Key Tronic Corporation (KTCC) Q1 2013 Earnings Report, Transcript and Summary

Welcome to the Key Tronic Corporation First Quarter Fiscal 2013 Conference Call. [Operator Instructions] As a reminder, today’s conference is being recorded Tuesday, October 30 of 2012. Now I would like to turn the conference over to Mr. Craig Gates, President and CEO. Please go ahead, sir.

Good afternoon everyone. I’m Craig Gates, President and Chief Executive Officer of Key Tronic. I’d like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Ron Klawitter , our Chief Financial Officer. Today we released our results for the first quarter of fiscal 2013. It was another good quarter for Key Tronic marked by a record quarterly revenue and increasing profitability. Our success continued to be driven by our unique combination of world-class engineering and global footprint and via the competitive advantages that result from our vertical integration and expanding production capabilities in Mexico, China and the U.S. We continue to capture market share and grow faster than many of our competitors. However this growth has been powered by an increasingly diverse mix of new customer programs. At the end of the first quarter of fiscal 2013, we generated revenue from 168 separate programs with 51 different customers, up from 135 programs with 36 customers at the end of the prior quarter. As our business has grown, we continue to overcome many challenges associated with rapid growth, steep program ramps, product mix changes and the addition of new facilities and people. We’ve focused on optimizing product design, production processes and supply chains and made changes in our business processes to enable continued profitable growth. As a result, we continue to see increases in our margins and profitability. During the quarter, we continued to expand our customer portfolio across a wide range of industries with the wins of new programs involving solar energy and power management products. While these new program wins will take many months to move into production, the outstanding unique services that we provide our customers during the ramp phase have played a key role in our growth of becoming a power differentiator to help us win new programs. Now, I would like to turn the call over to Ron to review our financial performance. Then I will come back to discuss our strategy going forward. Ron?

Okay, thanks Craig. 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 quarter ended September 29, 2012. For the first quarter of fiscal 2013 we reported total revenue of $97.5 million. This is up 40% from the $69.8 million in the same period of fiscal 2012. Despite the fact that we have been moving many new programs into production, we’ve continued to improve our gross margins. Our gross margin was approximately 10% in the first quarter of 2013. This is up from 7% in the same period of fiscal 2012. For the second quarter of this year, we expect to see our gross margins continue to be around 9% to 10%. Our total operating expenses were $3.8 million in the first quarter of fiscal 2013. This is up 12% in the first quarter of last fiscal year but up much less than our year-over-year growth in sales. Of all the new program start-ups that fueled our revenue growth have required addition of new engineers and program managers who have done a pretty good job of controlling our costs. Our operating margin was 6% in the first quarter of 2013. This is up from 2% in the same period of fiscal 2012. Our increased revenue and operating efficiencies had a positive impact on our bottom line. Net income for the first quarter of fiscal 2013 was $3.7 million or $0.35 per diluted share. This is up 200% from the $1.2 million or $0.12 per diluted share in the same period of fiscal 2012. Turning to the balance sheet, we continue to maintain our strong financial position as we expand our business. Our inventory was down $1.5 million or 3% in the previous quarter which reflects our planned reduction in safety stock associated with the completion of our production line move between 2 of our facilities in Juarez, Mexico. Our trade receivables were $56.7 million at the end of the first quarter. And our DSOs were approximately 50 days, which is comparable to recent quarters. Our capital expenditures for the first quarter of fiscal 2013 were approximately $740,000, and we expect our CapEx to be about $5 million for fiscal 2013, which again is comparable to fiscal 2012. Moving into the second quarter of 2013, we anticipate more of our customer programs moving into production and gradually ramping up. At the same time we still face an uncertain global economic environment with many of our competitors are projecting sequential declines in revenue. In addition, some of our older programs have reached maturity, which means they're not growing but are either at a sustained production level or declining. Taking these factors into consideration, we anticipate that second quarter of fiscal 2013 will look similar to the first quarter with revenue in the range of $93 million to $99 million. In the second quarter, we expect our gross margins to remain around 9% to 10%. We also expect our operating expenses to continue to increase at a slower rate than our revenue growth in coming periods. Taking these factors into consideration, we expect earnings in the range of $0.32 to $0.38 per share in the second quarter. This expected earnings range assumes an effective tax rate of 30%. In summary, the financial health of the company is excellent, and we believe that we are well-positioned to continue to profitably expand our business. That’s it for me, Craig.

Okay. Thanks Ron. Moving into the second quarter of fiscal 2013, we continue to believe our fundamental strategy remains sound. There are 3 major competitive advantages behind our continued success. First, increasing costs in China are driving demand for more localized production, Mexico for North American end users and China for Asian end-users. Among EMS providers, we stand alone in the excellence and breadth of our Mexican operations. Second, our unique organizational structure, which we’ve honed over 25 years of experience in running offshore operations, brings significant advantages to OEMs. Our growing portfolio of customers increasingly want offshore cost savings but fear IP loss, do not want to manage an offshore relationship, fear offshore schedule risk and inventory uncertainty and want U.S.-based engineering and prototyping. Third, our size and responsiveness compared to our degree of vertical integration and engineering capability become even more attractive as the push for localized production intensifies. While our growth has moved us into the Tier 2 category as an EMS provider, we continue to provide the flexibility of a Tier 3 provider and the capabilities of a Tier 1 provider. With these 3 competitive advantages powering us, we expect to continue to win market share. While mix changes in our program portfolio and costs associated with ramping up new programs will continue to be a part of our business, we expect our sustained focus on controlling cost on many production processes and enhancing our design capabilities will continue to result in competitive advantage. This year we expect to be approximately the sixth largest U.S.-based contract manufacturer. Despite the continued macro-economic uncertainty and short-term signals of market degradation from our competition, we have positive business momentum and an increasingly diversified customer base. We anticipate more of our new customer programs moving into production and gradually ramping up and our pipeline of new business opportunities remains robust. Over the longer term the EMS market is expected to see growth, and we believe Key Tronic is increasingly well-positioned to continue to capture market share and capitalize on emerging opportunities. This concludes the formal portion of our presentation. Ron and I will now be pleased to answer your questions.

[Operator Instructions] And our first question is from the line of Bill Dezellem with Tieton Capital Management.

A couple of questions. First of all, just the same one I ask every quarter. The new programs that you won, what size were those?

I think the smaller one was about $3 million and the bigger one was $50 million.

And given that you spent time in your opening remarks describing your competitive - 3 competitive advantages, would you please kind of take those 2 programs that you won this quarter and relate those to those competitive advantages? And maybe also tying in to what you had mentioned on, I think, it was last quarter’s call, how products that are more unique rather than just traditional board stuffing, you really have an opportunity to do better than your competition because of your capabilities?

Okay. Well the first program, the smaller of the 2 is a U.S.-based production that we’ve won for our facility up here in Spokane. But we’re attractive to this customer because if they were to grow the product could potentially move to Mexico and benefit from the fact that the machines that we have here in Spokane are exactly the same as the machines that we have in Mexico, which are exactly the same as the machines that we have in China. So the way we set up our factories a customer can choose us without having to place his bet on the factory that he wants to utilize. And then if the business changes in size, either gets bigger or smaller, it’s simply a matter of calling us and talking to that customer’s program manager and saying that well, our forecasts have gone up, and we think we have the volume to support production in Mexico. So please move it. With the normal -- normally organized competitor of ours, which most of them are organized in this fashion, the various facilities are stand-alone profit centers. And when you try to move a piece of business from say Mexico to China, you as the customer have to act as the referee, because the facility that’s losing the business doesn't want to let it go and the facility that’s gaining the business wants to take it quicker, and there are often hand-offs and trade-offs that have to happen, which don't happen smoothly when the 2 organizations that are supposed to deal with each other are fighting. Well, there is the internecine strife aspect of it that does not happen in Key Tronic, because we run our locations all as cost centers, factories only. They're not revenue centers, they are not P&L centers. And in fact, they're not procurement centers. So they are simply a manufacturing site. So when it comes to actually managing moves-in and moves-out they are not responsible for that. On top of that, the fact that we got them organized such that all of the documentation, all of the methods, all of the MRP material resource planning is centralized in Spokane means that a move from one factory to another is no big thing. One thing that’s happening is that raw materials are going to a different facility, but they're using the same processes, they’re using the same equipment. They are using the same training manuals. They are using the same inspection methods as what was currently qualified in one of the other factories. That’s pretty unique. We don't see that and hardly any of our competitors and our customers tell us they value that very, very highly. So the other program is based on the fact that it’s currently in production but the customer is looking for our help in redesigning both the external and the internal portion of the product. Internally they want our help in taking costs out of the product by redesigning the electronics that are inside of the product. And then they want our help in conjunction with industrial design, I’ll call an ID house if I am not careful with, an ID house that will make the cool sexy curvy shape that we can help them implement into a reality by using our mechanical design skills to do the mechanical design of the curvy sexy shape. And then the plastic molds, the construction of the plastic molds, the trials in plastic molds, implementation of plastic molds, be that in China, Mexico or Spokane so that the customer doesn't have to do a whole lot other than give us hints on what they want the new shape to look. And they’re going to end up with a product that is less expensive and higher quality and looks better.

How about from a uniqueness factor in terms of the products themselves that you're producing? Is there a uniqueness factor with either of these?

These 2 are pretty standard. There is not - they’re not way out on the weird spectrum. They’re a lot more in the mainstream than most of our recent wins have been.

And our next question is from the line of Mike Hughes with SGF Capital.

Couple of questions for you. On the last call you seemed a little bit more open to acquisitions than you’d been in the past. First, is that correct? And then second, on acquisitions, what are the financial and strategic criteria for them?

So we are in a acquisition mind set at this point in time. We’re generating capital a lot more rapidly than we have in the past. We believe that our operational formulas and methods so to speak are very easy to step and repeat. So we are on the lookout for a company that could benefit from - or whose customers could benefit from where we have locations today. So if we were to purchase somebody who had only one or 2 locations and none of those were in Mexico or China or their Mexican and China operations were floundering a bit, that would be a pretty good acquisition for us. And I can tell you that there are a lot of EMS companies whose offshore locations tend to be a little bit in trouble and floundering in terms of operational excellence. So we’re looking for somebody who we can add to our company and make one plus one equal more than 2 because of our abilities in running offshore facilities and our abilities in satisfying customers in ways that they couldn’t do without us. And then from a financial standpoint, we just want to make sure that once we're done with the purchase we’re able to make more money than our cost of capital.

So is it fair to say that you’re potentially looking for a fixer-upper?

Yes, either that or somebody - it’s either got to be a fixer-upper or it’s got to be somebody that isn't necessarily broke but they are lacking in something that the 2 of us could provide together.

Okay. You’ve obviously over the last 18 months or so done a terrific job organically on acquisition obviously, could be a diversion, how much of a consideration is that?

Well, we had actually looked at an acquisition a couple years ago and decided that we weren't ready for it in terms of our management bandwidth. As you can tell from looking at our revenue growth, although it continues we went through a very, very steep phase that really left our tongues hanging out and our brows pretty sweaty. Through all that we've developed a lot of processes - I said earlier that we believe we can step and repeat what we’re doing now. So the thought of acquiring somebody doesn't scare us like it did a couple years ago. I think if we had done it a couple years ago we might have busted our pick but I'm pretty confident today that if we were to do one that was in reasonable shape, we could do it without much of a sweat.

In my understanding these smaller EMS companies can be bought at very low multiples, is that correct?

Well, we'd like to think so but we'll find out.

Is there kind of a range that you’d like to target?

We think that something between 4 and 5 EBITDA - 4x, 5x EBITDA is a way that you could end up making money on a financials basis thing on how much of a fixer-upper was.

And then would you fund an acquisition through the revolver? How would you go about that?

We’re thinking that within a couple of quarters and Ron and I have a standing bet I have lost for the last 3 quarters but we are thinking that we should be out of a borrowing position with our banks within a couple of quarters. And our performance has been so good and the level of trust with our bank is so high that they come in here about once every couple of months and ask us to borrow more money and buy somebody. So we don't see any problem in funding it through our current bankers. And whether we would do it through the revolver or some other facility is kind of up to Ron and the bankers as we get closer to making a deal.

But your thought is you could actually pay down the $11 million that’s on the revolver in the next 2 quarters?

That's what I think. Ron would say I am being a little bit aggressive, but he doesn’t think it’s a lot longer than that.

One more question for you. On the return on invested capital, on an after-tax basis I calculated it around 16% for the current quarter. That’s significantly better than your peers. And if I kind of dissect it, your operating margins are about 120 basis points better than Plexus which most people consider the premier player in the space. One, speak to why your operating margins are better than - and maybe you don’t want to look at Plexus specifically but your peers in general? And then secondarily, your capital-intensity of your business is much lower than your peers. Just kind of looking at the sales you can generate for the PPE -- PP&E you have in place, can you also speak to that?

I will try. Taking them in reverse order, as far as capital intensity we buy a lot of used equipment. I've got 4 cars and all 4 of those cars were actually salvaged vehicles that I made out of 2 cars. So we’re kind of genetically cheap. I’ve got to admit I have one new car but I bought that [indiscernible] years ago. We as an organization have found that we can be at the bruised edge of technology, not at the bleeding edge of technology and do that for $0.25 to $0.50 on a $1. So a lot of the equipment you will see in our factories isn’t right up at the edge of technology but then we’re not building Apple cell phones either. So we’ve been able to grow the way we’ve grown without a whole lot of capital by buying equipment that's used. We’ve also for a long time believed that Mexico was going to be the place where a lot of business came back to as what all of the dreamers thought was going to happen and that was the standard of living in the Third World started to come up. So we've been able to purchase our facilities in Mexico at very attractive prices because of people's fear over what they viewed as the danger of doing business in Mexico. Over the last 9 months that has proven to be a pretty good strategy as the crime rate in Juarez has declined precipitously. And yet we’ve been able to pick up real estate at fire sale prices. So I guess as my comment to how can we be as good as we are on a capital usage basis, I go back to the first comment, that we’re genetically cheap. And frugal was what Ron would like to say. And I got -- at some point you can call me, I will tell you the story about when Ron bought a used Christmas tree for his kids. But this is not the time or the place. That’s the answer to the second question. The first question was how we’re able to generate the margins that we do, and that goes back to Bill’s question about the weird products we build. It’s when we look across our spectrum of customers, when we see customers that all we are doing is building a PCB and testing it and shoving it in a white plastic box and shipping it. Those margins tend to be as tight as anybody else's out in the industry. When we see that we’re doing something that's quite bizarre in terms of what our competitors would think when they look at it, those are the margins where we can do well because it required a special skill. It’s hard to learn how to do and many times we have to help our customer move it from his factory to ours and we have to put a lot of time and effort into helping design the processes or redesign the processes that are used to build it. So we end up in a lot more of a partnership relationship with the customer than we are a commodity supplier that they can dump whenever things don't go wonderfully because in this business things don't always go wonderfully. So it has as much to do with the weirdness of our products and that has everything to do with the capabilities that we've built over the years in building these electromechanical products that are not just a board stuffed into a box. When our competitors talk about box build, they talk about shoving a board into a white plastic box. When we talk about box build we’re talking about a product that typically has shafts and gears and pulleys and timing motors and ampage requirements and potting and it's a product that is electromechanical in nature, not just electronics in a box. So that’s the answer to the second - I mean the first question.

And our next question is a follow-up question from Bill Dezellem.

Although I would like to ask about the used Christmas tree story, I probably will refrain for now. The question I do have though is relative to the 3 programs, you brought on 3 programs this quarter into revenue producing mode or maybe it turns out to be more than that but a net 3. Just as you look forward, what are your thoughts on the additional net ramps versus the revenue from ramping existing programs that are still not fully ramped and the interplay between those 2 on your revenues?

I can’t get real precise about that. There is quite a bit of revenue left to ramp from programs we’ve already won. They're not at all mature on a number of different customer fronts and on a number of different programs. There is -- of the new customers obviously nothing has ramped from them and the ones that we’ve won right now, I don't see any of the explosive ramps that we had a year ago. So they’re a lot less disruptive to the company, which is part of the answer to the other question why we think we can bring on acquisition without killing ourselves. So I guess -- has that answered your question Bill?

And our next question is from George Melas with MKH.

Could you talk a little bit about what you did in Mexico when the capacity expansion and how much capacity do you still have in your plants?

Well, it’s a pretty complicated answer, I will try to simplify it, just because we’re on the telephone. The factory in Juarez could really be looked at in 3 distinct chunks. One chunk is the complete product build. The next chunk is the PCA automatic assembly tests and hand assembly that goes along with it. And the third is plastic molding and actually the fourth is the inventory that you have to hold to keep all that running. So if you look at our plastic molding capability, we have been outlying presses in the smaller tonnage, which is around 100 ton presses to manage a big piece of automotive molding business that we won. Total, that’s even more complicated to have an answer because in the large tonnage presses we have quite a bit of capacity in large tonnage, I mean from 250s up to 3,000 tons. But in the small tonnage down around 100 to 200 - from 80 to 200 basically were quite tight and we’re probably going to end up buying another 4, 5, 6, 7 of those small presses over the next year. If we were to look at the total molding hours in total that have to run to the mold shop in Mexico, we are probably about 65% loaded but that is - you can’t really use that as any kind of an answer because it depends upon the tonnage size. If you look at the box build or product build capacity in Mexico, that is bounded by square footage floor space. I would guess on that basis we’re probably 75% loaded and have room to pop in another 25%. To do that we might have to lease a bit of space to hold raw materials. But it’s there if we need it. And then the SMT shop, we are probably running about 70% right now in SMT. If I was to look at today's hours we've got between 5.5 and 6 lines there. Those lines are step and repeat, if you had to go on and buy another one of those you can do that in about 6 weeks. I think we - our engineers were proud of the fact that in the last quarter we added a line to get it running it under in 8 weeks. Well, that’s not a real constraint, we never won a customer in under 8 weeks. So we can only get capacity ahead of customers. So that’s Mexico. China doesn't have plastic molding. They do final product assembly and SMT. Their SMT load is about 50% right now. Their factory capacity assembly load is probably about 65% loaded based on square footage and Spokane does plastic molding PCB and assembly, very low volume products with NPIs which is new product introductions prototyping and that’s probably running at the 30% capacity or less on the plastic machines. We just had to expand our assembly capacity here in Spokane, because as more Chinese stuff comes back to Mexico, more Mexico stuff comes back to the States and our SMT line here in Spokane is about 65% loaded. So that's a long answer, but I didn’t know how to compress it for you.

And then I have a quick other question. In terms of the customer diversification, you expect your top 3 customers specifically to represent a similar or lower percentage of your revenue that you did in the fiscal year that just ended?

I think that they’re going to probably represent a lower than last year. As we’re more or less projecting that we stay flat this next quarter, what we’re seeing is that a couple of the largest customers are seeing some pressure in their markets and their decline is being replaced by the add of new customers. So the competitors that are talking about 3% to 5% to 6% quarter after quarter reductions, we’re seeing that same percentage out of our existing customers but it is being masked so far by the implementation of new customers. So the way I see it right now is we’re going to end the year with less concentration than we began it.

With no further additional questions, I would like to turn the conference back to management for additional remarks.

Okay. Well, thank you again for participating in today’s conference call. Ron and I look forward to speaking with you again next quarter. Thanks and have a good day and for those of you in New York, I hope you made it through there safe and sound and we’re glad you're able to make the call.

Thank you sir. Ladies and gentlemen, this concludes the Key Tronic Corporation first quarter fiscal 2013 conference call. If you’d like to listen to a replay of today’s conference, please dial 1-800-406-7325, or internationally at 303-590-3030 with access code 4569452 followed by the pound sign. We thank you so much for your participation and have a pleasant day. You may now disconnect.