Key Tronic Corporation

Welcome to the Q2 Fiscal 2021 Keytronic Corporation Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Brett Larson. Please go ahead.

Thank you. Good afternoon, everyone. I am Brett Larson, Chief Financial Officer of Keytronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Craig Gates. our President and Chief Executive Officer. 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 of the the company has filed with the SEC, specifically our latest 10-K, quarterly 10-Qs, and 8-Ks. Please note, on this call, we will discuss historical financial and other statistical information regarding our business and operations. Some of this information is included in today's press release, and a recorded version of this call will be available on our website. Today we released our results for the quarter ended December 26, 2020. For the second quarter of the fiscal year 2021, we reported total revenue of $128.3 million, up 10% from the $116.7 million in the same period of fiscal year 2020. For the first six months of fiscal year 2021, total revenue is $251.5 million, up 13% from $222 million in the same period of fiscal year 2020. The revenue increase during the second quarter of fiscal year 2021 was due to the successful ramp of several new customer programs and increased demand from existing customers. At the same time, our revenue continued to be constrained by temporary government-imposed shutdowns and labor shortages at our facilities in Juarez due to the COVID-19 pandemic and associated public health measures. During the second quarter of fiscal year 2021, we again incurred additional cause by COVID-19. The COVID-19 crisis totaling approximately $1.8 million, or roughly 13 cents per share. Despite the pandemic's adverse impact on revenues and expenses, Our margins improved in the second quarter of fiscal year 2021 due to increased revenue. Our gross margin was 8.3%, and operating margin was 2.1%, up from gross margin of only 7% and an operating margin of 1.3% in the same period of fiscal 2020. For the second quarter of fiscal year 2021, men income was $1.6 million, or 14 cents per share, up from $800,000, or 8 cents per share, for the same period of fiscal year 2020. For the first six months of fiscal year 2021, net income was $3.3 million, or 30 cents per share, up from $2.4 million, or 22 cents per share, for the same period of fiscal year 2020. Turning to the balance sheet, we continue to maintain a strong financial position. As a result of the pandemic, related production delays in the second quarter of fiscal year 2021, and the continued ramp and transfers of new programs, our inventory turns remain flat with the prior quarter. In future quarters, we expect to see our net inventory turns increase to be more in line with the expected revenue. At the end of the second quarter, trade receivables were up $8.5 million from the prior quarter, reflecting the increased revenue levels and the timing of shipments later in the quarter. Our DSOs increased to about 69 days, which reflects both timing of shipments during the quarter and some typical delay in payments from customers at the calendar year end. Overall, we have a healthy balance sheet with total working capital of $174 million in a current ratio of 2.9 to 1. Nevertheless, we feel it is prudent to preserve cash and expand liquidity where possible. In this light, we added additional credit facility from our bank in Mexico to bring our total credit facility up to $105 million to manage pandemic risk and give us more flexibility to ramp up production in the coming months. Total capital expenditures for the first six months of fiscal 2021 were approximately $7 million, and we have increased our expected capex to be roughly about $12 million for the full fiscal year. While we are keeping a careful eye on expenditures during fiscal year 2021, we plan to continue to invest in our production equipment, F&T equipment and plastic molding capabilities, as well as in efficiency improvements in our facilities as we prepare for growth and add capacity. For the third quarter of fiscal year 2021, we currently expect to report revenue of approximately $130 million to $140 million and earnings of approximately $0.20 to $0.25 per diluted share. That said, there's a lot of uncertainty surrounding these current estimates. We're working closely with our customers, key suppliers, and employees to minimize the effects of delays attributable to the continued global pandemic, increased global freight and logistic demand, and the signs of certain commodity constraints that have increased lead times and limited availability of key components. While our facilities in the US, Mexico, China, and Vietnam are currently operating and rigorously following current health guidelines, uncertainty as to the possibility of future temporary closures, customer fluctuation in demands and costs, and future supply chain disruptions during the rapidly changing COVID-19 environment could significantly impact operations in the coming periods. Due to the heightened risks associated with the pandemic, We may also issue updated guidance during the coming quarter. In summary, while the COVID-19 crisis continues to cause disruptions during the second quarter and remains a risk in future periods, we are encouraged by our continued growth as we move into the third quarter of fiscal 2021 and by our prospects for future growth. The overall financial health of the company is strong. And we believe that we are increasingly well-positioned to win new EMS programs and continue to profitably expand our business over the longer term. That's it for me. Craig?

Okay. Thanks, Brett. Despite the headwinds presented by the pandemic, we're very pleased with our strong, positive momentum in the second quarter. As we've discussed in detail on previous calls, the pressures on our customer base to lessen their supply China concentration remain very powerful. To date, these tailwinds have driven a significant increase in our business, and that increase has been along multiple vectors. Firstly, current customers with programs in Asia outsourced to other providers have awarded some of that business to us, and we are in the midst of ramping it. Secondly, current customers with new programs that were in the process of being awarded have eliminated Asia from their selection process and selected Keytronic based on our North American footprint. We are in the midst of ramping those programs also. Thirdly, new customers with both existing and new programs have also selected Keytronic based upon our footprint and experience. We would not have won several of these new programs without the opportunity to first ramp the programs in our USA plants and subsequently transfer them to our lower cost plants in Mexico. Another factor in many of our recent wins has been the realization by many companies in our target market that they have lost design control of their products in the process of outsourcing them. Keytronic's strength in engineering has proven to be a powerful asset as these companies work to regain design control, and several new project wins are due in part to our design services. Then another factor in many of our recent wins has been an unusually high level of vertical integration. As a customer seeks to recreate an existing supply chain, the risk and effort is multiplied by the number of new suppliers that must be identified, qualified, bid, selected, ramped, and managed. We believe Keytronic is unique. among our Tier 2 competitors in that we offer a one-stop shop for molding, metals, printed circuit boards, assembly, test, and distribution. Additionally, many of our new customers' products require a manufacturing process that is unique to their product. Keytronic has a long history of developing and optimizing such processes as we onboard a new customer, and this development is aided by our vertical integration. and certainly surrounds the continuing impact of the pandemic and the new U.S. administration stance towards China. Nevertheless, we believe that the lessons learned through the China-U.S. tariffs and the pandemic will continue to drive our current and prospective customers' actions. We believe they will continue to weigh carefully the degree to which they concentrate their supply chain on any one region and cede their design control to their outsourced partners. They more fully recognize the significant impacts an elongated supply chain can have on both cost and availability, the risks of IP appropriation, and the attractiveness of doing business with an outsource partner who can minimize their risk on all of these factors. We structured Keytronic to be the obvious answer as the market began to understand and calculate the costs and risks of over-concentrated outsourcing. We were experiencing increased positive effects of our structure before the advent of tariffs and pandemic. When both of these unprecedented situations came along, they served to accelerate the positive results of our strategy. Even if both of these challenges gradually disappear, we expect that our market will still have been fundamentally and permanently tilted in our favor. We are at an unprecedented point in Keytronic history. We see demand of over $150 million per quarter for the foreseeable forecast window. Our results for the last two quarters have been dampened by COVID effects on our workforce, part availability, and industry-wide shipping and logistics issues. These constraints will continue to be the case, but the growing demand from new and existing customers is a far better problem to have than not enough customer demand. At the same time, we remain focused on protecting the health of all of our employees by adhering to current health guidelines as well as increasing retention of available employees. As Brett noted, we are incurring increased expenses related to the pandemic in order to attract and retain employees who need to meet our growing demand, as well as preventative measures and equipment for employees at all of our facilities in U.S., Mexico, China, and Vietnam. While our supply chain remains vulnerable to temporary disruptions caused by a flare-up of the virus and associated lockdowns and regulations, we've so far been mainly able to work around temporary disruptions or closures. We've also managed transportation complexities and disruptions to our supply chain via alternative sourcing, air freight, product redesigns, and alternate component qualifications. We're closely monitoring inventories and will continue to use safety stock as much as possible to ensure minimum interruptions to our customers. Nevertheless, while we've been able to find solutions for most of the COVID-related challenges to date, clearly none of us are out of the woods with respect to the global pandemic. In closing, I want to once again thank our great employees for their dedication during these challenging times. and for adhering to our strict guidelines for social distancing, masks, and other recommended precautions during the pandemic. Because of their courage, hard work, and strategic foresight, we expect continued revenue and earnings growth in the third quarter, and we continue to invest in new capacity to prepare for long-term growth. Let me assure you that we will continue to make protecting the health of our employees our highest priority. I also want to wish you and your families good health and safe passage during the pandemic. This concludes the formal portion of our presentation. Brett and I will now be pleased to answer your questions.

Well, thank you. If you would like to signal with questions, please press star 1 on your touchtone telephone. If you're joining us today using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, that is star 1 if you would like to ask questions.

Star 1. And our first question will come from Bill Desilam with Titan Capital.

Thank you. First of all, congratulations on what I think is a record quarter in terms of revenue. I don't believe you called that out, but am I mistaken that that's not the case?

It is. Thank you.

Congratulations. So let's start with my normal first question, please. What is the size of each of the new programs that you won in the quarter?

Those are about two to eight million apiece.

And Is it correct that there were three of them, or did you have multiple wins in any of those categories?

No, there's two.

Okay, thank you. Let me start by asking about a comment that you just made towards the end of your comments, that that you said you have 150 million or have line of sight on 150 million of demand per quarter for the foreseeable future. Can you talk about kind of the gap, I guess, if you will, between, I mean, around 130 million where you're at today and 150 million and what you see as your ability or lack thereof to be able to march towards that 150 million demand level?

Sure, the gap is strictly and completely caused by the pandemic. So we have problems, as I said in the comments, getting parts. I don't know if you're aware that a container that used to cost $3,000 to get to use, I mean, to use to ship your parts across the ocean is now anywhere from $10,000 to $12,000. When you can get it, There are multiple ships anchored offshore at the ports trying to get space to get unloaded because the teamsters are suffering through the pandemic just like the rest of us. So we've got a logistics issue. We have continued risks and unavailability of employees in order to get our products built and shipped. So those two items are what stand in between the demand and what we actually project that we can build. We continue to drive to put ourselves in a position to hit that number. That's causing our inventory to be inflated above what we would like it to be. But the forecast that we are making, our official forecast, is based upon our view today of what's happening in the parts availability, logistics, and workforce portions of our operation.

Thanks, Greg.

And if we look at the $150 million If the pandemic were to instantaneously disappear and you were to alleviate the shipping and the labor problems, would there be a demand side of the equation that would also pull back and therefore you wouldn't have that number to hit? Or do you see enough demand without the pandemic that you would be able to move that direction?

That's a tough one to answer.

I would say that maybe a little bit would go away, but quite a bit of it looking forward is based upon new customer ramps.

All right. Thank you.

Before we go to new customers, a couple of existing, at least one existing customer question. I think in Brett's opening remarks, there was the comment that increased demand from existing customers was out there. Would you talk about that increasing demand for that segment of your customer base? And then secondarily, you raised the CapEx guidance by about $3.5 million. Talk to that point and where that money is going, please.

We've been winning new programs from existing customers.

We see a trend where our business with them was shared with one or two or three other suppliers. And as our customers have been exiting those suppliers and redistributing their supply chain We've been the beneficiary of those decisions. So that means that we are going to need more equipment in order to build and increase volume. So there's that aspect of it. And then the ramp of new customer programs that we're just beginning to enjoy the revenue from those programs is also required that we bring in more capital equipment. We are, in fact, right now outsourcing not a significant, let's call it a barely significant portion of our production, parts of it anyway, because we're concerned about COVID deflation, as you're asking the question, and we don't want to have put too much capital in should a couple of customers decline. if COVID ever goes away fully. So we're trying to hedge our bets and not go out and buy equipment to completely bring all this business completely in-house. But even with doing that, we are going to have to spend a little bit more capital on some SMP lines and other things.

Great. Thank you very much. And then

Lastly for now, on the last call, you'd mentioned $100 billion prospect, piece of new business floating around out there. Would you talk to that point and bring us up to speed and update on what you're seeing on that front?

It's still floating around out there, and we remain hopeful. What's the next important either decision point or milepost with that situation?

It has to go from a verbal handshake award to a contract.

So you already have a verbal award?

Yes. Well, congratulations. I'll step back in queue and let someone else ask questions.

Once again, if you would like to signal with questions, please press star 1 on your touchtone telephone.

Again, star 1 if you would like to ask questions.

And our next question will come from George Milos with MKH Management.

Good afternoon, Brett and Glenn. Hope you guys are well. I'll follow up on Bill's question. This is a record revenue quarter. And if one were to... to add back the COVID-related cost to your operating income. This is your best operating margin since 2013. So you're clearly doing something right, and you are getting some scale. You're also improving your gross margin. So maybe can you talk a little bit about the profitability of the business? And what has improved the profitability in the last, let's say, couple of years? And where do you see that going?

Okay.

Number one, as we get farther away from breakeven, our profits improved in a nonlinear fashion. We've always been in the position where if we wanted to, we could cut our overhead and try to go for maximized profit rather than the balance between profit and growth. And we've always chosen the balance. But as we get farther away from break even, we see a continued improvement in profit because the fixed costs become not linear. We don't see having to add a lot more fixed costs in the labor and management side of the equation, except in steps as we go up. So there's been a lot of work done on efficiencies in the factories. We're very proud of the cost that we've been achieving and the productivity that we've been achieving in all of the factories. We are through the purchase, not purchase, but the whole setup and startup of Vietnam. We're through the downsizing of our China Shanghai facility. We are through a number of expensive ramps. So streamlining or domestic operations? Domestic operations have been changed quite a bit, so there's a lot of really cool slides that I'm pretty proud of that talk about cost per hour and cost per unit and on time delivery and roll throughput yield and everything else we measure and through a lot of work by our staff and by all of our employees. Most of those graphs are heading in the right direction, but the overall driver is in this business, revenue is just king and new business, although it costs you a bit more than you'd like to get it in the building, has a non-linear impact on profit.

Okay, great. Thank you.

That's very helpful. I think you had, I think if I remember right, you had two new $100 million prospects floating around. And remind me if that's correct, and what are the characteristics of these two prospects?

Well, if we're going to stick with the analogy, one of them sank. Okay, one sank. Okay. Yep. The other one is floating and is coming up on plane nicely.

Okay. And what would be the characteristic of this new customer or program? Is it one that requires design on your part? Is this one that is very complicated? Maybe can you characterize it for us?

Sure. It did require design in our part that played a major role in our winning the handshake agreement. It's another example of a product that you would look at and say that, well, gee, not many people have experience in doing this. Why is it that Keytronic thinks they can do this? So it's not necessarily complicated, but it is in a different market than where we've been before. And that kind of slots it into our most successful customer relationships. As I said in my comments, where we run into a customer who has a unique product, not necessarily a product that you would look at and go, my God, that's really strange, but a product that is not really that easily outsourced because it has some really unusual process that's not in the wheelhouse of normal contract manufacturers who grew up as board stuffers. We really shine on those. So this is an example. This is actually on top of the one we won previously, which also required our design expertise, our adopting, learning, and capitalizing a new and wondrous process to us. This is the exact twin of that in terms of those characteristics.

That's great. That's very encouraging because that's where you guys shine in this combination of design expertise and complex processes.

Great. And nothing else. Sounds really good. Thank you very much. Thanks, George.

And our next question will come from Bill Desilam with Titan Capital.

Thank you. So I do want to circle back to that $100 million prospect. What will it take to move from the handshake where you're at now to an actual contract?

Well, that's always a beautiful mystery to understand. We've done everything we can and have to do. Now we're waiting for our customer to finalize a couple of their supply agreements, and I'm told and I believe that that's all that's required.

And nothing else once they make it through those supply agreements that you all will need to do other than get out your pen and sign the contract.

Well, sure, that sounds easy, but yeah, okay.

Essentially, that's the short version.

That's a really, really, really short version, but yeah, okay.

I'll get the pen and hand it to you if that's helpful. Yeah, thanks. Let me actually shift to the other part of the press release that we haven't discussed yet, which is all things COVID. It referenced in the release government-imposed shutdowns. I'm familiar with those with restaurants, but that doesn't seem to apply to you all, and I don't have a lot of familiarity with Mexico. Would you talk us through what you experienced in terms of shutdowns and how much of the million eight came from whatever shutdowns you dealt with?

Sure.

Sure. So, we have about 5,000 employees in Juarez right now. Last quarter, was it last quarter? Yeah, last quarter.

Yeah, the weekends.

So, last quarter we had, sorry, the quarter we're talking about here, we had two weekends that we were forced to shut down. Those are pretty critical weekends to us because we had planned on installing a number of pieces of capital equipment and we weren't able to do that. So as a result, we had to run through the last week of the December quarter, which is really, really hard in Mexico. People really like to observe their Christmas holiday, so overtime and bonuses All different kinds of costs mount up pretty quickly. So that's what happened in this last quarter. Previous to that, I don't know if you remember, but we had our warheads facilities shut down for almost two and a half, three weeks. So those are the kind of things that can happen. The good news is that the infection rate, hospitalization rate, and death rate in Juarez is falling dramatically, so we are hopeful that's going to continue. They've adopted a very intelligent approach to public safety that I'm not going to get into because I sound like I'm preaching on top of the soapbox, but they're doing really well in terms of controlling the pandemic spread. We're really proud of the fact that We've had almost zero transmissions within all of our facilities. And when you're talking about 5,000 people, that's a lot of work to make that happen, right? So I'm really proud of our team and what they've done in Juarez. But that's what we're talking about when we're talking about government-imposed closures of our facilities.

All right, that's helpful. And this next question, I'll just apologize in advance for my ignorance. On the surface, if you were shut down for nearly three weeks in the prior quarter and this quarter you were only shut down for two weekends, it seems like the cost impact would have been less, but you called it out as $1.4 million in the prior quarter and $1.8 million in this quarter. Would you reconcile those two for us?

Yeah, absolutely, Bill. So during those three weeks, we were not required to pay all of the labor and or overhead during those three weeks the plant was shut down. Included in this quarter are a number of employees that due to pre-existing conditions are excluded from coming to work. Those are, we are paying to stay at home. In addition to what Craig mentioned is if you are open during that Christmas week in Juarez, you're going to have to pay double, if not two and a half times to get people to show up. And you're also going to likely have a bunch of yield issues and inefficiencies. So those all combined into having a little more of an impact in our second quarter than our first quarter.

That's helpful. Thank you very much. So let me take something else that was said and try to understand it better, that you had equipment that you were going to install on those weekends that you weren't allowed to be open for. Presumably you were putting that equipment in for business that you had. Did that delay the ramp of business that that equipment was going towards? And if so, what's the timeline now for moving forward?

It did indeed delay the ramp, and that's why we're projecting a higher quarter this quarter than last quarter.

Understood. Thank you both.

Yep.

And our next question will come from Scott Bundy with Moores & Cabot.

Just one question, if I may. Have you had to add additional square footage in your Mexican facilities to accommodate some of this new business that you have coming your way?

Yes. Can you give us an idea of how much square footage you've had to add?

I think it's about 100,000 square feet, so we are currently in a five-year lease of that facility. We've done some tenant improvements, which are including CapEx, but that is what we've invested in today. And I'm ignorant. I apologize. What is that as a percentage of what is currently available in Mexico?

That's about a 10% increase. Not insignificant. Thanks, guys. Appreciate your time. Thank you. Yep. Thank you.

And that does conclude the question and answer session. I'll now turn the conference back over to you for any additional or closing remarks.

Okay. Thank you all again for participating in today's conference call. I hope all of you and your families stay healthy and safe, and I look forward to speaking with you again next quarter.

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