Business context and reporting period
Key Tronic Corporation provides electronics manufacturing services to original equipment manufacturers across consumer, medical, communications, industrial, automotive, defense and other markets. This unaudited Form 10-Q covers the 13-week second quarter and 26-week first half of fiscal 2018, ended December 30, 2017; comparisons are to the periods ended December 31, 2016.
Financial results and position
| Metric | Quarter | Six months |
|---|---|---|
| Net sales | $111.7 million, down 5.7% | $220.9 million, down 6.2% |
| Gross profit / margin | $8.8 million / 7.9%, versus $9.6 million / 8.1% | $16.6 million / 7.5%, versus $19.3 million / 8.2% |
| Operating income / margin | $1.7 million / 1.5%, versus $2.5 million / 2.1% | $2.8 million / 1.3%, versus $5.3 million / 2.3% |
| Net income (loss) | $(0.2) million, or $(0.02) per diluted share; prior-year income was $1.5 million, or $0.14 per share | $0.2 million, or $0.02 per diluted share; prior-year income was $3.3 million, or $0.30 per diluted share |
| Operating cash flow | Not presented separately | $6.9 million, versus $3.1 million |
| Investing / financing cash flow | Not presented separately | $(1.2) million / $(5.7) million |
Quarterly sales declined mainly due to lower demand from existing customers, partly offset by new program wins. First-half margin pressure reflected higher overhead costs, while quarterly gross margin also faced lower sales and overhead pressure. SG&A increased as a share of sales, reflecting legal and commission costs. Interest expense was $0.6 million for the quarter and $1.2 million for the half year.
At December 30, 2017, cash was $0.45 million, current assets were $180.6 million and current liabilities were $83.7 million; management reported a 2.2 current ratio. Total debt was approximately $37.4 million before $0.1 million of unamortized issuance costs. The $45 million revolving facility had $15.6 million drawn and $29.0 million available, with $0.4 million in letters of credit. The company reported compliance with its financial covenants. Six-month operating cash flow benefited from collections and higher accounts payable, partly offset by inventory growth and lower accrued compensation. Receivables sales under purchase programs totaled $55.4 million in the half year, versus $38.9 million a year earlier.
Order backlog was $119.9 million at quarter-end, down from $133.4 million a year earlier; the filing cautions that backlog is not a reliable measure of future sales. The top three customers represented 30.6% of quarterly sales, down from 33.8% in the prior-year quarter.
Material changes and management commentary
- First-half net sales fell $14.7 million and net income declined $3.1 million year over year. Management attributed weaker sales primarily to lower demand from current customers.
- The second-quarter effective tax rate was 121.6%, versus 23.4% a year earlier; the first-half rate was 87.0%, versus 20.9%. Management said U.S. tax reform-related discrete items contributed approximately $1.1 million in tax expense, or about $0.10 per share, affecting quarterly results. Management expects the estimated effective tax rate to decline from 25% to 20% in coming periods. The filing also describes tax reform remeasurement, repatriation and deferred-tax adjustments; the eventual toll-tax amount remains subject to further study and guidance.
- Management cited new-program ramps and a strong pipeline, including two new IoT programs, as potential growth drivers. It expects Mexico facility streamlining to reduce expenses by approximately 9% by the fourth quarter, while noting that new programs are expected to require less labor.
- The company expects to adopt the new revenue standard in fiscal 2019 using the modified retrospective method. It expects EMS revenue recognition to shift from delivery-based recognition to recognition over time, potentially materially increasing contract assets and reducing finished-goods and work-in-process inventory at adoption. Management also expects the new lease standard to materially affect the balance sheet.
Guidance, risks and contingencies
For fiscal 2018 third quarter, management forecast revenue of $110 million to $115 million and earnings from break-even to $0.05 per diluted share. This outlook assumes approximately $0.7 million of legal fees for the former-customer arbitration, approximately $0.5 million of Mexico severance expense and a 20% effective tax rate. Actual results will depend on customer orders and the timing of new-program production starts.
The arbitration concerns approximately $9 million of inventory purchased and approximately $1 million of receivables, along with cancellation fees and carrying costs the company believes are contractually due from a former customer. No gain or loss has been accrued; legal costs are expensed as incurred, and the outcome could materially affect financial position, results and cash flows. Management expected further clarity by the end of fiscal third quarter 2018.
Key risks include variable customer demand and limited long-term purchase commitments, customer and supplier concentration, component shortages, competitive pricing and new-program ramp costs, foreign-exchange and interest-rate exposure, foreign operations, covenant and financing constraints, and potential inventory or receivables losses. The company hedges some Mexican peso expenses and part of its term-loan interest exposure. Foreign-currency hedge liabilities were material, and approximately $3.0 million of net unrealized hedge losses were expected to be reclassified into earnings within 12 months.
Important facts for investors to verify
- Whether sales and margins stabilize as new customer programs ramp, and whether the $119.9 million backlog converts to shipments.
- The outcome and timing of the former-customer arbitration, potential recovery of inventory and receivables, and associated legal costs.
- Whether the expected tax-rate reduction is realized and how subsequent tax guidance, earnings-pool studies and foreign withholding taxes affect tax expense and cash repatriation.
- Working-capital needs, including inventory growth and receivables factoring, along with revolver availability, debt repayment and covenant compliance.
- The actual costs and savings from Mexico facility streamlining and the financial-statement effects of adopting the revenue and lease accounting standards.