Kimball Electronics, Inc. (KE) Q3 2016 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. My name is Raniya, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball Electronics Third Quarter Fiscal 2016 Financial Results Conference Call. All lines have been placed on listen-only mode to prevent any background noise. After the Kimball speakers' opening remarks, there will be a question-and-answer period where Kimball will respond to questions from analysts. [Operator Instructions] Today's call, May 5, 2016 will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Risk factors that may influence the outcome of forward-looking statements can be seen in Kimball's annual report on Form 10-K for the year ended June 30, 2015 and today's release. The panel for today's call is Don Charron, Chairman of the Board and Chief Executive Officer, and Mike Sergesketter, Vice President and Chief Financial Officer of Kimball Electronics. I would now like to turn today's call over to Don Charron. Mr. Charron, you may begin, sir.

Thank you Raniya and welcome everyone to our third quarter conference call. Our earnings release was issued yesterday afternoon on the results of our third quarter ended March 31, 2016. We have posted a financial summary presentation to accompany this conference call. The presentation can be found on our Investor Relations website within the Events and Presentations tab, or if you are listening via the webcast, you can find it in the Downloads tab on the webcast portal. I will begin by making a few remarks on the overall quarter and then I will turn it over to Mike for the financial overview. After that, we will answer any questions that you may have. Our sales in the third quarter of fiscal year 2016 improve slightly over both of previous quarter and the same quarter last year. Led by a double-digit increase in China and further strengthening in Europe. Sales in our automotive end-market vertical were up 14% when compared to the same quarter last year. We completed the launch and transition from our current and next generation product for one of our largest customers, which helped to increase the sales on our medical vertical by 10% when compared to the third quarter of fiscal year 2015. Our sales in our public safety end-market vertical were down 8% year-over-year on lower demand. And our sales in the industrial end-market vertical were down 11% when compare to the third quarter of fiscal year 2015. However, we were encouraged by the sequential increase in our sales in the industrial end-market vertical, which were up 7% from the second quarter. We are making good progress on the launches of a number of new business awards with both existing and new customers. We are expecting sales from these launches starting in the fourth quarter of this fiscal year. Now our new business opportunities pipeline remains healthy and we continue to work diligently to achieve our medium range goal of $1 billion in annual sales by fiscal year 2018. As we have stated previously, over the last few quarters and continuing in this quarter, our operating margin is under pressure due to incremental cost related to the Romania Greenfield start-up and capital deployments for new customer programs in advance of revenue. Margin improvement through cost control and productivity improvements continues to be a high focused are for us, as we remain committed to our 4% operating income goal. We continue to excellent progress in Romania, since completing the construction of a new facility in November 2015, we went live with our ERP system and passed our ISO quality management system certification audit. We also hosted several customer audit and during this past quarter, we received approval from one of our industrial customer to begin production. Also during this past quarter, we produced validation units for one of our automotive customers. Once we receive the customer approval, we expect a steady ramp up of revenue over a multi quarter period. We continue to take advantage of the flexibility provided by our strong balance sheet, making investments that will drive future growth in sales and profits. After investing $37 million in capital expenditures in fiscal year 2015, we are on pace and expect to invest slightly more than that in capital investments in fiscal year 2016, with the largest portion of these capital expenditures directly supporting new business awards. We are focused on getting to the launch cycle, ramping up production and ensuring that these new program and the newly deployed capital that supports them to achieve our expected returns. During the third quarter of fiscal year 2016, we also returned $4.4 million to our shareowners by purchasing 402,000 shares of our common stock, which brings our total to $8.2 million and 745,000 share purchased under the $20 million share repurchase program approved by our Board in October of 2015. And finally, we are excited about the Medivative acquisition which we closed on May 2, and was disclosed in our Form 8-K yesterday. Medivative adds capabilities in the clinical design, precision plastics, combination devices, instruments and complex system assembly to our overall package of value and positions us to better serve both existing and new customers in our medical end-market vertical. Medivative has been successful building long term relationships with a number of well known medical and bioscience customers and we look forward to growing relationships in the future as Medivative becomes a unit of Kimball Electronics. Now I will turn it over to Mike to discuss our third quarter results in more detail. We will then open the call to your questions. Mike.

Thanks Don. I'll briefly cover for financial highlights for the third quarter then as Don mentioned will open the call for your questions. Our third quarter net sales were $214.1 million, which was a 4% increase compared to the net sales of $206.9 million in the prior third quarter. Comparing our net sales by vertical to the same quarter a year ago, our automotive vertical was up driven by higher demand in all markets with China leading away. Our medical vertical was up on an increase demand from existing customers and as Don mentioned the successful launch of a next generation product for one of our largest customers. Our industrial vertical was down as a result of lower end-market demand, largely for climate control products and our public safety vertical was down from lower demand in certain governments programs. Our gross margin in the third quarter was 7.6%, which was down from 9.2% in the same quarter of last year. Margins are tighter partly the result of contracted customer price reductions running slightly ahead of productivity improvements. Product mix, foreign currency fluctuations, and costs associated with new product introductions, have also impacted margins. Selling and administrative expenses were $9.1 million in the third quarter, which were up almost $1 million or 30 basis points compared to the prior year third quarter. Selling and administrative expenses in the current year quarter included incremental costs of $700,000 related to our Greenfield start-up in Romania. Costs related to the spinoff in the third quarter a year ago were $300,000. No spinoff costs were incurred in the current quarter year third quarter. As we mentioned in our call the last couple of quarters, the spinoff is substantially complete. Other income and expense in that was income of $200,000 in the fiscal year 2016 third quarter compared to an expense of $900,000 in the third quarter of fiscal year 2015. Included in other income and expense during the current year third quarter are net gains of $300,000 related to foreign currencies and derivatives as a result of exchange rate fluctuations. The prior year third quarter included net losses of $900,000 related to foreign currencies and derivatives. The effective tax rate for the current year of third quarter was a negative 2.3% as a result of the $1.8 million discreet of foreign tax benefit we recognized during the quarter resulting from available tax growing related to the capitalization of our Romania subsidiary. The effective tax rate for the prior year of third quarter was 27.6%. Net income in the third quarter of fiscal year 2016 was $7.5 million compared to $7.2 million in the third quarter of last year. Adjusted net income, excluding spinoff costs, was $7.5 million in Q3 of last year. Diluted earnings per share were $0.26 in the third quarter of this fiscal year compared to $0.25 in the prior year quarter. Cash and cash equivalents at March 31, 2016, were $59.8 million. We had a strong cash flow provided by our operations during the current year third quarter of $11.7 million compared to $7.7 million provided in the third quarter last year. The strong operating cash flow during the quarter was primarily the result of the earnings plus noncash adjustments, and an increase from accounts payable. Capital investments in the third quarter totaled $8.6 million, largely related to our investment in new manufacturing equipment to support new product introductions capacity and our new Romania operation. As Don mentioned, we also repurchased $4.4 million of our common stock during the quarter. Our short-term liquidity available, represented cash and cash equivalents plus the unused amount of our credit facilities, totaled $116.5 million. As Don mentioned the Medivative acquisition which closed earlier this week the acquisition price was $8.3 million in cash subject to own closing working capital adjustments and was splendid with available liquidity. The acquisition as expected add approximately 2% to our sales run rate with further upside potentials three to four quarters out. We anticipate Medivative to be neutral for slightly accretive to our earnings in the next fiscal year. Our balance sheet continues to be very strong and we think we are well positioned for growth. With that, I would like to open up today's call for questions from the analysts. Raniya, do we have any analysts with questions in the queue?

[Operator Instructions] And our first question comes from the line of Herve Francois from B. Riley. Your line is now open.

Herve Francois thank you. Guys thanks for the call. Jus in regards to the start-up cost in Romania, how much further I guess how many more quarters do you expect that to take place, are you pretty much crowning. I think you said you are coming to an end on that and then going forward since you received the tax benefit in the quarter because of the Romania operations how do you see your tax rate corporate wise going forward.

Okay. And maybe I'll take the first part of that question Herve, this is Don Charron. And then I’ll let Mike take the part about the tax part relating to the tax question. In terms of Romania where we are in the process of getting customer approval and certification in place to start production. I mentioned we received approval from one of our industrial customers and that’s a huge milestone for us to achieve that allow us to begin to ramp up production for that customer and certainly would pave the way for other industrial customers. It’s a little bit more difficult in terms of getting qualified and certified for automotive which is the next step. And we have built validation units but we've not yet cleared the validation testing protocols and received customer approval to begin production. And we expect that to happen in this quarter that we are in, but there is still a variable that if we haven't been approved. So we are not approved until we are approved. But once that happens, we expect, as I mentioned it would be a multi quarter ramp up, normally the risk mitigation strategy around start-up like this involves dual production for a period of times. So that’s why we are saying it would be a multi quarter ramp up of this nice program. We got a way to go yet with Romania in terms of getting it back to profitability, it’s at least several quarters for us, but we are making excellent progress.

And in regarding your question on a tax rate. The tax benefits that we received related to the start-up in Romania, which is really a one-time tax benefit and going forward we would expect our tax rate continue to settle in somewhere in the mid 20%, 25% somewhere in that range.

Got you that’s helpful. If can have a follow-up, again if you think about the gross margin base off of what you said it could be a multi quarter ramp. So do you expect that to continue to have pressure on your gross margins over the next several quarters as well as you are not only with this new industrial customers, but then you are also waiting to get the validation protocols on the auto side?

Yes, we expect it to impact our margin over the next several quarters at least three to four quarters now from where we are. And again, the variable there is we have not yet received automotive approval and so we hope to have some good news on that soon, hopefully maybe on our next conference call, in term of actually achieving that approval. And I think once that happens we will be able to build a little bit more predictable path to at least where Romania has been neutralized or contributing to our operating profit. But it's at least three or four quarters out.

Okay guys, thanks very much. I’ll go ahead and get back into the queue. Thank you.

[Operator Instruction] And our next question comes from the line of Hendi Susanto from Gabelli & Company. Your line is now open.

Don and Mike good morning. Would you be able to share some color on the weaknesses in public safety and industrials, what were the corresponding end-markets that resulted in your year-over-year decline, does that reflect your customers, the markets or both?

Yes so I will start will public safety, that end-market vertical is our smallest vertical, so any movement there can look larger in the percentages than obviously the absolute dollar movement. And that particular end-market vertical for us Hendi is probably the most lumpy from quarter-to-quarter, in terms just how the demand flows through the system. I don’t know that other than as Mike mentioned, we did see a few programs that are more tied to government spending that seems to slow in the quarter, I wouldn’t say that that’s trend you may correct itself in the upcoming quarters, it's just the nature of that business tend to be a little more lumpy in the way it comes through to fulfillment. On the industrial end-market vertical, as we reported in the last couple of calls, it's been sluggish in a number of area within our end-market vertical there. Mike mentioned climate controls, that’s been an area that been a little bit soft when you compare the revenue for this quarter to last year at same time. But it's not just that one sub category if you will, we look across the board at our industrial end-market vertical and we had just been sluggish in a number of areas. I think at least with the sequential growth there been up 7% over the prior quarter. We are hopeful that maybe we've seen the bottom and maybe we will start to see gradual improvement in the upcoming quarters on our industrial vertical, because we were have some really good customers that we support in that end-market vertical. Frankly the market leaders and so we think once we overall end-market improves we will see that pretty quickly in our demand, because of the quality or customers we have in that vertical.

Okay and then a question for Mike. So let's say excluding the Romania start-up costs, do you have any estimate on the gross margin, in other words how much impact the Romanian start-up costs on the gross margin and then how much further upside is the Romanian facility has fully ramp up in the future.

Well Hendi, on the impact of Romania right now the start-up costs are pretty much out flowing through the S&A. as we started production we will see those costs move, but in the short run there is really very little impact on gross margin, it's all in the S&A line. So we will see that started shift over the next couple of quarters as we ramp up production and revenue.

I see. Thank you.

Thanks Hendi.

[Operator Instructions] And we do have a question from the line of Austin Hopper from AWH Capital. Your line is now open.

Hey guys good morning. You've talked to fair amount about Romania, I just was hoping can you maybe helps us understand kind of your expectation on the revenue specific on the revenue ramp for Romania over the next few quarters?

Yes, so I think a couple of comments maybe that will help you understand what were facing there. So coming back all the way to I guess the primary driver in terms of making that investment in Romania was driven by the fact we were approaching full capacity in our Poland operation and so expanding Romania was driven primarily by capacity needs. And so in the first phases of what we're doing in terms of establishing revenue and the facility is actually a programs that are currently run in our Poland operation and identified as candidates to be moved to free up capacity in Poland and obviously start revenue in Romania. So that part of our plan is fairly predictable and that we’re in control of everything except the validation and customer approval process that's where the variability comes in. And again, I think it's very positive that we got the approval on the first project on the industrial side, we are now starting to ramp revenue there and then the next big step for us is getting automotive approvals and so until we have our automotive certification, quality system certification and approval from the first customer. It's difficult to build a predictable path to when we could see that revenue ramp will at least get us to the breakeven point for the operation. But we have a number of programs that are lined up behind both of these initial projects that I'm speaking about. So we really hope that once we get the automotive approval like we have the industrial approval that we will see projects fall in line rate after that and we will start to be able to build a more predictable path on that ramp up. So it's really key for us right now in this particular quarter. As we as I stated in my comments that we built the validation units, we've had the customer on-site were going through testing as we speak on those validation units. So we are hopeful that will receive word this quarter and I think that's a pretty key piece for us then as we move forward with our plan for ramp up.

Okay. And the revenues that you are talking about are they additive to the company or are they revenues basically coming from your other facilities?

Well in the end they are additive, the programs that are transferring from Poland will be backfilled it with new business awards that are targeted for our Poland operation. So we continue to have good attraction in Europe overall with our growth plans there. So yes, while we are transferring a couple of programs from Poland into the new business opportunity pipeline that I spoke of for the whole company is also very healthy in Europe. So yes in the end it will be additive growth to the company.

Okay, I'm sorry. You said that - what was the $700,000 cost associated? Was that kind of what Romania cost in the quarter or...

That was Romania. Yes.

Okay. And that's in the S&A line I think you mentioned.

That’s correct.

And so as you ramp on revenues, I was just trying to understand the nature of that. As you ramp up revenues, you have additional cost associated with that? And just as you ramp on revenues is that $700,000 on a net basis go down or is it just additional cost as well?

Yes. Let me talk a little bit about that as we were talking about this heavier than normal period we are in, in terms of new product introduction typically what we see in our business especially with the automotive end-market vertical is that we are deploying capital and adding resources in advance of the revenue. The launch cycle typically is anywhere from 18-months to 24-months and so as we get closer to building validation units in that cycle we’re deploying the capital. And certainly as I mentioned, we are adding resources that would in part be found in the S&A line, but also in part found in the cost of goods sold line. And that’s going to advance sort of revenues developing. Once the revenue begins than we go through a period where we’re ramping up and in some cases if it's a multi vehicle platform that we are supporting, there is a stagger that exist in each vehicle platform that's introduced. So we may go through a six-month or nine-month sort of ramp up of each of those vehicle platforms even after we’re approve for series production. So were in the middle of that right now with a couple of very large automotive programs and so when we talk about the impact on our margins, it's just for that reason. it's the capital we deployed and the resources we've already added to support those programs and again it's in advance of the revenue developing.

I think just as a little clarification on Romania being at start-up, all the cost had [indiscernible] until production begins and once production ramps up a lot of those cost will move into the cost of goods sold. So there are some added cost, the $700,000 some of that will move above the line and we will be then offset with the revenue and so forth as we launch that operation.

Okay guys. Thank you.

[Operator Instructions] And we do have a follow up from Herve Francois from B. Riley. Your line is now open.

Yes hi guys. So just a follow-up. I guess once you include the Medivative acquisition that closed earlier this week and then I guess when you talk about getting to full ramp within Romania, how do you think your operating margins are going to look like at the corporate level?

Yes well I would with a just a goal of getting back to the 4% operating income number. Obviously with where we are at right now in the gross margin line and where we are at with SG&A, we’re off of that by a margin that’s coming in at 3.3% this quarter versus our 4% goal. So we are focused on getting back to that 4% operating income level on a consistent basis. Obviously Romania is a key part of that, continuing to ramp these NPIs that I spoke of is a key part of that. We do expect in this quarter to start to see some measurable revenue from the NPIs as I mentioned in the webcast earlier. So we hope that we are on a path to start to seeing some consistent improvement back towards our goal of 4% operating income. But we recognize that getting through the Romania ramp up is really critical and these next two quarters really in terms of the NPIs we’re working on are going to be also very critical to help give us firm footing on our way back to that 4% number.

And just to be clear the NPI ramps are you talking about is that across the sectors and across your company or is that predominantly from Romania - the NPIs?

Well it's across the company all four verticals and really with the addition of Medivative, eight facilities all of which have some level of NPI activity going on. I would say by vertical though, its heaviest in the automotive end-market vertical for us and so the activity is highest there, but really it's beyond just Romania's NPIs it's NPIs - if you look at our CapEx I think it's a pretty good indication of you know when I said heavier than normal activity in this area. I think if you look at our historical results, our CapEx would be more normalized around the rate of depreciation it's slightly higher than that. And if you look at what we did last year on CapEx at $37 million being on-track for this year to be slightly higher than that with the majority of those expenditures really going to equipment to support these new product introductions. You get a sense for just how heavy the period is for us and how heavy it's been for us. That rate would be nearly twice depreciation current depreciation, so it's pretty heavy activity for us across the board all four verticals and now with Medivative all eight plants.

That's helpful. Thank you.

And our next question comes from the line of [Indiscernible] from Claret Asset Management. You may go ahead.

Hi good morning both. Just a question from me. Let me just go back to the industrial space of your business, I was wondering if you can give us more color about the climate control some mixed sale during the quarter? Any thoughts would be helpful in terms of the content of the dynamics you are seeing there? Thanks.

Yes. So we have a couple of pretty large customers that make up the majority of that sort of sub vertical of the industrial vertical of our business. One based in Europe and one based in the U.S. and so in general we would say that we see the softness in both areas. So one primarily serving the Euro zone let’s say and the other one serving NAFTA, we don’t really see too much difference on the end-markets from the geographic standpoint. It just seems like there has just been a general slowing in spending in those areas that's effecting the overall end-market demand. I think obviously when you are talking about climate controls, so that there is a lot of things that can impact that overall end-market demand spending levels in one but also the weather patterns and others obviously contributing to that. And then you also have in some cases legislation that is contributing to that in terms of energy efficiency requirements and what the OEMs in that space have to face going forward to be able to hit or managed their business to those requirements. There is a number of pieces to the puzzle to try to figure out what's really going on. As I said before, we've been looking at now a multiple quarter sort of softness here and we’re at least encouraged by the fact that we ticked up a little bit this quarter when compared to the last quarter a little bit being 7% and so were hopeful of that regular bottom is behind us.

Okay. Thank you.

And at this time, I'm not showing any further questions. I would now like to turn the call back to Mr. Don Charron.

Thank you Raniya and that brings us to the end of today's call. We appreciate your interest and look forward to speaking with you on our next call. Thank you and have a good day.

At this time, listeners may simply hang up to disconnect from the call. Thank you and have a nice day.