Kimball Electronics, Inc. (KE) Q2 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. My name is Michelle and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball Electronics Second Quarter Fiscal 2018 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, February 8, 2018, 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, 2017, and in 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 the call over to Don Charron. Mr. Charron, you may begin.

Thank you, Michelle, and welcome everyone to our second quarter conference call. Our earnings release was issued yesterday afternoon on the results of our second quarter ended December 31, 2017. We have posted a financial summary presentation to accompany this conference call. The presentation can be found on our Investor Relations Web-site 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 second quarter of fiscal year 2018 were up 2% from the previous quarter and up 12% when compared to the second quarter of fiscal year 2017. Double-digit year-over-year growth in our automotive and medical end market verticals helped us set a new quarterly sales record for the eighth consecutive quarter and kept us on pace to exceed our long-stated goal of $1 billion in annual sales in this fiscal year 2018. As we stated last quarter, our compound annual growth rate or CAGR was approximately 8% over the past three fiscal years and our goal is to sustain this growth rate over the next few years through fiscal year 2020, as we look to grow the Company beyond $1 billion in annual sales. Our margins improved slightly in the second quarter of fiscal year 2018 when compared to the first quarter of this fiscal year. However, we are still below our new operating income target of 4.5%. We expect to make sequential incremental improvement toward achieving our new goal as we continue to drive actions to improve our yields and throughput margins on recently launched new programs. Our next phase of ramp-up activity in Romania is on track. We expect our sales run rate to more than double from the fourth quarter of fiscal year 2017 to the fourth quarter of fiscal year 2018, and we expect to approach our operating income breakeven point by the end of fiscal year 2018. The impact of the Romania ramp-up on our second quarter fiscal year 2018 operating income was relatively flat with the same period last year. While we made good progress in fiscal year 2017, we still have work to do to achieve our long-term goal of 12.5% ROIC. Margin expansion and capital efficiency will continue to be priorities of focus for us this fiscal year. We continue to make investments that will drive further growth in sales and profits. We invested $8.7 million in capital expenditures in the second quarter of fiscal year 2018, bringing our fiscal year 2018 total to $14.8 million. As we stated on our first quarter call, due to stronger-than-expected forecasted demand from several of our existing customers, we expect fiscal year 2018 capital expenditures to approximate the fiscal year 2017 level of $34 million. We are focused on securing raw materials, getting through launch cycles, and ramping up production to new forecasted levels. We remain focused on ensuring that the newly deployed capital achieves our expected returns. During the second quarter of fiscal year 2018, we also returned $3 million to our shareowners by purchasing 152,000 shares of our common stock, which brings our total to $41 million and 3 million shares purchased since October 2015 under our Board authorized share repurchase program. And finally, as we stated on our last call, our work has begun on the implementation of our Board-approved updated strategic plan. We are committed to optimizing our EMS business by focusing on capital efficiency, margin expansion and high-quality revenue growth, and we are committed to making new investments that will help us develop our sales beyond EMS to a multifaceted manufacturing solutions company. We are also exploring opportunities that would establish new platforms and create optionality for us in the future. Now, I will turn it over to Mike to discuss our second quarter results in more detail. We will then open the call to your questions. Mike?

Thanks Don. During my comments, I'll be referring to the slide deck Don mentioned, which can be found on our Investor Relations Web-site, 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. As shown on Slide 3, our second quarter net sales were a record $258.2 million, which was a 12% increase compared to net sales of $230.3 million in the prior year second quarter. Partially assisting in the increase from a year ago was a favorable exchange rate movement which affected our net sales growth by 3%. Slide 4 represents our net sales mix by vertical market. Comparing our net sales by vertical to the same quarter a year ago, net sales in our automotive vertical were up over 20% compared to a year ago to a new quarterly record of $116.4 million. The increase from a year ago was largely due to the ramp-up of new program introductions and strong demand in North America and Europe. While our China automotive sales were down year-over-year, we did see a nice improvement sequentially from the prior quarter. Our medical vertical was up by double digits compared to Q2 last year, primarily from the ramp-up of new programs. Our industrial vertical was up from a year ago as a result of the continued ramp-up of new product launches related to smart metering devices as well as increased demand for our climate control products. Lastly, our public safety vertical was down by double-digits from the prior year second quarter as a result of lower overall demand. Our gross margin in the second quarter, reflected on Slide 5, was 8.1%, which was down from 8.9% in the same quarter last year. However, our gross margin did improve sequentially from 7.7% posted in the first quarter of this fiscal year. Our decline in gross margin in the current year quarter compared to a year ago was due in part to the impact on yields and higher cost associated with the support of new product introductions as well as higher domestic healthcare cost during the current quarter. Selling and administrative expenses, Slide 6 in the deck, were $10.8 million in the second quarter, which were up $2.5 million in absolute dollars, and up 60 basis points compared to the prior year second quarter. The increase in selling and administrative absolute dollars compared to prior year was in part due to higher stock compensation which accounted for a 20 basis point increase. Also contributing to the S&A increase are increases in employee salaries and related benefit cost, mostly associated with higher employee count, and expense related to the normal revaluation of the supplemental employee retirement plan or SERP liability. As a reminder, the expense related to the revaluation of the SERP liability recorded in selling and administrative expenses is exactly offset by a gain in the investment in the SERP that is recognized in other income/expense, net. Therefore, the impact from the revaluation of the SERP is neutral to net income. Our operating income on Slide 7 in the deck came in at $10.2 million, or 3.9% of net sales, which compares to operating income of $12.2 million or 5.3% of net sales a year ago. Other income/expense, net was an income of $400,000 in the fiscal year 2018 second quarter, compared to an expense of $1 million in the second quarter of fiscal year 2017. During the current year second quarter, other income/expense, net includes a $300,000 gain on the fair value of investments in the SERP. The prior year second quarter other income/expense, net was primarily the result of net foreign currency exchange losses driven by the strengthening of the U.S. dollar a year ago. Our effective tax rate for the current year second quarter was significantly impacted by enactment during the quarter of the U.S. Tax Cuts and Jobs Act, the tax reform. The tax reform lowered the U.S. corporate federal tax rate from 35% to ultimately 21%. However, as we are a June 30 fiscal year end, our current fiscal year blended federal statutory rate will be 28.1%, with the new 21% rate kicking in for our fiscal year 2019. While we applaud this move of lowering the corporate federal tax rate and believe this is positive for U.S. businesses and expect in the long run it will improve the competitiveness of U.S. businesses in the global market, it did have a significant unfavorable impact for us during the current quarter. The tax reform imposed a one-time deemed repatriation tax on accumulated unremitted foreign earnings of 15.5% for the accumulated unremitted foreign earnings held in cash and other liquid assets, and 8% of the residual accumulated unremitted foreign earnings. We estimated and recorded in the current quarter approximately $12.8 million of tax expense for the deemed repatriation tax, which is payable over an eight-year period. In addition, as a result of the change in the U.S. statutory rates, we were required to revalue our deferred tax assets as of December 31, 2017 using the new rates, which resulted in the recording of additional tax expense in the current quarter of approximately $3.8 million. These discrete tax items had a $0.62 unfavorable impact to diluted earnings per share for the quarter. Slide 8 reflects our net income trend. In the second quarter of fiscal year 2018, we recognized an $8.3 million net loss as a result of the tax reform. However, our non-GAAP adjusted net income for the current quarter, excluding the discrete tax items related to tax reform, was $8.2 million, which compares to net income of $7.8 million recorded in the prior year second quarter. We recognized a dilutive loss per share of $0.31 in the current year second quarter, while our non-GAAP adjusted diluted EPS was income of $0.31, which excludes the $0.62 impact from the discrete tax reform items. Diluted EPS in the prior year second quarter was $0.28. Cash and cash equivalents at December 31, 2017 were $35.6 million. Operating cash flow trends are shown on Slide 11. Our cash flow from operations during the current year second quarter was a strong $11.6 million, as our net loss adjusted for depreciation, income tax charges related to tax reform, and an increase in accounts payable more than offset usage of cash related to an increase in inventory. Our cash flow from operating activities in the prior year second quarter was $12.1 million. Our cash conversion days increased one day for the three months ended December 31, 2017 when compared to the same period in the prior year, as our PDSOH, our Production Days Sales on Hand, which is our inventory metric, increased by six days to support increased volumes and new introductions and implementation of new inventory management program for one of our largest medical customers, which more than offset an increase in our accounts payable days compared to the prior year quarter and a reduction in our days sales outstanding receivables metric. Slide 12 reflects our capital and depreciation trend. Capital investments in the second quarter totaled $8.7 million, largely related to our investment in new manufacturing equipment to support increased manufacturing capacity, and new product awards. As Don mentioned, we repurchased $3 million of our common stock during the quarter. Borrowings on our credit facilities at December 31, 2017 were $11 million, which was up $1 million from June 30 of 2017. Our short-term liquidity available, represented as cash and cash equivalents plus the unused amount of our credit facilities, totaled $96 million at December 31, 2017. I would like to conclude by saying, our balance sheet is very strong and we are well positioned to support our continued growth. With that, I would like to open up today's call to questions from our analysts. Michelle, do we have any analysts with questions in the queue?

[Operator Instructions] I am showing we have a question from Hendi Susanto with Gabelli & Company. Your line is open. Please go ahead.

First question, it's good to see strength in automotive, and you mentioned there is some ramp-up of new product introductions, where are we in terms of the ramp-up? Do we still have some leg for further ramp-up for the next several quarters or the ramp-up may have reached some kind of the final stage?

No, we still have programs that are launching for the remainder of this fiscal year, Hendi. So, we are quite busy in launch mode. I would say though, pretty similar activity level as we've had over the last four or five quarters. So, we still have two or three quarters ahead of us, so it look a lot like the last four or five quarters in terms of ramp-up activity in automotive.

So, will that imply that further sequential growth every quarter?

Hendi, we don't give guidance as you know on our sales projection, but certainly as we ramp up new programs in automotive and we launch those programs, there's a certain amount of visibility and predictability that we do have given just the characteristics of that end market vertical. So yes, we would expect continued strength in automotive because of our existing base combined with the new program launches that we have going on ahead of us, yes.

Okay. And then, Mike, you mentioned that the 21% tax rate will kick in 2019. Is that fiscal year 2019 or calendar year 2019?

The fiscal year 2019, Hendi.

Okay. So, Q4 will still see the same tax rate as in Q3?

Similar, yes.

Okay. And then how much of a drag now the ramp-up of your Romania facility?

How much was the impact?

Yes, on the operating margin.

It's been running around 40 to 50 basis points on our operating income line, Hendi. And as I said today in the Webcast, we believe the phase of ramp-up that we're in is on track and that we will be approaching our breakeven on the operating income line in the fourth quarter of this fiscal year.

And that would you be able to tie up when you start breakeven, how much utilization, let's say like qualitatively?

Can you repeat that, Hendi? I don't know if I caught you.

When you said that you are targeting breakeven in your Romania facility by the end of fiscal year 2018, how should we relate that to let's say the utilizations?

The utilization of the operation?

Yes.

So, yes, we would put our utilization somewhere in the 55% to 65% range at that point in time. And again, that would be for the Phase 1 of the Romanian facility. So, we would still have our further expansion plans available to us, which is important to our European customer base, but the current structure would be somewhere between 55% and 65% utilized as we exit the fourth quarter of this fiscal year.

Okay. And then, Don, can you share what kind of business insights for every vertical that you are expecting for the March quarter?

Can you ask that again, Hendi? I'll make sure I understood your question.

Okay, like the business environment for your different verticals for the March quarter?

Yes, I think we exited Q2 with obviously some pretty good momentum with 12% overall growth, and of course automotive and medical both together leading the way with very strong growth. We feel that momentum coming with us into the third quarter of our fiscal year. So, yes, I would say across all four end market verticals, we are seeing some good momentum, maybe with the exception of public safety which is a little bit lumpier for us, it's our smallest vertical, but when we look at automotive, medical, and industrial, we carry some good momentum with us out of the second quarter of our fiscal year 2018 into this quarter that we're currently in.

Okay. And then last question for me, how should we think about share buyback in fiscal year 2018? You did lot of share buyback of like 22 million in fiscal year 2017. Should we expect like a similar magnitude?

There's a number of factors that play into the buyback program, obviously the market conditions, other options of investments that we have available to us, our current operating environment, a number of factors that will weigh into it. We have approximately $19 million left on the Board authorized buyback program, and so we certainly will continue to keep return to our shareowners through the buyback as part of our shortlist of priorities for capital allocation as we go forward. As I mentioned in my closing, we are really excited about our Board-approved updated strategic plan and we do see ourselves looking at making future investments to support that updated strategic plan. And so, certainly as we think about capital allocation and priorities going forward, some of the things we want to do relative to our updated strategic plan will be priority items on that list.

Got it. Thank you, Don. Thank you, Mike.

Our next question comes from the line of Chase Basta with AWH Capital. Your line is open. Please go ahead.

Can you help us understand the cash implications of the deemed repatriation tax charge?

Sure, I can talk a little bit to that. The deemed repatriation calculation, as we mentioned, it was a pretty significant expense that we booked in the quarter. But the payment schedule on that to the government is over an eight-year period. So, the first five years 8% of the balance is due, and then in the last three years it goes to 15%, 20% and then 25%. So it's kind of a back-loaded effect. And so we'll see that effect in our cash flow over the next eight years.

Okay, that's helpful. Then you guys, you mentioned that the Romania headwind in terms of its impact on the gross margin was around 40 to 50 basis points a quarter. What needs to happen to get to breakeven? Do you need new customer wins or is the order book built, I mean what needs to happen along the way to kind of ramp to breakeven in Q4?

It's top line growth, and I think the good news we had reported there is that we feel like we've got good visibility to that growth in Q3 and Q4 this fiscal year. As you may recall from previous quarters, we talked about how critical it was to get customer approvals and to get to validation protocols, and therefore have a predictable ramp ahead of us. We've done that for the most part. We've got a very predictable ramp ahead of us. That's what gives us confidence to say that we're on track as we ramp up Q3 and Q4 to approach our breakeven point on the operating income line in the fourth quarter of this fiscal year.

Okay, so you hit breakeven in Q4, so Romania goes from being a negative 40 to 50 basis impact on operating margin, but how should we think about how additive that could be kind of once you're on the other side of breakeven?

It's hard to say because on the other side of that we've got more work to do to secure more business wins and to continue to ramp-up in Romania, but as we look at the quarter we just finished at 3.9% operating income, we feel like with the work we're doing getting Romania to operating income breakeven in the fourth quarter this fiscal year, basically holding serve everywhere else in our Company, in our footprint, we could be approaching our goal of 4.5% operating income at the same time we get Romania to breakeven.

Okay, that's helpful. Thanks guys.

[Operator Instructions] I'm showing no further questions at this time and I'd like to turn the conference back over to Mr. Don Charron for any closing remarks.

Thank you, Michelle. 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 great day.

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