Key Tronic Corporation (NASDAQ:KTCC) Q1 2024 Earnings Call Transcript

Key Tronic Corporation (NASDAQ:KTCC) Q1 2024 Earnings Call Transcript October 31, 2023

Operator: Good day, and welcome to the Key Tronic First Quarter Fiscal 2024 Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Mr. Brett Larsen. Please go ahead.

Brett Larsen: Thank you. Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for today’s conference call. Joining me here in our Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer. As always, I would like to remind you that during the course of this call, we might make projections or other forward-looking statements regarding future events or the company’s future financial performance. Please remember that such statements are only predictions. Actual events or results may differ materially. For more information, you may review the risk factors outlined in the documents the company has filed with the SEC, specifically our latest 10-K, quarterly 10-Qs and 8-Ks. Please note that on this call, we will discuss historical financial and other statistical information regarding our business and operations.

Some of this information is included in today’s press release, and a recorded version of this call will be available on our website. Today, we released the results for the three months ended September 30, 2023. For the first quarter of fiscal 2024, we reported revenue of approximately $147.8 million, up 8% from $137.3 million in the same period of fiscal 2023. The increase in revenue reflects the continued ramp in production for new programs, particularly those produced in our U.S. facilities. Revenue is down sequentially from the fourth quarter of fiscal 2023 due to the customers’ redesign of a large outdoor power equipment program, but we estimate that program to come back online later in fiscal 2025. The company’s gross margin for the first quarter of 2024 was 7.4%, and operating margin was 2.2% compared to a gross margin of 7.6% and an operating margin of 2.4% in the same period of fiscal 2023.

The margins in the first quarter of fiscal 2024 included severance costs of about $0.6 million as we reduced our workforce by over 100 employees in Mexico and in the U.S. The workforce reduction reflects some softening demand for a number of different programs for the next few quarters in Mexico and is expected to reduce operating expenses by more than $5 million on an annualized basis. Excluding these severance costs in the first quarter of fiscal 2024, gross margins and operating margins would have been approximately 7.8% and 2.6%, respectively. Our recent production efficiencies, strategic labor cost reductions and the gradual stabilization in the supply chain and labor markets has been largely offset by the strengthening of the Mexican peso relative to the U.S. dollar in recent months.

However, in the second quarter of fiscal 2024, we are beginning to see the peso weakened to the U.S. dollar, which may translate into improving conditions moving forward. For the first quarter of fiscal 2024, net income was $0.3 million or $0.03 per share compared to $1.2 million or $0.11 per share for the same period of fiscal 2023. The year-over-year decline in earnings was primarily due to a $1.1 million increase in interest expense on higher interest rates and an unanticipated severance cost of $0.6 million or approximately $0.04 to $0.05 per diluted share. Net income continued to be adversely impacted by the strength of the Mexican peso. Turning to the balance sheet. We ended up the first quarter of fiscal 2024 with reducing inventory by approximately $43 million or roughly 25% from the same time a year ago, primarily reflecting increased shipments and a concerted effort to drive inventory reductions.

Total inventory turns increased to 4x in the first quarter of fiscal 2024, up from 3.1 turns a year ago. We are pleased to see our inventory levels start to become in line with our current revenue. At the same time, the state of the worldwide supply chain still requires that we look out much further in the future than in historical periods. We are still recovering from the COVID supply chain chaos as our customers have revamped their forecasting methodologies, and we have significantly modified and improved our material resource planning algorithms. As a result, we should be better equipped for future disruptions in the supply chain even as we continue to drive inventory down. During the first quarter, we also reduced accounts payable, leasing obligations and overall debt by a combined amount of $22.7 million during the quarter.

At the same time, accounts receivable remained relatively flat on increased revenues year-over-year with DSOs at 81 days, down from 91 days a year ago, which we believe reflects some improvement of certain customers with respect to disruptions from supply chain issues. Total capital expenditures were about $0.4 million for the first quarter of fiscal 2024, and we expect total CapEx for the full fiscal year to be around $8 million. While we’re carefully keeping an eye out on capital expenditures, we plan to continue to invest selectively in our production equipment, SMT equipment and plastic molding capabilities, utilize leasing facilities as well as make efficiency improvements to prepare for growth and add capacity. For the second quarter of fiscal 2024, we’re seeing a continued increase in demand for programs based in our U.S. facilities and some softening of customer demand for our Mexico-based programs.

As previously announced, the large program with a leading power equipment company, is now expected to resume materially in fiscal 2025 rather than 2024 with a customer redesigned product. For the second quarter of fiscal 2024, we expect to report revenue in the range of $135 million to $145 million and earnings in the range of $0.05 to $0.10 per diluted share. In the second half of fiscal 2024, we expect increased demand for our Mexico-based programs and continued growth in the U.S. and Vietnam. We also have a strong pipeline of potential new business. Over the longer term, we believe that we are increasingly well positioned to win new EMS programs and continue to profitably expand our business. That’s it for me. Craig?

Craig Gates: Thanks, Brett. During the first quarter of fiscal 2024, we continue to ramp many new programs produced in our U.S. facilities and remain profitable despite a temporary softening of customer demand for our Mexico-based programs. We’re also pleased to see our inventories be more in line with current revenue levels and other improvements made on the balance sheet. Over the past four years, we have seen a 9.4% CAGR of revenue, largely driven by an increase in new programs predominantly in North America. During the same four years, we have seen our total number of new customer programs grow by approximately 100% from the number in fiscal 2020, while revenues increased by 31% over the same period. This has led to less concentration in any single customer and has enabled us to be less financially dependent on any single program.

During fiscal 2023, we had only one customer that represented over 10% of revenues, and they represented only 12%. Meanwhile, our U.S. sites have added over $60 million in new program wins in the past 12 months as a direct result of continued onshoring. Moving into fiscal 2024, we continue to see the favorable trend of contract manufacturing returning to North America. As a result, we continued to expand our customer base and won new programs involving security equipment, sporting goods, environmental solutions and industrial control systems. Global logistics problems and China-U.S. geopolitical tensions continue to drive OEMs to examine their traditional outsourcing strategies. We believe these customers increasingly realize that they have become overly dependent on their China-based contract manufacturers for not only product but also for design and logistics services.

Over time, the decision to onshore or nearshore production is becoming more widely accepted as a smart long-term strategy. As a result, we see opportunities for continued growth. Moreover, a growing number of potential customers are actively evaluating the migration of the China-based manufacturing to our facility in Vietnam. In the coming years, we expect our Vietnam facility to play a major role in our growth. While China growth has slowed and many companies have decided to take risk mitigation steps with their China manufacturers, the fact remains that many components must be sourced from China. Our procurement group in Shanghai, which serves the entire corporation, remains important for managing the China component supply chain on an ongoing basis.

The combination of our global footprint and our expansive design capabilities is proving to be extremely effective in capturing new business. Many of our large and medium-sized manufacturing program wins are predicated on Key Tronic’s deep and broad design services. And once we have completed a design and ramped it into production, we believe our knowledge of a program-specific design challenges makes that business extremely sticky. We also invested in vertical integration and manufacturing process knowledge, including a wide range of plastic molding, injection below gas assist multi-shot as well as PCB assembly, metal forming, painting, and coating, complex high-volume automated assembly and the design, construction and operation of complicated test equipment.

This expertise may set us apart from our competitors of a similar size. As a result, a customer looking to leave their contract manufacturer will find a one-stop shop in Key Tronic, which is expected to make the transition to our facilities much less risky than cobbling together a group of providers each limited to a portion of the value chain. In fact, most of the new customers we have onboarded take advantage of this one-stop shop capability that we provide. We believe global logistics problems, China-U.S. political tensions and heightened concerns about supply chains will continue to drive a favorable trend of contract manufacturing returning to North America as well as to our Vietnam facilities. We continue to see improvement across the metrics associated with business development, including a significant increase in the number of active quotes with prospective customers.

This unprecedented increase in demand for our unique mix of skills, location and people has enabled us to negotiate more favorable pricing terms and business parameters than in the past as well as to be much more selective in the new customers we bring on. While this shift in leverage will not manifest in the short term, its effect on our long-term performance should be profound. We move into fiscal 2024 with a strong pipeline of potential new business, and we’re seeing some improvement in our gross margins. Production delays and softness in demand in Q2 and higher interest rates and a strong peso will continue to dampen our growth and profitability in the near term. Nevertheless, we’re very encouraged by our progress and potential for growth in fiscal 2024 and beyond.

This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions.

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Q&A Session

Operator: [Operator Instructions] And our first question will come from Bill Dezellem with Tieton Capital.

Bill Dezellem: Thank you. First of all, let’s start with the normal. You had four wins. What was the size of each of them, please? And then any commentary and discussion around each of them would be appreciated.

Craig Gates: I would say, security equipment about $12 million, sporting goods $10 million and then hopefully another $8 million, environmental solutions $4 million, industrial control systems $3 million.

Bill Dezellem: And would you kind of walk through each of those for us? And just in terms of whatever additional information you can share besides the industry that they’re in.

Craig Gates: Sure. All of them take advantage of multiple capabilities that we have, so they’re not just board stuffing. All of those are actually in the U.S. sites rather than in Mexico. And three of them are return quote opportunities from a couple of years ago, which is that interesting. I’m not sure if I can draw a conclusion from that, but we call them boomerang accounts, boomerang quotes. And all of them, four out of the five are PCBs and final box builds and some mechanics along with it.

Bill Dezellem: And so talk a little bit about those. I like the term boomerang, the boomerang quotes and wins, the dynamics there. Is it your understanding they went somewhere else and another CM failed or that they kept with their current situation and finally decided to make a change? What happened?

Craig Gates: Well, that’s why it’s a little bit hard for me to draw a conclusion because there’s a whole bunch of different stories behind each of them. So a couple of them we’ve been talking to for years and the programs we quoted on were new development programs, didn’t ever win anywhere. And the other one, awarded the business to somebody else that didn’t work out well and they came back.

Bill Dezellem: Thank you. And then, Craig, in your opening remarks, you referenced that the number of customers versus four years ago has doubled or is up 100%. How do you think about that? Because there is this trade-off between less customer concentration and yet the challenges of managing the smaller pieces of business. What are the dynamics around that as you think about it?

Craig Gates: Well, there’s a lot of different aspects to that situation, and it’s hard to draw a real generalized conclusion other than the ones I’ve stated that it does tend to improve our leverage with the customer in negotiations when the customer knows they’re not 15% of our business. We don’t see a big delta in cost between running a $5 million program and a $40 million program in terms of support costs and overhead. It’s actually a little bit easier to manage when it’s on the smaller side because you don’t have such massive amounts of parts that you’re trying to keep your arms around. And it’s also easier in that many times, these programs were not part of it, our business is not part of a big corporation that we can’t get to somebody who will listen to the situation at hand and respond logically.

So even though it seems like with the $50 million program, you should have a lot more ability to talk to people who have the power to make decisions. Oftentimes, that $50 million program is part of some billion dollar corporation, and you can’t get to somebody who you need to talk to, to make logical sense on what’s going on. So we don’t see what’s classically taught in the business schools that the smaller programs are less profitable. We probably see at least parity between them and probably an advantage going to the $10 million to $20 million program compared to a $50 million to $80 million program. That doesn’t mean we’re not always looking for the $50 million, $80 million program. But if you look back in history, other than a couple of them that have been long standing, they tend to be more flash in the pan than you would hope.

So we are happy with the fact that we’re growing in the $5 million to $20 million programs on a steady basis and much faster in that realm than we were three, four years ago.

Bill Dezellem: That’s helpful. Thank you, Craig. And then you referenced a couple of times, I think you both did that the customers that you are manufacturing for in your U.S. facilities are showing strength, whereas the customers that are in your Mexico facilities are showing some weakness. Is there any conclusion to draw from the location at which you are manufacturing and the relative strength?

Craig Gates: I’m struggling to do so. I would like to be able to give you an earth-shattering revelation on why at this point, Mexico was down and U.S. is up. I think it has to do with the fact that there’s so much growth in new programs coming into the U.S. sites that although they have seen downturns in some of their customers, those downturns have been swamped by all the new business coming on board. The business in Juarez was unexpectedly dampened by the power equipment business having to go on hiatus while the customer redesigned the product. And so what should have been new business that was swamping out other small decreases in the other business in Juarez is not there right now. So I think that set of just individual circumstances is the driver rather than any kind of market or business overarching trend that you can point to or at least that I can point to.

Bill Dezellem: That commentary is appreciated, even though it’s not the revelation that you had hoped you’d be able to share. I did hear where we heard of another company that saw weakness right after Labor Day. Curiously, it did correspond with Hamas attacking Israel and then things two or three weeks later returning to normal. Have you seen anything similar to that peculiarity that, that company saw?

Craig Gates: No. When we talk about positive to negative phone calls we get from our customers and the ratio of those, we had a little bit of a dip four or five months back that we thought were worried was the signal for a broader base on coming recessionary freight train. Then that ratio flattened out, and we started to get hopeful. And then a couple of months ago, the ratio went bad again. But it has now once again flattened out. So if you look at it, it was a small step down, a medium step down, but now it’s flat again. We’re typically a front-end particular of what’s going to happen. And right now, I can’t give you any good indication that it’s going to continue to get worse, it’s going to stabilize or it’s going to get better.