Key Tronic Corporation (NASDAQ:KTCC) Q2 2024 Earnings Call Transcript

Key Tronic Corporation (NASDAQ:KTCC) Q2 2024 Earnings Call Transcript February 6, 2024

Key Tronic Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and welcome to the second Quarter Fiscal 2024 Key Tronic’s 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: 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, and Tony Voorhees, our Vice President of Finance and Corporate Controller. 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 our results for the three months ended December 30, 2023. For the second quarter of fiscal 2024, we reported total revenues of $154.4 million, up 18% from $123.7 million in the same period of fiscal 2023. Revenue growth for the second quarter of fiscal 2024 was driven by increased production at our U.S.-based and Vietnam-based facilities, as well as by the sale of approximately $8.1 million of inventory from a discontinued program. For the first six months of fiscal 2024, total revenue was $293.2 million, up 12% from $261 million in the same period of fiscal 2023. For the second quarter of fiscal 2024, our gross margin was 8.1%, and our operating margin was 2.7%, compared to gross margin of 7.2%, and an operating margin of 2.9% in the same period of fiscal 2023.

The increase in gross margin for the second quarter of fiscal 2024 reflects a favorable product mix for the quarter and improved operating efficiencies. In recent periods, our improved production efficiencies, strategic labor cost reductions, and the gradual stabilization in its supply chain have been largely offset by the strengthening of the Mexican peso relative to the U.S. dollar and increasing labor costs in Mexico and in the U.S. For the second quarter of fiscal 2024, net income was $1.1 million, or roughly $0.10 per share, compared to $1 million, or $0.09 per share, for the same period of fiscal 2023. For the first six months of fiscal 2024, net income was $1.4 million, or $0.13 per share, compared to $2.1 million, or $0.20 per share, for the same period of fiscal 2023.

As we’ve discussed, our profitability in the fiscal 2024 continues to be negatively impacted by increased labor costs in both the U.S. and Mexico and by higher interest rates on our line of credit. Turning to the balance sheet, we ended the second quarter of fiscal 2024 by reducing inventory and contract assets, which are finished products, by approximately $48.3 million, or roughly 24% from the same time a year ago. These improvements in inventory levels primarily reflect increased component availability and our concerted efforts to drive inventory reductions. Total inventory turns increased to 3.8 times in the second quarter of fiscal 2024, up from 2.6 turns a year ago. We are pleased to see our inventory levels continue to become more in-line with our current revenue.

At the same time, the state of the worldwide supply chain still requires that we drive demand for parts differently than in historical periods. 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 manage inventory more cost effectively. During the second quarter, we also reduced our accounts payable, leasing obligations, and overall debt by a combined amount of $51 million from a year ago. At the same time, accounts receivable DSOs was at 85 days compared to 78 days a year ago, which we believe reflects some increased delays in collections from certain customers, despite continuing improvement of most customers with respect to disruptions from supply chain issues.

Total capital expenditures were about $2.1 million for the second quarter of fiscal 2024, and we expect total CapEx for the year to be around $8 million. While we’re keeping a careful eye 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, particularly in our U.S. and Vietnam locations. For the third quarter of fiscal 2024, we’re seeing steady demand for most established programs relative to our second quarter. As previously announced, the large program with a leading power equipment company is now expected to resume materially in fiscal 2025 with a redesigned product.

For the third quarter of fiscal 2024, we expect to report revenue in the range of $135 million to $145 million. While new programs continue to ramp in our Mexico facilities, efficiency improvements, a muted rebound to pre-COVID production levels amongst existing Mexico customers, and a continued pressure of a strengthened peso have combined to create an excess of overhead in our Juarez facilities. After careful consideration and analysis, we expect to incur a severance expense of approximately $1 million to $2.5 million from headcount reductions in our Mexico-based operations. These severance expenses are unfortunate, but a clear requirement. Among other considerations, the payback period for this decision is expected to be under a half of a year.

Taking all these factors into consideration, we expect net income in the range of break-even to $0.15 per diluted share. In the second half of calendar 2024, we expect continued sales growth in the U.S. and Vietnam, and we have a strong pipeline of potential new business. Over the longer term, we believe that we are increasingly well-positioned to win new programs and to continue to profitably expand our business. That’s it for me. Craig?

Craig Gates: Okay. Thanks, Brett. During the second quarter of fiscal 2024, we continue to ramp many new programs produced in our U.S. and Vietnam facilities, and we remain profitable. We’re also pleased to see improvements in our operating efficiencies, inventory levels, and other improvements made on the balance sheet. Moving into the third quarter of fiscal 2024, we continue to see the favorable trend of contract manufacturing returning to North America. As a result, we continue to expand our customer base and won new programs involving security products, medical devices, and military aerospace. 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 they have become overly dependent on their China-based contract manufacturers for not only product, but also for design and logistic services. Over time, the decision to onshore or near-shore production is becoming more widely accepted as a smart long-term strategy. As a result, we see opportunities for continued growth, and those opportunities are becoming more clearly defined over time. At the same time, we are seeing a sustained trend of a strong Mexican peso and continued wage increases in Mexican wages, particularly along the U.S.-Mexico border. As it has become clear that these changes in the base cost of Mexican production are longstanding, it has also become clear that customers have a different calculus for selecting a geographic location for business they are bringing back from China.

For those customers who struggled with China production due to their flexibility needs, the decreasing cost differential between our U.S. and Mexico plants means they will probably choose one of our U.S. sites. There, we believe, they can enjoy the ultimate in flexibility, engineering support, and ease of communication. Meanwhile, for those customers whose requirements had adapted to the China model of limited flexibility, challenging communications, and slow-motion engineering support, our Mexico facilities remain the answer. Therefore, we are reconfiguring our Mexico sites to endeavor to be a lower-cost, high-quality, but more commodity-level service provider. Over the past 12 months, revenue from our U.S. production facilities has increased approximately 15%.

In Q2 of 2024, production in the U.S. represented about 31% of our total revenue. While our Vietnam facility continues to be a modest contributor to our over-revenue at approximately 4%, production there has increased by about 29% over the past 12 months. Moreover, a growing number of potential customers are actively evaluating a migration of their 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 Keytronic’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’s 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 a one-stop shop in Keytronic, 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 the one-stop shop capabilities we provide. We believe global logistics problems, China-U.S. political tensions, and heightened concerns about supply chains will continue to drive the favorable trend of contract manufacturing returning to North America, as well as to our expanding 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 reflective customers.

We move into the second half fiscal 2024 with a strong pipeline of potential new business. While we’re seeing some improvement in our gross margin, recent wage increases, higher interest rates, and a strong peso will dampen our growth and profitability in the near term. Moreover, we will continue to rebalance our manufacturing across our facilities in Mexico, the U.S., and Vietnam. We remain very encouraged by our progress and potential for growth over the long term. In preparation for our future, we recently announced our leadership succession plan beginning June 30. I am very pleased that our board of directors named Brett to succeed me as president and chief executive officer. I expect to remain a member of the board. We are most fortunate that Brett joined Keytronic in 2004 and has served as our executive vice president of administration, chief financial officer, and treasurer since 2015.

He has assumed ever-increasing roles and responsibilities over the past 20 years. Brett and I have worked very closely, and he has been a critical member of the management team formulating and executing our strategies over the years. In addition, Tony will be promoted to executive vice president of administration, chief financial officer, and treasurer. Tony has served in various financial management roles with us since 2010 and has worked closely with Brett for many years. I am confident Brett, Tony, and their outstanding team will continue to take Keytronic to new heights. This concludes the formal portion of our presentation. Brett, Tony, and I will now be pleased to answer your questions.

See also 15 Most Powerful Asian Countries in 2024 and 15 Best Bitcoin Wallets For iPhone and Android.

Q&A Session

Operator: Thank you. [Operator Instructions] Your first question comes from the line of Bill Dezellem with Tieton Capital. Please go ahead.

Bill Dezellem: Thank you. First of all, congratulations to all three of you for retiring and promotions. So let’s start with my normal first question. Would you discuss each of the three program wins in terms of size and then any interesting details around them, please?

Craig Gates: Yes, the security products are between $10 and $20 million a year and that’s with an existing customer. The medical devices are around, I don’t know, $2 to $5. And military aerospace is around $3 to $10. So the medical devices and the military are both new customers.

Bill Dezellem: So many military and or aerospace products have very high level of qualifications that are required. Sometimes we wonder if it’s to the point of excess and then next thing you know, a door blows off a plane and maybe it’s not to excess. So my question is, did you go through, did you go through the process of getting the equipment and then getting some higher level of qualification than would be normal for, well, a security product or HVAC product or anything of those nature?

Craig Gates: Yes.

Bill Dezellem: And would you like to expand on that further?

Craig Gates: Okay. There are two aspects of that. One is we were concerned since this was, I guess, really our first significant military aerospace program in quite some time that the contractual requirements would be so far out of line that we could never reach a common ground with the customer. And that turned out to be unfounded. So even though we started a long way apart, it seems like that we’re going to be able to make that work as far as a contractual relationship goes. Then as far as the actual manufacturing capabilities and qualification capabilities and in fact, in this case, specialized manufacturing equipment, we did go through a significant qualification period and analysis by our new customer to determine if indeed we could get there. And then some of that is going to continue to serve us well with other perspectives of military customers and aerospace customers.

Bill Dezellem: And Craig, is this a customer that is of a size that would give you the opportunity for a significant amount of business over the coming years if this program is successful?

Craig Gates: Yes. It’s one of the big guys.

Bill Dezellem: Great. Thank you. And then I believe on the last conference call, there was a fair amount of uncertainty that you interjected into what you were seeing in the macro environment and with your customers, many or I shouldn’t say many, some of which that you said you were seeing a pullback in demand. At that point, I believe you said it was nothing that you were panicking over, but directionally the arrow was pointed the wrong way. This quarter, did we hear correctly that demand is stable? And so you would have a different perspective now than you did then? And I’m hoping you’ll talk around those various points, please.

Craig Gates: Okay. This quarter, we would say that the demand has stabilized. There are still ups and downs, but there’s not a consistent down. We’re still confused about the directions of the economy overall. Our customers are still confused. There has been, I think part of why we say our arrow is horizontal rather than down or up is that a couple of the larger customers had been tightening up inventory as they feared an oncoming recession or as they burnt off some COVID-driven inventory. And now that seems to have gotten behind them and us, and so they are increasing their orders again. But saying that, one of those customers, one division has hacked their forecast almost to a third of what it was while the other three divisions are increasing their forecast. So it’s not a, I don’t think we’re at a time right now where we can say it’s stabilized. It’s just that right now the puts and takes are about balancing out. There’s a lot of, go ahead…

Bill Dezellem: After you, please.

Craig Gates: There’s a lot of data that says that even though unemployment looks good, the actual job market is quite a bit tighter than what we’ve gotten used to post-COVID. There’s a lot of data that people, everybody was, the great retirement, the great separation. That data has switched to people are staying in their jobs. The data that says that people, even though they don’t like it, are coming back to the office would seem to contradict the data that says unemployment is very low. Wage increases seem to have taken a pause over the last quarter and a half. So it’s very hard for us to say we have a handle on what’s going to happen next.

Bill Dezellem: An those wage pauses, I presume you’re referring to the US and that is not talking to Mexico, correct?

Craig Gates: Correct.

Bill Dezellem: So let’s use that as a segue to Mexico. Would you please expand on what you are doing in Mexico in the near term with the restructuring and then longer term how you are thinking about it? I’m really looking for more detail than you had in your opening remarks, please.

Craig Gates: Okay. So, boy, Bill, I worked long and hard on those two paragraphs. I hope they were self-explanatory.

Bill Dezellem: They actually were and they actually created a whole bunch more questions.

Craig Gates: Okay. Why don’t you ask me a few of those questions and maybe we’ll kick off that way.

Bill Dezellem: All right. So what was the trigger point that made you decide now is the time as opposed to six months from now or waiting longer to make the decision?

Craig Gates: We started trying to look at all of the quotes we were seeing and really, really dig hard into where we are coming out on just pure cost versus our competitors. It’s always a mix of service level, trust in the company, personal interrelationships, and everything else that goes into a win or a loss on a bid. But we decided it was time with the increasing wages and pesos that we needed to take a hard look at just separating that one component of a decision, which is price. And after we did that, dug into it hard, we started looking at that in relation to the choices people were making on where they wanted their product to go. And it’s kind of an interesting thing. It’s a split between the products that didn’t ever really belong in China.

And before COVID, we had a hard time and we did it. We grew the company doing it, but we had a hard time selling against the downsides or the upsides of China with the downsides of China. And now that people are paying more attention to the downside, they’re willing to pay more to avoid those downsides. So a product that shouldn’t have been in China because it was either an immature product or it was impossible to forecast the demand well or say changes in style required instantaneous changes in production, even though it went to China, it still had all those disadvantages. And when the company, the customer made the decision to come back, when there isn’t that massive delta between Mexico and the states, those customers who really wanted all of that extra service are willing to pay for that service out of the states.

And that’s why we see the growth in our U.S. sites. And it’s not only customers that went to China and then came back. It’s customers who would have gone to China and are now happy that they don’t have to. When I say they are happy, it’s the folks that have to deal with the day-to-day business of getting product made and getting it to where it needs to be to get sold on time. So that, I guess, hurdle has increased to the point where we used to see new business opportunities for the U.S. sites that were in the one that was in the $3 million range. And anybody with a bigger volume than that, and I know volume isn’t the same as revenue, but let’s just say that as it is now. So those smaller programs were making it into our U.S. sites, but the bigger ones we were competing for out of our Mexico site only.

And in the last year, we’ve seen a shift in that hurdle to where people are now wanting to put $10 million programs, $15 million programs into our sites in the states because they recognize the value of the service level that the states can provide at a price that is no longer so much higher than Mexico. On the other hand, that means that the hurdle rate to stay in Mexico has gotten higher and therefore the people who want to stay in China — I meant to say Mexico, the people who want to stay in Mexico are willing to deal with the type of service they got used to out of China. So they’re not willing to pay for the extra services that we had put in place in Mexico over time. And to make that clear, for example, if you’re a customer and you call us up and say, hey, I know I had 10,000 widgets that I wanted next month.

I need them next week. And the way we would make that happen is through a lot of people in the salary ranks who would hustle around and get parts across the border quickly and get lines changed over and monitor the switch and we would move employees and train employees and all that would happen and the customer would be happy, but it costs more. And now those customers who need that type of service are willing to pay U.S. prices. That leaves the folks who aren’t willing to pay for those prices with our Mexico facility competing against other commodity type service levels out of Mexico. So that means we can take a lot of this added service cost out of our Mexico facility without harming the customers who were willing to pay for it before because they’re not there anymore.