Key Tronic Corporation (NASDAQ:KTCC) Q1 2025 Earnings Call Transcript

Key Tronic Corporation (NASDAQ:KTCC) Q1 2025 Earnings Call Transcript November 5, 2024

Operator: Good day, and welcome to the Key Tronic FY ’25 Q1 Investor Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Tony Voorhees, Chief Financial Officer. Please go ahead.

Tony Voorhees: Good afternoon, everyone. I am Tony Voorhees, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in our Spokane Valley headquarters is Brett Larsen, 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. During this call, we will also reference slides that accompany our discussion. The slides can be viewed with the webcast, and the link can be found on our Investor Relations website. In addition, the slides, together with a recorded version of this call will be available on the Investor Relations section of our website. We will also discuss certain non-GAAP financial measures on this call. Additional information about these non-GAAP measures and reconciliations to the most directly comparable GAAP measures are provided in today’s press release, which is posted in the Investor Relations section of our website. For the first quarter of fiscal 2025, we reported total revenue of $131.6 million compared to $150.1 million in the same period of fiscal 2024.

Revenue in the first quarter of fiscal 2025 was adversely impacted by customer-driven design and qualification delays of three programs that we believe impacted revenue by approximately $9 million. These delays have since been resolved on two of these programs and shipments have resumed in the second quarter. Production in our Mexico facilities in the first quarter of fiscal 2025 increased by approximately 10% sequentially from the prior quarter. Despite the production delays and lower-than-anticipated revenue, we saw significant improvement in our operating efficiencies compared to the first quarter of fiscal 2024, primarily as a result of recent headcount reductions, a favorable weakening of the Mexican peso and continued improvements in the supply chain.

Gross margin was 10.1% and operating margins were 3.4% in the first quarter of fiscal 2025, up from 7.2% and 22.2%, excuse me, respectively in the same period of fiscal 2024. Partially offsetting these improvements was a write-down of approximately $0.8 million of capitalized variances during the first quarter of fiscal 2025. Accumulated capitalized variances occur when higher production costs are captured in inventory built into previous periods. We expect that in the coming quarters, the reported margins from improving efficiency will be partially offset by the reduction in capitalized variances. Our net income was $1.1 million or $0.10 per share for the first quarter of fiscal 2025 compared to $0.3 million or $0.03 per share for the same period of fiscal 2024.

Adjusted net income was $1.2 million or $0.11 per share for the first quarter of fiscal 2025 compared to breakeven for the same period of fiscal 2024. For more on these non-GAAP measures, see the non-GAAP financial measures description and reconciliations in our earnings release. Turning to the balance sheet. We ended the first quarter of fiscal 2025 by reducing inventory by approximately $31 million or 24% for the same time a year ago. These improvements in inventory levels primarily reflect our concerted effort to drive inventory reductions and increased component availability. We’re pleased to see our inventory levels continue to become more in line with our current revenue. At the same time, the state of the worldwide supply chain still requires that we drive demand for parts differently than in historical periods.

Our customers have revamped their forecasting methodologies, and we have significantly modified and improved our materials resource planning algorithms. As a result, we should be better equipped for future disruptions in the supply chain even as we continue to manage inventory more cost effectively. During the first quarter, we also reduced our total liabilities by a combined amount of $29.7 million or 11% from a year ago. Our current ratio was 2.6:1 compared to 2.4:1 from a year ago. At the same time, accounts receivable DSOs were at 92 days compared to 88 days a year ago, reflecting reductions in net sales at higher rates than reductions in receivables. Total capital expenditures were about $0.4 million for the first quarter of fiscal 2025, and we’re expecting for the full year to be approximately $8 million to $10 million.

While we’re keeping a careful eye on capital expenditures, we plan to continue to invest selectively in our production equipment, SMT equipment, plastic molding capabilities while utilizing leasing facilities as well as make efficiency improvements to prepare for growth and add capacity, particularly in our Vietnam and U.S. locations. For the second quarter of fiscal 2025, we expect to report revenue in the range of $130 million to $140 million. Further moving into fiscal 2025, we are pleased to continue to see our new programs ramping, cost and efficiency improvements from our recent overhead reductions taking hold and a continued weakening of the Mexican peso. Taking all these factors into consideration, we expect net income in the range of $0.05 to $0.15 per diluted share.

We expect to see growth in our U.S. and Vietnam production, have a strong pipeline of potential new business and remain focused on improving our balance sheet. Over the longer term, we believe we are increasingly well positioned to win new programs and profitably expand our business. That’s it for me, Brett.

Brett Larsen: Thanks, Tony. While we did not meet revenue expectations in our first quarter of fiscal 2025 due to unavoidable delays for a few programs, we are pleased to see our improved operating efficiencies and margins begin to take place. Our recent workforce reduction in Mexico, trimming of non-profitable programs and making a concerted effort to reduce working capital are starting to pay off. The weakening Mexican peso during the quarter also further strengthened our reported margins. We also continue to reduce our inventories, which are now much more in line with our revenue levels. Over the longer term, we expect that these strategic changes will improve our overall profitability. During the first quarter, we continued to expand our customer base, winning new programs involving manufacturing production equipment, vehicle lighting and commercial pest control.

The strong pipeline of potential new business underscores the continued trend towards onshoring and dual sourcing of contract manufacturing. Global logistics problems and China-U.S. geopolitical tensions may continue to drive OEMs to re-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 growth, and those opportunities are becoming more clearly defined. At the same time, we are seeing a sustained trend of continued wage increases in Mexico.

As it has become clear that these changes in the base cost of Mexican production are long-standing, we have rightsized our operations in order to remain cost competitive. It has also become clear that our customers nearshoring from China may have a different calculus for selecting a geographic location for business. We believe our Mexico operations provide a full suite of vertical manufacturing for customers looking to nearshore their manufacturing processes. Our Mexico capabilities include plastic molding, sheet metal fabrication and paint, printed circuit board assembly and final production assembly, all contained within a consolidated campus. For those customers who struggled with China production due to their flexibility requirements, we believe our U.S. sites offer outstanding flexibility, engineering support and ease of communications.

While our Vietnam facility continues to be a modest contributor to our overall revenue, a growing number of potential customers are actively evaluating a migration of their China-based manufacturing to our facility in Vietnam. A significant amount of this fiscal year’s planned capital expenditures are scheduled to add additional capacity and capability in our Danang [ph] Vietnam location. In coming years, we expect our Vietnam facility to play a major role in future growth. While our China growth has slowed and many companies have decided to take risk mitigation steps with their China manufacturers, the fact remains that many components still must be sourced from China. Our procurement group in Shanghai, which serves the entire corporation, remains important for managing the China component supply chain on an ongoing basis.

Additionally, our China production facility continues to be profitable, continues to build legacy Key Tronic programs and has found recent success in winning new programs with direct Chinese customers. The combination of our global footprint and our expansive design capabilities is proving to be extremely effective in capturing new business. Many of our large and medium-sized manufacturing program wins are predicated on Key Tronic’s deep and broad design services. And once we have completed the design and ramped it into production, we believe our knowledge of a program-specific design challenges makes that business extremely sticky. We anticipate continued increase in number and capability of our design engineers in coming quarters. We also continue to invest in vertical integration and manufacturing process knowledge, including a wide range of plastic molding, injection, blow gas assist, multi-shot as well as PCB assembly, metal forming, painting and coating, complex high-volume automated assembly and the design, construction and operation of complicated test equipment.

We believe this expertise will increasingly set us apart from our competitors of a similar size. We believe global logistics problems, increased cost of capital, geopolitical tensions and a heightened concern about supply chain will continue to drive the favorable trend of contract manufacturing returning to North America as well to our expanding Vietnam facilities. We continue to see improvement across the metrics associated with business development, including a significant increase in the number of active quotes with prospective customers. While the customer-driven delay temporarily disrupted our growth and profitability in the first quarter of fiscal 2025, as we move further into fiscal 2025 with a strong pipeline of potential new business, and we’re seeing significant improvements in our operating efficiencies and a continued weakening peso.

Moreover, we will continue to rebalance our manufacturing across our facilities in Mexico, the U.S. and Vietnam. We remain very encouraged by our progress and the potential for profitable growth over the longer term. This concludes the formal portion of our presentation. Tony and I will now be pleased to answer your questions.

Q&A Session

Operator: Thank you. [Operator Instructions] And our first question will come from Bill Dezellem with Titan Capital.

Bill Dezellem: Thank you. Let’s start with the three wins that you noted in the press release. What is the size of those?

Brett Larsen: Sure. First two are around $5 million and the third is just under.

Bill Dezellem: Great. Thank you. And then let’s talk, if you would, please, and go into some more depth on the circumstances of the three programs that were delayed.

Brett Larsen: Sure. Three of those programs did have roughly a $9 million impact to the overall quarter. The first was a delay in production for some qualification improvements on essentially their product. That production successfully resumed in the early part of October. The second was a new updated version. And fortunately, as of last week, we’re back ramping production of that and expect by the third quarter of this fiscal year to be back up to the level it was historically. And then the third is a next-gen design that likely will delay until roughly the middle of our third quarter, February or March time frame.

Bill Dezellem: All right. So Brett, since I’ve never actually run a manufacturing business, this question is coming from a point of ignorance. But if the second of the three programs restarted this month, why is it not until next quarter that they’ll be fully ramped?

Brett Larsen: It’s actually the – it is a – for a couple of reasons. One is that the materials required have a longer lead time. Some of the new updated version required some changes in some of the components. So some of that has a little bit of a longer lead time to get full production. And the rest is just ramping staff and production back up. Right in the middle of holiday. No, just with the anticipated couple of weeks of holidays this quarter as well.

Bill Dezellem: Okay. Thank you. And then the one that is not ramping until February or March, what are the dynamics that are leading to what seems like a long delay to get that one back on track?

Brett Larsen: There’s some seasonal demand for that particular product. So the customer is cautiously reviewing the current design and making certain modifications. The delay in that really doesn’t hurt their demand cycle. And again, we’re expecting that to come back online in February.

Bill Dezellem: Okay. That is helpful. And then did I understand correctly in the opening remarks and what you have said that each of these were existing programs, but the next generation and the issues were tied to qualification of the next generation?

Brett Larsen: Yes. All three were. That is correct.

Bill Dezellem: And Brett, was that next-gen qualification tied to something to do with their end customers or with the product working its way through the Key Tronic plants?

Brett Larsen: No, it’s really on their side. It’s design and capability and just taking it to the next gen of that particular product. It was scheduled to be more seamless on all three of those. And each of them, unfortunately, we did see some hiccups in the actual timing of when we can get production.

Bill Dezellem: So none of these were a function of something that you all didn’t do well or a misstep on your side essentially?

Brett Larsen: Absolutely not. In fact, I think we have helped in each of those three instances in providing some expertise, I think, that has actually expedited the resolution of all three.

Bill Dezellem: Okay. Great. Thank you. And then, Tony, would you please re-explain the capitalized variance that you referenced in your opening remarks? I either may have been distracted or otherwise didn’t quite follow what you were conveying.

Tony Voorhees: You bet. Thanks for the question, Bill. Yes. So we did write down our capitalized variances by about $800,000 during the quarter. Those capitalized variances occur or occurred when we had higher costed products sitting in inventory. And as we sell through or ship those products to our customers, we’ll see those capitalized variances come off of our balance sheet. So as they are – as they come off, our capitalized variances will kind of reflect that. It just so happens that in this case, there are write-down of inventory. And we expect, like I kind of mentioned in my opening remarks there, we expect to see that to continue to happen for another quarter or two possibly.

Bill Dezellem: So essentially, the net effect is that your gross margin ends up being hurt by the amount of the capitalized variance write-down. Essentially, it’s said in the old-fashioned way, you’re just working through higher cost inventory.

Tony Voorhees: That’s exactly correct, Bill. I should have just said that.

Bill Dezellem: Okay. And you said you’ll be working through that higher cost inventory for another one quarter or more?

Tony Voorhees: Two quarters.

Bill Dezellem: Okay. Thank you. And then something that I have never really thought a great deal about. But in the opening remarks, Brett, I think you mentioned Chinese business for China in your Shanghai plant. And the question that it prompts is why would a Chinese customer choose Key Tronic Shanghai facility rather than one of the myriad of Chinese competitors?

Brett Larsen: That’s a good point. I think we offer a pretty good solution similar to how we do in each of our global locations. We have quite a bit of technical expertise for the size of operation we are. If you were to look at all of the different legacy products we’ve built in that Shanghai facility, they’re very well versed and very experienced in building product. And I think that’s something that shows through as they’re looking now for more local Chinese OEMs is to provide, hey, these are all the types and different industries that we’ve built for in the past, and we can offer similarly those type of products for a Chinese customer.

Bill Dezellem: Okay. Thank you. And then a couple of additional questions, please. So first of all, you are hitting the – or your guidance for the second fiscal quarter. The lower end of that guidance is flat with this quarter’s guidance, and yet you’re going to have some, I’ll call it, catch-up revenue from a program that start resumed or started up in October, another one that started up in this week or now-ish. Why isn’t that guidance a bit higher? It just seems either that you’re being conservative or that there’s something coming out of the revenue out of the bottom of the bucket, if you will, that I’m not understanding.

Brett Larsen: That’s a good question, Bill. I think as you look at our second quarter, we are typically a little lower in sales and shipments just due to the holidays. I know that our – most of our facilities will be completely closed Christmas week and then for half of the week in over Thanksgiving. So part of it is just the amount of production time that’s available during the quarter. I’d say we’re about a week and a half light compared to what we’ll be able to do then in the third quarter. So that has a direct relationship on how much in shipments we can get out.

Bill Dezellem: Okay. Thank you. And then one additional macro question. We have seen different economic data points that would suggest opposite things and have heard different things from various companies about activity levels picking up versus activity levels staying pretty constant. What are you seeing when you look at your broad base of customers, what’s happening out there?

Brett Larsen: Bill, it’s a mix for us as well. I would say on the whole, I would say that we’re actually seeing some recovery in demand. If you net the ups and the downs, I think we mentioned that in our first quarter, actual production of legacy product was up 10% sequentially in Mexico. We’re expecting that to be flat for this quarter and then an uptick again in Q3 and Q4 of this year. So cautiously optimistic that demand is actually shifting a little more positive. It’d be very interesting to see where things end up after this election cycle. But for now, I think a slight uptick on the net.

Bill Dezellem: Great. Thank you.

Operator: And our next question will come from George Melas with MKH Management.

George Melas: Thank you, operator. Hi, Brett and Tom. So congratulations on the gross margin. It’s really nice to see it in double digit. Tom, I just want to understand that variance that you’re talking about, did it reduce the gross margin? Or did it improve it?

Tony Voorhees: Yeah, George, good question. That reduced our gross margin by about $800,000 for the quarter. So gross margin actually would have even been better without writing off that capitalized variance.

George Melas: Okay. So that’s quite a remarkable feat. And I was looking at your peers and it seems that in terms of gross margin, you’re sort of at the high end of the peers because of smaller scale from an operating margin perspective, you’re sort of slightly below some of your peers, but I think a lot of that is related to the scale. And I think your 3.4% EBIT margin is the best in over a decade. So – and that’s despite the variance. So that’s quite remarkable. It seems like now the balance sheet is improving, but you still have a fairly high level of debt and in particular, high interest expense. And trying to understand how you think you can improve your balance sheet and maybe refine [ph] the debt in the next year or so.

Brett Larsen: That’s a great question, George. I think you nailed that. I think we’re going to continue to drive improvements in working capital. You’ve seen a quarter-over-quarter decline in inventory that started about 18 months ago. I guess it’s now 21 months ago. Our expectation will continue to be managed, as Tony mentioned, that’s critical to our success. The cost of capital is having a significant detriment to our profit. As you mentioned, the amount of interest cost that we’re paying on a quarter-to-quarter is frustrating for us as well. We are busily looking to refinance some portion of that debt and continue to drive some more liquidity. We still feel uncomfortable with this amount of debt.

George Melas: Right. Okay. Okay. And just in terms of the – in the guidance that you have for next quarter, is the capitalized variance roughly at the same magnitude?

Brett Larsen: Roughly, yes. I would say a slight – around $1 million, yes.

George Melas: Okay. Okay. Great. And let me ask you about – and I hope I get this right, but you had this very large power generation customer that had some design issues, I believe. And basically, I think you had very little or no revenue from that customer for – in the last few quarters. Is this customer still on the table? And is there a likelihood that you resume production with that customer?

Brett Larsen: Good question, George. It’s a power equipment provider, and we have not had any substantial revenue from that particular customer for at least three quarters. We still are in discussions with them. They are looking at potentially requesting some more product in next season. So next season would be next summer and fall period. So it’s still on the table. And I think the relationship is still strong with them. Now it’s just determining whether the redesigned product that we came up with would be a good fit for their total offering.

George Melas: Okay. And so you were very involved in the product redesign?

Brett Larsen: Yes, absolutely.

George Melas: Okay. Great. And then one final one, and it’s kind of hypothetical, but if you had been able to produce that extra $9 million from those three programs that were delayed, and you assume sort of a similar gross margin and then it pretty much falls to the pretax line. It seems like it would have added almost $1 million in pretax income and taxing that, let’s say, at 20%, maybe roughly $0.07 per share. Is that sort of a right calculation?

Brett Larsen: On paper, yes, George. Yes.

George Melas: And what would be different in reality.

Brett Larsen: No, I think, yes. I think the incremental margin on $9 million worth of business would have equated to at least another $1 million of margin. So, yes.

George Melas: Right, right. Okay. And then just my final question on the gross margin, being so focused on it. Is it – assuming the peso remains where it is now, is it a sustainable level of gross margin?

Brett Larsen: We’d like to say so. Yeah, I think our goal has always been 9% to 10%. We just exceeded that for the first time that I can remember. And yeah, we want to continue to drive that efficiency and that profitability. The peso definitely has helped. You’ll see on our balance sheet that we have entered into some forward contracts. We’re about 50% hedged for the rest of the fiscal year at some fairly high or low-cost peso. So yes, my expectation is that, that gross margin will continue to remain healthy as long as some other unforeseen event doesn’t happen.

George Melas: Okay. And so that’s – you remember many years ago, you were somewhat hedged. You had these 3 years rolling hedges. And so you re-entered into some hedges at this point because you saw the opportunity.

Brett Larsen: Yeah. We saw the opportunity. And at the point in time, we saw the weakness in June, we started making some hedges, and we’ve continued to do so. And that’s part of our business practice is to take advantage of a weakened peso when possible. But even more so to be able to more accurately budget our production costs moving forward and make sure that, that’s included in our price to our customers.

George Melas: Right, right. Okay. Great. Okay. I look forward to a time when the balance sheet keeps improving and then would have a really big impact on the bottom line. Thank you.

Brett Larsen: Thanks, George.

Operator: And our next question will come from Bill Dezellem with Titan Capital.

Bill Dezellem: Thank you. I have two follow-up questions. First, relative to the Mexican operations restructuring, are those activities now complete? And if so, has the benefit fully flowed through the P&L in the first fiscal quarter? Or will it be in a future quarter?

Brett Larsen: That’s a complex question, Bill. It’s a great one. Part of that cost is still stuck in capitalized variances. So while the actual labor or the wages that we’re paying now, yes, are 100% we’re seeing that improvement in our wages that we’re paying. However, some of the higher cost inventory is still stuck on the balance sheet as we write through that. So actual production costs, yes, Bill, I think those are definitely – that’s a big part of why we were able to achieve 10% plus gross margin this quarter is because of those reductions in force. To say that we’re done, I don’t think we’ll ever be done. I think there’s always – we’re going to continue to look for ways to be more efficient. And I think the fact that we were able to go through those reductions with limited to no impact to timeliness of building product for our customers, is there some more efficiencies that we can gain?

Is there some additional headcounts that may not be required. So to say that we’re done, I don’t think we’re done. We’ll continue to monitor that and continue to compare that to the current load down in Mexico. But yes, the reductions that we did earlier in this calendar year were fully seen in overall wage reduction. That was a long-winded answer, but hopefully able to address your question.

Bill Dezellem: Well, it did, and it expanded on it a bit, which was very helpful. But just to be clear, the activities that you – or cost cutting that you had originally identified, that was done at the beginning of the fiscal Q1, even though there may be more to come as you put a finer look on it.

Brett Larsen: That is correct. That is correct.

Bill Dezellem: So I’m going to try to piece a couple of things together here because I’ve not heard you in the past talk about the capitalized variances. And so I’m thinking about the significant cost reductions that you had in place at the beginning of the quarter. And so ultimately, you’re producing product at a lower cost than what was in inventory. And so is essentially the restructuring that you have done and were completed with at the beginning of the quarter, the reason that we now have a call out for these capitalized variances or said another way, because you cut costs and that was done at the beginning of the quarter, but you then had a flow-through of that higher cost inventory that that’s not a phenomenon that you’ve experienced in the past. And so that’s why it’s a new call out this quarter and then we’ll carry it forward a bit longer.

Brett Larsen: Yeah. I think the magnitude of the write-down of that capitalized variance, that’s one of the reasons why we discussed it this quarter.

Bill Dezellem: And is it a correct supposition that had you not done the cost reductions or the restructuring that there wouldn’t have been this capitalized variance because your current inventory cost would be very similar to your prior or old inventory cost?

Brett Larsen: That is correct. Yeah.

Bill Dezellem: Okay. That is helpful. And then one additional question. And I’m going to go back quite some time now ago, but you all had, at one point, had a real focus on return on capital. And I’m wondering to what degree that’s entering into your current or future mindset. And just would love to get a perspective on that, please.

Brett Larsen: Yeah, 100%. Yeah, that is definitely our goal. That is what we’re looking at. Each and every program is highly scrutinized. What is the amount of capital – we’re not just looking at top line revenue. We’re even not just looking at the margins that’s generated from shipments of that program. We’re also looking at how much capital is employed on that particular program? And is it a good fit for Key Tronic. So we have done some trimming of some certain programs. And I would also say that we’ve even put a finer filter on new quote opportunities coming into the sales funnel based off of that same KPI is what is the true return on invested capital in that potential program. So yeah, that definitely top of mind. A lot of – I think that’s driven us to get there is just the cost of capital is exponentially what it was 2 or 3 years ago.

Bill Dezellem: Right, great. Thank you for the additional perspective.

Brett Larsen: You bet.

Operator: [Operator Instructions] We’ll go to George Melas with MKH Management.

George Melas: Hi, guys. Thanks for taking the follow up. A quick question on CapEx. It was very low in the first quarter. They seem to be sort of more normal for the rest of the year. But I think you said a big chunk of that is slated for Vietnam. Is this based on – are you spending – are you putting capital there ahead of customers, ahead of revenue? Or is that more like a success-based CapEx where if you have new customers going to Vietnam, you will spend that money?

Brett Larsen: George, great question. That’s actually a little bit of both. We see a customer that is headed there, and we’re taking the opportunity to go ahead and build out some additional capacity beyond what just that customer is going to require. We’re excited for what Vietnam could be in the future. We’ve had some incredible success of a greenfield there in Danang and seeing where costs are at in Mexico. The geopolitical tension in China, I just think it’s worth us to strategically invest in that Vietnam facility. So will the amount of CapEx that we’re investing in Danang be immediately utilized by that new customer? Absolutely not. We’re going to have some extra capacity and it will show very, very well to potential customers visiting.

George Melas: Okay. And Vietnam, I gather, is less than 10% of revenue now, but do you expect it to reach those levels by the end of fiscal ’25?

Brett Larsen: I’d like to say yes. I think, you know, by early next fiscal year, I think they’ll easily be 10% of total revenue.

George Melas: Okay, great. Good luck with everything.

Brett Larsen: Thanks, George.

Operator: And that does conclude the question-and-answer session. I’ll now turn the conference back over to you for any additional remarks.

Brett Larsen: We appreciate you joining our conference call today. Tony and I look forward to speaking to you again next quarter. Thank you.

Operator: Thank you. That does conclude today’s conference. We do thank you for your participation. Have an excellent day.