Kimball Electronics, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements Certain statements contained within this document are considered forward-looking under the Private Securities Litigation Reform Act of 1995. The statements may be identified by the use of words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “projects,” “estimates,” “forecasts,” “likely,” “future,” “may,” “should,” “would,” “could,” “will,” “potentially,” and similar expressions. These forward-looking statements are subject to risks and uncertainties including, but not limited to, global economic conditions, geopolitical environment and conflicts such as the war in Ukraine, global health emergencies, availability or cost of raw materials and components, foreign exchange fluctuations, and our ability to convert new business opportunities into customers and revenue. Additional cautionary statements regarding other risk factors that could have an effect on the future performance of Kimball Electronics are contained in our Annual Report on Form 10-K for the year ended June 30, 2023. Business Overview We are a global, multifaceted manufacturing solutions provider. We provide electronics manufacturing services (“EMS”), including engineering and supply chain support, to customers in the automotive, medical, and industrial end markets. Our core competency is producing durable electronics, and we further offer contract manufacturing services for non-electronic components, medical devices, medical disposables, drug delivery devices and solutions, precision molded plastics, and production automation, test, and inspection equipment. Our manufacturing services, including engineering and supply chain support, utilize common production and support capabilities globally. We are well recognized by our customers and the industry for our excellent quality, reliability, and innovative service. CIRCUITS ASSEMBLY, a leading brand and technical publication for electronics manufacturers worldwide, has previously recognized us four times for achieving the Highest Overall Customer Rating in their Service Excellence Awards, and most recently, we received Highest Overall Customer Ratings in four of the seven categories in 2023. The contract manufacturing services industry is very competitive. As a mid-sized player, we can expect to be challenged by the agility and flexibility of the smaller, regional players, and we can expect to be challenged by the scale and price competitiveness of the larger, global players. We enjoy a unique market position between these extremes which allows us to compete with the larger scale players for high-volume projects, but also maintain our competitive position in the generally lower volume durable electronics market space. We expect to continue to effectively operate in this market space; however, one significant challenge will be maintaining our profit margins while we continue our revenue growth. Pricing is competitive in the market as production efficiencies and material pricing advantages for most projects drive costs and prices down over the life of the projects. This characteristic of the contract electronics marketplace is expected to continue. 20 The Worldwide Manufacturing Services Market - 2023 Edition , a comprehensive study on the worldwide EMS market published by New Venture Research (“NVR”), provided worldwide forecast trends through 2027. NVR projects the worldwide assembly market for electronics products to grow at a compound annual growth rate (“CAGR”) of 4.3% over the next five years, with the EMS industry projected to grow at a CAGR of 5.5%. We continue to monitor the current economic and industry conditions for uncertainties that may pose a threat to our future growth or cause disruption in business strategy, execution, and timing in the markets in which we compete. The EMS industry continues to experience component shortages, component allocations, and shipping delays, particularly with semiconductors, which were especially challenging in the prior fiscal year. Component shortages or allocations could continue to increase component costs and potentially interrupt our operations and negatively impact our ability to meet commitments to customers. We have taken various actions to mitigate the risk and minimize the impact to our customers as well as the adverse effect component shortages, component allocations, or shipping delays could have on our results; however, the duration or severity of the components shortages is unknown. Supply chain restraints have also resulted in an industry-wide inflation of components, labor, freight, and other operating costs. Through contractual pricing arrangements and negotiations with our customers, we have been able to mitigate a majority of these cost increases; however, our profitability has been impacted, and necessary extended lead times on inventory purchases has negatively impacted our working capital. The financial impact on our future results cannot be reasonably estimated but could be material. Net sales in the first quarter of the current fiscal year increased 8% compared to the prior fiscal year first quarter, with double-digit increases in the automotive and industrial market verticals. Beginning in fiscal year 2024, we changed our presentation of revenue for miscellaneous sales previously included in Other to include in the respective customers’ end market verticals. Prior year periods have been recast to conform to the current year presentation. The increase in sales to customers in the automotive market were largely driven by the continued ramp-up of certain programs, the launch of new programs, and the supply chain catching up with demand. In the medical market, sales decreased due to decreased sales with a large medical customer who is remediating a recall. The cause of the recall is unrelated to the products we provided. In the industrial market, sales increased in large part due to the continued ramp-up of certain programs. We have a strong focus on cost control balanced with managing the future growth prospects of our business. We expect to make investments that will strengthen or add new capabilities to our package of value as a multifaceted manufacturing solutions company, including through our recently announced and completed capacity expansions. Managing working capital in conjunction with fluctuating demand levels is likewise key. In addition, a long-standing component of our profit-sharing incentive bonus plan is that it is linked to our financial performance which results in varying amounts of compensation expense as profits change. We continue to maintain a strong balance sheet, which included a current ratio of 1.9, a debt-to-equity ratio of 0.6, and Share Owners’ equity of $528 million at September 30, 2023. Recently, we have invested to support our expansions and growth in Mexico, Thailand, and Poland. At the same time, we have supported our customers through strategic inventory purchases to mitigate parts shortages. We expect our balance sheet to normalize as parts shortages abate and our expansions continue to ramp up production. Refer to the Future Liquidity section of Liquidity and Capital Resources below for further discussion of our liquidity. 21 The continuing success of our business is dependent upon our ability to replace expiring customers/programs with new customers/programs. We monitor our success in this area by tracking the number of customers and the percentage of our net sales generated from them by years of service as depicted in the table below. While variation in the size of program awards makes it difficult to directly correlate this data to our sales trends, we believe it does provide useful information regarding our customer loyalty and new business growth. Three Months Ended September 30 Customer Service Years 2023 2022 More than 10 Years % of Net Sales 74 % 80 % # of Customers 33 31 5 to 10 Years % of Net Sales 20 % 16 % # of Customers 20 18 Less than 5 Years % of Net Sales 6 % 4 % # of Customers 11 11 Total % of Net Sales 100 % 100 % # of Customers 64 60 A detailed discussion of risk factors and uncertainties that could have an effect on our performance are located within the “Risk Factors” section of our Annual Report on Form 10-K for the year ended June 30, 2023. 22 Results of Operations At or for the Three Months Ended September 30 (Amounts in Millions, Except for Per Share Data) 2023 as a % of Net Sales 2022 as a % of Net Sales % Change Net Sales $ 438.1 $ 405.9 8 % Gross Profit $ 35.5 8.1 % $ 29.3 7.2 % 21 % Selling and Administrative Expenses 16.0 3.7 % 15.7 3.9 % 2 % Operating Income 19.5 4.4 % 13.6 3.3 % 44 % Other Income (Expense) (6.2) (1.4) Provision for Income Taxes 2.5 2.7 (8) % Net Income $ 10.8 $ 9.5 13 % Diluted Earnings per Share $ 0.43 $ 0.38 13 % Open Orders $ 907 $ 1,069 (15) % Net Sales by Vertical Market Three Months Ended September 30 (Amounts in Millions) 2023 2022 % Change Automotive $ 212.5 $ 188.2 13 % Medical 102.4 116.0 (12) % Industrial 123.2 101.7 21 % Total Net Sales $ 438.1 $ 405.9 8 % First quarter fiscal year 2024 consolidated net sales increased 8% compared to the first quarter of fiscal year 2023. The impact from foreign currency fluctuations on net sales was a favorable 1% in the current quarter compared to the first quarter of fiscal year 2023. Beginning in fiscal year 2024, we changed our presentation of revenue for miscellaneous sales previously included in Other to include in the respective customers’ end market verticals. Prior year periods have been recast to conform to the current year presentation. By end market vertical, our market verticals fluctuated as follows: • Sales to customers in the automotive market increased 13% during the first quarter of fiscal year 2024, compared to the first quarter of fiscal year 2023. This double-digit increase is largely due to the continued ramp-up of certain programs, new product launches, and improved component availability. • Sales to customers in the medical market declined during the first quarter of fiscal year 2024, compared to the first quarter of fiscal year 2023. This decrease is primarily due to decreased sales with a large medical customer who is remediating a recall. The cause of the recall is unrelated to the products we provided. Partially offsetting this decrease in sales was a ramp-up of certain programs and new product launches. • Sales to customers in the industrial market increased 21% during the first quarter of fiscal year 2024, when compared to the first quarter of fiscal year 2023 largely due to the continued ramp-up of certain programs. 23 Sales to Nexteer Automotive, Philips, ZF, and HL Mando accounted for the following portions of our net sales: Three Months Ended September 30 2023 2022 Nexteer Automotive 16% 15% Philips * 17% ZF 14% 12% HL Mando 10% * * amount is less than 10% of total Gross profit as a percent of net sales in the first quarter of fiscal year 2024 improved when compared to the first quarter of fiscal year 2023 as we continue to optimize operating performance levels following recent facility expansions. Selling and administrative expenses declined as a percent of net sales and remained relatively flat in absolute dollars in the first quarter of fiscal year 2024 when compared to the first quarter of fiscal year 2023. Other Income (Expense) consisted of the following: Three Months Ended September 30 (Amounts in Thousands) 2023 2022 Interest income $ 299 $ 17 Interest expense (5,447) (1,920) Foreign currency/derivative gain (loss) (674) 534 Gain (loss) on SERP investments (177) (235) Other (280) 201 Other income (expense), net $ (6,279) $ (1,403) Interest expense has increased in the three months ended September 30, 2023 compared to the three months ended September 30, 2022 due to higher interest rates and higher borrowings on credit facilities. Foreign currency/derivative gains (losses) result from net foreign currency exchange rate movements during the periods. The revaluation to fair value of the SERP investments recorded in Other Income (Expense) is offset by the revaluation of the SERP liability recorded in Selling and Administrative Expenses, and thus there is no effect on net income. Our provision for income taxes for the first three months ended September 30, 2023 and September 30, 2022 was $2.5 million, or 18.6% of income before taxes on income, and $2.7 million, or 21.9% of income before taxes on income, respectively. Open orders were down 15% as of September 30, 2023 compared to September 30, 2022. The decrease in open orders from September 30, 2022 is primarily driven by reduced orders from a large medical customer who is remediating a recall. Open orders are the aggregate sales price of production pursuant to unfulfilled customer orders, which may be delayed or canceled by the customer subject to contractual termination provisions. The majority of open orders as of September 30, 2023 are expected to be filled within the next twelve months. Open orders at a point in time may not be indicative of future sales trends due to the contract nature of our business and the variability of order lead times among our customers. Liquidity and Capital Resources Working capital at September 30, 2023 was $452.7 million compared to working capital of $454.3 million at June 30, 2023. The current ratio was 1.9 at September 30, 2023 and at 2.0 June 30, 2023. The debt-to-equity ratio was 0.6 at September 30, 2023 and 0.5 at June 30, 2023. Our short-term liquidity available, represented as cash and cash equivalents plus the unused amount of our credit facilities, some of which are uncommitted, totaled $147.1 million at September 30, 2023 and $149.1 million at June 30, 2023. 24 Cash Conversion Days (“CCD”) are calculated as the sum of Days Sales Outstanding plus Contract Asset Days plus Production Days Supply on Hand less Accounts Payable Days and less Advances from Customers Days. CCD, or a similar metric, is used in our industry and by our management to measure the efficiency of managing working capital. The following table summarizes our CCD for the quarterly periods indicated. Beginning in the third quarter of fiscal year 2023, we included Advances from Customers Days in our CCD calculation as these are customer deposits related to inventory. Prior periods have been recast to conform to the current quarter presentation. Three Months Ended September 30, 2023 June 30, 2023 September 30, 2022 Days Sales Outstanding 58 56 54 Contract Asset Days 17 14 14 Production Days Supply on Hand 108 97 106 Accounts Payable Days 71 65 73 Advances from Customers Days 9 8 7 Cash Conversion Days 103 94 94 We define Days Sales Outstanding as the average of monthly trade accounts and notes receivable divided by an average day’s net sales, Contract Asset Days as the average monthly contract assets divided by an average day’s net sales, Production Days Supply on Hand as the average of monthly gross inventory divided by an average day’s cost of sales, Accounts Payable Days as the average of monthly accounts payable divided by an average day’s cost of sales, and Advances from Customers Days as the total customer deposits divided by an average day’s cost of sales. Over the past several quarters, we have supported our customers through strategic inventory builds to mitigate parts shortages, which adversely impacted our PDSOH and CCD metrics. We expect inventory levels and working capital to normalize as the part shortages abate and our expansions continue to ramp up production. Cash Flows The following table reflects the major categories of cash flows for the first three months of fiscal years 2024 and 2023. Three Months Ended September 30 (Amounts in Millions) 2023 2022 Net cash provided by (used for) operating activities $ 12.8 $ (60.2) Net cash used for investing activities $ (11.3) $ (19.3) Net cash provided by financing activities $ 14.0 $ 50.8 Cash Flows from Operating Activities Net cash provided by operating activities for the first three months of fiscal year 2024 was driven by net income adjusted for non-cash items, partially offset by changes in operating assets and liabilities. Net cash used for operating activities for the first three months of the prior year was driven by changes in operating assets and liabilities. Net income and non-cash adjustments provided cash of $22.5 million, while changes in operating assets and liabilities used $9.7 million of cash in the first three months of fiscal year 2024 compared to $75.5 million of cash used by changes in operating assets and liabilities in the first three months of the prior year. Net income adjusted for non-cash items provided cash of $22.5 million in the first three months of fiscal year 2024. Partially offsetting this was cash used of $9.7 million from changes in operating assets and liabilities, largely due to an increase in inventory, which used cash of $34.0 million, driven by investment to support our newly expanded facilities, a decrease in accounts payable, which used cash of $11.6 million, and an increase in contract assets, which used cash of $8.9 million. Partially offsetting cash used by inventory, accounts payable, and contract assets was a decrease in accounts receivable, which provided cash of $45.3 million primarily resulting from decreased sales volumes compared to the three months ended June 30, 2023. The cash used of $75.5 million from changes in operating assets and liabilities in the first three months of fiscal year 2023 is largely due to an increase in inventory, which used cash of $57.6 million primarily due to the component shortages as we continue to purchase material not impacted by the shortages so we can fulfill our customer orders once the impacted components are received in addition to increased demand, and an increase in accounts receivable, which used cash of $33.3 million primarily resulting from increased sales volumes. Partially offsetting cash used by inventory was an increase in accounts payable, which provided cash of $17.5 million largely resulting from increased inventory purchases. 25 Cash Flows from Investing Activities For the first three months of fiscal years 2024 and 2023, net cash used for investing activities was $11.3 million and $19.3 million, respectively. During the first three months of fiscal year 2024, we invested $11.3 million into capital expenditures primarily to support new business awards, facility expansions, and replacement of older machinery and equipment. During the first three months of fiscal year 2023, we invested $19.5 million into capital expenditures primarily for expansions at our Mexico, Thailand, and Poland facilities and to support new business awards. Cash Flows from Financing Activities For the first three months of fiscal year 2024, net cash provided by financing activities of $14.0 million resulted largely from net borrowings on our credit facilities of $15.4 million primarily for working capital purposes and capital expenditures. For the first three months of fiscal year 2023, net cash provided by financing activities of $50.8 million resulted largely from net borrowings on our credit facilities of $52.2 million. Credit Facilities The Company maintains a U.S. primary credit facility (the “primary credit facility”) scheduled to mature May 4, 2027. The primary credit facility provides for $300 million in borrowings, with an option to increase the amount available for borrowing to $450 million at the Company’s request, subject to the consent of each lender participating in such increase. The Company also maintains a 364-day multi-currency revolving credit facility (the “secondary credit facility”), which allows for borrowings up to $50 million and has a maturity date of February 2, 2024. The proceeds of the loans on the primary credit facility and the secondary credit facility are to be used for working capital and general corporate purposes of the Company. We were in compliance with the financial covenants of the primary and secondary credit facilities during the period ended September 30, 2023. We also maintain foreign credit facilities for working capital and general corporate purposes at specific foreign locations rather than utilizing funding from intercompany sources. These foreign credit facilities can be canceled at any time by either the bank or us and generally include renewal clauses. As of September 30, 2023, we maintained foreign credit facilities at our Thailand operation, our EMS operation in China, our Netherlands subsidiary, our Poland operation, and our Vietnam operation. See Note 6 - Credit Facilities of Notes to Consolidated Financial Statements for more information on our credit facilities, including the terms of the credit facilities such as interest, commitment fees, and debt covenants. Factoring Arrangements The Company utilizes accounts receivable factoring arrangements with third-party financial institutions in order to extend terms for the customer without negatively impacting our cash flow. These arrangements in all cases do not contain recourse provisions which would obligate us in the event of our customers’ failure to pay. Receivables are considered sold when they are transferred beyond the reach of Kimball Electronics and its creditors, the purchaser has the right to pledge or exchange the receivables, and we have surrendered control over the transferred receivables. In the three months ended September 30, 2023 and 2022, we sold, without recourse, $103.0 million and $97.6 million of accounts receivable, respectively. See Note 1 - Business Description and Summary of Significant Accounting Policies of Notes to Condensed Consolidated Financial Statements for more information regarding the factoring arrangements. Future Liquidity We believe our principal sources of liquidity from available funds on hand, cash generated from operations, and the availability of borrowing under our credit facilities, will be sufficient to meet our working capital and other operating needs for at least the next 12 months. The unused borrowings in USD equivalent under all of our credit facilities totaled $90.5 million at September 30, 2023, including the $50 million secondary credit facility expiring in February 2024. We will evaluate the need to renew the secondary credit facility as we approach the maturity date. Additionally, accounts receivable factoring arrangements could provide flexible access to cash as needed. While our primary credit facility includes a covenant that limits the amount of sold receivables outstanding at any time, currently and historically, we have been considerably below this limit. We expect to continue to prudently invest in capital expenditures, including for capacity expansions and potential acquisitions, that would help us continue our growth as a multifaceted manufacturing solutions company. We recently completed our Thailand facility expansion in the third quarter of fiscal year 2022, our Mexico facility expansion in the first quarter of fiscal year 2023, and our Poland expansion in the fourth quarter of fiscal year 2023. At September 30, 2023, our capital expenditure commitments were approximately $12 million, consisting primarily of capital related to new program wins and equipment for facility expansions. We anticipate our available liquidity will be sufficient to fund these capital expenditures. 26 We have purchase obligations that arise in the normal course of business for items such as raw materials, services, and software acquisitions/license commitments. In certain instances, such as when lead times dictate, we enter into contractual agreements for material in excess of the levels required to fulfill customer orders to help mitigate the potential impact related to component shortages, which require longer lead times. In turn, our material authorization agreements with customers cover a portion of the exposure for material which is purchased prior to having a firm order. At September 30, 2023, our foreign operations held cash totaling $54.1 million. Most of our accumulated unremitted foreign earnings have been invested in active non-U.S. business operations, and it is not anticipated such earnings will be remitted to the United States. Our intent is to permanently reinvest the remaining funds outside of the United States, and our current plans do not demonstrate a need to repatriate these funds to our U.S. operations. However, if such funds were repatriated, a portion of the funds remitted may be subject to applicable non-U.S. income and withholding taxes. The Company’s Repurchase Plan allows the repurchase of up to $100 million of our common stock. Purchases may be made under various programs, including in open-market transactions, block transactions on or off an exchange, or in privately negotiated transactions, all in accordance with applicable securities laws and regulations. The Repurchase Plan has no expiration date but may be suspended or discontinued at any time. The extent to which the Company repurchases its shares, and the timing of such repurchases, will depend upon a variety of factors, including market conditions, regulatory requirements, and other corporate considerations, as determined by the Company’s management team. The Company expects to finance the purchases with existing liquidity. The Company has repurchased $88.8 million of common stock under the Repurchase Plan through September 30, 2023. Our ability to generate cash from operations to meet our liquidity obligations could be adversely affected in the future by factors such as general economic and market conditions, lack of availability of raw material components in the supply chain, a decline in demand for our services, loss of key contract customers, unsuccessful integration of acquisitions and new operations, global health emergencies, and the related uncertainties around the financial impact, and other unforeseen circumstances. In particular, should demand for our customers’ products and, in turn, our services decrease significantly over the next 12 months, the available cash provided by operations could be adversely impacted. Additional cautionary statements regarding our risk factors are contained in our Annual Report on Form 10-K for the year ended June 30, 2023. Fair Value During the first quarter of fiscal year 2024, no level 1 or level 2 financial instruments were affected by a lack of market liquidity. For level 1 financial assets, readily available market pricing was used to value the financial instruments. Our foreign currency derivative assets and liabilities, which were classified as level 2, were independently valued using observable market inputs such as forward interest rate yield curves, current spot rates, and time value calculations. To verify the reasonableness of the independently determined fair values, these derivative fair values were compared to fair values calculated by the counterparty banks. Our own credit risk and counterparty credit risk had an immaterial impact on the valuation of the foreign currency derivatives. See Note 7 - Fair Value of Notes to Condensed Consolidated Financial Statements for additional information. Off-Balance Sheet Arrangements As of September 30, 2023, we do not have any material off-balance sheet arrangements. Critical Accounting Policies Kimball Electronics’ Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require the use of estimates and assumptions that affect amounts reported and disclosed in the Condensed Consolidated Financial Statements and related notes. Actual results could differ from these estimates and assumptions. Management uses its best judgment in the assumptions used to value these estimates, which are based on current facts and circumstances, prior experience, and other assumptions that are believed to be reasonable. There have been no material changes to our critical accounting policies since our Annual Report on Form 10-K for the year ended June 30, 2023. For further information regarding our critical accounting policies, refer to “Note 1 - Business Description and Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements and “Critical Accounting Policies” in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended June 30, 2023. 27 New Accounting Standards New accounting standards which have been issued but not yet adopted are typically disclosed in Note 1 - Business Description and Summary of Significant Accounting Policies of Notes to Condensed Consolidated Financial Statements for information regarding New Accounting Standards. Currently, there are no issued but not yet adopted accounting standards that are expected to have a material impact on the Company.