KEY TRONIC CORP 10-Q

Item 1: Financial Statements KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited, in thousands; except share data) October 2, 2021 July 3, 2021 ASSETS Current assets: Cash and cash equivalents $ 1,544 $ 3,473 Trade receivables, net of allowance for doubtful accounts of $303 and $275 126,453 110,324 Contract assets 23,651 24,781 Inventories, net 143,131 137,329 Other 29,554 23,345 Total current assets 324,333 299,252 Property, plant and equipment, net 31,198 35,735 Operating lease right-of-use assets, net 18,994 15,745 Other assets: Deferred income tax asset 10,252 9,656 Other 6,554 1,458 Total other assets 16,806 11,114 Total assets $ 391,331 $ 361,846 LIABILITIES AND SHAREHOLDERS ’ EQUITY Current liabilities: Accounts payable $ 111,659 $ 92,823 Accrued compensation and vacation 8,476 11,471 Current portion of debt, net 3,951 2,143 Other 17,938 20,268 Total current liabilities 142,024 126,705 Long-term liabilities: Term loans 7,463 7,906 Revolving loan 100,760 90,362 Operating lease liabilities 13,727 11,428 Other long-term obligations 4,300 1,740 Total long-term liabilities 126,250 111,436 Total liabilities 268,274 238,141 Commitments and contingencies (Note 8) Shareholders’ equity: Common stock, no par value—shares authorized 25,000; issued and outstanding 10,762 and 10,762 shares, respectively 47,249 47,181 Retained earnings 75,267 74,452 Accumulated other comprehensive income 541 2,072 Total shareholders’ equity 123,057 123,705 Total liabilities and shareholders’ equity $ 391,331 $ 361,846 See accompanying notes to consolidated financial statements. 3 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited, in thousands, except share and per share amounts) Three Months Ended October 2, 2021 September 26, 2020 Net sales $ 132,762 $ 123,207 Cost of sales 122,624 113,192 Gross profit 10,138 10,015 Research, development and engineering expenses 2,449 2,245 Selling, general and administrative expenses 5,595 4,974 Total operating expenses 8,044 7,219 Operating income 2,094 2,796 Interest expense, net 992 681 Income before income taxes 1,102 2,115 Income tax provision 287 396 Net income $ 815 $ 1,719 Net income per share — Basic $ 0.08 $ 0.16 Weighted average shares outstanding — Basic 10,762 10,760 Net income per share — Diluted $ 0.07 $ 0.16 Weighted average shares outstanding — Diluted 11,052 11,040 See accompanying notes to consolidated financial statements. 4 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited, in thousands) Three Months Ended October 2, 2021 September 26, 2020 Comprehensive income (loss): Net income $ 815 $ 1,719 Other comprehensive income (loss): Unrealized gain (loss) on hedging instruments, net of tax ( 1,531 ) 1,268 Comprehensive income (loss) $ ( 716 ) $ 2,987 Other comprehensive income (loss) for the three months ended October 2, 2021 and September 26, 2020, is reflected net of tax expense (benefit) of approximately $( 0.3 ) million and $ 1.5 million, respectively. See accompanying notes to consolidated financial statements. 5 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited, in thousands) Three Months Ended October 2, 2021 September 26, 2020 Operating activities: Net income $ 815 $ 1,719 Adjustments to reconcile net income to cash used in operating activities: Depreciation and amortization 1,335 1,752 Amortization of interest rate swap 75 — Amortization of deferred loan costs 32 13 Provision for obsolete inventory 138 178 Provision for warranty 75 19 Provision for doubtful accounts 26 — Share-based compensation expense 68 63 Deferred income taxes ( 220 ) ( 81 ) Changes in operating assets and liabilities: Trade receivables ( 16,155 ) ( 5,449 ) Contract assets 1,130 ( 705 ) Inventories ( 5,940 ) ( 4,949 ) Other assets ( 7,092 ) 292 Accounts payable 18,835 ( 1,059 ) Accrued compensation and vacation ( 2,995 ) ( 2,787 ) Other liabilities ( 4,753 ) 1,555 Cash used in operating activities ( 14,626 ) ( 9,439 ) Investing activities: Purchase of property and equipment ( 1,791 ) ( 3,186 ) Cash used in investing activities ( 1,791 ) ( 3,186 ) Financing activities: Payment of financing costs ( 80 ) ( 307 ) Proceeds from issuance of long term debt 5,055 5,000 Interest rate swap termination fee — ( 925 ) Repayments of long term debt ( 532 ) ( 10,842 ) Borrowings under revolving credit agreement 151,916 45,975 Repayments of revolving credit agreement ( 141,470 ) ( 25,358 ) Principal payments on finance leases ( 401 ) — Cash provided by financing activities 14,488 13,543 Net (decrease) increase in cash and cash equivalents ( 1,929 ) 918 Cash and cash equivalents, beginning of period 3,473 553 Cash and cash equivalents, end of period $ 1,544 $ 1,471 Non-cash investing activities: Beneficial interest in transferred receivables — ( 9 ) Supplemental cash flow information: Interest payments $ 999 $ 578 Income tax payments, net of refunds $ 210 $ 351 Recognition of operating lease liabilities and right-of-use assets $ 4,695 $ — Recognition of financing lease liabilities and right-of-use assets $ 4,456 $ — See accompanying notes to consolidated financial statements. 6 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (Unaudited, in thousands; except share data) Three Months Ended October 2, 2021 September 26, 2020 Total shareholders’ equity, beginning balances $ 123,705 $ 115,557 Common stock (shares): Beginning balances 10,762 10,760 Exercise of stock appreciation rights — — Ending balances 10,762 10,760 Common stock: Beginning balances $ 47,181 $ 46,946 Share-based compensation 68 63 Ending balances 47,249 47,009 Retained Earnings: Beginning balances $ 74,452 $ 70,111 Net income 815 1,719 Ending balances 75,267 71,830 Accumulated other comprehensive income: Beginning balances $ 2,072 $ ( 1,500 ) Unrealized gain (loss) on hedging instruments, net ( 1,531 ) 1,268 Ending balances 541 ( 232 ) Total shareholders’ equity, ending balances $ 123,057 $ 118,607 See accompanying notes to consolidated financial statements. 7 KEY TRONIC CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation The consolidated financial statements included herein have been prepared by Key Tronic Corporation and subsidiaries (the Company) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The year-end condensed consolidated balance sheet information was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The financial statements reflect all normal and recurring adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods presented. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The results of operations for the periods presented are not necessarily indicative of the results to be expected for the full year. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 3, 2021. The Company’s reporting period is a 52/53 week fiscal year ending on the Saturday closest to June 30. The quarters ended October 2, 2021 and September 26, 2020 were 13 week periods, respectively. Fiscal year 2022 will end on July 2, 2022, which is a 52 week year. Fiscal year 2021 which ended on July 3, 2021, was a 53 week year. Certain Significant Risks and Uncertainties Related to Outbreak of Coronavirus Disease 2019 (“COVID-19”) Due to the COVID-19 pandemic, the Company has seen extreme shifts in demand from its customer base, and shifts in supply chain and logistics risks. The possibility of future temporary closures, as well as adverse fluctuations in customer demand, freight and expedite costs, precautionary safety expenses and labor shortages, collectability of accounts, and future supply chain disruptions during the rapidly changing COVID-19 environment can materially impact operating results. Additionally, continued adverse macroeconomic conditions and significant currency exchange fluctuations can also materially impact operating results. 2. Significant Accounting Policies Earnings Per Common Share Basic earnings per common share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the combination of other potentially dilutive weighted average common shares and the weighted average number of common shares outstanding during the period using the treasury stock method. The computation assumes the proceeds from the exercise of equity awards were used to repurchase common shares at the average market price during the period. The computation of diluted EPS does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an anti-dilutive effect on EPS. Derivative Instruments and Hedging Activities The Company has entered into foreign currency forward contracts that are accounted for as cash flow hedges in accordance with ASC 815, “ Derivatives and Hedging”. The effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI) and is reclassified into earnings in the same period in which the underlying hedged transaction affects earnings. The derivative’s effectiveness represents the change in fair value of the hedge that offsets the change in fair value of the hedged item. The Company uses derivatives to manage the variability of foreign currency fluctuations of expenses in our Mexico facilities. The foreign currency forward contracts have terms that are matched to the underlying transactions being hedged. As a result, these transactions fully offset the hedged risk and no ineffectiveness has been recorded. The Company’s foreign currency forward contracts potentially expose the Company to credit risk to the extent the counterparty may be unable to meet the terms of the agreement. The Company minimizes such risk by utilizing a counterparty with a strong credit rating. The Company’s counterparty to the foreign currency forward contracts is a major banking institution. This institution does not require collateral for the contracts, and the Company believes that the risk of the counterparty failing to meet their contractual obligations is remote. The Company does not enter into derivative instruments for trading or speculative purposes. 8 Income Taxes We compute our interim income tax provision through the use of an estimated annual effective tax rate (ETR) applied to year-to-date operating results and specific events that are discretely recognized as they occur. In determining the estimated annual ETR, we analyze various factors, including projections of our annual earnings, taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and available tax planning alternatives. Discrete items, including the effect of changes in tax laws, tax rates, and certain circumstances with respect to valuation allowances or other unusual or non-recurring tax adjustments, are reflected in the period in which they occur as an addition to, or reduction from, the income tax provision, rather than included in the estimated annual ETR. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences and benefits attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as tax credit and net operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized. We utilize a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50 % likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments based on new assessments and changes in estimates and which may not accurately forecast actual outcomes. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense. The tax years 1998 through the present remain open to examination by the major U.S. taxing jurisdictions to which we are subject. Refer to Note 6 for further discussions. Recently Issued Accounting Standards In January 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2021-01, Reference Rate Reform (Topic 848) to identify alternative reference rates that are more observable or transaction based and less susceptible to manipulation. The Company is currently assessing the effects on its consolidated financial statements, and if it will elect this optional standard. In March of 2020, the FASB issued ASU 2020-03, Codification Improvements to Financial Instruments, which clarifies specific issues raised by stakeholders. Specifically, the ASU clarifies the following: 1) that all entities are required to provide the fair value option disclosures in ASC 825, Financial Instruments 2) clarifies that the portfolio exception in ASC 820, Fair Value Measurement, applies to nonfinancial items accounted for as derivatives under ASC 815, Derivatives and Hedging; 3) clarifies that for purposes of measuring expected credit losses on a net investment in a lease in accordance with ASC 326, Financial Instruments - Credit Losses, the lease term determined in accordance with ASC 842, Leases, should be used as the contractual term; 4) clarifies that when an entity regains control of financial assets sold, it should recognize an allowance for credit losses in accordance with ASC 326; and 5) aligns the disclosure requirements for debt securities in ASC 320, Investments - Debt Securities, with the corresponding requirements for depository and lending institutions in ASC 942, Financial Services - Depository and Lending. The amendments in the ASU have various effective dates and transition requirements which are dependent on timing of adoption of ASU 2016-13. The Company is currently assessing the effects on its consolidated financial statements, and it intends to adopt the guidance as they become effective. In December 2019, the FASB issued ASU 2019-12, Simplifying the Accounting for Income Taxes (Topic 740), which modifies certain provisions of ASC 740, Income Taxes, in an effort to reduce the complexity of accounting for income taxes. ASU 2019-12 became effective for the Company during the first quarter of fiscal year 2022. Implementation of this standard does not have a material impact on our consolidated financial position, results of operations, or cash flows. In June 2016, the FASB issued ASU 2016-13 “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” and also issued subsequent amendments to the initial guidance: ASU 2018-19, ASU 2019-04 and ASU 2019-05, which replaces the existing incurred loss impairment model with an expected credit loss model and requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected. The guidance is effective for the Company beginning in the first quarter of fiscal year 2024 with early adoption permitted. The Company is currently assessing the impact on its consolidated financial statements, and it intends to adopt the guidance when it becomes effective in the first quarter of fiscal year 2024. 9 3. Inventories Total inventory as of October 2, 2021 is $ 143.1 million which is net of $ 23.9 million of reserves, customer payments, and customer deposits compared to $ 137.3 million which is net of $ 14.9 million in reserves, customer payments, and customer deposits as of July 3, 2021. Substantially all of the Company’s inventory balances are raw materials. 4. Long-Term Debt On September 3, 2021, the Company entered into an amendment to the Company’s current loan agreement with Bank of America. The amendment increases the Company’s current credit facility of $ 93 million to $120 million, subject to the Company’s borrowing base, maturing on September 3, 2026. As of October 2, 2021, the Company had an outstanding balance under the asset-based revolving credit facility of $ 101.3 million, $ 0.3 million in outstanding letters of credit and $ 12.0 million available for future borrowings. As of July 3, 2021, the Company had an outstanding balance under the credit facility with Bank of America of $ 90.9 million, $ 0.3 million in outstanding letters of credit and $ 2.1 million available for future borrowings. Generally, the interest rate applicable to loans under the Bank of America loan agreement will be, at the Company’s option: (i)(A) the base rate which is the highest of (1) the prime rate for the applicable day (as such rate is determined from time to time by the Bank), (2) the federal funds rate for the applicable day plus 0.50%, and (3) LIBOR for a 30-day interest period as of the applicable day plus 1.00% (provided that in no event shall the base rate be less than zero), plus the applicable interest margin for base rate loans; and (B) LIBOR rate for an applicable interest period (provided that in no event shall the LIBOR rate be less than 0.50%), plus the applicable interest margin for LIBOR rate loans. Depending on average daily excess borrowing availability over applicable periods under the Credit Facility, applicable interest margins on: (x) base rate loans will be 1.25-1.75%; and (y) LIBOR rate loans will be 2.25-2.75%, resetting on a quarterly basis beginning in early 2021. If there is an event of default under the loan agreement, all loans and other obligations will bear interest at a rate of an additional 2.00% on the otherwise applicable interest rates. In addition to interest charges, the Company is required to pay a fee of 0.25% per annum on the unused portion of the Credit Facility, monthly in arrears. Under the new loan agreement with Bank of America, the asset-based revolving credit facility bears interest at LIBOR plus 2.5%, as elected by the Company. On August 14, 2020, the Company also entered into a $ 5.0 million equipment financing facility relating to the Company’s existing U.S. manufacturing equipment that bears interest at 4.85 % and matures on August 14, 2025. Under this loan agreement, equal monthly payments of approximately $ 94,000 commenced on September 14, 2020 and will continue through the maturity of the equipment financing facility on August 14, 2025. As of October 2, 2021, the Company had an outstanding balance of $ 4.0 million. As of July 3, 2021, the Company had an outstanding balance of $ 4.2 million under the Bank of America equipment term loan agreement. On November 24, 2020, the Company entered into a $ 6.0 million equipment financing facility related to the Company’s existing manufacturing equipment that bears interest at 5.52 % and matures on April 24, 2026. Under this loan agreement, equal monthly payments of $ 100,000 commenced on May 24, 2021 and will continue through the maturity of the equipment financing facility on April 24, 2026. As of October 2, 2021, the Company had an outstanding balance of $ 5.5 million. As of July 3, 2021, the Company had an outstanding balance of $5.8 million. The interest rates on outstanding debt as of October 2, 2021 range from 3.25 % - 5.52 % compared to 3.25 % - 5.52 % as of July 3, 2021. 10 Debt maturities as of October 2, 2021 for the next five years and thereafter are as follows (in thousands): Fiscal Years Ending Amount 2022 (1) $ 1,611 2023 2,190 2024 2,239 2025 2,290 2026 1,187 Thereafter 101,332 Total debt $ 110,849 Unamortized debt issuance costs ( 572 ) Long-term debt, net of debt issuance costs $ 110,277 (1) Represents scheduled payments for the remaining nine-month period ending July 2, 2022. The Company must comply with certain financial covenants, including a fixed charge coverage ratio and a cash flow leverage ratio. The credit agreement requires the Company to grant certain inspection rights to Bank of America, limit or restrict the Company’s cash management; limit or restrict the ability of the Company to incur additional liens, make acquisitions or investments, incur additional indebtedness, engage in mergers, consolidations, liquidations, dissolutions, or dispositions, pay dividends or other restricted payments, prepay certain indebtedness, engage in transactions with affiliates, and use proceeds. The Company was in compliance with all financial covenants as of October 2, 2021. 5. Income Taxes The Company expects to repatriate a portion of its foreign earnings based on increased net sales growth driving additional capital requirements domestically, cash requirements for potential acquisitions and to implement certain tax strategies. The Company currently expects to repatriate approximately $ 7.5 million of foreign earnings in the future. All other unremitted foreign earnings are expected to remain permanently reinvested for planned fixed assets purchases and improvements in foreign locations. Repatriations of cash will generally be tax-free in the U.S. However, withholding taxes in China may still apply to any such future repatriations. Management has not changed its indefinite investment assertions with regard to the portion of accumulated earnings and profits in China that may be repatriated in the future. Accordingly, management estimates that future repatriations of cash from China may result in approximately $ 0.7 million of withholding tax. We do not anticipate there would be any offsetting foreign tax credits in the U.S. and as such, this potential liability is a direct cost associated with actual repatriations. Withholding taxes would not apply to future repatriations from Mexico or Vietnam. The Company has available approximately $ 6.4 million of gross federal research and development tax credits as of October 2, 2021. ASC 740 requires the Company to recognize in its financial statements uncertainties in tax positions taken that may not be sustained upon examination by the taxing authorities. Accordingly, as of October 2, 2021, the Company has recorded $ 2.6 million of unrecognized tax benefits associated with these federal tax credits, resulting in a net deferred tax benefit of approximately $ 3.8 million. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted in response to the COVID-19 pandemic. The CARES Act is not expected to have a material impact on the provision or timing of cash payments for income taxes. However, under the CARES Act, AMT credits not previously refunded for the 2018 tax year became refundable in the 2019 taxable year rather than in years 2019-2021, and taxpayers could elect to claim 100% of the AMT credits in the first taxable year beginning in 2018 by applying for a tentative refund claim on or before December 31, 2020. The Company made this election by applying for a tentative refund claim in the fourth quarter of fiscal year 2020. The Company is continuing to evaluate the impacts of other aspects of the CARES Act, and at this time the Company does not believe they will have a material impact on our consolidated financial position, results of operations, or cash flows. 11 The Company is evaluating tax law changes and regulatory guidance issued through the quarter. Such changes and regulations include guidance under Sec. 162(m), Sec. 245A, Sec. 951A, foreign tax credits, and rules relating to consolidated NOL carryback claims. The Company is still evaluating the ongoing impact of these law and regulatory changes, and does not expect them to have a material impact on its provision for income taxes. On January 27, 2021, the Company received official notice from the Vietnamese tax authorities, confirming tax benefits awarded (the “Tax Holiday”) related to the Company’s principal product line in Vietnam. The tax rate related to this product line will be zero percent for four years beginning with fiscal year 2021, then five percent for nine years, then ten percent for one year (as opposed to the normal twenty percent each year). Consequently, Management determined that the net operating loss in Vietnam more likely than not would result in minimal, if any, tax benefit, and the Company recorded a valuation allowance against the entire Vietnam net operating loss deferred tax asset ($0.2 million) in the third quarter of fiscal year 2021. 6. Earnings Per Share The following table presents a reconciliation of the denominator in the basic and diluted EPS calculation and the number of antidilutive common share awards that were not included in the diluted earnings per share calculation. These antidilutive securities occur when equity awards outstanding have an option price greater than the average market price for the period. Three Months Ended (in thousands, except share and per share information) October 2, 2021 September 26, 2020 Net income $ 815 $ 1,719 Weighted average shares outstanding—basic 10,762 10,760 Effect of dilutive common stock awards 290 280 Weighted average shares outstanding—diluted 11,052 11,040 Net income per share—basic $ 0.08 $ 0.16 Net income per share—diluted $ 0.07 $ 0.16 Antidilutive SARs not included in diluted earnings per share 629 329 7. Share-based Compensation The Company’s incentive plan provides for equity and liability awards to employees and non-employee directors in the form of stock options, stock appreciation rights (SARs), restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based or cash-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is recorded as employee compensation expense in cost of goods sold, research, development and engineering, and selling, general and administrative expenses. Share-based compensation is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on historical experience and future expectations. In addition to service conditions, SARs contain a performance condition. The additional performance condition is based upon the achievement of Return on Invested Capital (ROIC) goals relative to a peer group. All awards with performance conditions are evaluated quarterly to determine the likelihood that performance metrics will be achieved during the performance period. These awards are charged to compensation expense over the requisite service period based on the number of shares expected to vest. The SARs cliff vest after a three-year period from date of grant and expire five years from date of grant. The grant date fair value for the awards granted below were estimated using the Black Scholes option valuation method: August 9, 2021 July 23, 2020 SARs Granted 165,000 155,000 Strike Price $ 7.17 $ 6.94 Fair Value $ 2.73 $ 2.32 Total share-based compensation expense recognized during the three months ended October 2, 2021 and September 26, 2020 was approximately $ 68,000 and $ 64,000 , respectively. As of October 2, 2021, total unrecognized compensation expense related to unvested share-based compensation arrangements was approximately $ 0.6 million. This expense is expected to be recognized over a weighted average period of 2.39 years. No SARs were exercised during the three months ended October 2, 2021 or September 26, 2020. 12 8. Commitments and Contingencies Litigation and Other Matters The Company is party to certain lawsuits or claims in the ordinary course of business. The Company does not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on the financial position, results of operations or cash flow of the Company. Warranties The Company provides warranties on certain product sales. Allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. If actual return rates and/or repair and replacement costs differ significantly from management’s estimates, adjustments to recognize additional cost of sales may be required in future periods. The Company’s warranty reserve was approximately $ 32,000 as of October 2, 2021 and $ 25,000 as of July 3, 2021, respectively. 9. Derivative Financial Instruments As of October 2, 2021, the Company had outstanding foreign currency forward contracts with a total notional amount of $ 19.1 million. The maturity dates for these contracts extend through June 2022. For the three months ended October 2, 2021, the Company entered into $ 13.9 million of foreign currency forward contracts and settled $ 5.5 million of contracts. During the same period of the previous year, the Company did not enter into any foreign currency forward contracts and settled $ 6.7 million of contracts. As of October 2, 2021, the aggregate notional amount of the Company’s outstanding foreign currency contracts along with their unrealized gains (losses) are expected to mature as summarized below (in thousands): Quarter Ending Notional Contracts in MXN Notional Contracts in USD Estimated Fair Value January 1, 2022 $ 137,973 $ 5,129 $ 1,586 April 2, 2022 $ 149,893 $ 7,224 $ ( 23 ) July 2, 2022 $ 141,493 $ 6,726 $ ( 23 ) On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of September 30, 2022, related to the borrowings outstanding under the term loan with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. On the date of termination this interest rate swap was in a liability position of $ 148,400 , which will be amortized to interest expense over the original term of the swap. On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of November 1, 2023, related to the borrowings outstanding under the line of credit with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. On the date of termination this interest rate swap was in a liability position of $ 776,500 , which will be amortized to interest expense over the original term of the swap. 13 The following table summarizes the fair value of derivative instruments in the Consolidated Balance Sheet as of October 2, 2021 and July 3, 2021 (in thousands): October 2, 2021 July 3, 2021 Derivatives Designated as Hedging Instruments Balance Sheet Location Fair Value Fair Value Foreign currency forward contracts Other current assets $ 1,586 $ 3,614 Foreign currency forward contracts Other current liabilities $ ( 46 ) $ — The following tables summarize the gain (loss) on derivative instruments, net of tax, on the Consolidated Statements of Income for the three months ended October 2, 2021 and September 26, 2020, respectively (in thousands): Derivatives Designated as Hedging Instruments Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) AOCI Balance as of July 3, 2021 Effective Portion Recorded In AOCI Effective Portion Reclassified From AOCI Into Income AOCI Balance as of October 2, 2021 Forward contracts Cost of sales $ 2,721 $ 224 $ ( 1,830 ) $ 1,115 Interest rate swap Interest expense ( 649 ) — 75 ( 574 ) Total $ 2,072 $ 224 $ ( 1,755 ) $ 541 Derivatives Designated as Hedging Instruments Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) AOCI Balance as of June 27, 2020 Effective Portion Recorded In AOCI Effective Portion Reclassified From AOCI Into Income AOCI Balance as of September 26, 2020 Forward contracts Cost of sales $ ( 759 ) $ 1,043 $ 359 $ 643 Interest rate swap Interest expense ( 741 ) ( 223 ) 89 ( 875 ) Total $ ( 1,500 ) $ 820 $ 448 $ ( 232 ) As of October 2, 2021, the net amount of unrealized gain expected to be reclassified into earnings within the next 12 months is approximately $ 1.2 million. As of October 2, 2021, the Company does not have any foreign exchange contracts with credit-risk-related contingent features. 10. Fair Value Measurements The Company currently has forward contracts to hedge known future cash outflows for expenses denominated in the Mexican peso. These contracts are measured on a recurring basis based on the foreign currency spot rates and forward rates quoted by banks or foreign currency dealers. There are three levels of fair value hierarchy inputs used to value assets and liabilities which include: Level 1 – inputs are quoted market prices for identical assets or liabilities; Level 2 – inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3 – inputs are unobservable inputs for the asset or liability. These contracts are marked to market using level 2 input criteria every quarter with the unrealized gain or loss, net of tax, reported as a component of shareholders’ equity in accumulated other comprehensive gain (loss), as they qualify for hedge accounting. The following table summarizes the fair value of assets (liabilities) of the Company’s derivatives that are required to be measured on a recurring basis as of October 2, 2021 and July 3, 2021 (in thousands): October 2, 2021 Level 1 Level 2 Level 3 Total Fair Value Financial Assets: Foreign currency forward contracts $ — $ 1,586 $ — $ 1,586 Financial Liabilities: Foreign currency forward contracts $ — $ ( 46 ) $ — $ ( 46 ) 14 July 3, 2021 Level 1 Level 2 Level 3 Total Fair Value Financial Assets: Foreign currency forward contracts $ — $ 3,614 $ — $ 3,614 The carrying values of cash and cash equivalents, accounts receivable and current liabilities reflected on the balance sheets at October 2, 2021 and July 3, 2021, reasonably approximate their fair value. The Company’s long-term debt, which is measured at amortized cost, primarily consists of an asset-based revolving credit facility, lease liability, and an equipment loan. These borrowings bear interest at LIBOR plus 2.5 % per the loan agreement. Each of these rates is a variable floating rate dependent upon current market conditions and the Company’s current credit risk as discussed in Note 4. As a result of the determinable market rates for our asset-based revolving credit facility and equipment loan, they are classified within Level 2 of the fair value hierarchy. Further, the carrying value of each of these instruments reasonably approximates their fair value as of October 2, 2021 and July 3, 2021. 11. Revenue Revenue Recognition The Company specializes in services ranging from product manufacturing to engineering and tooling services. The first step in its process for revenue recognition is to identify the contract with a customer. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied. The Company generally enters into manufacturing service agreements (“MSA”) with its customers that outline the terms of the business relationship between the customer and the Company. This includes matters such as warranty, indemnification, transfer of title and risk of loss, liability for excess and obsolete inventory, pricing, payment terms, etc. The Company will also bid on a program-by-program basis for customers in which an executed MSA may not be in place. In these instances, as well as when we have an MSA in place, we receive customer purchase orders for specific quantities and timing of products. As a result, the Company considers its contract with a customer to be the combination of the MSA and the purchase order. The transaction price is fixed and set forth in each purchase order. In the Company's normal course of business, there are no variable pricing components, or material amounts refunded to customers in the form of refunds or rebates. The Company assesses whether control of the product or services promised under the contract is transferred to the customer at a point in time (shipment) or over time (as we manufacture the product). The Company is first required to evaluate whether its contracts meet the criteria for 'over-time' or 'point-in-time' recognition. The Company has determined that for the majority of its contracts the Company is manufacturing products for which there is no alternative use due to the unique nature of the customer-specific product, IP and other contract restrictions. The Company has an enforceable right to payment including a reasonable profit for performance completed to date with respect to these contracts. As a result, revenue is recognized under these contracts 'over-time' based on the input cost-to-cost method as it better depicts the transfer of control. This input method is based on the ratio of costs incurred to date as compared to the total estimated costs at completion of the performance obligation. For all other contracts that do not meet these criteria, such as manufacturing contracts for which the terms do not provide an enforceable right to payment for performance completed to date, the Company recognizes revenue when it has transferred control of the related manufactured products which generally occurs upon shipment to the customer. Revenue from engineering services is recognized over time as the services are performed. The Company’s sales arrangements do not contain any significant financing component for its customers. The Company generally provides a warranty for workmanship on its manufacturing contracts. Historically, the amount of returns for workmanship issues has been de minimis under the Company’s warranties. The Company elected to not disclose information about remaining performance obligations as they are part of contracts that that have expected durations of one year or less. During the first three months of fiscal year 2022, no revenues were recognized from performance obligations satisfied or partially satisfied in previous periods. 15 Contract Balances A contract asset is recognized when the Company has recognized revenue, but has not issued an invoice for payment. Contract assets are classified separately on the condensed consolidated balance sheet and transferred to receivables when the right to payment becomes unconditional. The following table summarizes the activity in the Company’s contract assets during the three months ended October 2, 2021 (in thousands): Contract Assets Beginning balance, July 3, 2021 $ 24,781 Revenue recognized 129,481 Amounts collected or invoiced ( 130,611 ) Ending balance, October 2, 2021 $ 23,651 Disaggregation of Revenue The following table presents the Company’s revenue disaggregated for the three months ended October 2, 2021 and September 26, 2020 (in thousands): Revenue Recognition Three Months Ended October 2, 2021 September 26, 2020 Over-Time $ 129,481 $ 120,836 Point-in-Time 3,281 2,371 Total $ 132,762 $ 123,207 16 12. Leases The Company has several commitments under operating and financing leases for warehouses, manufacturing facilities, office buildings, and equipment with initial terms that expire at various dates during the next 1 year to 10 years. The components of lease cost for the three months ended October 2, 2021 were (in thousands): Lease cost Classification Three Months Ended Operating lease cost Cost of sales $ 1,433 Operating lease cost Selling, general and administrative expenses $ 308 Financing lease cost Cost of sales $ 434 Financing lease cost Selling, general and administrative expenses $ 10 Total lease cost $ 2,185 Fixed lease cost $ 1,777 Short-term lease cost $ 408 Total lease cost $ 2,185 Amounts reported in the Consolidated Balance Sheet as of October 2, 2021 were (in thousands, except weighted average lease term and discount rate): October 2, 2021 Operating Leases: Operating lease right of use assets $ 18,994 Operating lease liabilities (1) $ 18,953 Weighted-average remaining lease term (in years) Operating leases 5.73 Weighted-average discount rate Operating leases 4.0 % Financing Leases (2) : Financing lease right of use assets $ 4,948 Financing lease liabilities $ 4,456 Weighted-average remaining lease term (in years) Financing leases 2.83 Weighted-average discount rate Financing leases 8.7 % (1) The current portion of the total operating lease liabilities of $ 5.2 million is classified under Other Current Liabilities , resulting in $ 13.7 million classified under Operating Lease Liabilities in the Long-term Liabilities section of the condensed consolidated balance sheet. (2) The total finance lease right of use assets of $4.9 million is classified under Other Long-term Assets. The current portion of the total finance lease liabilities of $1.9 million is classified under Current portion of debt, net, resulting in $2.6 million classified in Other Long-term Liabilities section of the condensed consolidated balance sheet. 17 Other information related to leases was as follows (in thousands): Three Months Ended October 2, 2021 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 1,446 Financing cash flows used in financing leases $ 401 Future lease payments under non-cancellable leases as of October 2, 2021 are as follows (in thousands): Fiscal Years Ending Operating Leases Finance Leases 2022 (1) $ 4,026 $ 1,477 2023 4,398 1,969 2024 3,811 1,642 2025 3,462 — 2026 2,667 — Thereafter 4,521 — Total undiscounted lease payments 22,885 5,088 Less: present value discount ( 3,932 ) ( 632 ) Total lease liabilities $ 18,953 $ 4,456 (1) Represents estimated lease payments for the remaining nine-month period ending July 2, 2022.