Key Tronic Corporation (NASDAQ:KTCC) Q2 2023 Earnings Call Transcript

Key Tronic Corporation (NASDAQ:KTCC) Q2 2023 Earnings Call Transcript January 31, 2023

Operator: Good day, and welcome to the Second Quarter Fiscal 2023 Key Tronic Corporation Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Brett Larsen. Please go ahead.

Brett Larsen: Thank you. Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer. As always, I would like to remind you that during this course — 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 our results for the quarter ended December 31, 2022. For the second quarter of fiscal 2023, we reported total revenue of $123.7 million compared to $134.5 million in the same period of fiscal 2022. For the first six months of fiscal 2023, our total revenue was $261 million compared to $267.2 million in the same period of fiscal 2022. As previously announced, our revenue for the second quarter of fiscal 2023 was impacted by a six-week delay in starting production for a large program with a leading power equipment company. This delayed revenue by approximately $20 million from the second quarter of fiscal 2023, but production for this program is currently underway and increasing in the third quarter.

While constraints in the global supply chain continued to limit production, we saw some gradual improvements with respect to lead times of certain key components. For the second quarter of fiscal 2023, our gross margin was 7.2% and operating margin was 2.9%, compared to a gross margin of 7.3% and an operating margin of 1.2% in the same period of fiscal 2022. The gross margin in the second quarter of fiscal 2023 was adversely impacted by business interruption and other operational losses related to storm damage in our Arkansas facility, as well as by preparations for expected sales growth in the second quarter and increased labor costs in both the U.S. and Mexico. While profitability is expected to improve in coming quarters with expected increases in revenue, higher interest rates on our line of credit and increasing wages will limit a portion of that expected improvement.

For the second quarter of fiscal 2023, net income was $1 million or $0.09 per share compared to $0.6 million or $0.05 per share for the same period of fiscal 2022. Our results for the second quarter of fiscal 2023 included a gain on insurance proceeds of $2.7 million or approximately $0.19 per share related to equipment damage — damaged in the storm at our Arkansas facility. We are still determining further business interruption proceeds related to the operational losses incurred in the past two quarters as a result of the storm damage. For the first six months of fiscal 2023, net income was $2.1 million or $0.20 per share compared to $1.4 million or $0.13 per share for the same period of fiscal 2022. Turning to the balance sheet. Despite the continuing production delays due to supply chain problems and the continued ramp and transfer of new programs, we ended the second quarter with total working capital of $190.7 million in a current ratio of 2.1 to 1.

Compared to the prior quarter, we’re encouraged to see our receivables decrease by $4.7 million and DSOs at 78 days, down from 91 days, which we believe reflects some improvement among our customers with respect to disruptions from COVID-19 and supply chain issues. At the end of the second quarter of fiscal 2023, our inventory increased by approximately $2.5 million or by 1.5% from the prior period, reflecting the delayed production for the large outdoor power equipment program and our preparations for expected growth in coming quarters. While the state of the worldwide supply chain still requires that we look out much further in the future than in historical periods, we attempt to carefully balance customer demand and the likelihood of successfully bringing in parts in time for planned production.

In future quarters, we expect see our net inventory turns slowly improve to more historical levels. Total capital expenditures were $1.4 million for the second quarter of fiscal 2023 and we expect total CapEx for the year to be around $9 million. We’re also utilizing the $2.7 million gain on insurance proceeds for storm damage to modernize our operations, which should increase efficiencies in our Arkansas facility. While we are keeping a careful eye on capital expenditures, we plan to continue to invest selectively in our production equipment, SMT equipment and plastic molding capabilities, utilizing leasing facilities as well as make efficiency improvements to prepare for growth and add capacity. Despite the ongoing disruptions from the global supply chain that will continue to limit production and adversely impact operating efficiencies, we are expecting significant growth in fiscal 2023.

For the third quarter of fiscal 2023, we expect to report revenue in the range of $160 million to $170 million, and earnings in the range of $0.15 to $0.25 per diluted share. While profitability is expected to improve in coming quarters with increasing expected revenue, higher interest rates on our line of credit and increasing wages will limit a portion of that expected improvement. While our facilities in the U.S., Mexico, China and Vietnam are currently operating, uncertainty does still remain as to the possibility of future temporary closures. Customer fluctuations and demand costs, future supply chain disruptions and other potential factors, any of which could significantly impact operations in coming periods. In summary, we continue to grow our pipeline of new sales prospects and continue to increase our customer demand to unprecedented levels for Key Tronic.

We believe that we are increasingly well positioned to win new EMS programs and continue to profitably expand our business over the longer term. That’s it for me. Craig?

Craig Gates: Okay. Thanks, Brett. We’re pleased with the successful ramp of new programs and our expanding customer base in the second quarter of fiscal 2023 despite six-week delay for production from the large previously announced power equipment program. Production for that program is now back on track and rapidly ramping up. In essence, the revenue from that program simply pushed by a quarter. During the second quarter of fiscal year 2023, we continue to see the favorable trend of contract manufacturing returning to North America. Currently awarded new business has created backlog that will support over 65% growth in the U.S. sites over the next fiscal year. We won new programs involving outdoor power equipment, battery management, automated sprinklers and biometric sensor technology.

We move into the third quarter with record backlog and we’re seeing improvement in the global supply issues for certain components that have severely limited our production in recent periods. Global logistics problems, the war in Europe, China-U.S. geopolitical tensions continue to drive OEMs to examine their traditional outsourcing strategies. We believe these customers increasingly realize they had become overly dependent on their China-based contract manufacturers not only for product but also for design and logistic services. Over time, the decision to onshore or nearshore production is becoming more widely accepted as a smart long-term strategy. As a result, we see opportunities for continued growth. As we’ve discussed in prior calls, we built Key Tronic to offer the ideal solution for customers as they move to respond to geopolitical pressures.

Our facilities in Mexico represent a campus of 1.1 million square feet in Juarez, most of which is (ph) located in nine facilities acquired over time. Our three U.S.-based manufacturing sites have also benefited greatly from the macro forces driving business back to North America. Moreover, our new Vietnam facility continues to increase production levels and the abatement of COVID-related government restrictions in Vietnam is allowing us to travel there and tour the plant with potential customers. Our Shanghai plant has added capabilities in management staff and systems that allow it to serve Chinese customers directly. Shanghai has replaced the business that we moved to Vietnam and our procurement group in Shanghai, which serves the entire corporation, is important for managing the supply issues that crippled many of our competitors without boots on the ground in China.

The combination of our global footprint and our expansive design capabilities is proving to be extremely effective in capturing new business. Many of our large- and medium-size manufacturing program wins are predicated on Key Tronic’s deep and broad design services. And, once we have completed a design and ramped it into production, we believe our knowledge of 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 blow, gas assist, multi-shot, as well as PCB assembly, metal forming, painting and coating, complex high volume automated assembly, and the design construction and operation of complicated test equipment.

This expertise may set us apart from our competitors of a similar size. As a result, a customer looking to leave their contract manufacturer will find one-stop shopping in Key Tronic, which is expected to make the transition to our facilities much less risky than cobbling together a group of providers each limited to a portion of the value change. Moving further into fiscal 2023, the headwinds from the global supply chain continue to present uncertainty and multiple business challenges, but do show some signs of gradually abating, particularly with respect to the recent price stabilization for some commodity components. At the same time, these price reductions are offset by increasing wages at our North American facilities. We believe global logistics problems, China-U.S. political tensions and heightened assurance of supply concerns will continue to drive the favorable trend of contract manufacturing returning to North America, as well as to our expanding Vietnam facilities.

The fact that we see record level backlogs and expect record revenue in the third quarter indicates our growing momentum. Along with the records we are setting for backlog and revenue, we see a dramatic improvement in all metrics associated with business development. For example, over the past year, a number of active quotes with prospective customers has increased eightfold. This unprecedented increase in demand for our unique mix of skills, location and people has powerful implications beyond the obvious revenue growth potential. In particular, we have been able to negotiate more favorable pricing terms and business parameters than in the past, as well as to be much more selective in the new customers we bring on. While this shift in leverage will not manifest in the short term, its effect on our long-term performance should be profound.

As the implacable effects of global demographics combine with the unique attributes of the North American economy to drive the re-industrialization of the U.S. and the accelerating industrialization of Mexico, Key Tronic should be uniquely positioned for significant growth in fiscal 2023 and beyond. This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions.

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Q&A Session

Operator: Thank you. Our first question comes from Bill Dezellem with Tieton Capital. Please go ahead.

Bill Dezellem: Thank you. Let’s start, if we could, with the power equipment customer that had the delays and that led to the preannouncement. Walk us through, if you would, what happened there? And what if anything that Key Tronic could have done to influence those revenues coming in sooner?

Craig Gates: Well, Bill, I’m not sure I can be as specific as you would like about what happened there. I can, in general, only say that it was a brand new program on a brand new product that we shared in the joint design and development thereof. There were delays all across the board. In fact, the final delay was the artwork for the packaging. So, we were six weeks off out of a 11 months design program, which was pretty annoying. But on the other hand, we got it done. And in fact, we mentioned the new programs involving outdoor power equipment, that same customer has just awarded us another piece of business on another product. And before you ask me, it’s about $11 million.

Bill Dezellem: That’s quite helpful. And congratulations on that next piece of business.

Craig Gates: Yes, thank you.

Bill Dezellem: Continuing with them, so — since I’ve never been in the position of doing artwork for packaging, six-week delay sounds like a lot, but walk us through kind of that? That just seems extreme to me.

Craig Gates: It is actually more common than you would hope in our business, where we are manufacturing a product for a customer that is selling it to a retail customer. So, retail packaging, as you know, is very, very critical for sales and product market acceptance. And unfortunately — or probably fortunately knowing how artistic I and the rest of my engineers are, we have no say in the artwork. And it’s a joint agreement that has to happen between our customer and our customers’ customer. And it’s a joint agreement that has to happen between quite a few artistic people. So, it’s fairly common that we are, with our backs against the wall, trying to get either packaging or artwork for packaging done and approved and actually produced. In fact, we’re looking at a big upside right now for a different product, and yet again, the delay is our ability to get packaging in time with the customer’s increased demand into a new market.

Bill Dezellem: Fascinating. Thank you. And so, with this power equipment customer, just to help us have a perspective of the trend line that’s taking place, what was the revenue level in October, then the month of November, the month of December and then in January? What does that look like?

Craig Gates: Pretty easy, Bill, zero, zero, zero. And then, January…

Bill Dezellem: Yes.

Craig Gates: What?

Bill Dezellem: At least one more month of January. Go ahead.

Craig Gates: Yes. I’m not going to comment on what it was in January, but it was a lot more than zero.

Bill Dezellem: And are you able to talk about what the peak level of production will be for this customer?

Craig Gates: No.

Bill Dezellem: And is January, probably not at the full run rate given that they were zero in December, so that will be even higher in coming months?

Craig Gates: Yes, right now we’re at about five-eighth of our required run rate after really about three weeks of full production.

Bill Dezellem: Okay. That’s helpful. And then, originally, if I have the right customer in mind, I think you had a press release that stated that you anticipated that they would be an annual run rate of about $80 million. Is that still this piece of business is looking like? I’m excluding the new piece of business that you won, but just this original piece of business?

Craig Gates: This original piece of business, we expect to be somewhat less than that in this first period as far as an annualized run rate. But at the beginning towards the middle of next fiscal year, it should be up to that number for a run rate.

Bill Dezellem: Okay. That’s quite helpful. Thank you. And then, you did allude to the fact that I asked about the new product wins and the size. Would you talk through the other three in terms of the size? And then, whatever discussion that you have on these four wins would be helpful.

Craig Gates: The other three were around (ph) each.

Bill Dezellem: Okay.

Craig Gates: Those would be headed into the Midwestern facilities. And those are pretty — what’s the right word, those are pretty representative of what the Midwestern — the three sites in the Midwest have been winning at a really amazing rate over the last year. When we said that they’re going to be over 65% growth, that’s pretty astounding since they had been basically stable for the last 4.5 years, 5 years. As I’ve always told you, we expected everything that’s happening to happen. It was a little bit delayed, but now it’s actually happening to a larger extent than we thought it was going to. So, they — the folks in the Midwest are uniquely constituted to run programs in the $1 million to $10 million range. And these size programs just continue to come in over the transom and then be gapped and hooked and cleaned. That is just an amazing rate to me. It’s been really, really fun.

Bill Dezellem: And presumably — even though it’s maybe more exciting for us externally to talk about a large customer, presumably these smaller ones, I’ll call them bread and butter ones, are higher margin than a large piece of business?

Craig Gates: Yes, you can pretty reliably predict that something that’s going to be run in the U.S. facilities is lower volume, higher margin, stickier overall and typically quicker to develop also, unless there’s a design program that went with it.

Bill Dezellem: Thank you. And I don’t want to take up more than — more time than I should here. But I would like you to talk through the change that’s taken place with the U.S. facilities or the Midwest facilities, going from essentially flat for a number of years to this accelerated growth. What happened? What changed to lead to this?

Craig Gates: Well, as we said in the narrative, as more and more of the general agreed opinion is that it’s risky to be overseas. And the size of the company that will command the attention that you need to be successful with that piece of outsourced business continues to grow more and more of the smaller pieces of business that just automatically went to Asia are now more automatically staying in the U.S., as Asian prices have gone up, as uncertainty with Asian supply has increased, and as the friction — the business friction of doing business overseas has become more generally acknowledged. It’s just so much different than it was five years ago when every piece of business we won, we had to dig out from under a rock. Business is now coming to us. And people aren’t just kicking tires. People are — have been given edicts by their corporate leaders and business leaders to get stuff out of Asia because it’s too risky.

Bill Dezellem: Thank you. And did we hear correctly that your quotes you said were up eightfold from one year ago?

Brett Larsen: Yes.