Item 7. Management’s Discussion and Analysis
Item 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Key Tronic is a leading contract manufacturer offering value-added design and manufacturing services from its facilities in the United States, Mexico, China and Vietnam. We provide full engineering services, materials management, worldwide manufacturing facilities, assembly services, in-house testing, worldwide distribution and unparalleled customer service. Our customers include some of the world’s leading original equipment manufacturers, and our combined capabilities and vertical integration are proving to be a desirable offering to our expanded customer base.
Our domestic and international production capability provides our customers with benefits of improved supply-chain management, reduced inventories, lower transportation costs, and reduced product fulfillment time. We continue to make investments in all of our operating facilities to give us the production capacity, capabilities and logistical advantages to continue to win new business. The following information should be read in conjunction with the consolidated financial statements included herein and with Part II Item 1A, Risk Factors included as part of this filing.
Our mission is to provide our customers with superior manufacturing and engineering services at the lowest total cost for the highest quality products, and create long-term mutually beneficial business relationships by employing our “Trust, Commitment, Results” philosophy.
Executive Summary
During the fourth quarter of fiscal year 2023, we won new programs involving inventory control, clean energy, and distribution monitoring equipment.
We reported net sales of $588.1 million for fiscal year 2023, the highest annual revenue in the Company’s history, and up 11% from $531.8 million for fiscal year 2022. Record annual revenue and strong earnings in fiscal year 2023 was driven by successful new program ramps and increased demand from a number of longstanding customer programs.
Moving into fiscal 2024, we expect a strong Mexican Peso valuation to the US Dollar and relatively high interest expense to constrain our bottom line. At the same time, global logistics problems and heightened assurance of supply concerns continue to drive the favorable trend of contract manufacturing returning to North America.
For the first quarter of fiscal year 2024, the Company expects to report revenue in the range of $140 million to $150 million. We continue to see a trend of contract manufacturing returning to North America and a growing number of potential customers evaluating a migration of their China-based manufacturing to our facility in Vietnam. We move into fiscal year 2024 with a strong backlog and pipeline of potential new business, our inventory more in line with our revenue levels, and continuing improvement in the global supply issues and lower labor turnover. However, we are also seeing some softening in demand from several large customers and one large customer is pausing production during the next quarter to resolve certain of their design issues. Over the longer term, we are well positioned for continued growth and profitability.
We have continued to diversify our customer base by adding additional programs and customers. Our current customer relationships involve a variety of products including consumer electronics, electronic storage devices, plastics, household products, gaming devices, specialty printers, telecommunications, industrial equipment, military supplies, computer accessories, medical, educational, irrigation, automotive, transportation management, robotics, RFID, power supply, off-road vehicle equipment, fitness equipment, HVAC controls, consumer products, home building products, material handling systems, lighting equipment, consumer security products, smart security, architectural LED lighting, power meters and smart grid, wireless power solutions, sanitizer dispensing, automotive controllers, oil and gas drilling, power equipment, and wireless security.
Gross profit as a percentage of net sales was 8.1 percent in both fiscal year 2023 and 2022, respectively. During fiscal year 2023, the gross margins benefited by increased revenue levels along with some stabilization in the labor market. However, our gross margin was also adversely impacted by the strengthening of the Mexican Peso relative to the US Dollar. The level of gross margin is impacted by product mix, timing of the startup of new programs, facility utilization, and pricing within the electronics industry and material costs, which can fluctuate significantly from quarter-to-quarter and year-to-year.
Operating income as a percentage of net sales for fiscal year 2023 was 2.8 percent compared to 1.7 percent for fiscal year 2022. The increase in operating income as a percentage of net sales was primarily driven by the gains on insurance proceeds from the claim on a lightning strike at our Arkansas production facility.
Net income for fiscal year 2023 was $5.2 million or $0.47 per share, as compared to $3.4 million or $0.31 per share for fiscal year 2022. Earnings for fiscal 2023 continued to be adversely impacted by supply chain, transportation and logistics issues, and increased interest expense.
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We maintained a strong balance sheet with a current ratio of 2.3 and a debt-to-equity ratio of 0.99. Total cash used in operating activities as defined on our cash flow statement was $11.3 million during fiscal year 2023, as working capital has increased to support increased revenue. We believe we maintain sufficient liquidity for our expected future operations, dependent upon executing projected cash flows from operations and potentially adding additional credit capacities through refinancing current credit agreements or pursuing additional debt structures.
RESULTS OF OPERATIONS
Comparison of the Fiscal Year Ended July 1, 2023 with the Fiscal Year Ended July 2, 2022
The following table sets forth for the periods indicated certain items of the consolidated statements of income expressed as a percentage of net sales. The financial information and discussion below should be read in conjunction with the consolidated financial statements and Footnotes contained in this Annual Report on Form 10-K.
Fiscal Year Ended
July 1, 2023 % of
net sales July 2, 2022 % of
net sales $ change % point
change
Net sales $ 588,135 100.0% $ 531,815 100.0% $ 56,320 —
Cost of sales 540,663 91.9 488,601 91.9 52,062 —
Gross profit 47,472 8.1 43,214 8.1 4,258 —
Operating expenses:
Research, development and engineering 9,735 1.7 9,821 1.8 (86) (0.1)
Selling, general and administrative 25,715 4.4 24,598 4.6 1,117 (0.2)
Gain on insurance proceeds, net of losses (4,301) (0.7) — (4,301) (0.7)
Total operating expenses 31,149 5.4 34,419 6.4 (3,270) (1.0)
Operating income 16,323 2.8 8,795 1.7 7,528 1.1
Interest expense, net 10,023 1.7 5,104 1.0 4,919 0.7
Income before income taxes 6,300 1.1 3,691 0.7 2,609 0.4
Income tax provision 1,143 0.2 314 0.1 829 0.1
Net income $ 5,157 0.9% $ 3,377 0.6% $ 1,780 0.3
Effective income tax rate 18.1 % 8.5 %
Net Sales
The increase in net sales of $56.3 million from the prior fiscal year was primarily due to the successful ramp of new customer programs and increased demand from existing customers. However, the Company's revenue was constrained by tightening worldwide supply chain and transportation and logistics issues, which delayed the arrival of certain key components, causing factory downtime and overtime expenses.
The following table shows the revenue by industry sectors as a percentage of revenue for fiscal years 2023 and 2022:
Fiscal Year Ended
July 1, 2023 July 2, 2022
Consumer 45 48
Industrial 41 41
Communication 9 7
Transportation 3 1
Gaming 1 1
Medical 1 —
Printers — 1
Computer and Peripheral — 1
Total 100% 100%
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We provide services to customers in a number of industries and produce a variety of products for our customers in each industry. Key Tronic does not target any particular industry, but rather seeks to find programs that strategically fit our vertical manufacturing capabilities. As we continue to diversify our customer base and win new customers, we expect to continue to see a change in the industry concentrations of our revenue.
Sales to foreign locations represented 14.60% percent and 17.64% percent of our total net sales in fiscal years 2023 and 2022, respectively.
Cost of Sales
Total cost of sales as a percentage of net sales was 91.9 percent in fiscal year 2023 and 91.9 percent in fiscal year 2022.
We record our inventories at net realizable value based on specific identification of inventory against current demand and recent usage. We also consider our customers' ability to pay for inventory whether or not there is a lead-time assurance agreement for a specific program. The amounts charged to expense for these inventories were approximately $427,000 and $950,000 in fiscal years 2023 and 2022, respectively.
We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. Warranty expense is related to workmanship claims. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense was approximately $313,000 and $446,000 in fiscal years 2023 and 2022, respectively.
Gross Profit
Gross profit as a percentage of net sales was 8.1 percent in fiscal years 2023 and 2022. During fiscal year 2023, the gross margins benefited by increased revenue levels along with some stabilization in the labor market. However, our gross margin was also adversely impacted by the strengthening of the Mexican Peso relative to the US Dollar.
Changes in gross profit margins reflect the impact of a number of factors that can vary from period to period, including product mix, start-up costs and efficiencies associated with new programs, product life cycles, sales volumes, capacity utilization of our resources, management of inventories, component pricing and shortages, end market demand for customers’ products, fluctuations in and timing of customer orders, and competition within the contract manufacturing industry. These and other factors can cause variations in operating results. There can be no assurance that gross margins will not decrease in future periods.
Research, Development and Engineering
Research, development and engineering expenses (RD&E) consist principally of employee related costs, third-party development costs, program materials, depreciation, and allocated information technology and facilities costs. Total RD&E expenses were $9.7 million and $9.8 million in fiscal years 2023 and 2022, respectively. Total RD&E expenses as a percent of net sales was 1.7 percent in fiscal year 2023 and 1.8 percent in fiscal year 2022.
Selling, General and Administrative
Selling, general, and administrative expenses (SG&A) consist principally of salaries and benefits, advertising and marketing programs, sales commissions, travel expenses, provision for doubtful accounts, facilities costs, and professional services. Total SG&A expenses were $25.7 million and $24.6 million in fiscal years 2023 and 2022, respectively. Total SG&A expenses as a percent of net sales were 4.4 percent and 4.6 percent in fiscal years 2023 and 2022, respectively. This 0.2 percentage point decrease in SG&A as a percentage of net sales is primarily related to an increase in legal expenses related specifically to the SEC’s review of the whistleblower complaint in fiscal year 2021.
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Interest Expense
We had net interest expense of $10.0 million and $5.1 million in fiscal years 2023 and 2022, respectively. The increase in interest expense is primarily related to increased interest rates, an increase in the average balance outstanding on our line of credit, and financing leases.
Income Tax Provision
We had an income tax expense of approximately $1.1 million during fiscal year 2023 and an income tax expense of approximately $0.3 million during fiscal year 2022. The income tax expense recognized during both fiscal years 2023 and 2022 was primarily a function of U.S. and foreign taxes recognized at statutory rates, the net benefit associated with federal research and development tax credits, the impact of foreign exchange gains in fiscal year 2023, and the net benefit of carrying back the fiscal year 2021 net operating tax losses to years with higher federal tax rates in fiscal year 2022.
We continually review our requirements for liquidity domestically to fund current operations, revenue growth, and to look for potential future acquisitions. We anticipate repatriating a portion of our unremitted foreign earnings. The estimated taxes associated with these expected repatriations are included in the income tax calculation. For further information on taxes, please review Footnote " Income Taxes” of the “Notes to Consolidated Financial Statements”.
International Subsidiaries
We offer customers a complete global manufacturing solution. Our facilities provide our customers the opportunity to have their products manufactured in the facility that best serves specific cost, product manufacturing, and distribution needs. The locations of our active foreign subsidiaries are as follows:
• Key Tronic Juarez, SA de CV owns five facilities and leases four facilities in Juarez, Mexico. These facilities include an SMT facility, an assembly and molding facility, a sheet metal fabrication facility, and assembly and warehouse facilities. This subsidiary primarily supports our U.S. operations.
• Key Tronic Computer Peripherals (Shanghai) Co., Ltd. leases one facility with SMT, assembly, global purchasing, and warehouse capabilities in Shanghai, China, which began operations in 1999. Its primary function is to provide contract manufacturing services.
• Key Tronic Vietnam leases one facility in Da Nang, Vietnam. This facility includes SMT, assembly, and warehouse capabilities. Its primary function is to provide contract manufacturing services for export.
Foreign sales (based on shipping instructions) from our worldwide operations, including domestic exports, were $85.9 million and $93.8 million in fiscal years 2023 and 2022, respectively. Products and manufacturing services provided by our subsidiary operations are often shipped to customers directly by the parent company.
RESULTS OF OPERATIONS
Comparison of the Fiscal Year Ended July 2, 2022 with the Fiscal Year Ended July 3, 2021
To review the results of operations comparison of the fiscal year ended July 2, 2022 with the fiscal year ended July 3, 2021, please refer to our Annual Report on Form 10-K filed September 14, 2022 with the Securities and Exchange Commission or follow the link below.
https://www.sec.gov/ix?doc=/Archives/edgar/data/719733/000071973322000063/ktcc-20220702.htm
Capital Resources and Liquidity
Operating Cash Flow
Net cash used in operating activities for fiscal year 2023 was $11.3 million compared to $4.9 million in fiscal year 2022. The additional cash used in fiscal year 2023 was predominately used for revenue growth that required additional working capital in increased receivables and paying down supplier payables during the year.
The $11.3 million of net cash used in operating activities during fiscal year 2023 is primarily related to $5.2 million of net income adjusted for $9.5 million of depreciation and amortization, $14.8 million increase in accounts receivable, a $17.4 million decrease in inventory, a $16.0 million increase in other liabilities, partially offset by a $5.5 million decrease in accounts payable, $8.0 million increase in contract assets, and a $1.5 million increase in accrued compensation and vacation.
The $4.9 million of net cash used in operating activities during fiscal year 2022 was primarily related to $3.4 million of net income adjusted for $7.6 million of depreciation and amortization, $25.6 million increase in accounts receivable, a $19.4 million increase in inventory, a $3.6 million increase in other liabilities, partially offset by a $28.6 million increase in accounts payable, and a $2.8 million decrease in contract assets.
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Accounts receivable fluctuates based on the timing of shipments, terms offered, and collections. We purchase inventory based on customer forecasts and orders. When those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable fluctuates with changes in inventory levels, volume of inventory purchases, negotiated supplier terms, and taking advantage of early pay discounts.
Investing Cash Flow
Cash flows used in investing activities were $4.5 million for fiscal year 2023. Cash flows used in investing activities were $8.1 million in fiscal year 2022. Our primary use of cash in investing activities during fiscal years 2023 and 2022 was purchasing equipment to support increased production levels for new programs. During fiscal year 2023, cash flows used in investing activities also included prepayments on finance lease obligations. During fiscal year 2023, the source of cash provided by investing activities came from insurance claims paid for replacing equipment and facility repairs in our Arkansas facility related to a lightning strike and water damage.
Leases are often utilized when potential technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds as well as our revolving line of credit facility and equipment term loan .
Financing Cash Flow
Cash flows provided by financing activities were $17.7 million and $11.2 million in fiscal years 2023 and 2022, respectively. Our primary financing activities during fiscal year 2023 were proceeds from capital equipment finance leases and borrowings and repayments under our revolving line of credit facility; partially offset by repayments on our term loans and principal payments on finance leases. Our primary financing activities during fiscal year 2022 were repayments on our term loans as well as borrowings and repayments under our revolving line of credit facility.
As of July 1, 2023, approximately $4.6 million was available under the asset-based revolving credit facility and we were in compliance with our loan covenants.
Our cash requirements are affected by the level of current operations and new programs. We believe that projected cash from operations, funds available under the revolving credit facility and potential additional debt capacity will be sufficient to meet our working and fixed capital requirements for the foreseeable future. The Company further notes projected cash from operations is projected to improve in the coming quarters as supply chain availability will boost additional inventory turns and existing inventory is consumed by fulfilling customer backlog. As of July 1, 2023, we had approximately $3.6 million of cash held by foreign subsidiaries. If cash is to be repatriated in the future from these foreign subsidiaries, the Company would be subject to certain withholding taxes in the foreign jurisdictions. The total amount of tax payments required for the amount of foreign subsidiary cash on hand as of July 1, 2023 would approximate $64,000.
The Company also has approximately $33.2 million of foreign earnings that have not been repatriated to the U.S. Of that amount, the Company estimates that $7.6 million is to be repatriated in the future, requiring foreign withholding taxes of $0.8 million that is currently accrued in our deferred tax liabilities. The remaining $25.6 million is considered to be permanently reinvested in Mexico, China and Vietnam. If these amounts were required to be repatriated, we estimate it would create an additional $0.8 million in foreign withholding taxes payable.
We have accrued withholding taxes for expected future repatriation of foreign earnings as discussed in Note 6 of the “Notes to Consolidated Financial Statements”.
Off-Balance Sheet Arrangements and Contractual Obligations
In the normal course of business, we enter into contracts which obligate us to make payments in the future. We have certain contractual obligations that extend beyond fiscal year 2023 under lease obligations and debt arrangements.
As of July 1, 2023, we had open purchase order commitments for materials and other supplies. Actual needs under these blanket purchase orders fluctuate with our manufacturing levels and as such cannot be broken out between fiscal years. In addition, we have contracts with many of our customers that minimize our exposure to losses for material purchased within lead-times necessary to meet customer forecasts. Purchase orders generally can be cancelled without penalty within specified ranges that are determined in negotiations with our suppliers. These agreements depend in part on the type of materials purchased as well as the circumstances surrounding any requested cancellations. We do not use off-balance sheet financing techniques other than traditional operating leases, and we have not guaranteed the obligations of any entity that is not one of our wholly owned subsidiaries.
For a summary of our lease obligations as of July 1, 2023, please refer to Note 15 “Leases” of the “Notes to Consolidated Financial Statements.”
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For a summary of our long-term debt obligations as of July 1, 2023, please refer to Note 4 “Long-Term Debt” of the “Notes to Consolidated Financial Statements.”
Critical Accounting Policies and Estimates
Preparation of our consolidated financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses. Note 1 “Significant Accounting Policies” of the “Notes to Consolidated Financial Statements” describes the significant accounting policies used in the preparation of our consolidated financial statements. Management believes the most complex and sensitive judgments, because of their significance to our consolidated financial statements, result primarily from the need to make estimates about effects of matters that are inherently uncertain. The most significant areas involving management judgments are described below. Actual results in these areas could differ from management’s estimates.
Revenue
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 outlines 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. Further, 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.
Inactive, Obsolete, and Surplus Inventory Valuation
Inventories are stated at the lower of cost or net realizable value. Inventory valuation is determined using the first-in, first-out (FIFO) method. We write down inventories that we deem inactive, obsolete, or surplus to net realizable value. The write down is calculated based upon the demand for the products that we produce to value this related inventory at net realizable value. Demand is determined by expected sales, customer purchase orders, or customer forecasts. If expected sales do not materialize, excess inventory would be the result and a write down of that inventory against earnings would occur. In the case where we have purchased material based upon a customer’s forecast or purchase orders, we are usually covered by lead-time assurance agreements or purchase orders with each customer. These contracts state that the financial liability for material purchased within agreed upon lead-time and based upon the customer’s forecasts, lies with the customer. If we purchase material outside the lead-time assurance agreement and the customer’s forecasts do not materialize or if we have no lead-time assurance agreement for a specific program, we would have the financial liability and may have to charge inactive, obsolete or surplus inventory against earnings. We also write down inventory values related to specific customers covered by lead-time assurance agreements when those customers are experiencing financial difficulties or reimbursement is not reasonably assured.
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Allowance for Doubtful Accounts
We value our accounts receivable net of an allowance for doubtful accounts. As of July 1, 2023, the allowance for doubtful accounts was approximately $23,000. As of July 2, 2022, the allowance for doubtful accounts was approximately $12,000. This allowance is based on estimates of the portion of accounts receivable that may not be collected in the future. The estimates used are based primarily on specific identification of potentially uncollectible accounts. Such accounts are identified using publicly available information in conjunction with evaluations of current payment activity. However, if any of our customers were to develop unexpected and immediate financial problems that would prevent payment of open invoices, we could incur additional and possibly material expenses that would negatively impact earnings.
Income Taxes
Income tax expense includes U.S. and international income taxes and a provisional estimate for U.S. taxes on undistributed earnings of foreign subsidiaries. We do not record foreign withholding taxes on undistributed earnings of international subsidiaries that are deemed to be permanently reinvested. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. The deferred income taxes are classified as long-term assets or liabilities. The most significant areas involving management judgments include deferred income tax assets and liabilities, uncertain tax positions, and research and development tax credits. Our estimates of the realization of the deferred tax assets related to our tax credits are based upon our estimates of future taxable income which may change.
New and Future Accounting Pronouncements
See Note 1 “Significant Accounting Policies” of the “Notes to Consolidated Financial Statements.”
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