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Edited Transcript of KTCC earnings conference call or presentation 30-Apr-19 9:00pm GMT

Q3 2019 Key Tronic Corp Earnings Call

SPOKANE May 4, 2019 (Thomson StreetEvents) -- Edited Transcript of Key Tronic Corp earnings conference call or presentation Tuesday, April 30, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brett R. Larsen

Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer

* Craig D. Gates

Key Tronic Corporation - President, CEO & Director

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Conference Call Participants

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* Drew Thelen

* George Melas-Kyriazi

MKH Management Company, LLC - President

* William J. Dezellem

Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer

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Presentation

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Operator [1]

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Good day, and welcome to the Key Tronic Third Quarter Fiscal 2019 Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Brett Larsen. Please go ahead, sir.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [2]

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Good afternoon, everyone. I am Brett Larsen, Chief Financial Officer of Key Tronic. I would like to thank everyone for joining us today for our investor conference call. Joining me here in the Spokane Valley headquarters is Craig Gates, our President and Chief Executive Officer. As always, I would like to remind you that during the course of this call, we might make projections or other forward-looking statements regarding future events or the company's future financial performance. Please remember that such statements are only predictions. Actual events or results may differ materially.

For more information, you may review the risk factors outlined in the documents the company has filed with the SEC, specifically our latest 10-K, quarterly 10-Qs and 8-Ks. Please note that on this call, we'll discuss historical, financial and other statistical information regarding our business and operations. Some of this information is included in today's press release, and a recorded version of this call will be available on our website.

Today, we released our results for the third quarter ended March 30, 2019. The results were in line with the company's announcement of preliminary results on April 10, 2019. For the third quarter of fiscal year 2019, we reported total revenue of $108 million compared to $108.4 million in the same period of fiscal year 2018.

As previously reported, our revenue in the third quarter of fiscal 2019 was adversely impacted by reduced orders from two large, longstanding customers. One of these customers needed to lower its inventory in the third quarter, but expects a rebound in demand in the fourth quarter. The other large customer is managing inventory as it is transitioning its production from Key Tronic's China facilities to Key Tronic's Mexico facilities. In addition, there were unanticipated delays in the launch of production for 2 customers in the third quarter.

Despite the sudden decline in revenue in Q3, our total revenue was $358.5 million for the first 9 months of fiscal year 2019. We're up 9% from $329.3 million in the same period of fiscal year 2018. In addition, net earnings, when excluding the write-off of goodwill and intangibles and for severance, is $3.4 million for the 9 months of fiscal year 2019 or 4x the net earnings of $850,000 during the same period of fiscal year 2018.

Due to strategic investments in increased operational efficiencies in recent periods, we were able to reduce our workforce by approximately 10%. This streamlining effort resulted in a severance charge of $1.1 million in the third quarter of 2019. Furthermore, due to accounting requirements, we also wrote-down our goodwill and intangibles by approximately $12.5 million in the third quarter of 2019. For the third quarter of fiscal year 2019, our gross margin was 6.3% compared to 7.5% in the same period of fiscal 2018.

We expect to see improving gross margin as our revenue levels rebound and cost reductions begin to be realized in the fourth quarter. The sudden decline in revenue, the charges for write-off of goodwill and intangibles, and the severance costs had an inverse -- adverse impact on our bottom line. For the third quarter of fiscal year 2019, the company had a net loss of approximately $12 million or $1.11 loss per share, compared to net income of $600,000 or $0.06 per share for the third quarter of fiscal 2018.

Because of the previously mentioned losses in Q3, the year-to-date net loss was $8.8 million or $0.82 loss per share for the first 9 months of fiscal year 2019 compared to net income of $900,000 or $0.08 per share for the same period of fiscal year 2018. Excluding the charges for both the write-off of goodwill and intangibles and for severance, the results would have been net income of approximately $0.02 per share and $0.32 per share for the third quarter and first 9 months of fiscal year 2019, respectively.

Turning to the balance sheet. We continue to maintain a strong financial position. Despite the sudden decline in revenue in the third quarter, the continued ramp of new programs and delays in shipments and due to component shortages, we had still been able to -- we were able to decrease our inventory by approximately $19.6 million, a 17% reduction from the third quarter of fiscal 2018. In the fourth quarter, we expect to see our net inventory levels come even more in line with the revenue levels.

Trade receivables at the end of the third quarter were $4.8 million from a year ago, and DSOs were about 43 days. Total capital expenditures in the third quarter of fiscal 2019 were approximately $2.3 million. We continue to invest in our production facilities, SMT equipment and sheet metal and plastic molding capabilities as well as improvements in our facilities in Arkansas, Minnesota and Vietnam. We plan to have approximately $10 million in total capital expenditures during fiscal 2019.

Moving into the fourth quarter of fiscal 2019 and continuing over the following few quarters, we expect more of our new customer programs to ramp and move into production. We also expect the demand from two large customers that had such sharp reductions in the third quarter to begin to recover in the fourth quarter. Taking these factors into consideration, we expect the fourth quarter of fiscal 2019 will have revenue in the range of $112 million to $117 million. For the fourth quarter of fiscal 2019, we also anticipate earnings in the range of $0.10 to $0.15 per share. This assumes an effective tax rate of 20%.

In summary, while we're disappointed by the sudden decline in our revenue and earnings for the third quarter, we remain encouraged by our prospects for future growth. The overall financial health of the company is strong, and we believe that we're well positioned to win new EMS programs and to continue to profitably expand our business over the longer time.

That's it for me. Craig?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [3]

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Thanks, Brett. While we were significantly impacted by the unanticipated decline in demand for two large customers in the third quarter of fiscal 2019, we expect both of these programs to rebound and to contribute significant revenue in the fourth quarter. At the same time, our new programs continue to ramp. We continue to win significant new business, and our investments in increased efficiencies in recent periods have allowed us to streamline our operations.

While our marketplace remains very competitive, we continue to win significant new business both from EMS competitors and existing customers, including new programs involving consumer kitchen tools, emergency medical equipment, paper dispensing products and outdoor LED lighting. Our broader and more diversified customer base lowers the potential future impact of a slowdown by any one customer. At the same time, the evolving tariff situation continues to have mixed ramifications for Key Tronic.

Tariffs continue to be problematic for Key Tronic Shanghai customers importing product back into the United States. Many of our current customers are experiencing a seamless transition of their business out of our Shanghai site into our Juarez or domestic sites. This is facilitated by our centralized command and control. This drastically reduces the risk and time associated with the transfer to our North American sites and thus allows some leeway to respond to the rapidly changing tariff landscape.

Furthermore, we believe that tariffs on production in China have made our Mexico-based production more appealing to potential new customers. Our North American sites have become extremely competitive for U.S. bound products that are subject to new tariffs. This has resulted in increased interest and request for quotes from prospective customers. On balance, we're increasingly well positioned for the returning tide to North American-based customers, as they correctly analyze the total cost for overseas production pushing production into both Mexico and the U.S.

During the third quarter, we continue to progress with the build-out of our new 86,000 square-foot manufacturing facility in Da Nang, Vietnam. We expect that commencing production in Vietnam will augment our Asian footprint and reduce production costs as well as provide an additional hedge against uncertainty in a lingering or future trade war with China. We expect the Vietnam facility to be operational by July 2019.

Over recent periods, we've been deploying innovative new manufacturing equipment in each of our facilities, which has improved efficiencies and made our production less labor intensive. The result of this effort is decreased manufacturing and operating expenses of approximately $3 million annually. While we're carefully managing our expenses, we're making investments in facilities, SMT, sheet metal and plastic molding capabilities in Mexico, Vietnam and the U.S. We also added more contiguous space in Minnesota and additional production equipment for growth.

With respect to integrated electronics and sheet metal-centric programs, we see very strong growth and few real competitors in North America. Our steady pipeline of new business opportunities continues to be boosted by our unmatched level of vertical integration, our multi-country footprint and the excellence of our manufacturing sites in comparison to other EMS competitors of our size.

As OEMs face an increasingly uncertain geopolitical landscape, we are uniquely equipped to offer risk mitigation with our vertical integration and manufacturing facilities located in China, Mexico and the U.S. and soon in Vietnam. As the market landscape continues to improve, industry supply chain shortages continue to be a factor. However, we expect revenue growth in the fourth quarter and for the full year fiscal 2019, and we're optimistic about our opportunities for growth in the coming periods.

This concludes the formal presentation -- formal portion of our presentation. Brett and I will be now be pleased to answer your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take our first question from Bill Dezellem of Tieton Capital.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [2]

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A group of questions. First of all, I'll start off with my standard. What is the size of each of those 4 new programs that you won?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [3]

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So If we take them in order, consumer, kitchen tools, 8 emergency medical equipment, 9 paper dispensing products. That's an interesting one. That's going to start out at around $3 million. These folks tell us that they have about $3 million of prototype low-volume runs they do with current contract manufacturers and then have to switch companies when they move them offshore as they grow. So all we're actually reporting for this one is about $3 million annually. But if it works out the way both the customer and we expect it will, it should be quite a bit more than that. And then the final one, which is the outdoor lighting is about $12 million.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [4]

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And if the paper dispensing customer works out as anticipated, how much larger size could that ultimately be?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [5]

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Somewhere between $10 million and $20 million.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [6]

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Great. And then you did have delays, speaking of new customers, in the production launch for a couple of new customers. Would you talk in as much detail as you can about each of those 2, please?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [7]

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Yes. The biggest one was worth about $6 million or should have been worth about $6 million in the quarter. And this is a kind of a classic example of a company who had all of their manufacturing being done by CM in China, and I'd say almost more of an ODM than a CM because our customer didn't have a really good handle on their design and the documentation that goes with it and some of the specifications that go with it. So as we have begun to manufacture it in Mexico, we run into a number of problems based upon the mismatch between the design they thought they were using and the actual design that was being implemented.

So that ended up being an absolute 0 in Q3. and we're planning on $6 million. And in this quarter right now, we're just now finally getting to ramp that product. So I suspect that's going to probably be $3 million or $4 million in this coming quarter rather than the $6 million we would hope it would be. And then the other one is a brand-new product that Key Tronic didn't design. And unfortunately, as that product began to hit the market, it was discovered that there were firmware issues, and we had to put our production on hold, while our customer figured out and modified their firmware. So that one also is beginning to ramp in this quarter.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [8]

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And what should it have been for revenue? And what do you expect it will be in Q4?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [9]

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Should have been around $2.5 million to $3 million in Q3. And we're just now beginning to ramp it. So we're hoping for $1 million or $1.2 million in Q4.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [10]

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Great. And then let's -- since we're talking new business, let's shift to SkyBell. Would you please give us an update there?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [11]

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SkyBell continues to see strong demand. We are doing well in the factory in terms of production costs matching up with our projections. So as far as we can tell, things are good.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [12]

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And how do we think about the ramp of that business going forward?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [13]

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I don't know what to tell you there. We're 3 -- at least 2 levels or maybe 3 levels away from the actual demand. So we have to go off of other people's forecasts.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [14]

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Great. And then let's talk if we could about the operational efficiencies that you've referenced. I think it was going to lower costs by $3 million or so. I want to make sure that my calculation is right. So that's roughly $0.20 per share per year benefit. Is that correct?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [15]

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Yes. That is correct. Yes.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [16]

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Yes.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [17]

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And so talk to us about that savings and what you've done to generate that $3 million? And does that include anything in terms of lower amortization from having written off intangibles?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [18]

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No. So there is essentially zero impact of writing off the intangibles on a quarterly basis. I think there is some maybe...

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [19]

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Yes. It's a couple hundred thousand dollars.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [20]

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Yes, it's very little. So the major impact was due to operations running more efficiently, equipment being run more efficiently, pretty significant management changes on the eastern side of the business. And the result was headcount reduction.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [21]

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Basically you're running the plants better and, therefore, you do not need as many people. Is that really the bottom line?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [22]

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Yes.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [23]

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And then one additional question for now. Vietnam, would you provide us further update as to that plant? And once it's ready for business in July, do you have customers lined up? What does the prognosis lineup look like after the initial customers that might be ready to move? Just a little more detail, please.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [24]

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So the factory right now is in a very embryonic state. The building exists. We're in the midst of our build out. The new site manager is onboard. The new chief engineer is actually coming out of Spokane and will be stationed over there for 2 to 3 years. The HR person is, I think, either onboard or very shortly....

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [25]

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Hired as of yesterday.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [26]

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Hired as of yesterday, so onboard. We are seeing that our projections for people costs are proving to be true. We are less and less concerned that people availability is going to be an issue. And overall, the process is going exactly as per plan. As you and I've discussed, this is kind of a done thing for Key Tronic. We've opened plants and closed plants so many times over the past 20 years, I've forgotten the total number. But for us, since we have all of the process management here in Spokane, it is really quite simple to open a plant and get it running. So that's all going great.

The guy who is doing it, Doug Burkhardt, our VP of Ops, has done it I don't know how many times before. So I am pretty relaxed about how it's all going to go in terms of operational efficiencies and ramp-ups and people. We have one of our largest customers, I think, maybe top 5, maybe top 6, is going to be our anchor customer for that facility. And so, we've already got the first listing selected. Documentation is in place. Inventories are being jiggered around to match up with what we're going to build where. And that will be enough to keep the factory growing and busy for probably the first 6 to 8 months of its existence once we start it in July, maybe even a year.

The other thing that's been interesting is we've had a number of, well, actually either existing customers with products that we aren't building today, that are being built by other people in China and future customers that have all either going or have been to look at the site in Vietnam, even when we tell them, look guys it's just a building with one guy sitting in an office. And people are still stopping by to look in, which is kind of a new phenomena for us and we hope indicates that people are pretty interested in the option that Vietnam is going to bring to us compared to China.

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Operator [27]

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(Operator Instructions) We'll take our next question from Drew Thelen of Crimson Advisors.

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Drew Thelen, [28]

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It sounds like the pipeline looks pretty good, and congratulations on the ability to readjust the expense base. Given that, when do you think you could get back to earning your cost of capital and earning a 10% type of return on your equity? Is that a next year type of thing or is that a few years out still?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [29]

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I would think a 10% return on invested capital -- I would expect that probably within -- difficult to say, but I would -- we're projecting to be there within a year from now.

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Drew Thelen, [30]

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Okay. Well that's very good news. And then one other question. We had talked a few years ago, probably 3 years ago at the B. Riley conference. And you had stated that you are going to digest your acquisition, but then would consider buybacks if your stock was at the same price. Obviously, you're a little bit lower than we were 3 years ago on the stock price. Are you in a place to start thinking about share buybacks? Are you still focused on the balance sheet?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [31]

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We're still focused on the balance sheet. And as time has gone by, I became more and more convinced that share buybacks are not that great of an idea.

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Drew Thelen, [32]

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Got it. So no matter how low the price goes, we probably won't see any share buybacks or insider buying or...

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [33]

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I can't say. I wouldn't say that it's a definite no. But I'd say we tend to wait for them at this point.

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Drew Thelen, [34]

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Okay. Got it. So as a shareholder, I guess, the stock price can obviously move around quite a bit. There are -- the number of people focused on value stocks, obviously goes down every year as people look more at growth and other various things. Given that, how do you think we can kind of get the stock price back on a better footing on a go-forward basis?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [35]

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Well, the easy answer to that is the obvious answer and it's always been the obvious answer, and that is do better. So we're going to do a little bit more road trips, if you want to call it that, as all this solidifies. So we're planning on doing some of that in the next 12 months because we think we have a very great story to tell. But we want to have a little bit more of the proof in the pudding before we go out and start telling the story. I know this is a market that looks at (inaudible) still in a quarter, but we're looking at a basically 2-year journey back from a $90 million program that disappeared on us. And we're there now, but we want to have some of the actual proof of it before we start blowing our horns.

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Operator [36]

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We'll take our next question from George Melas of MKH Management.

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George Melas-Kyriazi, MKH Management Company, LLC - President [37]

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There's sort of 2 questions. I'm trying to understand the guidance. And I think the initial guidance for this quarter was $120 million to $125 million, and we did roughly $108 million. And a fair number of the program, Craig, that you said sort of resulted in the revenue miss are coming back, right, the ramp of the 2 new customers and the large 2 customers sort of starting to recover. So I'm just trying to understand your revenue guidance because for the first half of the year you did...

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [38]

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Hey, George.

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George Melas-Kyriazi, MKH Management Company, LLC - President [39]

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Yes.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [40]

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I think you're starting with the wrong assumption. The original guidance was $115 million to $120 million.

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George Melas-Kyriazi, MKH Management Company, LLC - President [41]

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Okay. All right. I had that wrong in my model, okay. Are we -- in a way as you are adding these new customers on a regular basis and you tell us, to Bill's question, how much they should be adding, it seems like we should have a little bit more revenue growth. So I'm just trying to see what's not quite happening. Are you pruning small customers? Is there -- are you losing some customers? I'm just trying to get a sense.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [42]

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One thing. Even including the miss in quarter 3, we're still showing a 9% growth over last fiscal year. We did definitely have some impact to 2 large longstanding customers reduce their demand in Q3. But for the 9 months ended, we're still 9% over last year. We should exit fourth quarter with 10% over last year's total revenue.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [43]

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We've been doing quite a bit of analysis of data because I don't know if you remember, but we talked a while back about the fact that we were convinced our marketplace was getting tighter and moving a little bit more towards the commodity-type marketplace. What we've seen, if you look at the market, the Tier 2 guys, Tier 3 guys, which is our size and smaller, are really doing pretty rough in terms of growth. I think we're the only one that's actually showing growth, whereas the Tier 1 guys are cranking it up pretty good this year. And so, if you look at the market overall, you can get confused compared to what -- the way we judge ourselves. So compared to the market, we're growing quite a bit.

If you look at it just from a micro standpoint of what's actually happening with each of our customers, there are 2 reasons why you can't just take the numbers I give Bill and add them to our current number and say that this is what it should be next year. First is we always talk about the fact that these things take a long time to mature from the day we get them. This one that we're talking about this quarter that should have been $6 million in Q3, and probably it'll only be half of that in Q4, is a pretty good example of something that we projected is coming on pretty quick because it was a product already in production. It was a product that we could go buy and cut a part ourselves and say this is how you make it. And it was something that the customer really wanted badly to move. And yet even with that, it's going to take us a half year to move it.

So a lot of these numbers that I give Bill and you guys, you have to figure are going to take somewhere between 1 to 3 years before they actually hit that number. So that's part of why it isn't as rosy as what it sounds like if you just look at the wins. The other side of it is that we do lose some customers. We've been through a pretty significant analysis of trying to figure out which ones we lose and why do we lose them and which ones were something that we could have done something about versus ones that we had no chance. So really one of the thing that occurs again and again is that we start with a smaller customer, we help them succeed and they end up getting bought by some really big company, and we have no chance to retain them.

So that's happened to us twice in the last few years, and that's kind of heartbreaking because you see the big payoff at the end of the story never happens. We have modified our approach to these small customers that we take on and actually demand that we have an exclusivity period with them. Last one I signed was for 4 years. So that if this does happen, there is a pretty significant payout for us if the purchaser does decide they don't want us to build it for them. So that's one of the ones that has been painful and kind of draining out the bottom of the bucket. And really there's not a really significant statistical trend that says that this is what we should do to stop losing customers.

There seems to be, for most of it, a reason that was beyond our control. There are 1 or 2 in the last 5 years that I wish I would have done different, but 2020 vision is the kind you get to see in the rearview mirror. So those are the two reasons why you just can't take Bill's numbers and -- not Bill's numbers, I'm sorry, Bill's answers and stick them on to the current revenue. And I guess the third one is that the number we give you is the number that we were given to quote. Then we divide it by 2, and that's a number we give you. And maybe on average, we should divide it by 3, I don't know. Bill and I have long debates about what number I should be using. But that's a complete answer. That's what's behind the curtain.

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George Melas-Kyriazi, MKH Management Company, LLC - President [44]

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Okay. Those 2 instances where you had smaller customers that grew and were acquired. In the last few years, you mentioned two instances. When was that and how much did that take away from sales?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [45]

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Last one was one of the most painful. And I have the details at the top of my head on that one. That was 2 years ago, and that was about $25 million of annual business by the time we lost it.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [46]

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Well, there was one this year as well.

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George Melas-Kyriazi, MKH Management Company, LLC - President [47]

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Did you say one other one...

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [48]

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Yes. There's another one that was about $15 million a year.

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George Melas-Kyriazi, MKH Management Company, LLC - President [49]

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Okay. So these are significant numbers. Okay.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [50]

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Yes. It's heartbreaking because we do a lot of work and we put a lot of heart and soul into helping guys that aren't necessarily as skilled as they should be at doing what they are doing. And then we see it walk out the door. So as I said, we've changed the way we write the contracts. And so far, actually, it's worked. So we had one that was kind of scaring us, and it's turned out to be, due to the contract, it's going to be okay. As you can imagine...

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George Melas-Kyriazi, MKH Management Company, LLC - President [51]

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So you are able to implement these exclusivity or these timelines in the contract like you said? You are able to do that?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [52]

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Yes.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [53]

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Yes.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [54]

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And you can imagine the difficulty of that discussion upfront because, typically, a smaller customer doesn't understand that they are as unskilled as they actually are and doesn't understand how deeply at risk they are if they don't sign up with us. So it's a bit of a delicate balance to wait until they are in big enough trouble to say, "Okay, guys, now that you get it, we're not going to save you unless there is a payoff at the end of the rainbow." But as we have more examples, it's easier to have those discussions with people.

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George Melas-Kyriazi, MKH Management Company, LLC - President [55]

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Okay. And then on the balance sheet under working capital, it seems like working capital generated a little bit of cash this quarter, but that's primarily because the revenue was down quite a bit. But your working capital cycle days sort of creeped up some. I calculated at 81 days. What is the target here? And how could this be? Is there a way to reduce that?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [56]

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Yes. That's predominantly inventory. As we mentioned, inventories, while well down from where they were last year, they're still not in line with revenue. Some of that was due to the fact that we had fully anticipated higher revenue in Q3, so we were left carrying the inventory. That's going to be a constant battle. I think that's what drove the cash conversion days this quarter. And that's really what we need to continue to look at to drop to a more stable level to the amount of revenue we have.

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George Melas-Kyriazi, MKH Management Company, LLC - President [57]

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So what...

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [58]

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You can imagine if you...

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George Melas-Kyriazi, MKH Management Company, LLC - President [59]

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Go ahead, Craig.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [60]

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I was just going to say if you got $6 million of one new customer and $3 million of another customer that was supposed to build and ship in Q3, you have to have all those parts there.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [61]

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Because you're buying at lead times well in excess of the amount of time within that quarter.

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Operator [62]

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We'll take another question from Bill Dezellem of Tieton Capital.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [63]

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I actually would like to circle back to the answer, Brett, that you gave to prior questioner about return on capital and key the net 10% ROC. So when you are calculating capital for that calculation, is it as simple as adding a debt and the equity together?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [64]

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I was more looking at what would be our weighted average cost of capital on our equity.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [65]

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So a 10% return on equity is really what you were focused on?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [66]

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Yes.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [67]

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Understood. Okay. And so, if I look at your equity at roughly $113 million and then take a 10% return on that, we're talking roughly $13 million or with 10.8 million shares, a $1.20 or somewhere in that neighborhood?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [68]

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Those are all great numbers.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [69]

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Those are fabulous numbers.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [70]

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That's one of the reasons we gave guidance out just a quarter. But with our current backlog and where we are headed and the fact that we're going to have Vietnam integrated by that point in time, we're a year out from hopefully making those type of numbers.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [71]

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Great. I appreciate it. Let me actually circle back to the guidance that you gave for the fourth quarter when you did the pre-release versus today. Those numbers pulled back a little bit. Would you talk about the underlying dynamics that led to that?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [72]

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Yes. I just did. Those are -- if you take the $3 million we're going to miss off the one and the $1.5 million we're going to miss off the other, there you go.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [73]

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Yes.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [74]

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Got it. Okay. So you were assuming those were just simply going to be at a fuller run rate?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [75]

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Yes.

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [76]

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Correct.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [77]

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And that ultimate run rate has not changed. It's simply the timing of when that revenue is going to fall. Did I understand that correctly?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [78]

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Certainly, for the first sets of POs we have from both of these customers, that is true. We don't know for sure what the flat out run rate is going to be. We don't know yet, which is why we don't like to project more than a quarter.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [79]

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Understood. And then relative to that $1.1 million of severance, where did that fall on the income statement?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [80]

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That goes through cost of goods sold. So that is one of the drags on gross margin for this quarter.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [81]

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And none of it fell through SG&A?

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Brett R. Larsen, Key Tronic Corporation - Executive VP of Administration, CFO & Treasurer [82]

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No.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [83]

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Great. And then one additional question. So listening to all of the good things that you have developing when I was asking my first set of questions and the other 2 questioners and the 10% ROE target, that leads me to believe there is a lot more going on behind the black curtain than historically has been. So in that spirit, what is -- can you talk through the magnitude of the new program ramps that you have either ongoing or anticipate very shortly today versus the past? And I don't know if that's best addressed in dollars or in number of programs, but hopefully you get the gist of what I'm trying to wrap my arms around.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [84]

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Yes, and we struggle to figure out a way to answer that for you. We can give you qualitative answers that you're probably tired of hearing. But if you look at -- I kind of started on the story a while back. If you look at the fact that we decided our market was getting tougher and turns out we were right. If you look at our size and below, they are shrinking. We're growing. What we did about that was changed our sales structure quite a bit, changed our quoting process quite a bit, invested in a number of new technologies and the factories to decrease our costing. That experiment, I would say -- and we just got done analyzing that over the last 18 months, that experiment has paid off quite well. So the number of quotes that are outstanding right now, the number of business wins that are currently being ramped and the number of close to awards but not quite yet awarded, all of those are probably 3 to 4x what we've seen in the past at any given point in our history.

In terms of how do I answer your question of new products or projects that are ramping in the factory versus in the past. I haven't looked at it that way to tell you what's actually going to count as new in the quarter. And that's our problem -- is when we're trying to do regression analysis of this and you try to look at what did you win. And so, as you and I argue, when do I put that in there, when the PO is cut, when the first product came out of the factory, or when they hit the actual number of units that we quoted. Then if you look at what did we lose, is that when it first started to decline, is it when we finally built no more for somebody, when it was 50% of the decline. So I get to see anything in the literature, get to see anything in other people's financial reports and announcements, anything that I can see as a standardized method of reporting to you, the question you want answered. And short of exposing everybody that's quoting with us, exposing everybody that's awarded us handshake business, exposing everybody that's given us our first PO, I don't know how to do it.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [85]

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Craig, if I heard you correctly, quotes, wins that are ramping, handshakes or near wins, those are all 3 to 4x higher than they have historically been?

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [86]

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Yes.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [87]

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Well, that is helpful. And we look forward to that turning into a $1.20 of earnings in the year.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [88]

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So do we.

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Operator [89]

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At this time, we have no further questions. I'll turn it back to management for closing remarks.

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Craig D. Gates, Key Tronic Corporation - President, CEO & Director [90]

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Okay. Well, we appreciate your all calling in. Thanks for listening to us and look forward to talking to you next time. Have a good day.

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Operator [91]

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Thank you, ladies and gentlemen. This concludes today's conference. You may now disconnect.