Key Tronic Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
May 7, 2024

There are 6 speakers on the call.

Operator

Good day, and welcome to the Third Quarter Fiscal 20 24 Key Tronic Corporation Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Brett Larson. Please go ahead.

Speaker 1

Good afternoon, everyone. I am Brett Larsen, 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 Craig Gates, our President and Chief Executive Officer and Tony Voorhees, our Vice President of Finance and Corporate Controller. 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.

Speaker 1

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 ks, 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.

Speaker 1

Today, we released our results for the 3 months ended March 30, 2024. For the Q3 of fiscal 2024, we reported total revenue of $140,500,000 compared to $164,600,000 in the same period of fiscal year 2023. Revenue for the Q3 of fiscal 2024 was constrained by approximately $5,000,000 due to severe winter weather events that took Key Tronic's facilities in Mississippi and Arkansas offline for approximately 2 weeks. In addition, we saw softening demand for a number of different programs produced in Mexico. For the 1st 9 months of fiscal 2024, our total revenue was $433,700,000 compared to $425,500,000 in the same period of fiscal 2023.

Speaker 1

For the Q3 of fiscal 2024, our margins and profitability were significantly impacted by an unusual combination of events. First, we incurred severance costs of approximately $3,700,000 or $0.27 per diluted share, as we reduced our workforce by over 4 50 employees in Mexico. The severance costs were incurred late in the 3rd quarter, which limited the payroll expense reduction that could be recognized for the quarter. We also continue to be adversely impacted by high labor costs and interest expense and by the continued strengthening of the Mexican peso. Relative to the U.

Speaker 1

S. Dollar, the peso rose by approximately 5%, increasing our expenses by approximately $1,500,000 or $0.11 per diluted share. Furthermore, the temporary facility closures in the U. S. Due to severe weather resulted in loss of contribution margin of approximately $1,000,000 or $0.07 per diluted share.

Speaker 1

As a result of these factors, our gross margin was 5.8 percent and operating margin was a loss of 0.4% for the Q3 of fiscal 2024 compared to gross margin of 8.7% and an operating margin of 3.1% in the same period of fiscal year 2023. Our net loss was $2,200,000 or $0.21 per share for the Q3 of fiscal 2024 compared to net income of $2,000,000 or $0.18 per share for the same period of fiscal 2023. For the 1st 9 months of fiscal 2024, the net loss was $802,000 or $0.07 per share compared to net income of $4,100,000 or $0.38 per share for the same period of fiscal year 2023. As we also noted in today's earnings release, we cured a breach of our fixed charge coverage ratio covenant in our asset based revolving credit facility as of the end of the third quarter by executing a new amendment to the agreement with our lender today. This amendment will provide relief on the financial covenants for the next 12 months, increase the re interest rate by 100 basis points and advance the maturity date of the agreement to September of 2025.

Speaker 1

Turning to the balance sheet. We ended the Q3 of fiscal 2024 by reducing inventory by approximately $39,000,000 or roughly 22% from the same time a year ago. These improvements in inventory levels primarily reflect increased component availability and our concerted effort to drive inventory reductions. 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.

Speaker 1

Our customers have revamped their forecasting methodologies and we have significantly modified and improved our material sourcing 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 Q3, we also reduced our accounts payable, leasing obligations and overall debt by a combined amount of $57,100,000 from a year ago. Our current ratio was 2.8:one compared to 2.2 a year ago. At the same time, accounts receivable DSOs was at 83 days compared to 79 days a year ago, which we believe reflects some increased delays in collections from certain customers, despite continuing improvement of most customers with respect to disruptions from supply chain issues.

Speaker 1

Total capital expenditures were $700,000 for the Q3 of fiscal 2024 and we expect total CapEx for the year to be around $5,000,000 While we're keeping a careful eye on capital expenditures, we plan to continue to invest selectively in our production equipment, SMG equipment and plastic molding capabilities, utilize leasing facilities as well as make efficiency improvements to prepare for growth and add capacity, particularly in our U. S. And Vietnam locations. For the Q4 of fiscal 2024, we're seeing a rebound among our legacy customers relative to our Q3 and a strong backlog of new customer program opportunities. For the Q4 of fiscal 2024, we expect to report revenue in the range of $135,000,000 to $145,000,000 While new programs continue to ramp in our Mexico facilities, efficiency improvements, a muted rebound to pre COVID production levels amongst existing Mexico customers and the continued pressure of a strengthened peso combined prompted us to reduce our overhead in our Juarez facilities.

Speaker 1

In the Q4, we expect to incur additional severance expense of approximately $500,000 to $1,000,000 from additional headcount reductions in our Mexico based operations late in Q4. The payback period for this decision is expected to be under half of a year. Taking all these factors into consideration, we expect net income to be in the range of $0.03 to $0.10 per diluted share. In the Q4 of fiscal 2024 and moving into fiscal 2025, we expect continued sales growth in the U. S.

Speaker 1

And Vietnam, and we have a strong pipeline of potential new business. Over the longer term, we believe that we are increasingly well positioned to win new programs and to continue to profitably expand our business. That's it for me. Craig?

Speaker 2

Okay. Thanks, Brett. During the latter half of fiscal twenty twenty four, we are taking necessary steps to reduce our workforce in Mexico due to the softening demand for a number of different programs with high support labor content, which is expected to save us more than $10,000,000 annually. In the coming quarters, we expect sales from Mexico based production to recover due to recently won programs and we do not anticipate needing to increase our headcount in coming periods, reflecting the significant improvements to our operating efficiencies. At the same time, our while lower volume products with higher service level requirements will migrate to our other sites.

Speaker 2

We're also pleased to see overall improvements in our operating efficiencies and inventory levels and other improvements made on the balance sheet. During the quarter, we continue to expand our customer base, winning new programs involving up to $20,000,000 in energy management account, around $5,000,000 in the telecommunications account, around $3,000,000 in the consumer audio account and around $5,000,000 in industrial manufacturing account. The strong pipeline of new business underscores a continued trend towards on shoring and dual sourcing of contract manufacturing. Global logistics problems in China U. S.

Speaker 2

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 growth and those opportunities are becoming more clearly defined. At the same time, we are seeing a sustained trend of strong Mexican peso and continued increases in Mexican wages, particularly along the U.

Speaker 2

S.-Mexican border. As it has become clear that these changes in base cost of Mexican production are longstanding, it has also become clear that customers have a different calculus for selecting a geographic location for businesses that they are bringing back from China. For those customers who struggled with China production due to their flexibility needs, the decreasing cost differential between our U. S. And Mexico plants means that they will probably choose 1 of our U.

Speaker 2

S. Sites. There we believe they can enjoy the ultimate in flexibility, engineering support and ease of communications. Meanwhile, for those customers whose requirements had adapted to the China model of limited flexibility, challenging communications, slow motion engineering support, our Mexican facilities remain the answer. Therefore, we are reconfiguring our Mexico sites to endeavor to be a lower cost, high quality, but more commodity level service provider.

Speaker 2

Over the past 12 months, revenue from our U. S. Production facilities has increased approximately 15%. In Q3 of 2024, production in the U. S.

Speaker 2

Represented about 30% of our total revenue. 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. In coming years, we expect our Vietnam facility to play a major role in our growth. While China growth has slowed and many companies have decided take risk mitigation steps with their China manufacturers, the fact remains that many components 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.

Speaker 2

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 the program specific design challenges makes that business extremely sticky. We also continue to invest in vertical integration and manufacturing process knowledge, including a wide range of plastic molding, injection, glow, 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.

Speaker 2

As a result, a customer looking to leave their contract manufacturer will find a one stop shop in Key Tronic, which is expected to make the transition to our facilities much less risky and cobbling together a group of providers, each limited to a portion of the value chain. In fact, most of the new customers we have onboarded take advantage of the one stop shop capabilities we provide. We believe global logistics problems, China U. S. Political tensions and heightened concerns about supply chains will continue to drive the favorable trend of contract manufacturing returning to North America as well as to our expanding Vietnam facilities.

Speaker 2

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 unfortunate combinations of factors temporarily disrupted our growth and profitability in the 3rd quarter, we move into the Q4 of fiscal 2024 with a strong pipeline of potential in the business. While we're seeing improvement in our operating efficiencies, recent wage increases, higher interest rates and a strong pace that will dampen our growth and profitability in the 4th quarter. Moreover, we will continue to rebalance our manufacturing across our facilities in Mexico, the U. S.

Speaker 2

And Vietnam. We remain very encouraged by our progress and potential for profitable growth over the long term. As we previously discussed, Brett will succeed me as President and Chief Executive Officer at the end of June, while I expect to remain a member of the Board. Additionally, Tony will become our Chief Financial Officer. Since this will be my 60th and last quarterly investor conference call, I want to express my deep gratitude to our shareholders, customers and vendors.

Speaker 2

I want to express my sincere thanks to our outstanding employees for their dedication and commitment to our success. It has been a great honor to lead this team and I have full confidence that Brett, Tony and their outstanding team will continue to take Key Tronic to new heights. This concludes the formal portion of our presentation. Brett, Tony and I will now be pleased to answer your questions.

Operator

Thank Your first question comes from the line of Bill Dezellem with Tieton Capital.

Speaker 3

Please go ahead. Craig, you preempted my first question, but I did miss the energy management. What was the size of that one? Bill,

Speaker 2

it was my parting gift to you. That was up to 20,000,000

Speaker 3

dollars Okay. That's excellent. Thank you. Would you please walk through each of these and highlight maybe important aspects to them, whether they're existing customers or whether they are new customers. What if anything was unique about these wins that highlights a competitive advantage that you all have or something else interesting?

Speaker 3

And I do appreciate the parting gift.

Speaker 2

Thank you. You're welcome. The first one is an interesting one because this and it's a new customer. This customer came to us almost 2 years ago and had an edict that they needed to significantly increase their outsourcing in Mexico. And they played a significant role in helping us upgrade our metal coating capability because they have a very high end requirement for withstanding the salt spray test.

Speaker 2

So after a number of changes to our chemistry and in our painting process, we were able to pass that long term salt spray test. And since then, the flood gates have opened and they have been giving us more quotes and awards than we can handle. So that's been a 2 year success story that we were never sure was really the pot of gold at the end of the rainbow the customer was telling us. But our technical folks hung in there and in the end it's going to be a very nice and long standing program.

Speaker 3

And so is this a single program or is this up to $20,000,000 one of the many programs that they are giving you?

Speaker 2

It's already more than one program and there are many more to come.

Speaker 3

That's helpful. And the other 3?

Speaker 2

The other 3 are pretty much run of the mill in terms of standard reasons why they chose Key Tronic.

Speaker 1

The consumer audio is a customer in house today. This was just a new program, right? The other 2 are new customers and new programs for Key Tronic.

Speaker 3

Thank you. That's helpful. And then if I may, jumping to the softening demand that's referenced in the press release and then possibly, Brett, in your opening remarks, you referenced that that has maybe even turned to a rebound. Would you pull all of that together for us, please?

Speaker 2

This is somewhat of a COVID hangover. A lot of people, you and I have discussed this, were concerned a year ago that there was a massive COVID hangover. And what we found is that it's scattered and spotty. A couple of our large customers did have too much inventory that they had built or had us built for them as parts became available and what were really COVID driven false demand signals tempted them to continue building at a high rate. But it wasn't widespread.

Speaker 2

And as we've seen just in the last 2 or 3 months, those customers have drawn their inventory down of the products we make for them to the point that their forecast and orders are rebounding to the normal throughput levels that we would expect. So that's really that's the overall set of circumstances. It's governing what we talked about as a softening and then a slight return or muted return, I think we used the word.

Speaker 3

So from your standpoint, if you were to look out just from an overall economic view, is it your sense that demand continues reasonably strong, I'll call it end demand and now you've worked through some inventory, excess inventory and so that volatility if we were to exclude that, we're discontinuing with more of the same of decent demand. Is that a fair way to look at what you're experiencing?

Speaker 2

Yes.

Speaker 3

Great. Thank you. And then let me jump to the severance, if I may. Severance came late in the quarter, as you pointed out. Why was that?

Speaker 3

Because this is something, if I recall, that we talked about on the last call, And so I would have expected it maybe to happen sooner.

Speaker 2

Well, when you affect people's lives and many of these people have been with us for quite some time, you want to be absolutely sure you're doing the right thing and you're doing it with the right people. So it took us a little longer than we thought to get it done. But we are confident that we have done it in a caring and professional manner and done what needed to be done.

Speaker 3

And Craig, this sounds a little bit different than layoffs that you have had in the past where demand falls off and line workers are laid off. I'm just getting a different vibe than historical layoffs. Am I over reading into this or is there something more to be discussed here?

Speaker 2

There's a lot more to be discussed because these layoffs represent a significant strategic change in how we view Mexico versus America versus China versus Vietnam. We tried to get at it in my prepared remarks, but actually the way I think about it is a little bit more simpler and crude I think than the flowered way we put it. That is in the past year, 6 months to a year, there's been a sea change in the average makeup of the customers who are interested in Mexico. So take this as we're clear that this is the average, it's not every customer. But what's happened is that the people who wanted to be in China, but are not being allowed to do so by a management edict, are now making up a significant portion of the folks that are interested in Juarez.

Speaker 2

So those people were either in China or were headed to China and they were going China driven mainly by cost and we're willing to accept the lack of flexibility in moving orders in and out, lack of ability to send their engineers into the factory in short term, lack of ability to get their parts here in a week rather than month and a half, lack of ability to do business in English versus a mix. So they had become used to all that or were ready to endure all that in return for the lowest possible price they could get. Those a lot of those people are being told it's too risky, you are not going to go to China and figure something else out. So they end up knocking on our door, but they had sticker shock when they saw the cost that we were proposing out of Aurora's plant because Aurora's plant was configured for a different set of people. And those set of people were the ones who didn't want to go to China, knew that they couldn't live with all the disadvantages I just listed and were willing to pay a little more to be in Mexico and enjoy all the near shore advantages Mexico has to offer.

Speaker 2

Well, those people used to make up the majority of our available market share. Now the majority of our available market share on average is made up by the people on the other side of the fence who want to be in China, but are not being allowed to go there. So that means that all of the overhead in our factory in Mexico, the people overhead, the quality technicians, the engineers, the folks who worked in scheduling and on the plant for material handlers, program managers, all those people that we had built up over the years to provide U. S.-based service levels, but at a cost. We're not willing to be paid for by this new set of customers.

Speaker 2

And so those are the folks that may end up the majority of this layoff, which has never happened before in our history. So those folks are long term employees of Key Tronic. The wage structure and laws of Mexico require a significant severance payoff for folks in that category. And you're exactly right. This is nowhere near the normal type of layoff, but it strategically positions the Mexican facility to compete and win as we've seen in the last 6 months, a new breed of customer that represents a very big available market.

Speaker 2

So that's why it took longer than normal. That's why the severance was much higher than normal. And that's why you're sensing that it was different than normal.

Speaker 3

That's really insightful. Thank you, Craig. So these because these are not your standard line workers that you'll bring back with higher production rates, your cost structure is permanently being lowered then is what you're saying?

Speaker 2

Yes.

Speaker 3

Does it somehow also affect the capacity of the facility? And I'm not necessarily the layoffs, Craig, but the restructuring to have essentially less flexibility, that sounds to me like you'll have more hours of lines up and running and less time down with the customer noodling over whether they ought to do something a little different or whatever.

Speaker 4

Is that a

Speaker 3

correct interpretation or not?

Speaker 2

It is. And in fact, we have pruned a very small number of customers who no longer fit into the model that you just described. So it will result in more product being made with less line workers because every time you have to shut a line down and change it over, not only did you have to have a bunch of engineers and quality folks and material handlers out there swapping the line over, Inevitably, you couldn't time it perfectly. So you had line workers who were milling around waiting for some part or some process to come up the way it should. So it's going to turn much more into a bang bang slapping parts together.

Speaker 2

And I don't want to say that in a low quality means, but it's going to be a lot more of just run something at high volume than it is switch over every 10 minutes because the customer called up and is freaking out.

Speaker 3

That's helpful. And then I'm sorry, go

Speaker 2

ahead. That type of work is migrating back to the states because people are willing to pay even more to get that level of service than they have been in the past.

Speaker 3

Fascinating. Okay. Thank you. And then lastly, if we exclude the severance and the winter weather shutdown, then we're looking at $0.13 of earnings, just what would have happened had you not had the one intended event and then the weather that surprised you? Yes.

Speaker 3

Okay, great. Well, thank you. And I'll let others ask additional questions. But thank you for all the time you have given me on these conference calls to ask questions over the last, maybe even 60 calls. So thank you.

Speaker 3

Appreciate it. And Brett, we look forward to working more with you in the future.

Speaker 2

Thank you, Bill. You're more than welcome and we've appreciated your insightful questions also.

Speaker 4

Thank you.

Operator

Your next question comes from the line of Bob Pool with Brickler Capital.

Speaker 2

Hi, guys.

Speaker 5

So I'd like to apologize in advance because I'm going to ask some tough questions and make some tough comments. And I hope you'll I think they need to be asked and the comments need to be made. So but I do apologize in advance because this usually a pretty friendly forum. So, first of all, I want to sort of wage a protest that the way you present your financial results is totally out of line with I follow hundreds of companies and you're the only one who presents your results the way you do without making adjustments for things like severance and so forth and presenting your results and your guidance after things like severance. Nobody else does that.

Speaker 5

And I don't think that there's any special pass to financial heaven for being so puritanical in that presentation. Brett, you and I have discussed this a little bit. How do you feel about this going forward?

Speaker 2

Your comments are noted. Next.

Speaker 5

Okay. So the guidance is very hard to understand and I'll tell you why. You're basically projecting flat revenues from the Q3 to the Q4 and on $140,000,000 of revenues you had $575,000 loss in Q3. That included $3,700,000 of Mexican severance. So that should not exist in the Q4.

Speaker 5

You're taking out $10,000,000 a year or 2,500,000 dollars per quarter in Mexican labor. That should not be there in Q4. I think the impact of the peso is likely to be you've probably taken out half of your expenses in Mexico. If the impact of the peso, assuming it stays around the same level, there hasn't been a significant it seems to be pretty flat so far this quarter. That should be 750 better in the 4th quarter, which should bring if something else wasn't going on, that would bring operating income to 6,400,000, 6 $1,375,000 Taking into account the 1% increase in your bank spread, that's probably about $1,200,000 a year or $300,000 a quarter.

Speaker 5

So that keeps your interest from $2,800,000 to 3.1 that brings pretax income to $3,275,000 20 percent tax rate brings you to roughly 2 point $6,000,000 in after tax income on 10,800,000 shares. That's $0.24 a share. You're talking about $0.03 to $0.10 a share. If I make the adjustment for the new information that Brett gave about $500,000 to $1,000,000 more in severance in the 4th quarter, If I take that out, that gives you to $0.19 a share. So what am I missing?

Speaker 5

What haven't you told us that is negative in the Q4 that accounts for the difference between $0.03 to $0.10 $0.19

Speaker 1

That's a lot of moving pieces. I will let you know that I don't know that I agree with all of your adjustments.

Speaker 4

Our expectations

Speaker 5

Take a moment, please, Brett. Brett, tell me where I'm wrong.

Speaker 1

Well, I'm not going to get in an argument here. It's not worth it. But I will let you know that the peso recovery of $750,000 is not accurate. And I'm also ensuring that the cost structure that you're anticipating of the $10,000,000 that's not immediate. That is ramping over 4 quarters.

Speaker 1

So both of those, I think, are likely incorrectly calculated and no additional material events are included in that projection of 4th quarter results.

Speaker 5

So can you explain why if you've terminated all of these people, why you're not and the savings in a year is $10,000,000 Why is it not $2,500,000 a quarter?

Speaker 1

Because it's not we're not done with severances. We mentioned that we still have $500,000 to $1,000,000 of severance to occur in the Q4. Those have not been fully done even as of today. And we also mentioned that that would take up to 6 months to fully recover that severance amount. So to

Speaker 2

be able

Speaker 1

to say that we're recovering $2,500,000 of expenses in the 4th quarter, net of what we're paying in severance, is just not accurate.

Speaker 5

So actually, Brad, if you go back, you've paid $3,700,000 in severance so far. And let's say you pay another $1,000,000 that's $4,700,000 That if you're going to get that back in 6 months, that's about $2,500,000 a quarter, Brett.

Speaker 1

Again, it's I'm working

Speaker 5

with your numbers, Brett. So it's not like I'm making this stuff up,

Speaker 1

Bob, we're talking a few $100,000 of your $0.19 and our $0.10

Speaker 5

That's about a that's over $1,000,000

Speaker 1

That 4th quarter severance is still in process.

Speaker 5

Right. So, yes, so I've taken that out to get to the $0.19

Speaker 1

I disagree as well with your effective tax rate. I think you need to go back and recalculate that, particularly coming off of a loss in 3rd quarter. You told us in your guidance 25%. Okay. Is that what

Speaker 5

the Yes. So you need to update your business outlook because it's at 20%, Brett.

Speaker 1

Correct.

Speaker 5

So I'm working with your numbers. I mean, you guys got to get this together. It's really bad. Okay. Next question.

Speaker 5

You're sort of talking about a strong backlog business coming back, yet revenues really if you account for the fact that you lost $5,000,000 of revenues last quarter, that should have been $145,000,000 for the quarter and now you're projecting sort of $140,000,000 at the midpoint. Bill kind of asked this question, but it's hard to reconcile your comments about business getting better and having a strong backlog and another 3% to 4% decline in revenues? How do you reconcile those?

Speaker 2

I think the words I used were muted.

Speaker 5

Well, that's negative. That's not muted benefit. That's muted decline.

Speaker 2

Well, as you said, Bob, this is becoming unpleasant and I don't intend to argue with you. Semantics of what we said. We're giving you a true representation of our belief of the revenue going forward. We're giving you a true representation of the backlog we have and we're giving you a true representation of the new customer pipeline we have as well with new quotes. So that's that.

Operator

Thank you. Your next question comes from the line of George Melas with MKH Management. Please go ahead.

Speaker 4

Thank you. Maybe just a question about the the layoffs and the severance. And Craig, you mentioned $10,000,000 in savings. When do you expect to get that $10,000,000 in savings? And how much do you expect in the June quarter and in the quarters after that?

Speaker 2

So the quarter we're in right now, we're going to get a portion of it. And as we get into July, August, September, we should be seeing most of it per quarter.

Speaker 4

Okay. So does that mean that by September, you are at the full run rate of 10,000,000

Speaker 2

dollars Yes, that's correct. Yes.

Speaker 4

Okay, great. That's helpful. And roughly how much are you getting in the 2 quarters?

Speaker 1

It is roughly between $1,500,000 $2,000,000

Speaker 4

Okay. And why is that? Is that because you established the nuance, but you haven't you can let go everybody as of March 31st, is that what it is?

Speaker 1

That is correct.

Speaker 4

Okay. Very good. Then a question that relates to a bit to what Bill was asking. Do you actually have some customers migrating from Mexico to the U. S?

Speaker 4

Because as I look at, if you are reducing your capability in Mexico, having sort of fewer people to handle the project. The customers that you still have there that have these expectations, how do you manage that? I mean, are we going to have like a bifurcated service almost in Mexico? Yes. That's a very perceptive question.

Speaker 2

Yes. That's a very perceptive question. What we're moving from is a factory that was loaded with the overall ability to handle anything that happened to any customer at any time. And we're moving to a factory that is specifically loaded by customer to provide whatever services the customer decides that they would like to pay for. So it's almost impossible, at least we found it to be so, to control costs when you're peanut buttering it over the entire facility or 9 facilities.

Speaker 2

When you have specifically talked with existing and new customers about what is it you're looking for and this is your base price. And if you want to be able to call us and switch back and forth in a day, we're going to have to add this much support labor. And if you're not willing to pay for it in Mexico, but you want it, then you probably ought to go somewhere else. And if you do want to pay for it, maybe it makes more sense at the levels you think you're going to need to move to the states. And so we have seen some customers who have decided to move their production to our one of our facilities in the States.

Speaker 4

From Juarez to Mexico or from Juarez to the U. S?

Speaker 2

Yes. Not a large amount, but some.

Speaker 4

Okay. Yes. I'm just confused about how you ran a plan like this for 9 facilities with different set of expectations among different customers. And in a way, I sort of love the fact that we were sort of like had a real differentiation on designing and handling difficult jobs that then were sticky. But it seemed that these new customers is not really that.

Speaker 4

They're pretty commodity oriented guys.

Speaker 2

Well

Speaker 4

maybe I'm just running very too much into it.

Speaker 2

No, it's a really good question and I want to make sure we're perfectly clear on it because it's a very key strategic portion of our thinking. Okay? So we talk about design capabilities with difficult designs and difficult products that make those products sticky. Those designs and those processes come out of the engineering staff in Spokane. The ability to manage a poorly designed or dodgy product that Key Tronic didn't design that we just transferred, that has to come out of the folks in Juarez.

Speaker 2

So when we cut our ability to provide service on a peanut butter level, that means that if a customer wants to transfer to us a product that has a dodgy process, we now upfront say, yes, we don't want to call your baby ugly, but your baby is kind of ugly. And we realize that you have quotes from other suppliers that are lower than our quote. And we are happy to give you a quote that would be dirt floor levels of engineering support. But you're not going to succeed building this product with this design in a factory without engineering services. So we're either going to have to agree that our price is going to be higher than what you're hoping for or we're going to have to help you change the design or you're going to have to go somewhere else with this product.

Speaker 2

So that's I don't know if that helps you, but that's a little bit of insight to how we're doing it. And then secondly, with customers that have said, yes, we want this level of service, it's much easier to control the cost since we already have a lot of practice in creating miniature factories within factories. So we have a little factory inside a big factory that we can say, all right, we're going to put 1 or 2 people on the support for this department. And they're not just on the overall salary supporting the whole company whenever a problem comes up, they're only going to be full time on this department building this product for this customer because this customer is paying for it. So it's much easier to control the cost and much easier to calculate the cost when you've got it basically laser pointed onto a product and a customer rather than smeared across an overall strategic intent of being high service for everybody.

Speaker 2

So we haven't lost the ability to market ourselves as a high service supplier out of Juarez. What we've changed is our ability to provide a low service cost for those people who want it. So it's kind of like one of the few things I took away from business school was if you can't be niche, you have to be low cost. So we now have the ability, if we are not niche by virtue of design or service levels, to be low cost out of Juarez by clearly defining to the customer upfront that if you're going to want this, it's going to cost this. Does that make sense?

Speaker 4

It does make sense. It's an interesting thing to manage. Let me ask a question there that's related to that. So does that mean that the conversation that you have with your customer is meaningfully different than it was before. Yes.

Speaker 4

It's almost like you're proposing alternatives for them and they can choose from that. You didn't do that really before.

Speaker 2

We didn't have the opportunity to say, if you want to come to Juarez and be a low cost, low service customer, here is your new price because we didn't have the capability of removing all of that peanut buttered overhead from our cost structure on a given quote. And even if you could do that, it takes a while to figure out on a given product what that cost should be if you're trying to come up with a new formula. And if you can't do that quickly, it's hard to convince a customer that you actually are going to have that ability to give them what they want in very, very low cost, low service. So we have right now almost 80 active quotes. And people want 2 to 3 weeks of response time on a quote.

Speaker 2

And if you're trying to recalculate your cost structure every time you get a weird product, you can't do it quick enough. It's much easier to add than it is to try to find a way to subtract.

Speaker 4

Okay. And if you look at your customers now in Juarez, they are mostly the niche. They're mostly the high service customers. The low cost is still a very small group, but you think that's where the growth will come?

Speaker 2

No, that's not true. It's a mix. And part of the revelation is that on this is that as we were being forced by the wage rates and the peso, as we're being forced to raise prices across the board on customers, we realized that the low service customers were going to bolt. And as we struggled to figure out how we could keep those customers in the face of these wage and peso problems, that was part of our revelation on, okay, wait a minute, we're in a different market now.

Speaker 4

Got it. Okay. Super interesting. But in a way, if we look back 2 years ago, this would have come to you guys a little bit as a surprise. Well, I guess it was forced upon you, as you said, partly by the wage rates and the peso and then accelerated by the demand of some of the people who were operating in China?

Speaker 2

It actually goes back 4 years to the beginning of COVID and the gradual and accelerating end to the answer every single procurement agent we spoke with to the question of where should I be, the answer was China. And as COVID and Trump and China and the States and tariffs and supply chain and all of that is added together. And I'm not sure the general public knows this, but it used to be a 100% in fashion call. If you got a bunch of OEM CEOs together 5 years ago, it would be almost embarrassing for them to say they were building anywhere but China. They would be asked, what are you thinking?

Speaker 2

Their Board would be asking them, what are you thinking? Why are you not in China? That has changed dramatically now as a result of all those economic and political and physical events that have happened in the last 4 years. So that the market we are operating in is dramatically different than the one we were in 5 years ago, 4 years ago. And that's why we were doing what we were doing 5 years ago and that's why we're changing what we're doing now.

Speaker 4

Okay, great. And then maybe a couple of more questions. From a gross margin perspective, is and I think the idea is to try to get back to a 9% gross margin or maybe even higher. Is that still a possibility? Or does that sort of new strategy actually impair that?

Speaker 2

I think it's still a possibility. I don't think the strategy impairs it. And I think the ability to build more faster with less people is a help rather than a hindrance to that.

Speaker 4

Okay, great. Craig, thank you very much for everything, for your time, for your answers and you're not going away. So I'm happy about that. And Brett and Tony, best of luck with everything. We'll have many more conversations.

Speaker 2

Thanks, George. It's been good doing you. Thank you. Yes.

Operator

Thank you. Your next question comes from the line of Bill Dezellem with Tieton Capital. Please go ahead.

Speaker 3

I actually have a follow-up relative to something that I believe Craig you said in one of your remarks that by structuring Juarez to be lower cost, you're opening yourselves up to a much larger market. Number 1, did I hear that correctly? And then secondarily, by default also structuring the U. S. Maybe to be more of that high touch in a more maybe a more obvious way?

Speaker 3

I mean, I know it's been that all along, but maybe a more obvious way. Is that in any way expanding your potential market?

Speaker 2

I don't think the changes to the U. S.-based facilities are any more obvious than they have been in the past. They were structured to be high service at a price. The changes to Juarez that flow through and result in bids and quoting being lower than what they used to be is a change that results in a bigger available market to us.

Speaker 3

Do you have a quantification on that?

Speaker 2

No.

Speaker 3

And then one additional question, please. You mentioned you have 80 quotes today. How does that compare to what we would have seen over the course of the last couple of years?

Speaker 2

It's much higher.

Speaker 3

By a factor of 2% or 5% or 5%?

Speaker 2

Oh, no. It's probably a factor of there are times where we had quotes maybe 20 or 30 in the funnel.

Speaker 3

This is at least double, if not quadruple, maybe what you were accustomed to running at before?

Speaker 2

Yes. Great.

Speaker 3

Well, congratulations and look forward to a few more of those at the up to $20,000,000 mark.

Speaker 4

Us too.

Speaker 3

Enjoy retirement.

Speaker 2

Thanks.

Operator

This concludes today's question and answer session. I will now turn the call back to Craig Gates for any additional or closing remarks.

Speaker 2

Okay. Thank you, everyone, for participating in today's conference call. I'll speak for Brett and Tony when I say they look forward to speaking with you next quarter. Adios.

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Earnings Conference Call
Key Tronic Q3 2024
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