Good day, and welcome to the Key Tronic First Quarter Fiscal 2024 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.

Thank you. Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for today's conference call. Joining me here in our Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer. As always, I would like to remind you that during 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 three months ended September 30, 2023. For the first quarter of fiscal 2024, we reported revenue of approximately $147.8 million, up 8% from $137.3 million in the same period of fiscal 2023. The increase in revenue reflects the continued ramp in production for new programs, particularly those produced in our U.S. facilities. Revenue is down sequentially from the fourth quarter of fiscal 2023 due to the customers' redesign of a large outdoor power equipment program, but we estimate that program to come back online later in fiscal 2025. The company's gross margin for the first quarter of 2024 was 7.4%, and operating margin was 2.2% compared to a gross margin of 7.6% and an operating margin of 2.4% in the same period of fiscal 2023. The margins in the…

Thanks, Brett. During the first quarter of fiscal 2024, we continue to ramp many new programs produced in our U.S. facilities and remain profitable despite a temporary softening of customer demand for our Mexico-based programs. We're also pleased to see our inventories be more in line with current revenue levels and other improvements made on the balance sheet. Over the past four years, we have seen a 9.4% CAGR of revenue, largely driven by an increase in new programs predominantly in North America. During the same four years, we have seen our total number of new customer programs grow by approximately 100% from the number in fiscal 2020, while revenues increased by 31% over the same period. This has led to less concentration in any single customer and has enabled us to be less financially dependent on any single program. During fiscal 2023, we had only one customer that represented over 10% of revenues, and they represented only 12%. Meanwhile, our U.S. sites have added over $60 million in new program wins in the past 12 months as a direct result of continued onshoring. Moving into fiscal 2024, we continue to see the favorable trend of contract manufacturing returning to North America. As a result, we continued to expand our customer base and won new programs involving security equipment, sporting goods, environmental solutions and industrial control systems. 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 that they have become overly dependent on their China-based contract manufacturers for not only product but also for design and logistics services. Over time, the decision to onshore or nearshore production is becoming more widely accepted as a smart long-term strategy. As a result, we see opportunities for continued growth.…

[Operator Instructions] And our first question will come from Bill Dezellem with Tieton Capital.

Thank you. First of all, let's start with the normal. You had four wins. What was the size of each of them, please? And then any commentary and discussion around each of them would be appreciated.

I would say, security equipment about $12 million, sporting goods $10 million and then hopefully another $8 million, environmental solutions $4 million, industrial control systems $3 million.

And would you kind of walk through each of those for us? And just in terms of whatever additional information you can share besides the industry that they're in.

Sure. All of them take advantage of multiple capabilities that we have, so they're not just board stuffing. All of those are actually in the U.S. sites rather than in Mexico. And three of them are return quote opportunities from a couple of years ago, which is that interesting. I'm not sure if I can draw a conclusion from that, but we call them boomerang accounts, boomerang quotes. And all of them, four out of the five are PCBs and final box builds and some mechanics along with it.

And so talk a little bit about those. I like the term boomerang, the boomerang quotes and wins, the dynamics there. Is it your understanding they went somewhere else and another CM failed or that they kept with their current situation and finally decided to make a change? What happened?

Well, that's why it's a little bit hard for me to draw a conclusion because there's a whole bunch of different stories behind each of them. So a couple of them we've been talking to for years and the programs we quoted on were new development programs, didn't ever win anywhere. And the other one, awarded the business to somebody else that didn't work out well and they came back.

Thank you. And then, Craig, in your opening remarks, you referenced that the number of customers versus four years ago has doubled or is up 100%. How do you think about that? Because there is this trade-off between less customer concentration and yet the challenges of managing the smaller pieces of business. What are the dynamics around that as you think about it?

Well, there's a lot of different aspects to that situation, and it's hard to draw a real generalized conclusion other than the ones I've stated that it does tend to improve our leverage with the customer in negotiations when the customer knows they're not 15% of our business. We don't see a big delta in cost between running a $5 million program and a $40 million program in terms of support costs and overhead. It's actually a little bit easier to manage when it's on the smaller side because you don't have such massive amounts of parts that you're trying to keep your arms around. And it's also easier in that many times, these programs were not part of it, our business is not part of a big corporation that we can't get to somebody who will listen to the situation at hand and respond logically. So even though it seems like with the $50 million program, you should have a lot more ability to talk to people who have the power to make decisions. Oftentimes, that $50 million program is part of some billion dollar corporation, and you can't get to somebody who you need to talk to, to make logical sense on what's going on. So we don't see what's classically taught in the business schools that the smaller programs are less profitable. We probably see at least parity between them and probably an advantage going to the $10 million to $20 million program compared to a $50 million to $80 million program. That doesn't mean we're not always looking for the $50 million, $80 million program. But if you look back in history, other than a couple of them that have been long standing, they tend to be more flash in the pan than you would hope. So we are happy with the fact that we're growing in the $5 million to $20 million programs on a steady basis and much faster in that realm than we were three, four years ago.

That's helpful. Thank you, Craig. And then you referenced a couple of times, I think you both did that the customers that you are manufacturing for in your U.S. facilities are showing strength, whereas the customers that are in your Mexico facilities are showing some weakness. Is there any conclusion to draw from the location at which you are manufacturing and the relative strength?

I'm struggling to do so. I would like to be able to give you an earth-shattering revelation on why at this point, Mexico was down and U.S. is up. I think it has to do with the fact that there's so much growth in new programs coming into the U.S. sites that although they have seen downturns in some of their customers, those downturns have been swamped by all the new business coming on board. The business in Juarez was unexpectedly dampened by the power equipment business having to go on hiatus while the customer redesigned the product. And so what should have been new business that was swamping out other small decreases in the other business in Juarez is not there right now. So I think that set of just individual circumstances is the driver rather than any kind of market or business overarching trend that you can point to or at least that I can point to.

That commentary is appreciated, even though it's not the revelation that you had hoped you'd be able to share. I did hear where we heard of another company that saw weakness right after Labor Day. Curiously, it did correspond with Hamas attacking Israel and then things two or three weeks later returning to normal. Have you seen anything similar to that peculiarity that, that company saw?

No. When we talk about positive to negative phone calls we get from our customers and the ratio of those, we had a little bit of a dip four or five months back that we thought were worried was the signal for a broader base on coming recessionary freight train. Then that ratio flattened out, and we started to get hopeful. And then a couple of months ago, the ratio went bad again. But it has now once again flattened out. So if you look at it, it was a small step down, a medium step down, but now it's flat again. We're typically a front-end particular of what's going to happen. And right now, I can't give you any good indication that it's going to continue to get worse, it's going to stabilize or it's going to get better.

All right, great, thank you. I will step back and queue and reenter, so others have an opportunity.

And our next question will come from Sheldon Grodsky with Grodsky Associates.

Good afternoon, everybody.

Hi.

I have two questions that are unrelated. I'll start off with that power equipment manufacturing problem. That sounds like a pretty big disaster if it's going to be kind of held in abeyance for a year, does that relationship look like it's intact? I know you're not supposed to say bad things about your customers on these calls. But did they handle all the designs or do you in it together?

The way that many of our programs work is that we contract to provide design services, and that was the case with this customer. And in that situation, the customer will say, I would like you to design this bracket, it needs to be this strong, and it needs to withstand this many flexes. And we say, okay, and our engineers sit down in the CAD station, and we designed that bracket to meet that load and that number of flexes, and we put it on our test equipment, and we prove that it meets that load in that many flexes and customer approves the design, and we go out and we buy tooling and we manufacture it. When the product hits the market, and it turns out that the performance specifications that our customer gave us were underrated in some way and the part begins to fail. Usually, the situation is clear enough that we remain friends with our customer and the business goes on. And in many cases, the relationship has strengthened because as we go through the troubleshooting to determine what the problem has been and why our engineering team proves its metal under challenging and time-constrained conditions. And that's the situation that we're in with this customer today. I believe we are in a better position from a relationship standpoint than we were previously. And things are moving forward, and we are actually continuing to design next-generation product while this current generation product is being tweaked.

I have an unrelated question.

I want to tell you, Sheldon, that I never did that. I want to tell you, I never explained that that way before, and I'm pretty proud of that. That's pretty good. So I hope that helps.

It did. With regard to China, well, one little company that I follow has been having interesting problems suddenly getting export licenses, this kind of leads me to believe that the cold war between the United States and China is heating up. Have your people found situations where they either can't export to fulfill orders because of new requirements coming from the local communist officials or anything like that where that it's becoming a significant impediment to operations?

The reason that many of our new customers are new customers is that they have run into exactly that type of problem. So the trade war, you can read about what our President has said to their President and all those kind of things. But what really matters is what's happening to our current and prospective customers as they try to source product and do business overall. That means get new designs designed, get ramps either up or down, send engineers in there to help, all that has gotten dramatically harder in the last three, four years and continues to get worse. It's not static. It's actually continuing to get worse. What's interesting to us is that it's making the people that were more or less on the fringes of should we be in China or not. The people who don't have big money to throw at a problem when suddenly they can't get parts out of there for a day or a week or a month. It's making those people change their approach earlier than the folks who are bigger and have the wherewithal to kind of withstand the buffeting of the cold or as you call it. So that's why we see a lot of these $8 million to $10 million to $20 million wins that are happening for us because those are the people that are on the fringes and are the most severely impacted without the financial wherewithal to manage those impacts on a timely basis.

Okay. Thank you.

[Operator Instructions] And our next question will come from George Melas with MKH Management.

Thank you. Hi Craig. Hi Brett. How’re you?

We are okay.

Good. Okay. A follow-up to those questions on the smaller customers, you were sort of suggesting or telling us that you think that from a management perspective, maybe let's think about it from a numbers perspective. I think you're suggesting that from a gross margin perspective, they might be a little bit better because you have a little bit more leverage. From an SG&A perspective, that may be that they are equal to their larger peers as a percentage of revenue. So first of all, is that correct? Is that the right way to interpret that?

Yes. Additionally, customers that are on the very small end that have proven not to fit that model, we have been actively disengaging with. So there's been a trade of customers, specifically in our U.S. sites where those sites were struggling to maintain the revenue base that they had where those sites are now struggling to service the new growing revenue base that they now see. And as a result, we've been circling around and taking the bottom of our list of customers. And some of them we are ways with because they're just small and they have a much worse ratio of listings and overhead compared to the revenue base that we're enjoying with them. Some of them, we walk away from because they have proven to be untrustworthy, and we don't have to deal with it anymore. And some of them we walk away from because we don't see any type of future and we're concerned about their financial health. But that's a change. We haven't done any systemic pruning of our customer base since I've been with the company. We've done some a little bit here and there, but nothing as overt and as what's the right word... I don't know. Anyway, we haven't done...

Purposeful, like so you really sort of have that is part of your strategy now and it's not sort of occasional or opportunistic because somebody really business you offer. It's just a process of pruning.

George, I would never make a decision based upon how pissed off I am.

I wouldn't want you to because I think it can be pretty tough. So I don't know. Okay. All right. Okay. From a working capital perspective, these small customers, you tend to do a lot for them. So you do take advantage of a lot of your capabilities. Basically, it means a lot of parts. And how does that impact you from an inventory perspective? And also from an AR perspective, are these small customers, are you able to get slightly better terms?

Well, that's the interesting part of it, or interesting aspect of it. I didn't want to say parts because parts are coming into here. if you've got a customer who represents 15% of your business and that customer starts pushing you around in the sense of dumping a big forecast on us demanding that we buy into that forecast and then misses that forecast and then forces us to spend six months to a year in negotiating whether or not they're actually going to conform to the contract they signed and pay for those aged parts. That's a lot different than a $10 million customer who knows that they're a $10 million customer and are going to behave out of necessity as if they are in this together with us rather than taking advantage of our neediness. So even though more smaller customers results in a bigger parts catalog, it results in a lot more rational behavior in how we are forced to buy parts and how we can react when those parts do end up being excess for some time period. We have a lot more ability to enforce and I'm not saying that we're egregiously mean to these smaller customers. I'm just saying that we're in a lot better position to keep the relationship on an even fair and as anticipated in the contract basis, and we sometimes are with a customer that's 10%, 20% of our business. That's part of why we made the dramatic improvements in inventory that we see and we expect to continue to see. And the other part of it is that as COVID came and went, as the supply chain got horrible and now is just kind of horrible a lot of the standard behavior amongst our customers was challenged, and a…

Right. So maybe can we try to put a number to that. What do you think your inventory turns? What would be your goal in the next 12 months?

Well, I have a goal, but I'm not making you a promise. So I rarely give you any kind of a forward-looking number, but I'm going to under that proviso. So I'm taking a note, George. So a year from now, if you start badgering me about this, I'm going to say it was only a note. I want to get us to over six turns. We're at four now. We went from three to four. And that's my goal.

And I don't know much about how you manage MRPs and inventory turns. But what would enable you to get there? Are you talking about better forecasting from your customers, better MRP outdoors on your part. Because that would be really an improvement in the model than dramatic.

Yes. And I think both of those things are dramatic. So everything I laid out in the past 10 minutes of me talking, when you add all that up, that is a dramatic change in how all of this works. And we've just started to see it really drive things down from January through today. And our projections are that it's going to continue to do that. There may be some bumps and hiccups as we go, but overall, we continue to see that, I mean there are programs. We've got programs, George, big programs that we've got running so well. They're turning over 20 times a year. So mathematically, you should be able to get somewhere better than 4. If you can just keep all the, inventory is kind of a story of one damn thing after another. You can look at the top 25 customers and everyone that's not turning at 6. There's some damn reason why it's not. And it's not the math and it's not the process. It's something that happened. And so beyond the math and the process, there's the institutional discipline to look at every one of those damn things that happened and say, all right, we're never letting this happen again on any of our customers, not just this one customer. And as you start to drive the policing of making sure those one-offs never happen again, that starts to add up as well as all the process changes.

And might I add that at the point in time, one of those customer programs continue to be on the list of those that are turning at far less than six turns. That's also the point in time when we are purposefully looking at, is this a good fit for Key Tronic?

So we're going back to customers and saying, you're turning at two times. That either changes or you need to find somebody different.

And that is also, again, drastically different than how we've operated in the past.

And how we could operate in the past.

Okay, correct.

Because we were too desperate to keep every customer we had.

Okay. So I think that's some dramatic changes. It feels like always you have done so much for the customer, you have such breadth of capability, you've spent a lot in CapEx to be able to do all the different things. But never we're quite comped enough by the customer for all that you could do. So maybe now things are changing somewhat...

I think that's true.

Okay. Not certainly another quick question. You said you're right that you see gross margin gradually improving. What do you mean by that? Because in this quarter, they didn't and so I just want to understand what you mean by that?

Well, this quarter, we didn't because we got hit by, it was a triple whammy so we got hit by the sudden hack of the power equipment program. We got hit by the peso suddenly getting a lot stronger because our government keeps printing money. And we got hit by the fact that interest rates have gone up dramatically because our customer keeps printing money. So those three unexpected events or not unexpected, the events out of our control. drove the gross margin this quarter down lower to where we wanted it to be. We had to respond quickly with the layoffs. And we took quite a bit of charge for inefficiencies as we had extra people around beyond just the severance cost. So this quarter was a bit of an anomaly in that three things combined without a lot of warning to hammer us.

Okay. So where do you see gross margin going in, I don't know, let's think far in the future fiscal '25, what do you think they could be in terms of gross margin?

So we've always said we could be at 9%. We've been there every now and then. But again, it's one damn thing after another. But we believe 9% is achievable and should be able to get there.

Okay. And then Brett, a quick question on OpEx. OpEx is pretty low this quarter. Is there some explanation for that? Or...

There was a small gain on insurance. I think it was $300,000 or $400,000, George, which dropped overall OpEx. My expectation is OpEx should be fairly flat in our second quarter.

Okay. But if we can adjust SG&A, to simplify to make it easier to think about it, it was 5.8% this quarter. Is that a red rate...

Let's see here. You've got SG&A of 5.8. Last year, it was roughly 5.7. Sequentially, it's down quite a bit. In our Q4, as we had mentioned, there was some bonus calculation that went through the quarter that propped up Q4. But my expectation is that Q2 should be flat to Q1 and a slight increase in Q3 and Q4 of G&A.

Okay. Great. Okay. Thanks for that guys. Appreciate.

Thank you.

And we'll take a question from Bill Dezellem with Tieton Capital.

Thank you. I want to come back to the inventory turns for just a moment. If we roll the clock back a decade back in 2013, and Inventory turns were up north of that north of 6x even up into the 7s. Pardon me for lack of memory here, what is different or what was different back in 2013?

Fewer customers, and you had an infinite supply of parts...

Whereas now the supply chain and the challenge of getting parts in the door has created havoc.

Yes. And we're suffering and from the company's inventory position has kind of got long COVID in that what happened during COVID has taken almost until now. In fact, we still have some parts around that are a result of COVID. So what happened during COVID, we're still working our way through. And we've talked about this before, is that back in the teens, you could get just about any part you wanted in six weeks. And so the MRP systems were all designed to run with that as one of the variables. And then when COVID hit, it was the opposite of that. And none of the MRP systems actually had that as they're governing variable, I shouldn't say none. I'm sure there were some somewhere, but our certainly didn't and a lot of our customers didn't, and so that's what drove our inventory turns down as low as they went and that's why we're thinking we can get them back up to six even with more customers and longer lead times for parts.

And Craig, you may have just touched on something that you had mentioned much earlier in the call relative to system upgrades. And I think you referenced your system upgrades and maybe even customer system upgrades. Does this all tie into what you're talking about right now? Or are those two totally different things?

No, that's exactly the same thing.

And so the upgrades that took place in the systems that are planning out inventory is making the lead time actually a variable rather than a constant?

The lead time always was a variable, but it wasn't driving the algorithms as if it was a constraint as much as it should have been. More importantly, the way people understood the system and manage those lead times, we're not driving the system the way it should be working. So I'm not going to go into it. You can call me later, and I'll give you an MRP lesson if you want. But the bottom line is that the way we use the system and the way we've configured the system is much different than it was before we went into COVID. And the way many of our customers configure and use their system now is much different than it was before we went into COVID. I'll try to give you an example. So when we were in the midst of COVID, it took almost a year for many of our customers to actually revamp their thinking and realize that it wasn't a possibility to call us up and threaten and yell and abuse and become the squeaky wheel and get their parts. And that used to work. And so it was a big eye-opener for many customers that there was actually nothing that could fix this other than time. And no amount of yelling or degrading or threats or payments, some type of speed up payment, none of that was going to work. And that was a massive realization for everybody in the industry that has spent many of them their entire careers operating under the assumption that you could always get your parts in at least utmost eight weeks if you made enough noise. And so if you then take the ramifications of that and spread them back through the planning process and the algorithms that you use in your planning process, that's a profound change in thinking.

That's helpful. And then you referenced the customer systems, is your sense that the customer systems, generally speaking, have now taken this into account. And so kind of that heavy lifting is done?

Yes. Many, many of our customers are now investing money in having us stockpile, some of the troublesome components for them. That was people used to give that lip service before COVID, but I can't think of anybody that actually did that before COVID. Even though we would talk about it every time there was an event when they couldn't get a product and they needed it, and there would be this kind of relationship, challenging situation, and we'd be yelling at each other on the phone and we'd be flying out to see each other, and we talk about, God damn, if we would just take these scary parts, I remember the title, we had a scary parts list. And so if we just take the scary parts that are on this list, and you guys would invest $100,000 out of your $40 million spend. If you put $100,000 into this, you guys wouldn't have the situation crop up again and again and again. And the response was always was, we're not going to do it, you do it. And we always say, well, we can't afford to do it, you do it and then it would never get done. That has changed. We've probably got 30%, 40% of our customers who are in some type of standby inventory situation with us where they have realized that in order to ensure their supply chain, they need to invest wisely in one, two, three or four parts that are their customary problem parts on their bill of material. That's a really big change.

And they're paying for those parts?

Yes.

Great. May I ask one more question completely unrelated to this. You made reference to the strength in the pipeline of business for the Vietnam facility. Would you talk around that a little more? And is the actual number of programs potentially moving to Vietnam from China higher than it was three months ago?

No. It's actually the potential programs moving from the States to Vietnam and skipping Mexico.

So talk a little bit more about that and kind of your comment, I think, that you see Vietnam as part of the future growth of the company.

Yes. So Vietnam is less expensive than China and less expensive than Mexico. And Mexico continues to legislate higher and higher wages. And as they do that, more customers that were looking solely at Mexico as a way out of China are now willing to look at Vietnam and India. We haven't made a decision on India as of yet, but Vietnam is pretty close to India pricing and are ahead of the various supply chain issues that you see in India. So we have a number of big opportunities cooking for Vietnam. Vietnam got stalled out during COVID and is restarting in terms of business acquisition. So this is on the front end of it. But we're predicting that a year from now, there'll be a couple or three big wins to increase the size of what's going on in Vietnam for us.

And these would be new customers to you, Craig?

Yes.

And how about business moving from China to Vietnam, what are you seeing there?

Our business or business in total?

Business in total?

We don't see as much as that as you would think because people tend to think of it's all Asia. We need to get out of Asia.

Interesting. Okay. Thank you both for the time today.

And that does conclude the question-and-answer session. I'll now hand the call back over to Mr. Craig Gates.

Okay. Thank you, everybody, for participating in our conference call today. Brett and I look forward to speaking to you again next quarter.

Well, thank you. And that does conclude today's conference. We do thank you for your participation, and have an excellent day.