KTCC - Key Tronic

[60North Investments]

I've written about Key Tronic on Seeking Alpha on several occassions, you can find those writings from here. There are a few other articles on SA as well.

 

Key Tronic is an electronic manufacturing service provider, so they manufacture all kinds of things from electronics to medical equipment and consumer products. A truly not-sexy industry to say the least, as is the company's website. ROICs have been around 10-11% on average in the past 7 years. No dividends have been paid, and basically no leverage has been used until lately when they acquired CDR. CEO's comment regarding the announcement was very interesting: "I would never spend $46 million if I wasn't very excited." So far, it looks very decent. Management spoke about the acquisition being "1+1=3" -kind. In Q2 CC, they said it might actually be even 1+1=4 or 4.5.

 

Currently the shares trade at 16x FY14 earnings. FY15 Q1 was bad due to "legacy" big customer having issues, bad product mix, and accepting some losses in efficiency to serve customers as fairly as possible. Management explained it well in the CC so I'd recommend reading/listening to those.

 

Ramping up a new "program" takes somewhere around 12-24 months. The company used to have 3-4 new programs per Q, in FY15 Q1 they had 13 (now they don't mention those anymore). As management has explained, incremental gross margins are around 15-20%, so sales growth should eventually push gross margins to 10-11%.

 

Management seems very competent, honest and ethical. Comments like this regarding customers are nice to hear, "We'll help them find someone else if we can't provide anything". Geographically Key Tronic seems well located with factories in China, Mexico and the USA. Especially the Mexican factories (CDR acquisition added more of these) seem to be seeing big tailwinds from manufacturing moving back to U.S. based companies from China. Also, their ability to handle plastics, metals etc. means that they have a very broad array of products they can handle from beginning to end, something special for a company of their size.

 

Biggest risks are probably their ability to keep the whole package in their hands as the company scales up. OPEX can't grow too much or otherwise the growth doesn't add anything. For the past years, few of their largest customers have seen big declines in their own businesses. This seems to be steadying according to management. The CDR acquisition diversified them even more, but if the business from those big clients continues to decline it will obviously hurt them. It's a risk that has upside though, it could well be that they start getting more business from those big clients again.

 

My own estimates are such that they're trading at mid-single digit p/e when taking FY16-17 earnings. I see this as a very nice low downside risk + very high upside potential case.

 

Disclosure: long KTCC

[SpecOps]

Interesting company, their free cash flow is a bit hit a miss though, do you think they will be more cash generative in the future?

 

They do look a bit expensive on a P/Sales basis compared to historically.

 

http://i.imgur.com/Gzbs1E0.png

KTCC-Value-Report.pdf

[Guest Schwab711]

I can't stand P/S. It's rarely useful.

 

I didn't follow the hiccup of 2014 so I have no opinion but I have owned this. Anecdotal, but I really like management here. You make me want to look into this again.

[60North Investments]

Free cash flow generation hasn't been excellent as SpecOps noted. That's entirely due to changes in operating assets and liabilities though. Excluding those, their FCF would've been more or less the same as net income (assuming maintenance capex equals depreciation). Growth will require more working capital, therefore I wouldn't be looking for big improvements in FCF in the next few years. After the biggest growth spurt I'd imagine FCF to improve. If someone has a differing opinion I'd be glad to hear it.

 

I wouldn't at least make any conclusions from their p/s multiple. If they're able to execute on the growth (which to me seems to be on the most probable end of the spectrum) and keep costs reasonable (has been done in the past), then earnings will get a nice jump and shares will follow. As an example, in FY13 and FY12, with $360m and $346m in sales, their OPEX was 4.5% of sales. If they'll reach that level again in next 1-2 years when sales ramp up, and gross margin goes to 11% (has been 9.6% at best) due to higher incremental margins, you'll get net margins somewhere between 4-5%. I dare to say there's a very good chance they'll make $2-2.5 EPS within 2 years. Beyond that, I don't have a clear picture of how far they're able to go.

[60North Investments]

Schwab711, just curious, did you decide to pull the trigger on KTCC? Market seems to be offering this one on-sale.

 

I've been wondering whether anyone has a clue who are Key Tronic's largest customers? In which industries do they operate in, and if someone knows the specific companies. I'm not sure whether I've missed any hints from management regarding who those might be.

[Guest Schwab711]

Schwab711, just curious, did you decide to pull the trigger on KTCC? Market seems to be offering this one on-sale.

 

I've been wondering whether anyone has a clue who are Key Tronic's largest customers? In which industries do they operate in, and if someone knows the specific companies. I'm not sure whether I've missed any hints from management regarding who those might be.

 

No, I haven't bought anything in quite awhile. I don't like KTCC's business, it seems really average at best. Otherwise I agree with you. I also felt like I could follow your logic to $2-$2.5 eps so it seems reasonable. I don't follow KTCC much anymore.

 

[60North Investments]

There's not really much analyst coverage on KTCC, so when I saw B Riley initiating coverage I got curious. Since I can't get my hands on their report, I'm wondering whether a kind board member with access to it could forward it to me? It'd be interesting to see what analysts are thinking about the stock and reflect my own thoughts and views on theirs. For example, on some brief comments it said they're expecting 140 basis point improvement in GMs 2016. If you use 2014 as the base that gets you to pretty good GMs compared to what for example I'm anticipating.

 

TIA if anyone is able to help here!

[60North Investments]

Q4 and FY15 results are out. Pretty good stuff I would dare to say. $120m sales (exp. $115-125m) with $2.3m net income ($0.21 EPS, exp. $0.17-0.23). GM was 8.6% (up each quarter), OPEX 5.9%. Guidance for Q1 is $122-130m sales and $0.17-0.24 EPS. As always, the conference call is worth listening to. There they mentioned for example that they're anticipating further sequential growth. A bit before the Ayrshire acquisition, so about a year ago, they got a new customer that is now just about to go into production. If they deliver on those programs, the customer according to KTCC management will give them more programs, giving them a fairly reliable sequential growth driver. They didn't say how big they anticipated this customer to become, other than saying "big".

 

If something was disappointing it was that they now said their gross margin will likely be in the range of 9 to 10%, instead of 9 to 11%. If the tax rate will actually be 35% going forward, then the $2 EPS will probably require an extra year or so. Still, depending on what the sequential sales growth will look like, 2016 should be a very decent year for them. $500-550m for the full year in sales might be good guess for now (I don't know how much more do I dare to anticipate before time goes on).

 

I'd still be thankful if someone had access to the B Riley analyst report, I'm too curious to see what they're thinking. In the meantime KTCC continues being my largest position.

 

Q4 press release and CC webcast

CC transcript

 

[60North Investments]

Getting hammered today on the profit warning. $2m extra costs due to preparing for larger demand from one customer who then cancelled it. Stock down -15-20% for the day. I bought more stock and options. Would appreciate if someone talks me the bear case of this. I'll come back to it when I have my notes on Friday.

[jawn619]

This looks interesting. Looking forward to your writeup.

[60North Investments]

You can read my writeups from Seeking Alpha and this thread. On twitter there are some shorter comments. Not sure how much more I have to say about it after today's news as I just don't see it as that big of a deal. But I'll come back to it on Friday/Saturday. Please do let me know what your thoughts are if you have time to get to know the case.

[DTEJD1997]

Getting hammered today on the profit warning. Would appreciate if someone talks me the bear case of this. I'll come back to it when I have my notes on Friday.

 

I would have to look at this a bit more closely...but I've had a LOT of money & time invested in contract manufacturers in the past...it has been a rough time.

 

The bear case is that this is simply not a good business to be in at this point in time.  The easy money has all been made a LONG time ago.  The money was too made in the 80's & 90's when manufacturing was being moved from N. America to Asia.  Now the Asians are even having trouble and manufacturing is leaving China & moving to lower cost areas.

 

Additionally, customers are fickle, and frequently change their minds and make unreasonably demands.  Nam Tai being shafted by Apple is a perfect example of this.

 

You also have privately held players that are frequently irrantional and willing to operate with no or even negative margins in order to get more business.

 

Tough, tough business even for well run & well capitalized companies.

[60North Investments]

EMS is certainly not a great business to be in. I'm still not sure whether that means Key Tronic doesn't look very attractive here. As KTCC's CEO has been saying for quite a while now, manufacturing is moving back from Asia to for example USA and Mexico. This is great for Key Tronic who have capabilities in these areas, and they seem to be trusted partners.

 

Customers being fickle seems to be an issue as this latest profit warning indicates. However, Key Tronic is widening their customer base day by day. It used to be very concentrated, but is less and less concentrated as they get new customers (and got a bunch of them via Ayrshire). So it's not like having a company like Apple represent +50% of your revenues.

 

Now, I had hoped for roughly $530m sales, $18m EBIT, $10.5m net income for FY16. Take $2m out of those and you get almost $0.80 EPS for the year. Not too great but arguably worth at least $10 per share considering that they'll be growing. For FY17 there's no reason to assume this kind of $2m or whatever extra expense will happen again, leading me to think that $1.50 EPS is doable unless otherwise proven.

 

The ugly thing is that this is a business that gets hurt somewhat easily. A $2m expense is a large item for them at this time. Hoping for a decent guidance for Q2, something like sales of $135-140m would do good.

[60North Investments]

jawn619, did you dig deeper into KTCC? Curious to hear what thoughts you might have on it.

 

Trying to see what the current $85m market cap implies we could argue that the market is expecting KTCC to churn net income of less than $10m for the next years. How likely is this? This Q1 they'll lose extra $2m due to the one-time issue. Still, without further one-time issues of that magnitude they'll do about $8m net income for the year. Next year something very bad needs to happen for them not to go way above $10m net income (currently thinking it'll be $15-17m).

 

Very interesting to see whether I'm wrong, or if these $8/share prices will look funny in sometime.

[60North Investments]

Just noticed on Seeking Alpha a good description of what seems to have happened with KTCC and the profit warning news. I don't know if the customer was SMT, and don't think it matters a whole lot, when it seems quite clear that this issue won't be haunting for longer than this Q's results. As said, the market seems to be thinking that this $2m cost should be discounted to eternity.

 

Monday Key Tronic's shares plunged up to 20% in early trading, a $20m reduction to their valuation, after they told investors of order cancellations that would cost them $2m in F1Q16. As a result, even though revenue will be $1m above the analyst estimate, they'll earn just $0.06-0.08 compared to the $0.17-0.24 they'd expected. The pre-tax $2m cost equates to a hit of $0.12 per share, so EPS otherwise would've been $0.18-0.20, in-line with expectations.

 

The $2m event would justify a $20m reduction in their valuation if it altered our revenue and earnings projections beyond next quarter. We'd predict multiple quarter consequences if, a) the program/customer involved is a big fraction of revenue, which b) was likely to continue to decline going forward.

 

But I'm pretty sure the customer is Smart Technologies (NASDAQ:SMT), which is in the "computers and peripherals" industry sector, which, per KTCC's last 10-K, comprised just 2% of F2015 revenue.

 

The evidence of their identity is:

 

-We know SMT is a Key Tronic customer.

-SMT is classified as "computer and peripherals".

-SMT's sales have fallen since 2011, and KTCC's sales to that industry sector have fallen monotonically too, from 13% in 2011 to 2% in 2015 (see the 10-K's).

-SMT pre-announced bad results due to slower than expected demand growth for a new product. This was three days ago which explains why KTCC chose to pre-announce to prevent info leak.

-On the last conference call KTCC mentioned that a long-standing customer that had been declining for several years was preparing, with KTCC's help, a ramp up of a new product.

 

There's more, but that's sufficient to know with near certainty I think.

 

In raw dollars KTCC's sales to SMT fell from $33m in 2011 to $9m in 2015, assuming SMT comprises the whole of KTCC's "computer and peripherals" revenue category.

 

It hurts persistently when an existing >10% customer falls persistently for several years (especially when they're constantly predicting otherwise, as I think is SMT's habit).

 

It hurts temporarily when a marginal customer, a potential source of growth, fails to grow.

 

The 15-20% impact the news had on the shares wrongly reflects pricing of persistent problems.

 

Key Tronic must have expected revenue contribution from these SMT orders in 1Q16 otherwise we wouldn't see the $2m increase in COGS, which must mostly reflect people hired to handle the work. From what I know of their cost structure, which is about 25% fixed (including labor) and 70% variable (mostly components and materials), the shortfall relative to expected revenue might have been $10m, or $40m annualized.

 

And yet Key Tronic still met its revenue guidance, so either other programs are ramping up better than expected, or they're guiding conservatively to protect against stuff like this. (I think it was the abruptness of the forecast change that made the excess costs inevitable.)

 

When full 1Q16 results are released October 27th I expect to learn that sequential revenue growth is still expected for the remainder of 2016. The excess labor created by SMT should be quickly soaked up by KTCC's many other ramping programs, so if gross margin issues linger into 2Q16 the impact should be modest and short-lived. (I'd speculate that we also might learn that KTCC is looking to end its business relationship with a customer who has been jerking them around with rosy forecasts for far too long.)

 

In short, investors will learn that this is not a repeat of what plagued KTCC in 2013 and 2014 when a couple large customers, one of which was SMT, dragged down revenue and margin quarter after quarter. This was a truly temporary issue, a $2m one-time hit, caused by only one piece of a diverse pipeline of business that'll drive strong organic growth for the next couple years.

[60North Investments]

So the Q1 results were released a couple of days ago. Nothing special in the numbers, however the conference call revealed once again lot more than the pure numbers tell. Unfortunately, this year won't be a superb year, that's the bad news. The good news is that it's because of this one customer that has caused issues the past two years (SMT it seems). So now, by Q4, this one customer's decline will be replaced by completely new business. In other words, SMT is becoming a "rounding error" as someone mentioned during the CC, and won't be masking the underlying growth.

 

Other positive points from the call, i) there had been some yield issues (due to better than expected demand, taking away the opportunity to take some time to tweak/troubleshoot etc and instead forcing them to put extra funds into solving the issues you get with complex products), which have now been solved (masking 15Q4 and 16Q1 profitability), ii) CEO Gates mentioned that they've got "the best funnel I've ever seen" (=Ayrshire acquisition integrated and doing well), iii) as one could anticipate from how they operate, their customer churn is very low, iv) there's a lot of stuff on the pipeline, and big stuff ($10s of millions annually) that's going to ramp up as time goes.

 

I did revise my estimates for FY17, but still find the shares great value especially at today's $8/share prices.

 

Would recommend people to read the transcript or listen to the call.

http://seekingalpha.com/article/3611366-key-tronics-ktcc-ceo-craig-gates-on-q1-2016-results-earnings-call-transcript?part=single

https://streaming.webcasts.com/starthere.jsp?ei=1079838

[60North Investments]

I'll continue my monologue. Q2 results beat their own EPS estimate range of $0.08-0.13 by being $0.16. Gross margin up to 7.8%, OPEX at the same level as Q1. The problem customer was $15-16m sales in Q1, this Q2 it was $3-4m and expect to be the same in Q3. Roughly meaning that this customer won't be an issue anymore, which is superb.

 

4 new customer wins between $5-20m expected sales when they get into production, most due to the combination of Key Tronic and Ayrshire. Expect roughly $11m EBIT in FY unless they hit it out of the park in Q4 or something unexpected happens to the downside. Permanent (until otherwise decided) R&D tax credit supposedly takes tax rate from 35% to 30% which helps.

 

Guidance for Q3 implies 8-8.5% gross margin unless I'm mistaken. 8.5% would be great, given that they're ramping capacity up quite big and that goes partly into COGS. Would give more confidence in 9% gross margin for next year.

 

Conference call, good questions once again http://seekingalpha.com/article/3836766-key-tronics-ktcc-ceo-craig-gates-q2-2016-results-earnings-call-transcript?part=single

[60North Investments]

Q3 results, EPS $0.16 beat analyst estimates again, on the upper end of their own guidance of $0.12-0.17. GM 8.4%, OPEX 6%. Closing some facilities that'll incur 250k$ cost, and have $0.9m after-tax ($0.08 EPS) benefit in terms of expense reduction.

 

3 customer wins this quarter, expecting $5-15m annual sales from those once ramped up. Tax rate guidance now 25%, did not hear any mentioning of that on the conference call. Has a relatively large impact of 25% is the going-forward rate instead of 30% or 35%.

 

In the CC, gave quite a bit of confidence in reaching 9-10% GM next year. They currently estimate having $50-60m annual sales in ramp up phase, so hypothetically if they got no new business and the old business stayed as is, they'd be at $530-540m in sales (in 1-2 years?).

 

Think a low case for FY17 would be roughly $1 EPS, and a good case would be around $1.3 EPS. Looks more promising again. In addition, Royce dumped almost 700k (30% of volume) shares in Jan-Mar, and probably is done with it by now. Should leave the road open to appreciation.

[60North Investments]

Q4 was on the upper end of management's guidance. FY $485m sales, $10.4m EBIT, $6.5m net income, $0.6 EPS. 8% GM for the year, 8.7% for Q4.

 

Last year Q4 the gross margin range was dropped from 9-11% to 9-10%. Now, it was mentioned again as 9-11%. Capex was abnormally high this year due to some expensive equipment being purchased, management estimated it to be $7m next year. Maturing of new programs, some production efficiencies (closing inefficient Kentucky facility), and more sales to divide fixed expenses on hopefully lead to 9% gross margins for FY17. Q1 guidance is exactly the same as Q4 guidance was, so considering that Q4 still had some of the problematic customer in it + Q1 will get a small hit from closing of Kentucky facility, so it looks alright overall.

 

What I'm hoping to see next is inventory going down (a nice boost to cash flow that they can f.e. use to pay down debt), sales increasing +$40m from FY16 (needs to happen in Q2-Q4) and net margin getting to 2.5% (GM 9%, opex 5.4%, for example). It's not a high ROIC (gets a deservedly low multiple for it) or sexy business, but the trajectory is looking nice and (good) change is what gets paid in the market.

[jawn619]

60°North Investments

 

I spent a little time on this and wanted to give you my thoughts from a broader perspective. You've probably done more work in the weeds, but hope my thoughts are helpful.

 

Currently the market is valuing this at a $90M market cap + $40M of debt = $130M of enterprise value. The business is on track to generate $10M of EBIT this year. Add back interest and depreciation and you have about $16M of EBITDA on $130M of EV, about a 8x multiple. The market is saying that the business is worth 8x EV/EBITDA. I think this is actually very generous for a company like Keytronic because a lot of that EBITDA doesn't convert to free cash.

 

I don't think the market will ever give this company a higher multiple, so the company's only hope is better operations. More sales, higher margins, more income, etc.

 

The business is a contract manufacturer of OEM equipment, which doesn't sound like a great business to be in. Just a quick look at the margins the business has $480M in sales but only about a 2% operating margin. After taxes its not a lot of room to breathe, even for an OEM supplier.

 

Downside risks/Negatives

 

The products KTCC sells might be in secular decline. Keyboards and other computer peripheral equipment are not a growing market, and 10 years from now a lot of its products might not even exist. I know they diversified away from that, but It doesn't look like be able to ever get into higher margin stuff.

 

KTCC has no competitive advantage that I can see of.

 

Increasing inventory is a huge red flag. It tells me that the company is having a harder time selling its products, which means no one wants their likely obsolete products. This is a double red flag because KTCC has over its market cap in inventory. The inventory's market value is likely lower than its book value.

 

Conclusion

If you're going to buy it here, you have to think it's worth more than 8X EBITDA, which I'm not sure it is.

 

P.S. if you want to look at a similar but I think better businesses, check out Houston Wire and Cable. I think you can learn a lot from comparing the two.

 

 

 

[Spekulatius]

^ +1

[60North Investments]

Thanks jawn619, I appreciate the post and thoughts. I agree with most of your points. EV/EBITDA 8, EV/EBIT 13, P/E 13 are all multiples that I'd say are on the upper end of "fair". And I'm not assuming it trades at a higher valuation, I don't think it deserves it unless they get their ROIC well into double digits.

 

What I am arguing though is that it will be considerably higher within the next 12 months due to sales increases and better margins. Last year (FY16), gross margin improved from 7.1% in Q1 to 8.7% in Q4. For the year this meant 8% GM. Next year, assuming no catastrophe occurs, with sales increasing $40m or more (plus other factors such as learning curve on new productions that they've had a lot of lately), gross margin should be around 9% for the year. These would lead to +$15m EBIT and +$1 EPS for FY17.

 

I don't have big insights into their products and how they might fare. They just had one of their largest customers from years back going now into a zero (they say they replaced $40m of sales from that customer this year with new business), which has been a huge headwind. Mostly due to this customer, they also have the inventory issue. So yes, they have an issue with some part of the inventory, but I would not dare to draw a broader conclusion of saying that they have a hard time selling products in general. How big a problem is that problem customer's inventory going to be, I don't know. For the time being, I'll trust management to get the job done as they view the inventory levels coming to normal over the next year.

 

I agree that this is not a high ROIC compounder, or in any way a great business as you mention. I do think the company is much more valuable than $90m though, as described above. $10m EBIT, $0.6 EPS is not what they'll earn in the coming year, absent a catastrophy, they'll earn considerably more. With the problem customer now being a zero, growth shows in the topline, and assuming they get at least somewhat better hold on the inventory, they'll get to double digit ROIC too. I think this is a situation where one needs to look beneath the headline figures to see what is happening behind them. Here, they had a very large customer going to zero and essentially masking growth.

[writser]

I agree with the others. This is an OEM manufacturer with a horrible balance sheet making generic stuff and a history of marginal returns. It is not generating any cash and inventory levels are rising quickly. Your whole thesis basically comes down to "trusting management", as you say in your own words. You trust that they can grow sales by 10%, get rid of their huge inventory, double ROIC, and grow income by 150% in a single year. I agree with you that if management pulls that off, Keytronic would be a superb investment at the moment. But what are the chances that a random small OEM keyboard builder can pull that off? I'd say very, very small.

 

So there are  two explanations for the current share price:

 

1) This is a company with average management in a shit industry, management is probably too optimistic (as they usually tend to be) and the market is rightfully skeptical about that.

2) This is an exceptionally well managed microcap company, the exception to the rule and it will be performing a miraculous transformation during the coming year and everybody is too lazy to figure that out except for you.

 

I try to be skeptical when investing so I would almost certainly assume that 1) is the correct explanation unless you have exceptional evidence of the contrary. And I haven't seen that yet (you even state yourself that you don't have big insights into their products). I try not to bet on improbable small cap management promises.

[60North Investments]

In the case of EMS/OEM businesses that aren't serving one huge customer, I don't know if there's really a way to grasp the demand for their customers' products. If you writser or someone else has an idea of how to get a grasp of Key Tronic's products and the demand for those I'd be happy to listen. I'm repeating myself, but absent the zero-ing of the large customer, they would've grown roughly 10% this year. And unless management has lied, they still have at least the same amount of ramping business in the pipeline. Inventory is at $107m, of which maybe $10-20m is problematic. It is an issue. I'll wait and see if they can solve it.

 

I'm not saying they will, 100%, no doubts, grow 10%, solve the inventory issue, and grow margins to 9%. I think it looks like a reasonable option that they do, especially the growth and margins. Should growth, margins and somewhat better inventory level happen, ROIC improvement will happen as a result. I guess the disagreement is mostly on that I'd say the chances are decent instead of very, very small.

 

I do apologize if I've come out harsh or cocky or something. I might very well be wrong as I've so many times been. But looking at this (applies everywhere I guess, and I'm often lazy to dig in) just by the headline numbers, without seeing any further below, and one will miss the details that I think are important.