps have resulted in us incurring additional near term expenses, and to the extent these steps are not successful, we may incur significant additional time and expense.
In addition, we are cooperating with the SEC regarding matters related to the internal investigation. The completion of the internal investigation will not automatically resolve the SEC’s inquiries. If the SEC or any other regulator were to commence legal action against us, we could be required to pay significant additional legal fees, as well as penalties and become subject to injunctions, cease and desist orders or other remedies. We can provide no assurances as to the outcome of any governmental inquiry or investigation. Further, we, our officers and members of our board of directors could be named as defendants in lawsuits asserting claims arising out of the subject matter of the Audit Committee’s internal investigation. As a result of any legal proceedings and any related indemnification requirements to our officers and directors, we could be required to pay additional legal fees and/or monetary damages that may be in excess of our insurance coverage or may have additional penalties or other remedies imposed against us or our officers and directors.
All of these expenses, the delay in timely filing our periodic reports and the diversion of the attention of management and other personnel that has occurred and is expected to continue, could adversely affect our business, financial condition, results of operations and cash flows.
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Due to inherent limitations, there can be no assurance that our system of disclosure and internal controls and procedures will be successful in preventing all errors, theft and fraud, or in informing management of all material information in a timely manner.
Management does not expect that our disclosure controls and procedures and internal controls over financial reporting will prevent all errors or fraud. A control system is designed to give reasonable, but not absolute, assurance that the objectives of the control system are met. In addition, any control system reflects resource constraints and the benefits of controls must be considered relative to their costs. Inherent limitations of a control system may include: judgments in decision making may be faulty, breakdowns can occur simply because of error or mistake and controls can be circumvented by collusion or management override. Due to the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.
LEGAL AND ACCOUNTING RISKS
We are involved in various legal proceedings.
In the past, we have been notified of claims relating to various matters including contractual matters, intellectual property rights or other issues arising in the ordinary course of business. In the event of such a claim, we may be required to spend a significant amount of money to defend or otherwise address the claim. Any litigation or dispute resolution, even where a claim is without merit, could result in substantial costs and diversion of resources. Accordingly, the resolution or adjudication of such disputes, even those encountered in the ordinary course of business, could have a material effect on our business, consolidated financial conditions and results of operations.
Changes in securities laws and regulations will increase our costs and risk of noncompliance.
We are subject to additional requirements contained in the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) and more recently the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The Sarbanes-Oxley and Dodd-Frank Acts required or will require changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of the Sarbanes-Oxley and Dodd-Frank Acts, the SEC and NASDAQ promulgated new rules and additional rulemaking is expected in the future. Compliance with these new rules and future rules has increased and may increase further our legal, financial and accounting costs as well as a potential risk of noncompliance. Absent significant changes in related rules, which we cannot assure, we anticipate some level of increased costs related to these new regulations to continue indefinitely. We also expect these developments to make it more difficult and more expensive to obtain director and officer liability insurance, and we may be forced to accept reduced coverage or incur substantially higher costs to obtain coverage. Likewise, these developments may make it more difficult for us to attract and retain qualified members of our Board of Directors or qualified management personnel. Further, the costs associated with the compliance with and implementation of procedures under these and future laws and related rules could have a material impact on our results of operations. In addition, the costs associated with noncompliance with additional securities laws and regulations could also impact our business.
Changes in financial accounting standards may affect our reported financial condition or results of operations as well increase costs related to implementation of new standards and modifications to internal controls.
Our consolidated financial statements are prepared in conformity with accounting standards generally accepted in the United States, or U.S. GAAP. These principles are subject to amendments made primarily by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions which are completed before a change is announced. Changes to accounting rules or challenges to our interpretation or application of the rules by regulators may have a material adverse effect on our reported financial results or on the way we conduct business.
GENERAL RISKS
Our levels of insurance coverage may not be sufficient for potential damages, claims or losses.
We have various forms of business and liability insurance which we believe are appropriate based on the needs of companies in our industry. As a result, not all of our potential business risks or potential losses would be covered by our insurance policies. If we sustain a significant claim or loss which is not covered by insurance, our net income could be negatively impacted.
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We may encounter complications with acquisitions, which could potentially harm our business.
Any current or future acquisitions may require additional equity financing, which could be dilutive to our existing shareholders, or additional debt financing, which could potentially affect our credit ratings. Any downgrades in our credit ratings associated with an acquisition could adversely affect our ability to borrow by resulting in more restrictive borrowing terms. To integrate acquired businesses, we must implement our management information systems, operating systems and internal controls, and assimilate and manage the personnel of the acquired operations. The integration of acquired businesses may be further complicated by difficulties managing operations in geographically dispersed locations. The integration of acquired businesses may not be successful and could result in disruption by diverting management’s attention from the core business. In addition, the integration of acquired businesses may require that we incur significant restructuring charges or other increases in our expenses and working capital requirements, which reduce our return on invested capital.
Acquisitions may involve numerous other risks and challenges including but not limited to: potential loss of key employees and customers of the acquired companies; the potential for deficiencies in internal controls at acquired companies; lack of experience operating in the geographic market or industry sector of the acquired business; constraints on available liquidity, and exposure to unanticipated liabilities of acquired companies. These and other factors could harm our ability to achieve anticipated levels of profitability at acquired operations or realize other anticipated benefits of an acquisition, and could adversely affect our consolidated business and operating results.
Item 3.Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
We are subject to the risk of fluctuating interest rates in the normal course of business. Our major market risk relates to our secured debt. Our asset-based senior secured revolving credit facility and equipment financing facility are secured by substantially all of our assets. The interest rates applicable to our asset-based senior secured revolving credit facility fluctuate with LIBOR rates. There was outstanding $99.7 million in borrowings under our asset-based senior secured revolving credit facility and $8.4 million outstanding on our equipment financing facilities as of April 2, 2022. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity” and Note 4 – “Long-Term Debt” to the Consolidated Financial Statements for additional information regarding our revolving credit facility and term loans.
Foreign Currency Exchange Risk
A significant portion of our operations are in foreign locations. As a result, transactions occur in currencies other than the U.S. dollar. Exchange rate fluctuations among other currencies used by us would directly or indirectly affect our financial results. We currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. There was $6.7 million of foreign currency forward contracts outstanding as of April 2, 2022. The fair value of these contracts was $344,000. See Note 9 – “Derivative Financial Instruments” to the Consolidated Financial Statements for additional information regarding our derivative instruments.
Item 4.Controls and Procedures
Evaluation of Disclosure Controls and Procedures
It is the responsibility of our management to establish, maintain, and monitor disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 (the “Exchange Act”) are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. Additionally, these disclosure controls include controls and procedures that are designed to accumulate and communicate the information required to be disclosed to our company’s Chief Executive Officer and Chief Financial Officer, allowing for timely decisions regarding required disclosures.
As of the end of the period covered by this report, our management carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b).
Based on our assessment, we believe that as of April 2, 2022, the Company’s disclosure controls and procedures are effective based on that criteria.
Changes in Internal Control over Financial Reporting
There have been no significant changes in our internal controls over financial reporting during the three months ended April 2, 2022 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a – 15(f) and 15d – 15(f)).
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PART II. OTHER INFORMATION:
Item 1.Legal Proceedings
We are involved in various legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Item 1A.Risk Factors
Information regarding risk factors appear in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 3, “Quantitative and Qualitative Disclosures about Market Risk” of this Form 10-Q.
There are no material changes to the risk factors set forth in Part I Item 1A in the Company’s Annual Report on Form 10-K for the year ended July 3, 2021.
| Item 6. | Exhibits | |||||||||||||
| 3.1 | ||||||||||||||
| 3.2 | ||||||||||||||
| 31.1 | ||||||||||||||
| 31.2 | ||||||||||||||
| 32.1 | ||||||||||||||
| 32.2 | ||||||||||||||
| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. | |||||||||||||
| 101.SCH | Inline XBRL Taxonomy Extension Schema Document | |||||||||||||
| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document | |||||||||||||
| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document | |||||||||||||
| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document | |||||||||||||
| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document | |||||||||||||
| 104 | Cover Page Interactive Data File (formatted as inline XBRL with applicable taxonomy extention information contained in Exhibits 101.INS, 101.SCH, 101.CAL, 101.DEF, 101.LAB and 101.PRE) | |||||||||||||
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
| KEY TRONIC CORPORATION | |||||||||||
/s/ CRAIG D. GATES | |||||||||||
| Craig D. Gates | Date: | May 11, 2022 | |||||||||
| President and Chief Executive Officer | |||||||||||
| (Principal Executive Officer) | |||||||||||
| /s/ BRETT R. LARSEN | |||||||||||
| Brett R. Larsen | Date: | May 11, 2022 | |||||||||
| Executive Vice President of Administration, Chief Financial Officer and Treasurer | |||||||||||
| (Principal Financial Officer) | |||||||||||
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