Item 1. BUSINESS
Background
Key Tronic Corporation (dba: KeyTronicEMS Co.), was organized in 1969 as a Washington corporation that locally manufactured computer keyboards. The ability to design, build and deliver a quality product led to a reputation in the industry, allowing us to be a leading independent manufacturer of keyboards for computers in the United States. Our fully integrated design, tooling, and automated manufacturing capabilities enabled us to rapidly respond to customers’ needs for keyboards in production quantities worldwide. We supported our sales growth through the development and purchase of international manufacturing facilities. As the computer keyboard market matured with increasing competition from other international providers, we determined that our business could no longer solely rely on keyboard sales. After assessing market conditions and our strengths and capabilities, we shifted focus from keyboard manufacturing to contract manufacturing for a wide range of products. This strategy was based on our core strengths of innovative design and engineering expertise in electronics, mechanical engineering, and precision plastics combined with high-quality, low cost production, and assembly on an international basis. These strengths have made our company a strong competitor in the electronic manufacturing services (EMS) market.
Our Industry and Strategy
The expansion of the EMS industry during the last decade allowed us to continue to expand our customer base and the industries that we serve. The recent challenging global macroeconomic environment has had a negative impact on previously held customer programs. However, we successfully confronted the challenging global macroeconomic environment by reducing our costs while winning new customer programs, which allowed us to increase our profitability and strengthen our balance sheet during the global economic downturn. The increase in new programs represents a growing portion of our revenue and a promising foundation for our future. In keeping with our long-term strategic objectives, we have been successfully building a more diversified customer portfolio and a less concentrated revenue base, spanning a wider range of industries. We currently offer our customers the following services: integrated electronic and mechanical engineering, precision plastic molding, assembly, component selection, sourcing and procurement, worldwide logistics, and new product testing and production all at competitive pricing due to our global footprint.
We believe that we are well positioned in the EMS industry to continue the expansion of our customer base and achieve long term growth. Our core strengths continue to support our growth and our customers’ needs. We continue to focus on controlling operating expenses and leveraging the synergistic capabilities of our world-class facilities in the United States, Mexico, and China. This international production capability provides our customers with the benefits of improved supply-chain management, reduced inventory, lower labor costs, lower transportation costs, and reduced product fulfillment time. Given our competitive advantages and the growing need for some potential customers to move forward with their outsourcing strategies, we are strongly positioned to win new business in coming periods and grow our revenue and profits.
The EMS industry is intensely competitive. Although our customer base is growing we still have less than 1% of the potential global market and our revenue can fluctuate significantly due to reliance on a concentrated base of customers. We are planning for new customer growth in the coming quarters by securing new programs, increasing our worldwide manufacturing capacity, and continuing to improve our manufacturing and procurement processes. Ongoing challenges that we face include the following: Continuing to win programs from new and existing customers, balancing production capacity and key personnel in support of new customer programs, improving operating efficiencies, controlling costs while
developing competitive pricing strategies, successfully transitioning new program wins to full production and successfully addressing industry-wide shortages in the global supply chain.
Customers and Marketing
We provide a mix of manufacturing services for outsourced Original Equipment Manufacturing (OEM) products. We provide the following EMS services: Product design, surface mount technologies (SMT) and pin through hole capability for printed circuit board assembly, tool making, precision plastic molding, liquid injection molding, automated tape winding, prototype design and full product builds.
Sales of the majority of our products have historically not been seasonal in nature, but may be seasonal in the future if there are changes in the types of products manufactured. Sales can, however, fluctuate significantly between quarters from changes in customers and customer demand due to our concentrated customer base.
For the fiscal years ended July 3, 2010, June 27, 2009, and June 28, 2008, the five largest customers in each year accounted for 57%, 52%, and 68% of total sales, respectively. The following customers represented 10% or more of total net sales over the last three fiscal years: KAZ Inc. (18%, less than 10%, less than 10%) International Game Technology, Inc. (12%, 13%, 18%), and Lexmark International, Inc. (less than 10%, 14%, 15%). It is anticipated that our new customer program wins will dilute our concentration of revenue in the future.
Although keyboard manufacturing is still included in our product offerings, we do not expect annual keyboard sales to be a material component of our business. We realized revenues of approximately $4.5 million, $4.2 million, and $5.8 million in fiscal years 2010, 2009, and 2008, respectively, from the sale of keyboards. In order to accommodate the demand for standard keyboard layouts, we maintain a purchase-from-stock program. The more popular standard layouts are built and stocked for immediate availability. Although we are recognized as a reputable contract manufacturer we still market our products and services primarily through our direct sales department aided by strategically located field sales people and distributors. Although we maintain relationships with several independent sales organizations to assist in marketing our EMS product lines, commissions earned and paid are not material to the consolidated financial statements.
Manufacturing
We have continually made investments in developing and expanding a capital equipment base to achieve vertical integration and efficiencies in our manufacturing processes. We have invested significant capital into SMT for volume manufacturing of complex printed circuit board assemblies. We also design and develop tooling for injection molding and manufacture the majority of plastic parts used in the products we manufacture. Additionally, we have equipment to maintain a controlled clean environment for manufacturing processes that require a high level of precise control.
We use a variety of manual and automated assembly processes in our facilities, depending upon product complexity and degree of customization. Some examples of automated processes include component insertion, SMT, flexible robotic assembly, automated storage tape winding, computerized vision system quality inspection, automated switch and key top installation, and automated functional testing.
Our engineering expertise and automated manufacturing processes enable us to work closely with our customers during the design and prototype stages of production and to jointly increase productivity and reduce response time to the marketplace. We use computer-aided design techniques and software to assist in preparation of the tool design layout and component placement, to reduce tooling and production costs, improve component and product quality, and enhance turnaround time during product development.
We purchase materials and components for our products from many different suppliers, including both domestic and international sources. We develop close working relationships with our suppliers, many of whom have been supplying products to us for several years.
Research, Development, and Engineering
Research, development, and engineering (RD&E) expenses consist principally of employee related costs, third party development costs, program materials costs, depreciation, and allocated information technology and facilities costs. Our RD&E expenses were $2.8 million, $2.3 million, and $2.7 million in fiscal years 2010, 2009, and 2008 respectively. In each of these years, we focused most of our RD&E efforts on current customer EMS programs. The increase in RD&E in fiscal year 2010 compared to fiscal year 2009 is primarily the result of higher incentive compensation and increased headcount. The decrease in RD&E in fiscal year 2009 compared to fiscal year 2008 is the result of cost reduction efforts and lower incentive and bonus expenses.
Competition
The market for the products and services we provide is highly competitive. There are numerous competitors in the EMS industry, many of which have substantially more resources and are more geographically diverse than we are. Some of our competitors have similar international production capabilities, large financial resources and some have substantially greater manufacturing, research and development, and marketing resources. There is also competition from the manufacturing operations of our current and potential customers, who are continually evaluating the merits of manufacturing their products internally versus the advantages of outsourcing. We believe that we can currently compete favorably to these factors primarily on the basis of our international footprint, responsiveness, creativity, vertical production capability, quality, and cost.
Trademarks and Patents
Our name and logo are federally registered trademarks, and we believe they are valuable assets of our business. During 2001, we began operating under the trade name “KeyTronicEMS Co.” to better identify our primary business concentration. We also own several keyboard patents; however, since our focus is EMS, management believes that these patents will not have a significant impact on future revenues.
Employees
We consider our employees to be our primary strength and we make considerable efforts to maintain a well-qualified workforce. Our employee benefits include bonus programs involving periodic payments to all employees based on meeting quarterly or fiscal year performance targets. We regularly provide transportation, medical services, and meals to all of our employees in foreign locations. We maintain a 401(k) plan for U.S. employees, which provides a discretionary matching company contribution of up to 4% of an employee’s salary. We provide group health, life, and disability insurance plans. We also maintain stock option plans and other long term incentive plans for certain employees and outside directors. As of July 3, 2010 we had 2,036 employees compared to 1,963 on June 27, 2009, and 2,502 on June 28, 2008. Since we can have significant fluctuations in product demand, we seek to maintain flexibility in our workforce by utilizing skilled temporary and short-term contract labor in our manufacturing facilities in addition to full-time employees. Our employees in Reynosa, Mexico, are represented by a local union. We have no history of any material interruption of production due to labor disputes. We anticipate that this particular subsidiary will cease its operations during fiscal year 2011. As a result, we will no longer retain employees in Reynosa, Mexico.
Backlog
On July 31, 2010 our order backlog was valued at approximately $56.9 million, compared to approximately $29.9 million on July 25, 2009, which reflects an increase in expected revenue during fiscal year 2011. Even though our order backlog is comprised of firm purchase orders, the amount of backlog is not necessarily indicative of future sales but can be indicative of trends in expected future sales revenue. Due to the relationships with our customers, we will occasionally allow orders to be canceled or rescheduled and as a result is not a meaningful indicator of future financial results. If there are canceled or rescheduled orders, we will attempt to negotiate fees to cover the costs we have incurred. Order backlog consists of
purchase orders received for products expected to be shipped approximately within the next twelve months, although shipment dates are subject to change due to design modifications, customer forecast changes, or other customer requirements.
Foreign Markets
Information concerning net sales and long-lived assets (property, plant, and equipment) by geographic areas is set forth in footnote 12 of the consolidated financial statements of this Annual Report on Form 10-K, under the caption “Enterprise-Wide Disclosures”, and that information is incorporated herein.
Executive Officers of the Registrant
The table below sets forth the name, current age and current position of our executive officers and other significant employees as of July 3, 2010:
Name
Age
Positions Held
Executive Officers
Craig D. Gates
President and Chief Executive Officer
Ronald F. Klawitter
Executive Vice President of Administration, Chief Financial Officer and Treasurer
Douglas G. Burkhardt
Executive Vice President of Worldwide Operations
Lawrence J. Bostwick
Vice President of Engineering and Quality
Phil Hochberg
Vice President of Business Development
Brett R. Larsen
Vice President of Finance, and Controller
Don Sinclair*
Vice President of Materials
* Subsequent to July 3, 2010, Mr. Sinclair announced his resignation with the Company effective August 31, 2010.
Executive Officers
CRAIG D. GATES - President and Chief Executive Officer
Mr. Gates, age 51, has been President and Chief Executive officer of the Company since April 2009. Previously he was Executive Vice President and General Manager from August 2002 to April 2009. He served as Executive Vice President of Marketing, Engineering and Sales from July 1997 to August 2002 and served as Vice President and General Manager of New Business Development from October 1995 to July 1997. He joined the Company as Vice President of Engineering in October of 1994. From 1982 he held various engineering and management positions within the Microswitch Division of Honeywell, Inc., in Freeport, Illinois, and from 1991 to October 1994 he served as Director of Operations, Electronics for Microswitch. Mr. Gates has a Bachelor of Science Degree in Mechanical Engineering and a Masters in Business Administration from the University of Illinois, Urbana.
RONALD F. KLAWITTER - Executive Vice President of Administration, Chief Financial Officer, and Treasurer
Mr. Klawitter, age 58, has been Executive Vice President of Administration, CFO, and Treasurer since July 1997. Previously he was Vice President of Finance, Secretary, and Treasurer of the Company from October 1995 to July 1997. He was Acting Secretary from November 1994 to October 1995 and Vice President of Finance and Treasurer from 1992 to October 1995. From 1987 to 1992, Mr. Klawitter was Vice President of Finance at Baker Hughes Tubular Service, a subsidiary of Baker Hughes, Inc. Mr. Klawitter has a BA degree from Wittenberg University and is a Certified Public Accountant.
DOUGLAS G. BURKHARDT - Executive Vice President of Worldwide Operations
Mr. Burkhardt, age 52, has been Executive Vice President of Worldwide Operations of the company since July 22, 2010. Previously Mr. Burkhardt was Vice President of Worldwide Operations from July 2008 to July 2010 and Director of China Operations and Program Management from January 2006 to July 2008. Mr. Burkhardt also served as Director of Northwest and China Operations from November of 1998 to January of 2006. Mr. Burkhardt also served as Director of Customer Satisfaction from March 1997 to November 1998 and Director of Molding from September of 1995 to March of 1997. Prior to this, Mr. Burkhardt served in other various senior management positions within the company. Mr. Burkhardt has been with the company since May of 1989. Prior to joining Key Tronic, Mr. Burkhardt worked for House of Aluminum and Glass for 12 years where he was the plant manager.
LAWRENCE J. BOSTWICK - Vice President of Engineering and Quality
Mr. Bostwick, age 58, has been Vice President of Engineering and Quality since July 2008. Previously he was Director of Engineering and Quality from February 2007 to July 2008 and served as Corporate Director of Quality from February 2006 to February 2007. From 2003 to 2006 he was Director of Supply Chain Management and Quality for the Lancer Corporation and from 1998 to 2003 he was Vice President of Operations for Thermacore International. He is a graduate of the Westinghouse and General Electric - Engineering and Manufacturing Professional Development Programs. He is certified in both Quality and Industrial Engineering and is a Lean - Six Sigma Master Black Belt. Mr. Bostwick has a combined B.S. degree in Production and Operation and Industrial Engineering from Bowling Green State University and a Masters degree in Industrial Engineering and Business Administration from Syracuse University.
PHIL HOCHBERG - Vice President of Business Development
Mr. Hochberg, age 48, has been Vice President of Business Development since October 2009. Previously he was Director of Business Development and Program Management from July 2008 to October 2009. Mr. Hochberg served as Director of Business Development from October 2004 to July 2008 and as Director of EMS Sales and Marketing from July 2000 to October 2004. Prior to joining Key Tronic, Mr. Hochberg worked for Quinton Instrument Company as their Director of Marketing and Product Management from 1992 to 2000. From 1988 to 1992, he was employed by SpaceLabs Medical as their Business Development Marketing Manager. Mr. Hochberg has an MBA from the University of British Columbia, a BA Psychology, with a minor in Business from Washington University in St. Louis.
BRETT R. LARSEN - Vice President of Finance, and Controller
Mr. Larsen, age 37, has served as Vice President of Finance and Controller since February 2010. He was Chief Financial Officer of FLSmidth Spokane, Inc. from December 2008 to February 22, 2010. From October 2005 through November 2008, Mr. Larsen served as Controller of Key Tronic Corporation. From May 2004 to October 2005, Mr. Larsen served as Manager of Financial Reporting of Key Tronic Corporation. From 2002 to May 2004, Mr. Larsen was an audit manager for the public accounting firm BDO Seidman, LLP. He also held various auditing and supervisory positions with Grant Thornton LLP from 1997 to 2002. Mr. Larsen has a Bachelor of Science degree in Accounting and a Masters degree in Accounting from Brigham Young University and is a Certified Public Accountant.
DON SINCLAIR - Vice President of Material
Mr. Sinclair, age 57, has served as the Vice President of Materials since January 2010. Prior to joining Key Tronic, Mr. Sinclair was employed by Advanced Input Systems Division of Esterline Corporation, where he held various positions such as: Director of Materials, Managing Director - Offshore Operations, and Vice President of Business Development from 1998 to 2009. Prior to 1998, Mr. Sinclair held management positions at companies including Intermec Technologies, Honeywell and Westinghouse. Mr. Sinclair has a Bachelor of Science Degree in Business from Washington State University.
Available Information
Our principal executive offices are located at N. 4424 Sullivan Road, Spokane Valley, Washington 99216, and our telephone number is (509) 928-8000. Our website is located at http://www.keytronicems.com where filings of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q or current reports on Form 8-K are available after they have been filed with the Securities and Exchange Commission. The information presented on our website currently and in the future is not considered to be part of this document or any document incorporated by reference in this document.
Item 1A.
Item 1A. RISK FACTORS
There are risks and uncertainties that could affect our business. These risks and uncertainties include but are not limited to, the risk factors described below, in Item 7A: “Quantitative and Qualitative Disclosures about Market Risk” and elsewhere in this Form 10-K.
RISKS AND UNCERTAINTIES THAT COULD AFFECT FUTURE RESULTS
The following risks and uncertainties could affect our actual results and could cause results to differ materially from past results or those contemplated by our forward-looking statements. When used herein, the words “expects”, “believes”, “anticipates” and similar expressions are intended to identify forward-looking statements.
Potential Fluctuations in Quarterly Results
Our quarterly operating results have varied in the past and may vary in the future due to a variety of factors, including adverse changes in the U.S. and global macroeconomic environment, volatility in overall demand for our customers’ products, success of customers’ programs, timing of new programs, new product introductions or technological advances by us, our customers and our competitors, and changes in pricing policies by us, our customers, our suppliers, and our competitors. Our customer base is diverse in the markets they serve, however, decreases in demand, particularly from customers that supply the banking, consumer products, and gambling industries, could affect future quarterly results. Additionally, our customers could be impacted by the illiquidity of the credit markets which could directly impact our operating results.
Component procurement, production schedules, personnel and other resource requirements are based on estimates of customer requirements. Occasionally, our customers may request accelerated production that can stress resources and reduce operating margins. In addition, because many of our operating expenses are relatively fixed, a reduction in customer demand can harm our gross profit and operating results. The products which we manufacture for our customers have relatively short product lifecycles. Therefore, our business, operating results and financial condition are dependent in significant way on our ability to obtain orders from new customers and new product programs from existing customers.
Operating results can also fluctuate if changes are made to significant estimates and assumptions. Significant estimates and assumptions include the allowance for doubtful receivables, provision for obsolete and non-saleable inventory, the valuation allowance on deferred tax assets, impairment of long-lived assets, long-term incentive compensation accrual, and the provision for warranty costs.
Economic Conditions
Recently there have been adverse conditions and uncertainty in the global economy as the result of unstable global financial and credit markets, inflation, and recession. These unfavorable economic conditions and the weakness of the credit market could affect the demand for our customers’ products. The current global macroeconomic environment may affect some of our customers that could reduce orders and change forecasts which could adversely affect our sales in future periods. Additionally, the financial strength of our customers and suppliers and their ability to obtain and rely on credit financing may affect their ability to fulfill their obligations to us and have an adverse affect on our financial results.
Credit Markets
The current illiquidity and financial instability in the credit markets could adversely impact lenders and potentially limit the ability of our suppliers and customers to borrow. This may affect their ability to fulfill their obligations to us and have an adverse effect on our financial results.
Dependence on Suppliers
We are dependent on many suppliers, including sole source suppliers, to provide key components and raw materials used in manufacturing customers’ products. Over the past few quarters we have seen supply shortages in certain electronic components. This has resulted in longer lead times and the inability to meet our customers request for flexible production and we have missed or extended shipment dates. If demand for these components continues to outpace supply capacity these delays could further affect future operations. Delays in deliveries from suppliers or the inability to obtain sufficient quantities of components and raw materials could cause delays or reductions in shipment of products to our customers which could adversely affect our operating results and damage customer relationships.
Concentration of Credit Risk
Cash and cash equivalents are exposed to concentrations of credit risk. We place our cash with high credit quality institutions. At times, such balances may be in excess of the federal depository insurance limit or may be on deposit at institutions which are not covered by insurance. If such institutions were to become insolvent during which time it held our cash and cash equivalents in excess of the insurance limit, it could be necessary to obtain other credit financing to operate our facilities.
Competition
The EMS industry is intensely competitive. Competitors may offer customers lower prices on certain high volume programs. This could result in price reductions, reduced margins and loss of market share, all of which would materially and adversely affect our business, operating results, and financial condition. If we were unable to provide comparable or better manufacturing services at a lower cost than our competitors, it could cause sales to decline. In addition, competitors can copy our non-proprietary designs after we have invested in development of products for customers, thereby enabling such competitors to offer lower prices on such products due to savings in development costs.
Concentration of Major Customers
At present, our customer base is highly concentrated and could become more or less concentrated. Our largest EMS customer accounted for 18% of net sales in fiscal year 2010. This same customer accounted for 6% of sales in 2009 and 0% in 2008. For the fiscal years ended 2010, 2009, and 2008, the five largest customers accounted for 57%, 52%, and 68% of total sales, respectively. There can be no assurance that our principal customers will continue to purchase products from us at current levels. Moreover, we typically do not enter into long-term volume purchase contracts with our customers, and our customers have certain rights to extend or delay the shipment of their orders. We, however, require that our customers contractually agree to buy back inventory purchased within specified lead times to build their products if not used.
The loss of one or more of our major customers, or the reduction, delay or cancellation of orders from such customers, due to economic conditions or other forces, could materially and adversely affect our business, operating results and financial condition. Specifically, some of our major customers provide products to the banking and gambling industries which have been adversely affected by the unfavorable economic environment. The contraction in demand from our customers in these industries could continue to impact our customer orders and continue to have a negative impact on our operations over the next several fiscal quarters. Additionally, if one or more of our customers were to become insolvent or otherwise unable to pay for the manufacturing services provided by us, our operating results and financial condition would be adversely affected.
Foreign Manufacturing Operations
Most of the products manufactured by us are produced at our facilities located in Mexico and China. These international operations may be subject to a number of risks, including:
•
difficulties in staffing and managing foreign operations;
•
political and economic instability (including acts of terrorism, civil unrest, forms of violence and outbreaks of war), which could impact our ability to ship and/or receive product;
•
unexpected changes in regulatory requirements and laws;
•
longer customer payment cycles and difficulty collecting accounts receivable;
•
export duties, import controls and trade barriers (including quotas);
•
governmental restrictions on the transfer of funds;
•
burdens of complying with a wide variety of foreign laws and labor practices;
•
fluctuations in currency exchange rates, which could affect component costs, local payroll, utility and other expenses; and
•
inability to utilize net operating losses incurred by our foreign operations to reduce our U.S. income taxes;
•
our foreign locations may be impacted by hurricanes, earthquakes, water shortages, tsunamis, floods, typhoons, fires, extreme weather conditions and other natural or manmade disasters.
Our operations in certain foreign locations receive favorable income tax treatment in the form of tax credits or other incentives. In the event that such tax holidays or other incentives are not extended, are repealed, or we no longer qualify for such programs, our taxes may increase, which would reduce our net income.
Additionally, certain foreign jurisdictions restrict the amount of cash that can be transferred to the U.S or impose taxes and penalties on such transfers of cash. To the extent we have excess cash in foreign locations that could be used in, or is needed by, our operations in the United States, we may incur significant penalties and/or taxes to repatriate these funds.
Dependence on Key Personnel
Our future success depends in large part on the continued service of our key technical, marketing and management personnel and on our ability to continue to attract and retain qualified employees. There can be no assurance that we will be successful in attracting and retaining such personnel. The loss of key employees could have a material adverse effect on our business, operating results and financial condition.
Technological Change and New Product Risk
The markets for our customers’ products is characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and relatively short product life cycles. The introduction of products embodying new technologies or the emergence of new industry standards can render existing products obsolete or unmarketable. Our success will depend upon our customers’ ability to enhance existing products and to develop and introduce, on a timely and cost-effective basis, new products that keep pace with technological developments and emerging industry standards and address evolving and increasingly sophisticated customer requirements. Failure of our customers to do so could substantially harm our customers’ competitive positions. There can be no assurance that our customers will be successful in identifying, developing and marketing products that respond to technological change, emerging industry standards or evolving customer requirements.
Interest Rate Risk
We are exposed to interest rate risk under our revolving credit facility with interest rates based on various levels of margin added to published prime rate and LIBOR rates depending on the calculation of a certain financial covenant.
Compliance with Current and Future Environmental Regulation
We are subject to a variety of domestic and foreign environmental regulations relating to the use, storage, and disposal of materials used in our manufacturing processes. If we fail to comply with any present or future regulations, we could be subject to future liabilities or the suspension of current manufacturing operations. In addition, such regulations could restrict our ability to expand our operations or could require us to acquire costly equipment, substitute materials, or incur other significant expenses to comply with government regulations.
Foreign Currency Fluctuations
A significant portion of our operations are in foreign locations. As a result, transactions occur in currencies other than the U.S. dollar. Exchange rate fluctuations among other currencies used by us could directly or indirectly affect our financial results. Future currency fluctuations are dependent upon a number of factors and cannot be easily predicted. We currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. However, unexpected expenses could occur from future fluctuations in exchange rates.
Dilution and Stock Price Volatility
Holders of the common stock will suffer immediate dilution to the extent outstanding options to purchase the common stock are exercised. Our stock price may be subject to wide fluctuations and possible rapid increases or declines over a short time period. These fluctuations may be due to factors specific to us such as variations in quarterly operating results or changes in earnings estimates, or to factors relating to the EMS industry or to the securities markets in general, which, in recent years, have experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stocks are traded.
Disclosure and Internal Controls
Management does not expect that our disclosure controls and internal controls and procedures will prevent all errors or fraud. A control system is designed to give reasonable, but not absolute, assurance that the objectives of the control system are met. In addition, any control system reflects resource constraints and the benefits of controls must be considered relative to their costs. Inherent limitations of a control system may include: judgments in decision making may be faulty, breakdowns can occur simply because of error or mistake and controls can be circumvented by collusion or management override. Due to the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.
Item 1B.
Item 1B. UNRESOLVED STAFF COMMENTS
None
Item 2.
Item 2. PROPERTIES
We have manufacturing and sales operations located in the United States, Mexico, and China. The table below lists the locations and square footage of our operating facilities:
(1)
On June 15, 2010, the company amended its lease with Royal Hills Associates (RHA) to extend the lease for an additional ten years, which we continue to occupy as our headquarters (see Note 3 to Consolidated Financial Statements)
(2)
During fiscal year 2010, we purchased a 115, 000 square foot manufacturing facility in Juarez, Mexico for additional assembly space. In addition, as part of the purchase transaction we obtained an option to purchase an additional adjacent manufacturing facility.
(3)
In fiscal year 2009, we leased a new facility in Juarez, Mexico for more storage capacity and additional assembly space.
( ) These facilities are used exclusively to manufacture products for one EMS customer. We anticipate that this particular subsidiary will cease its operations during fiscal year 2011.
( ) In fiscal year 2010, we increased our leased space in China to 83,000 sq. ft. to accommodate an additional SMT line and for additional assembly space. Subsequent to fiscal year 2010, we entered into an agreement to lease an additional 36,000 square feet of manufacturing space.
The geographic diversity of these locations allows us to offer services near certain of our customers and major electronics markets with the additional benefit of reduced labor costs. We consider the productive capacity of our current facilities sufficient to carry on our current business. In addition, in Juarez, Mexico one of our buildings includes adjacent vacant land that could be developed into additional manufacturing and warehouse space and we have a purchase option on another facility. All of our facilities are ISO certified to ISO 9001:2008 standards, ISO-14001 environmental standards, and ISO-13485:2003 medical devices standards. The Spokane, Washington facilities are additionally registered to AS9100B, ITAR and ISO/TS 16949. Our China facilities are also registered to AS9100B and ISO/TS.
Item 3.
Item 3. LEGAL PROCEEDINGS
We are a party to certain lawsuits or claims in the ordinary course of business. We do not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on our financial position, results of operations or cash flow.
Item 4.
Item 4. RESERVED
PART II
Item 5:
Item 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is traded on the NASDAQ Global Market, formerly the NASDAQ National Market System under the symbol “KTCC”. Quarterly high and low closing sales prices for our common stock for fiscal years 2010 and 2009 were as follows:
High and low stock prices are based on the daily closing price reported by the NASDAQ Stock Market. These quotations represent prices between dealers without adjustment for markups, markdowns, and commissions, and may not represent actual transactions.
Holders and Dividends
As of July 3, 2010, we had 804 shareholders of common stock on record. As a result of our credit agreement with Wells Fargo, N.A. we are restricted from declaring or paying dividends in cash and stock. We have not paid a cash dividend and do not anticipate payment of dividends in the foreseeable future.
Equity Compensation Plan Information
Information concerning securities authorized for issuance under our equity compensation plans is set forth in Part III, Item 12 of this Annual Report, under the caption “Securities Authorized for Issuance under Equity Compensation Plans”, and that information is incorporated herein by reference.
Performance Graph
Set forth below is a line graph comparing the cumulative total shareholder return on our common stock with the cumulative total return of the NASDAQ Stock Market (U.S. & Foreign) Index and the NASDAQ Electronic Components Index in fiscal 2010.
Item 6:
Item 6: SELECTED FINANCIAL DATA
The following selected data is derived from our audited consolidated financial statements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements and related notes, and other information included in this report.
Financial Highlights
(In thousands, except for Supplemental Data and Book Value per Share)
(1)
Net working capital is defined as total current assets less total current liabilities. Net working capital measures the portion of current assets that are financed by long term funds and is an indicator of short term financial management.
(2)
Book value per share is defined as total shareholders’ equity divided by the number of shares outstanding at the end of the fiscal year.
Item 7:
Item 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
KeyTronicEMS is a leader in electronic manufacturing services and solutions to original equipment manufacturers of a broad range of products. We provide engineering services, worldwide procurement and distribution, materials management, world-class manufacturing and assembly services, in-house testing, and unparalleled customer service. Our 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 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 Item 1A, Risk Factors.
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.
Executive Summary
Our sales of $199.6 million in fiscal year 2010 increased by 8.0% as compared to sales of $184.9 million in fiscal year 2009. This increase in sales was primarily driven by new customer programs for both longstanding and new customers, partially offset by a continuance of an unfavorable macroeconomic environment and industry-wide shortages in the global supply chain. Sales for the first quarter of fiscal year 2011 are expected to be within the range of $58 million to $61 million. Results will depend on actual levels of customers’ orders and the timing of the start up of production of new product programs. We believe that we are well positioned in the EMS industry to win new business in coming periods and profitably grow our revenue as the economy recovers.
The concentration of our largest customers increased during fiscal year 2010 with the top five customers’ sales increasing to 57% of total sales in 2010 from 52% in 2009, and 68% in 2008. 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, and computer accessories. The total number of our customers continued to increase during fiscal year 2010. These new customers have programs that represent small annual sales while others have multi-million-dollar potential.
Gross profit as a percent of sales was 9.6% in fiscal year 2010 compared to 7.1% for the prior fiscal year. The increase in gross profit as a percentage of net sales was primarily due to higher sales, increased leverage of fixed costs, a decrease in manufacturing facility costs due to favorable foreign exchange changes, a decrease in headcount of overhead employees and severance costs incurred in fiscal year 2009 that did not recur in fiscal year 2010.
Operating income as a percentage of sales for fiscal year 2010 was 3.7% compared to 1.0% for fiscal year 2009. The increase in operating income as a percentage of sales was due to an improved gross margin, combined with our continued success in controlling operating expenses and improving efficiencies during fiscal year 2010.
Net income for fiscal year 2010 was $8.7 million or $0.85 per diluted share, up from $1.1 million or $0.11 per diluted share for fiscal year 2009. The increase in net income for fiscal year 2010 as compared to fiscal year 2009 was primarily due to an approximate 2.5% improvement in our gross margin. Also, our fiscal year 2010 results include an income tax benefit of $1.4 million, resulting in part from the release of our valuation allowance on deferred tax assets related to our domestic net operating loss carryforwards that occurred in the third quarter of fiscal 2010.
We maintain a strong balance sheet with a current ratio of 2.18 and a long-term debt to equity ratio of .03. Total cash provided by operating activities as defined on our cash flow statement was $3.7 million during fiscal year 2010. We maintain sufficient liquidity for our expected future operations and had $1.6 million in borrowings on our revolving line of credit with Wells Fargo, N.A. of which $18.4 million remained available at July 3, 2010. We believe cash flow generated from operations, our borrowing capacity, and equipment lease financing should provide adequate capital for planned growth over the long term.
Results of Operations
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 notes contained in this Annual Report.
Net Sales
Net sales were $199.6 million, $184.9 million, and $204.1 million in fiscal years 2010, 2009, and 2008, respectively.
Net sales increased $14.7 million during fiscal year 2010 as compared with fiscal year 2009. This increase in sales was primarily driven by new customer programs for both longstanding and new customers, partially offset by a continuance of an unfavorable macroeconomic environment and industry-wide shortages in the global supply chain. The $19.2 million decrease in net sales during fiscal year 2009 reflects the expected lower demand from established customers due to the unfavorable global macroeconomic environment. We anticipate that several more new customer programs will enter production in fiscal year 2011 and begin contributing to revenue.
The table below shows the revenue by industry sectors as a percentage of revenue for the following fiscal years:
We provide services to customers in a number of industries and produce a variety of products for our customers in each industry. As we continue to diversify our customer base and win new customers we may continue to see a change in the industry concentrations of our revenue.
Sales to foreign locations represented 17.9%, 11.3%, and 5.6% of our total net sales in fiscal years 2010, 2009, and 2008, respectively.
Cost of Sales
Total cost of sales as a percentage of net sales was 90.4%, 92.9%, and 91.8% in fiscal years 2010, 2009, and 2008, respectively.
Total cost of materials as a percentage of net sales was approximately 68.6%, 69.2%, and 66.9% in fiscal years 2010, 2009, and 2008, respectively. The change from year-to-year is directly related to changes in product mix.
Production and support costs as a percentage of net sales were 21.8%, 23.7%, and 24.9% in fiscal years 2010, 2009, and 2008, respectively. The decrease in fiscal year 2010 as compared to fiscal year 2009 is related to higher fixed cost absorption due to a $14.7 million increase in net sales, while production and support costs decreased $0.3 million due to favorable foreign exchange rates and a reduction of manufacturing facility payroll. These savings were partially offset by an increase in the provision for obsolete inventory. The decrease in fiscal year 2009 as compared to fiscal year 2008 was due to a $6.9 million decrease in production and support costs related to headcount reductions, favorable foreign exchange rates and cost saving initiatives. This was partially offset by a $19.2 million decrease in net sales.
We provide for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage. The amounts charged to expense for these inventories were approximately $2.2 million, $0.3 million, and $0.2 million in fiscal years 2010, 2009, and 2008, respectively. The increased provision in fiscal year 2010 was primarily due to no longer manufacturing for certain customers that were no longer viable.
We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense (recovery) was approximately $45,000, $(93,000), and $196,000 in fiscal years 2010, 2009, and 2008, respectively. Warranty expense for fiscal year 2010 is related to workmanship claims on keyboards and EMS products. The recovery in fiscal year 2009 was related to the release of a warranty claim for a specific product that was identified in fiscal year 2008. Warranty expense for fiscal year 2008 was primarily related to workmanship claims on a specific EMS product.
Gross Profit
Gross profit as a percentage of net sales was 9.6%, 7.1%, and 8.2% in fiscal years 2010, 2009, and 2008, respectively.
The 2.5 percentage point increase in gross profit as a percentage of net sales from fiscal year 2009 to 2010 was primarily the result of a $14.7 million increase in net sales, while production and support cost
decreased by $0.3 million due to favorable foreign exchange changes, a decrease in headcount of overhead employees and severance costs incurred in fiscal year 2009 that did not recur in fiscal year 2010. This was partially offset by a $8.9 million increase in material costs. The 1.1 percentage point decrease in gross profit as a percentage of net sales from fiscal year 2008 to 2009 was the result of lower fixed cost absorption due to net sales decreasing $19.2 million. Additionally we incurred charges of approximately $1.3 million for severance charges related to cost reduction efforts during fiscal year 2009.
We took early pay discounts to suppliers that totaled approximately $364,000, $142,000, and $51,000 in fiscal years 2010, 2009, and 2008, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.
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 EMS 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) consists principally of employee related costs, third party development costs, program materials, depreciation and allocated information technology and facilities costs. Total RD&E was $2.8 million, $2.3 million, and $2.7 million in fiscal years 2010, 2009, and 2008, respectively. As a percentage of net sales, RD&E was 1.4%, 1.2% and 1.3% in fiscal years 2010, 2009 and 2008, respectively.
The increase in RD&E expenses in fiscal year 2010 compared to fiscal year 2009 is primarily the result of higher incentive compensation expense and increased headcount. The decrease in RD&E expenses in fiscal year 2009 compared to fiscal year 2008 is the result of reduced headcount and lower incentive and bonus expenses.
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 $9.1 million, $8.4 million, and $8.3 million in fiscal years 2010, 2009, and 2008, respectively. As a percentage of net sales SG&A was 4.5%, 4.5%, and 4.0% in fiscal years 2010, 2009, and 2008, respectively. Approximately half of our SG&A expenses relates to salary costs of our employees.
The $0.7 million increase in SG&A expenses in fiscal year 2010 as compared to fiscal year 2009 is primarily due to a $1.6 million increase in incentive compensation expense. This was partially offset by an approximate $0.3 million decrease in salaries in addition to an approximate $0.6 million decrease in expense related to the write off of a receivable in the prior year. The increase in SG&A expenses in fiscal year 2009 compared to fiscal year 2008 is mainly attributable to foreign exchange losses on Mexican peso denominated financial assets and the addition of a sales representative which were partially offset by cost reduction efforts. Additionally, in fiscal year 2009 there was a charge of $0.6 million to provide for doubtful collection of receivables, of which $0.5 million was related to the write off of a foreign receivable.
Goodwill Impairment
We recorded an impairment charge of $765,000 during fiscal year 2009. We did not record an impairment charge during fiscal year 2010. As of July 3, 2010 and June 27, 2009, there was no goodwill recorded in the Company’s Consolidated Balance Sheet.
Interest Expense
We had net interest expense of $0.1 million, $0.6 million and $1.0 million in fiscal years 2010, 2009, and 2008, respectively. Interest expense decreased in fiscal year 2010 when compared to fiscal years 2009 and 2008 as the average balance of the revolving line of credit was lower along with a decrease in variable
interest rates. We do not currently use derivatives to hedge interest rate risk. We often utilize short-term fixed LIBOR rates on portions of our revolving line of credit to limit the affect of interest rate volatilities.
Income Tax Provision
We had an income tax benefit of $1.4 million during fiscal year 2010 as compared to $130,000 and $261,000 tax expense in fiscal years 2009, and 2008, respectively. The income tax benefit of fiscal year 2010 is primarily related the release of the valuation allowance on our deferred tax assets related to domestic tax net operating loss carryforwards (NOLs) and foreign tax credits, partially offset by the recognition of domestic deferred tax liabilities for an unremitted portion of foreign and the change of applicable tax regimes in Mexico.
Due to increased profitability, revenue growth, and new customer programs, we have determined that a valuation allowance against our domestic NOLs is not longer required. We anticipate that we will fully utilize our domestic NOLs prior to their expiration. In addition, we reviewed our requirements for liquidity domestically to fund our revenue growth and to look for potential future acquisitions. We have changed our previous assessments of being indefinitely reinvested and now anticipate repatriating a portion of our unremitted foreign earnings. The associated taxes and potential foreign tax credits are included in the income tax benefit that was realized during fiscal year 2010. The tax provision in fiscal years 2009 and 2008 is primarily related to income taxes in China and Mexico. For further information on taxes please review footnote 7 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 active foreign subsidiaries are as follows:
•
Key Tronic Juarez, SA de CV owns an SMT, assembly and molding facility, and three assembly and storage facilities in Juarez, Mexico. This subsidiary is primarily used to support our U.S. operations.
•
Key Tronic Reynosa, SA de CV leases manufacturing and warehouse facilities in Reynosa, Mexico. This subsidiary is used exclusively to manufacture products for one EMS customer. We anticipate that this particular subsidiary will cease its operations during fiscal year 2011, as its one EMS customer will no longer be needing manufacturing services.
•
Key Tronic Computer Peripherals (Shanghai) Co., Ltd. leases a facility with SMT and assembly capabilities in Shanghai, China, which began operations in 1999. Its primary function is to provide EMS services for export; however, it is also currently manufacturing certain electronic keyboards.
Foreign sales (based on shipping instructions) from our worldwide operations, including domestic exports, were $35.7 million, $20.9 million, and $11.4 million in fiscal years 2010, 2009, and 2008, respectively. Products and manufacturing services provided by our subsidiary operations are sold to customers directly by the parent company. Key Tronic Computer Peripherals (Shanghai) Co., Ltd., our subsidiary in Shanghai, China, had only minimal sales to customers in China during the past three fiscal years.
Capital Resources and Liquidity
Cash flows provided by operating activities were $3.7 million in fiscal year 2010 as compared to $10.0 million provided by operating activities in fiscal year 2009 and $(0.7) million used in fiscal year 2008.
The $6.3 million decrease in cash provided by operating activities in fiscal year 2010 as compared with fiscal year 2009 was primarily due to an increase in trade receivables and inventory, partially offset by an increase in accounts payable. Trade receivables increased by $10.1 million as a result of the increase in sales that occurred during the fourth quarter of fiscal year 2010. The $7.5 million increase in inventory was attributable to new customer programs and increasing lead times on certain components which led to some scheduled shipments not being shipped by the end of the fiscal year. We purchase inventory based on customer forecasts and orders and expected lead times, and when those forecasts cannot be met or changes are made to lead times, inventory can increase. The $10.5 million increase in accounts payable was primarily driven by the increase in inventory and extending payment terms during fiscal year 2010.
Accounts payable fluctuates with changes in inventory levels, volume of purchases, and negotiated supplier terms.
The $10.7 million increase in cash provided by operating activities in fiscal year 2009 as compared to fiscal year 2008 was primarily due to a decrease in trade receivables and inventory. Trade receivables and inventory decreased by $10.5 million and $5.3 million, respectively, during fiscal year 2009, partially offset by a $10.8 million decrease in accounts payable. These decreases are the result of lower sales in the fourth quarter of fiscal year 2009 as compared to fiscal year 2008 and a concerted effort to reduce our inventory and align it with our current level of business.
Cash used in investing activities includes capital expenditures and proceeds from the sale of property and equipment. Capital expenditures were $3.4 million, $1.9 million, and $1.2 million in fiscal years 2010, 2009, and 2008, respectively. Our capital expenditures are primarily for purchases of manufacturing assets to support our operations in Spokane Valley, Washington, Mexico and China. The increase in capital expenditures for fiscal year 2010 as compared to fiscal year 2009 was primarily related to the purchase of a manufacturing facility and to a lesser extent the increased investment in manufacturing equipment to support the requirements of our growing customer base and sales. Capital expenditures increased for fiscal year 2009 as compared to fiscal year 2008 as we invested in manufacturing equipment to support the requirements of new customers.
Our primary financing activity in fiscal years 2010, 2009, and 2008 was borrowing and repayment under our revolving line of our credit facility. Our credit agreement with Wells Fargo Bank N.A. provides a revolving line of credit facility of up to $20 million, subject to availability. The agreement specifies that the proceeds of the revolving line of credit be used primarily for working capital and general corporate purposes of the Company and its subsidiaries. The outstanding balance under the credit facility was $1.6 million as of July 3, 2010. We had availability to borrow an additional $18.4 million under the Wells Fargo line of credit and we were in compliance with our loan covenants.
Our cash requirements are affected by the level of current operations and new EMS programs. We believe that projected cash from operations, funds available under the revolving credit facility and leasing capabilities will be sufficient to meet our working and fixed capital requirements for the foreseeable future.
Contractual Obligations and Commitments
In the normal course of business, we enter into contracts which obligate us to make payments in the future.
The table below sets forth our significant future obligations by fiscal year:
Payments Due by Fiscal Year (in thousands)
(1)
The terms of the Wells Fargo Bank N.A. revolving loan are discussed in the consolidated financial statements at Note 4, “Long-Term Debt”. As of July 3, 2010 we were in compliance with our loan covenants. Breaching these covenants could have resulted in a material impact on our operations or financial condition.
(2)
We maintain vertically integrated manufacturing operations in Mexico and Shanghai, China. Such operations are heavily dependent upon technically superior manufacturing equipment including molding machines in various tonnages, SMT lines, clean rooms, and automated insertion, and test equipment for the various products we are capable of producing. In addition,
we lease some of our administrative and manufacturing facilities. A complete discussion of properties can be found in Part 1, Item 2 at “Properties”. Leases have proven to be an acceptable method for us to acquire new or replacement equipment and to maintain facilities with a minimum impact on our short term cash flows for operations. Amounts presented above include interest and principal, if applicable.
(3)
See Note 3 to Consolidated Financial Statements for additional discussion related to building and land purchase during the fourth quarter of fiscal year 2010.
(4)
As of July 3, 2010, we had open purchase order commitments for materials and other supplies of approximately $86.5 million. Included in the open purchase orders are various blanket orders for annual requirements. Actual needs under these blanket purchase orders fluctuate with our manufacturing levels. In addition, we have contracts with 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.
In addition to the cash requirements presented above, we have various other accruals which are not included in the table above. We owe our suppliers approximately $24.1 million for accounts payable and shipments in transit at the end of the fiscal year. We generally pay our suppliers in a range from 30 to 120 days depending on terms offered. These payments are financed by operating cash flows and our revolving line of credit.
We believe that cash flows generated from operations, leasing facilities, and funds available under the revolving credit facility will satisfy cash requirements for a period in excess of 12 months and into the foreseeable future.
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 to our 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.
Inactive, Obsolete, and Surplus Inventory Reserve
We reserve for inventories that we deem inactive, obsolete or surplus. This reserve is calculated based upon the demand for the products that we produce. Demand is determined by expected sales or customer forecasts. If expected sales do not materialize, then we would have inventory in excess of our reserves and would have to charge the excess against future earnings. In the case where we have purchased material based upon a customer’s forecast, we are usually covered by lead-time assurance agreements 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.
Allowance for Doubtful Accounts
We value our accounts receivable net of an allowance for doubtful accounts of $111,000 at July 3, 2010 and June 27, 2009. 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.
Accrued Warranty
An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. We review the adequacy of this accrual quarterly based on historical analysis and anticipated product returns and rework costs. As we have made the transition from manufacturing primarily keyboards to primarily EMS products, our exposure to warranty claims has declined significantly. Our warranty period for keyboards is generally longer than that for EMS products. We only warrant materials and workmanship on EMS products, and we do not warrant design defects for EMS customers.
Income Taxes
The Company had domestic income tax loss carryforwards (NOLs) of approximately $25.1 million at July 3, 2010. In accordance with ASC 740, Income Taxes, a valuation allowance is required if it is more likely than not that some or all of the deferred tax assets will not be realized in the future. Based on recent sustained profitability, revenue growth, new customer programs and updated forecasting that occurred during fiscal year 2010; management determined that an allowance was no longer necessary on the domestic income tax loss carryforwards.
The Company also changed its estimates of future repatriation of its undistributed earnings of its foreign subsidiaries during fiscal year 2010. Management expects to repatriate approximately $14.5 million based on increased sales growth driving additional capital requirements domestically, cash requirements for potential acquisitions and to implement certain tax strategies. As such earnings are recognized in the United States, the Company would be subject to U.S. federal and state income taxes and potential withholding taxes in foreign jurisdictions. A corresponding foreign tax credit for taxes paid on the repatriated amount can be used domestically to reduce the federal tax liability. The domestic tax, foreign tax credits and estimated withholding tax have been accrued as part of deferred taxes as of July 3, 2010.
Stock-Based Compensation
Stock-based compensation is accounted for according to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718, Compensation-Stock Compensation . ASC 718 requires us to expense the fair value of employee stock options, stock appreciation rights and other forms of stock-based compensation. Under the fair value recognition provisions of ASC 718, share-based compensation cost is estimated at the grant date based upon the value of the stock option and at each reporting period for stock appreciation rights classified as liability awards and is recognized as expense ratably over the requisite service period of the award (generally the vesting). Determining the appropriate fair value model and calculating the fair value of share-based awards requires judgment, including estimating the expected life of the share-based award, the expected stock price volatility over the expected life of the share-based award and forfeitures.
To determine the fair value of stock options on the date of grant and at each reporting period for stock appreciation rights classified as liability awards, we use the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock price volatility, option life, risk-free interest rate and dividend yield. The risk-free interest rate is a less-subjective assumption as it is based on factual data derived from public sources. We use a dividend yield of zero as we have never paid cash dividends and have no intention to pay cash dividends in the foreseeable future. The expected stock price volatility and option life assumptions require a greater level of judgment. Our expected stock-price volatility assumption is based upon the historical volatility of our stock which is obtained from public data sources. The expected life represents either the weighted average period of time that share-based awards are expected to be outstanding (stock options), giving consideration to vesting schedules and historical exercise patterns or using the simplified method by utilizing the midpoint between the remaining vesting period and the remaining contractual life (SARs). We determine the expected life assumption based upon the exercise and post-vesting behavior that has been exhibited historically, adjusted for specific factors that may influence future exercise patterns. If expected volatility or expected life were to increase, that would result in an increase in the fair value of our stock options which would result in higher compensation charges, while a
decrease in volatility or the expected life would result in a lower fair value of our stock option awards resulting in lower compensation charges.
We estimate forfeitures for all of our awards based upon historical experience of stock-based pre-vesting forfeitures. We believe that our estimates are based upon outcomes that are reasonably likely to occur. If actual forfeitures are higher than our estimates it would result in lower compensation expense and to the extent the actual forfeitures are lower than our estimate we would record higher compensation expense.
Impairment of Long-Lived Assets
Long-lived assets, such as property, plant, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge would be recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset.
In accordance with ASC 350, Intangibles - Goodwill and Other, goodwill is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss would be recognized to the extent that the carrying amount exceeds the asset’s fair value.
Upon the completion of the Company’s annual impairment test during fiscal year 2009 and as a result of the deteriorating global economy adversely affecting the Company’s common stock price. The Company concluded that 100% of the goodwill was impaired due to the significant and sustained decline in the Company’s market capitalization to below the book value. The Company recorded an impairment charge of $765,000 during the second quarter of fiscal year 2009. As of July 3, 2010 and June 27, 2009, respectively, there was no goodwill recorded in the Company’s Consolidated Balance Sheet.
Derivatives and Hedging Activity
Derivatives are recognized on the balance sheet at their estimated fair value. On the date a derivative contract is entered into, the Company designates the derivative as a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (a “cash flow” hedge). The Company does not enter into derivatives for speculative purposes. Changes in the fair value of a derivative that qualifies as a cash flow hedge are recorded in “Accumulated other comprehensive income”, until earnings are affected by the variability of cash flows. See Note 11 of the Company’s consolidated financial statements for additional information.
Accounting Pronouncements
See Note 1 to our consolidated financial statements.
Item 7A:
Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
We are subject to the risk of fluctuating interest rates in the normal course of business. Our major market risk relates to our secured debt. Our revolving credit facility is secured by substantially all of our assets. The interest rates applicable to our revolving credit facility fluctuate with the JP Morgan Chase Bank prime rate and LIBOR rates. There was outstanding $1.6 million in borrowings under our revolving credit facility as of July 3, 2010, and the rate of interest being paid on the outstanding balance was 3.25%. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources and Liquidity” and Note 4 - “Long-Term Debt” to the Consolidated Financial Statements for additional information regarding our revolving credit facility.
Foreign Currency Exchange Risk
A significant portion of our operations are in foreign locations. As a result, transactions occur in currencies other than the U.S. dollar. Exchange rate fluctuations among other currencies used by us would directly or indirectly affect our financial results. We currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. There was $30.9 million of foreign currency forward contracts outstanding as of July 3, 2010. The fair value of these contracts was approximately $(361,000). See Note 11 - “Derivative Financial Instruments” to the Consolidated Financial Statements for additional information regarding our derivative instruments.
Item 8:
Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Key Tronic Corporation
Spokane Valley, Washington
We have audited the accompanying consolidated balance sheets of Key Tronic Corporation (the Company) as of July 3, 2010 and June 27, 2009 and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended July 3, 2010. These financial statements are the responsibility of the Company’s management. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Key Tronic Corporation at July 3, 2010 and June 27, 2009, and the results of its operations and its cash flows for each of the three years in the period ended July 3, 2010, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ BDO USA, LLP
Spokane, Washington
September 13, 2010
KEY TRONIC CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands)
See accompanying notes to consolidated financial statements.
KEY TRONIC CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
KEY TRONIC CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
(In thousands)
Other comprehensive income for fiscal year 2010 is reflected net of tax $(119,000).
See accompanying notes to consolidated financial statements.
KEY TRONIC CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Business
Key Tronic Corporation and subsidiaries (the Company) is engaged in electronic manufacturing services (EMS) for original equipment manufacturers (OEMs), and also manufactures keyboards and other input devices. The Company’s headquarters are located in Spokane Valley, Washington with manufacturing operations in Spokane Valley; Juarez and Reynosa, Mexico; and Shanghai, China.
Principles of Consolidation
The consolidated financial statements include the Company and its wholly owned subsidiaries in Mexico and China. Intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates include the allowance for doubtful receivables, the provision for obsolete and non-saleable inventories, deferred tax assets and liabilities, impairment of long-lived assets, medical self insurance liability, long-term incentive compensation accrual, the provision for warranty costs, and the fair values of options granted under the Company’s stock-based compensation plans. Due to uncertainties with respect to the assumptions and estimates actual results could differ from those estimates.
Cash and Cash Equivalents
The Company considers investments with an original maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates fair value.
Allowance for Doubtful Accounts
The Company evaluates the collectibility of accounts receivable and records an allowance for doubtful accounts, which reduces the receivables to an amount that management reasonably estimates will be collected. A specific allowance is recorded against receivables considered to be impaired based on the Company’s knowledge of the financial condition of the customer. In determining the amount of the allowance, the Company considers several factors including the aging of the receivables, the current business environment, and historical experience. After all attempts to collect a receivable have failed, the receivable is written off against the allowance.
Inventories
Inventories are stated at the lower of cost or market. Cost is determined principally using the first-in, first-out (FIFO) method. The Company provides for obsolete and non-saleable inventories based on specific identification of inventory against current demand forecasts and recent usage.
Property, Plant and Equipment
Property, plant and equipment are carried at cost and depreciated using straight-line methods over the expected useful lives of the assets. Internally constructed molds and dies are depreciated over the expected useful lives of one to two years. Repairs and maintenance costs are expensed as incurred.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Impairment of Long-lived Assets
The Company, using its best estimates based on reasonable and supportable assumptions and projections, reviews assets for impairment whenever events or changes in circumstances have indicated that the carrying amount of its assets might not be recoverable. Impaired assets are reported at the lower of cost or fair value.
Deferred Loan Fees
Deferred loan fees included in other assets are amortized over the term of the related loan agreement.
Accrued Warranty
An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. Management reviews the adequacy of this accrual quarterly based on historical analyses and anticipated product returns.
Self-funded Insurance
The Company self-funds its domestic employee health plan. The Company contracted with a separate administrative service company to supervise and administer the program and act as its representative. The Company reduces its risk under this self-funded platform by purchasing stop-loss insurance coverage for claims. In addition, if the aggregate annual claims amount to more than 125% of expected claims for the plan year this insurance will also pay those claims amounts exceeding that level.
The Company estimates its exposure for claims incurred but not paid at the end of each reporting period and uses historical claims data supplied by the Company’s broker to estimate its self-funded insurance liability. This liability is subject to a total limitation that varies based on employee enrollment and factors that are established at each annual contract renewal. Actual claims experience may differ from the Company’s estimates. Costs related to the administration of the plan and related claims are expensed as incurred.
Revenue Recognition
Sales revenue from manufacturing is recognized upon shipment of the manufactured product per contractual terms. Upon shipment, title transfers and the customer assumes risks and rewards of ownership of the product. Unless specifically stated in contractual terms, there are no formal customer acceptance requirements or further obligations related to the manufacturing services; if any such requirements exist, then sales revenue is recognized at the time when such requirements are completed and such obligations are fulfilled. Revenue is recorded net of estimated returns of manufactured product based on management’s analysis of historical returns.
Revenues and associated costs from engineering design, development services and tooling, which are performed under contract of short term durations, are recognized only after the completed performance of the service. Revenue from engineering design, development services and tooling represented approximately 2%, 3%, and 3% of total revenue in fiscal years 2010, 2009, and 2008, respectively.
Shipping and Handling Fees
The Company classifies costs associated with shipping and handling fees as a component of cost of goods sold. Customer billings related to shipping and handling fees are reported as revenue.
Research, Development and Engineering
Research, development and engineering expenses include unreimbursed EMS costs as well as design and engineering costs associated with the production of EMS programs. Such costs are charged to expense as incurred.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized.
Earnings Per Common Share
Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is computed by dividing net income by the combination of other potentially dilutive weighted average common shares and the weighted average number of common shares outstanding during the period using the treasury stock method. The computation assumes the proceeds from the exercise of stock options were used to repurchase common shares at the average market price during the period. The computation of diluted earnings per common share does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an anti-dilutive effect on earnings per share.
Foreign Currency Transactions
The functional currency of the Company’s subsidiaries in Mexico and China is the U.S. dollar. Realized foreign currency transaction gains and losses are included in cost of goods sold.
Fair Value of Financial Instruments
The carrying values of financial instruments reflected on the balance sheets at July 3, 2010 and June 27, 2009, reasonably approximate their fair value. Based on the borrowing rates currently available to the Company for loans with similar terms and average maturities, the fair value of long-term debt is estimated to be $1.6 million and $2.6 million, respectively, as of July 3, 2010 and June 27, 2009, which approximates the carrying values.
Stock -based Compensation
The Company’s incentive plan provides for equity and liability awards to employees in the form of stock options, stock appreciation rights, restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based or cash-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is included in selling, general and administrative expenses.
Newly Adopted and Recent Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles. This statement establishes the FASB Accounting Standards CodificationTM (ASC) as the single source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. This statement was codified into FASB ASC Topic 105, Generally Accepted Accounting Principles. The Codification structure was created to organize GAAP pronouncements using numerical designation by topic, subtopic, section, and paragraph so users can more easily access the authoritative accounting guidance. This guidance is effective for interim and annual periods ending after September 15, 2009. The Company adopted this statement in the first quarter of fiscal year 2010 and all SFAS references have been replaced with ASC references.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
ASC 825, Financial Instruments, requires disclosure about fair value of financial instruments in interim financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. The Company adopted this statement in the first quarter of fiscal year 2010 and it did not have a material impact on the Company’s Consolidated Financial Statements.
In August 2009, the FASB issued Accounting Standard Update (ASU) 2009-05, Measuring Liabilities at Fair Value, concerning measuring liabilities at fair value. The new guidance provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using certain valuation techniques. Additionally, it clarifies that a reporting entity is not required to adjust the fair value of a liability for the existence of a restriction that prevents the transfer of the liability. We have adopted the provisions of ASU 2009-05, which did not have a material impact on our consolidated financial statements.
In January 2010, the FASB issued ASU 2010-06, Improving Disclosures About Fair Value Measurements, which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair-value measurements. ASU 2010-06 is effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010. The adoption of ASU 2010-06 did not have a material impact on our consolidated financial statements.
In February 2010, the FASB issued ASU 2010-09, Subsequent Events - Amendments to Certain Recognition and Disclosure Requirements (ASU 2010-09), that amends ASC Subtopic 855-10, Subsequent Events - Overall (ASC 855-10). ASU 2010-09 requires an SEC filer to evaluate subsequent events through the date that the financial statements are issued but removed the requirement to disclose this date in the notes to the entity’s financial statements. The amendments are effective upon issuance of the final update and accordingly, we have adopted the provisions of ASU 2010-09. The adoption of this provision did not have a material impact on our consolidated financial statements.
Fiscal Year
The Company operates on a 52/53 week fiscal year. Fiscal years end on the Saturday nearest June 30. As such, fiscal years 2010, 2009, and 2008, ended on July 3, 2010, June 27, 2009, and June 28, 2008, respectively. Fiscal year 2010 was a 53 week year, whereas fiscal years 2009, and 2008 were 52 week years.
2. INVENTORIES
Components of inventories were as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
3. PROPERTY, PLANT AND EQUIPMENT
During the fourth quarter of fiscal year 2010, the Company purchased a building and land in Juarez, Mexico at a total purchase price of $2.2 million. Of the total $2.2 million, 70% or $1.6 million was paid in cash and the remaining 30% or $0.6 million is payable prior to January 6, 2011.
During the fourth quarter of fiscal year 2007, the Company sold its Las Cruces, New Mexico facility. The total sales price for the facility and adjacent vacant land was $4.3 million. Due to the contingent nature of a portion of the sale, the Company recognized a $1.5 million gain on real estate held and a gain on sale of real estate of $951,000 in fiscal year 2008.
In December 2000, the Company sold its headquarters building, located in Spokane, Washington. In conjunction with the sale, the Company entered into a ten year leaseback agreement for a portion of the building. The gain on the sale of the building was deferred under other long-term obligations and is amortized to offset lease expenses over the remaining original lease term, which expires in December 2010. On June 15, 2010, the company amended the agreement to extend the lease for an additional ten years.
4. LONG-TERM DEBT
On August 19, 2009, the Company entered into a credit agreement with Wells Fargo Bank, N.A. providing for a revolving line of credit facility for up to $20 million and paid off its previously outstanding CIT Group/Business Credit, Inc. (CIT) revolving loan. The agreement specifies that the proceeds of the revolving line of credit be used primarily for working capital and general corporate purposes of the Company and its subsidiaries. Borrowings under this revolving line of credit bear interest at either a “Base Rate” or a “Fixed Rate”, as elected by the Company. The base rate is the higher of the JP Morgan Chase prime rate, daily one month London Interbank Offered Rate (LIBOR) plus 1.5%, or the Federal Funds rate plus 1.5%. The fixed rate is LIBOR plus 2.1% or LIBOR plus 2.5% depending on the level of trailing four quarters Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The new line of credit is secured by substantially all of the assets of the Company.
The agreement is for a term of two years beginning on August 19, 2009 and ending on August 18, 2011. The Company must comply with certain financial covenants, including a cash flow leverage ratio and a trading ratio. The credit agreement requires the Company to maintain a minimum profit threshold, limits the maximum lease expenditures and restricts the Company from declaring or paying dividends in cash or stock.
As of July 3, 2010, the Company had availability to borrow an additional $18.4 million under the Wells Fargo line of credit. The outstanding balance under the credit facility was $1.6 million as of July 3, 2010 and the rate of interest being paid on the outstanding balance was 3.25%. As of June 27, 2009, the outstanding revolving loan balance related to CIT was $2.4 million and the range of interest being paid to CIT on the outstanding balances was 1.82% to 3.25%.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. INCOME TAXES
Income tax expense (benefit) consists of the following:
The Company has domestic NOLs of approximately $25.1 million at July 3, 2010. In accordance with ASC 740, management assessed the Company’s recent operating levels and estimated future taxable income and determined there was not a need for a valuation allowance. A valuation allowance against deferred tax assets is required if it is more likely than not that some of the deferred tax assets will not be realized. Management determined during fiscal year 2010, based on the Company’s increased profitability and estimated repatriation from foreign subsidiaries that it was likely that the NOLs will be fully utilized prior to their expiration.
Management also updated its estimates of future repatriation of its undistributed earnings of its foreign subsidiaries during fiscal year 2010. Management expects to repatriate a portion of its foreign undistributed earnings based on increased sales growth driving additional capital requirements domestically, cash requirements for potential acquisitions and to implement certain tax strategies. The Company expects to repatriate approximately $14.5 million in the future. As such, as earnings are recognized in the United States, the Company would be subject to U.S. federal and state income taxes and potential withholding taxes in foreign jurisdictions. Both the domestic tax and estimated withholding tax have been recorded as part of deferred taxes as of July 3, 2010. All other unremitted foreign earnings are expected to remain permanently reinvested in planned fixed assets purchases in foreign locations.
The Company has wholly owned foreign subsidiaries in Mexico that apply certain tax credits related to production assets that currently offset all of the income tax liabilities under general Mexican income tax law. However, the Company is subject to a Mexican business flat tax called Impuesto Empresarial a Tasa Unica (IETU). Based on certain events that occurred during fiscal year 2010, the Company now anticipates that it will be taxable under IETU for the foreseeable future based on projected assets used in its operations. The effect of IETU and an associated presidential decree on fiscal year 2010 has been included in the effective tax rate as of July 3, 2010.
The Company is required to pay taxes in China on its statutory foreign profits. Its subsidiary in China did not have statutory profits during fiscal year 2010. The Company has a full valuation allowance on its Chinese tax net operating loss carryforwards until a consistent statutory profit can be maintained and it becomes likely that they will be utilized before expiration.
ASC 740 requires the Company to recognize in its financial statements uncertainties in tax positions taken that may not be sustained upon examination by the taxing authorities. If interest or penalties are assessed, the Company would recognize these charges as income tax expense. The Company does not have any uncertain tax positions as of July 3, 2010. Unrecognized tax benefits are not anticipated to increase or decrease over the next 12 months.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company’s effective tax rate differs from the federal tax rate as follows:
The domestic and foreign components of income before income taxes were:
Deferred income tax assets and liabilities consist of the following at:
At July 3, 2010 the Company had NOLs of approximately $25.1 million. The remaining net operating loss carryforwards expire in varying amounts through 2025. Utilization of NOLs would be limited in the event the Company’s ownership changes more than 50% in a three-year period. The Company also has
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
alternative minimum tax credits approximating $575,000. The alternative minimum tax credits do not expire.
6. EARNINGS PER SHARE
Basic earnings per share (EPS) is calculated by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Diluted EPS is computed by including both the weighted-average number of shares outstanding and any dilutive common share equivalents in the denominator. The following table presents a reconciliation of the denominator and the number of antidilutive common share options that were not included. These antidilutive securities occur when options outstanding have an option price greater than the average market price for the period.
7. STOCK OPTION AND BENEFIT PLANS
The Company has an executive stock option plan for certain key employees. Options under this plan vest over one to three years and become exercisable as they vest. Options under the plan become exercisable in full immediately prior to the occurrence of a “Change in Control” as defined in the plan documents. As of July 3, 2010, 266,169 options were outstanding and exercisable under the Executive Stock Option Plan and other plans which have terminated. The plan has terminated and no more options can be granted under this plan. These options expire five to ten years from the date of vesting.
The Company also has a stock option plan for “Nonemployee Directors.” Options under this plan vested over a three-year period and are exercisable. The Company reserved 300,000 shares for issuance under this plan. As of July 3, 2010, 57,325 options were outstanding. The plan has terminated and no more options can be granted under this plan. Outstanding options expire five to ten years from the date of vesting.
In May 2010, the Company established a new Stock Incentive Plan (the “2010 Incentive Plan”). The 2010 Incentive Plan was adopted by the Board of Directors in May 2010, and certain aspects are subject to approval by the shareholders at the 2010 Annual Meeting. The 2010 Incentive Plan provides for the granting of nonqualified stock options within the meaning of Section 422 Internal Revenue Code, as well as stock appreciation rights (SARs), restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock -based or cash-based awards. Stock appreciation rights may be settled in stock or cash. Because stock-based awards cannot be issued under the plan until it is approved by shareholders, the Company can only grant stock appreciation rights under the plan as cash-settled SARs. Once the plan has been approved by the shareholders, the Company can then convert the awards into stock-settled SARs at its discretion. Options and SARs under the plan become exercisable in full immediately prior to the occurrence of a “Change in Control” as defined in the plan documents. The 2010 Incentive Plan has a total of 1,200,000 shares authorized for grant. As of July 3, 2010, 555,000 SARs were outstanding. Outstanding options and SARs expire five to ten years from the date of vesting.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company granted 555,000 cash-settled SARs under the 2010 Incentive Plan to certain key employees and outside directors at a strike price of $5.89 and a grant date weighted average fair market value of $3.04 as of May 14, 2010. In addition to service conditions, these SARs contain a performance condition. The additional performance condition is based upon the achievement of Return on Invested Capital (ROIC) goals relative to a peer group. All awards with performance conditions are measured over the vesting period and are charged to compensation expense over the requisite service period based on the number of shares expected to vest. The SARs cliff vest over a three-year period from date of grant and expire in five years from date of grant. ASC 718 requires that the Company classify cash settled awards as liabilities in the Company’s Consolidated Balance Sheets and measure these awards at fair value at each reporting date until the award is ultimately settled (i.e. until the SAR is exercised or canceled). All changes in fair value are recorded in the Company’s Consolidated Statements of Income. As of July 3, 2010, approximately $57,000 related to cash settled awards was recorded as a liability in the Company’s Consolidated Balance Sheets with a related charge to compensation expense in the income statement.
The fair value for SARs was estimated using the Black-Scholes option valuation model with the following weighted average assumptions as of July 3, 2010:
Stock-based compensation expense is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. This forfeiture rate will be revised, if necessary, in subsequent periods if actual forfeitures differ from the amount estimated.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which differ significantly from the SARs, as traded options have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, particularly for the expected term and expected stock price volatility. Changes in these assumptions can materially affect the fair value estimates.
The intrinsic value for options exercised in fiscal years 2010, 2009 and 2008 was $0.5 million, $0.1 million and $0.2 million, respectively.
As of July 3, 2010, total unrecognized compensation expense related to nonvested share-based compensation arrangements was approximately $1.2 million. This expense is expected to be recognized over a weighted-average period of 2.9 years.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table summarizes option activity of all plans from June 27, 2009 through July 3, 2010:
The following is a summary of plan activity:
Additional information regarding options outstanding as of July 3, 2010, is as follows:
The Company also has a defined contribution plan (401(k)) available to U.S. employees who have attained age 21. The Company contributes an amount equal to 100% of the employee’s contribution on the first 3%
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
of the employee’s compensation and an additional 50% of the employee’s contribution on the following 2% of the employee’s compensation. Company contributions to the plan were approximately $0.4 million in fiscal years 2010, 2009, and 2008, respectively.
8. COMMITMENTS AND CONTINGENCIES
Leases: The Company has operating leases for certain equipment and production facilities, which expire at various dates during the next ten years. As of July 3, 2010, the Company did not have any property and equipment financed under capital leases. Future minimum payments under non-cancelable operating leases with initial or remaining terms of one year or more at July 3, 2010, are summarized as follows (in thousands):
Rental expense under operating leases was approximately $3.3 million, $3.4 million, and $3.7 million in fiscal years 2010, 2009, and 2008, respectively.
Warranty Costs: The Company provides warranties on certain product sales, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. The Company establishes warranty reserves based on historical warranty costs for each product line combined with liability estimates based on the prior twelve months’ sales activities.
If actual return rates and/or repair and replacement costs differ significantly from estimates, adjustments to recognize additional cost of sales may be required in future periods.
Components of the reserve for warranty costs during fiscal years 2010, 2009, and 2008 were as follows:
Warranty expense for fiscal years 2010 and 2008 is related to workmanship claims on keyboards and certain EMS products. The recovery in fiscal year 2009 is related to the release of a warranty claim for a specific product that was identified in fiscal year 2008.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Litigation: The Company is party to certain lawsuits or claims in the ordinary course of business. The Company does not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on the financial position, results of operations or cash flow of the Company.
Indemnification Rights: Under the Company’s bylaws, the Company’s directors and officers have certain rights to indemnification by the Company against certain liabilities that may arise by reason of their status or service as directors or officers. The Company maintains director and officer insurance, which may cover certain liabilities arising from its obligation to indemnify its directors and officers and former directors in certain circumstances.
9. GOODWILL
In accordance with ASC 350 Intangibles - Goodwill and Other, goodwill is not amortized, but must be analyzed for impairment at least annually. On December 27, 2008, the Company completed its annual impairment test. As the deteriorating global macroeconomic environment adversely affected the Company’s common stock price, the Company concluded that 100% of the goodwill was impaired due to the significant and sustained decline in the Company’s market capitalization to below the book value. The Company recorded an impairment charge of $765,000 during fiscal year 2009. As of July 3, 2010, and June 27, 2009, respectively, there was no goodwill recorded in the Company’s Consolidated Balance Sheet.
10. FAIR VALUE MEASUREMENTS
The Company has adopted ASC 820, Fair Value Measurements, which defines fair value, establishes a framework for assets and liabilities being measured and reported at fair value and expands disclosures about fair value measurements. There are three levels of fair value hierarchy inputs used to value assets and liabilities which include: Level 1 - inputs are quoted market prices for identical assets or liabilities; Level 2 - inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3 - inputs are unobservable inputs for the asset or liability.
The following table summarizes the Company’s financial assets and liabilities (only those required to be measured at fair value on a recurring basis) at fair value as of July 3, 2010 and June 27, 2009 (in thousands):
The Company currently has forward contracts to hedge known future cash outflows for expenses denominated in the Mexican peso. These contracts are measured on a recurring basis based on the foreign currency spot rates and forward rates quoted by banks or foreign currency dealers. These contracts are marked to market using level 2 input criteria every period with the unrealized gain or loss, net of tax, reported as a component of shareholders’ equity in accumulated other comprehensive income, as they qualify for hedge accounting.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
11. DERIVATIVE FINANCIAL INSTRUMENTS
In accordance with ASC 815, Derivatives and Hedging, the Company has expanded the quarterly and annual disclosures on its derivative instruments and hedging activities. The Company has entered into foreign currency forward contracts and those contracts are accounted for as cash flow hedges. The effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI) and is reclassified into earnings in the same period in which the underlying hedged transaction affects earnings. The derivative’s effectiveness represents the change in fair value of the hedge that offsets the change in fair value of the hedged item.
The Company transacts business in Mexico and is subject to the risk of foreign currency exchange rate fluctuations. The Company enters into foreign currency forward contracts to manage the foreign currency fluctuations for Mexican peso denominated payroll, utility, tax, and accounts payable expenses. The foreign currency forward contracts have terms that are matched to the underlying transactions being hedged. As a result these transactions fully offset the hedged risk and no ineffectiveness has been recorded.
As of July 3, 2010, the Company had outstanding foreign currency forward contracts of $30.9 million. These contract maturity dates extend through June 27, 2012. As of July 3, 2010, the net amount of existing gains (losses) expected to be reclassified into earnings within the next 24 months was $(361,000). During the fiscal year ended July 3, 2010, the Company entered into $30.9 million of foreign currency forward contracts and settled $17.8 million of such contracts. During the fiscal year ended June 27, 2009 the Company entered into $26.6 million and settled $8.8 million of foreign currency forward contracts. There were no significant foreign currency forward contracts entered into during fiscal year 2008. Subsequent to July 3, 2010, the Company entered into an additional $3.9 million of foreign currency forward contracts that extended the hedge position through September 2012.
The following table summarizes the fair value of derivative instruments in the Consolidated Balance Sheets as of July 3, 2010 (in thousands):
The following table summarizes the gain (loss) of derivative instruments on the Consolidated Statement of Operations for the fiscal year 2010 (in thousands):
The Company does not enter into derivative instruments for trading or speculative purposes. The Company’s counterparties to the foreign currency forward contracts are major banking institutions. These institutions do not require collateral for the contracts and the Company believes that the risk of the counterparties failing to meet their contractual obligations is remote.
As of July 3, 2010, the Company does not have any foreign exchange contracts with credit-risk-related contingent features.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. ENTERPRISE-WIDE DISCLOSURES
Products and Services
Of the revenues for the years ended July 3, 2010, June 27, 2009, and June 28, 2008, EMS sales were $195.1 million, $180.7 million, and $198.3 million, respectively. Keyboard sales for the years ended July 3, 2010, June 27, 2009, and June 28, 2008 were $4.5 million, $4.2 million, and $5.8 million, respectively.
Geographic Areas
Net sales and long-lived assets (property, plant, and equipment) by geographic area as of July 3, 2010, June 27, 2009, and June 28, 2008, respectively are summarized in the following table. Net sales set forth below are based on the shipping destination.
For the year ended July 3, 2010, 48.8% of the Company’s foreign net sales were to customers in Canada, 16.9% were to Australia, 13.9% were to China , and the remaining 20.4% were spread among customers in other parts of Europe and Asia.
For the year ended June 27, 2009, 52.3% of the Company’s foreign net sales were to customers in Canada, 24.7% were to Switzerland, 15.8% were to Asia, and the remaining 7.2% were spread among customers in other parts of Europe and Australia.
For the year ended June 28, 2008, 65.8% of the Company’s foreign net sales were to customers in Switzerland, 11.7% were to Canada, 10.2 % were to Asia, and the remaining 12.3% were spread among customers in other parts of Europe and Australia.
Significant Customers
The percentage of net sales to and trade accounts receivables from significant customers were as follows:
* Amount was less than 10% of total.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
There can be no assurance that the Company’s principal customers will continue to purchase products from the Company at current levels. Moreover, the Company typically does not enter into long-term volume purchase contracts with its customers, and the Company’s customers have certain rights to extend or delay the shipment of their orders. The loss of one or more of the Company’s major customers, or the reduction, delay or cancellation of orders from such customers, could materially and adversely affect the Company’s business, operating results and financial condition.
13. QUARTERLY FINANCIAL DATA
(Unaudited)
Item 9:
Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None
Item 9A
Item 9A (T): CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
It is the responsibility of our management to establish, maintain, and monitor disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 are recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission rules and forms. Additionally, these disclosure controls include controls and procedures that are designed to accumulate and communicate the information required to be disclosed to our company’s Chief Executive Officer and Chief
Financial Officer, allowing for timely decisions regarding required disclosures. As of the end of the period covered by this report, our management carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(f). Based on our assessment, we believe that as of July 3, 2010, the Company’s disclosure controls and procedures are effective based on that criteria.
Management’s Report on Internal Control over Financial Reporting
Our management has the responsibility to establish and maintain adequate internal controls over our financial reporting, as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934. Our internal controls are designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our external financial statements in accordance with generally accepted accounting principles (GAAP).
Due to inherent limitations of any internal control system, management acknowledges that there are limitations as to the effectiveness of internal controls over financial reporting and therefore recognize that only reasonable assurance can be gained from any internal control system. Accordingly, our internal control system may not detect or prevent material misstatements in our financial statements and projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and participation of management, including the Chief Executive Officer and Chief Financial Officer, we have performed an assessment of the effectiveness of our internal controls over financial reporting as of July 3, 2010. This assessment was based on the criteria established in Internal Control-Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, we believe that as of July 3, 2010, the Company’s internal control over financial reporting is effective based on that criteria.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit us to provide only management’s report in this annual report.
Changes in Internal Control over Financial Reporting
There have been no significant changes in our internal controls over financial reporting during our fourth fiscal quarter ended July 3, 2010 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a - 15(f) and 15d - 15(f)).
Item 9B:
Item 9B: OTHER INFORMATION
None
PART III
Item 10:
Item 10: DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors of the Registrant
Information on the nominees for election as Directors of the Company is incorporated by reference from the Company’s definitive proxy statement for the 2010 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A under the Exchange Act no later than 120 days after the end of the Company’s 2010 fiscal year.
Executive Officers of the Registrant
This information is included in a separate item captioned “Executive Officers of the Registrant” in Item 1 of Part 1 of this report pursuant to Instruction G(3) of Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K.
Compliance with Section 16(a) of the Exchange Act:
Incorporated by reference to Key Tronic Corporation’s 2010 Proxy Statement to Shareholders.
Code of Conduct
The Board of Directors has adopted a written Code of Conduct which applies to its directors and employees, including its executive officers. The Code of Conduct is available on the Company’s website at www.keytronic.com. The Company intends to disclose on its website any amendments to or waivers of the Code of Conduct.
Item 11:
Item 11: EXECUTIVE COMPENSATION
Information appearing under the caption “Executive Compensation” in the Company’s 2010 Proxy Statement is incorporated herein by this reference.
Item 12:
Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth the aggregate information for the Company’s equity compensation plans in effect as of July 3, 2010.
EQUITY COMPENSATION PLAN INFORMATION
(1)
Consists of the Key Tronic Corporation 2000 Employee Stock Option Plan. Not included are the 1,200,000 shares subject to the 2010 Plan, the issuance of which is subject to shareholder approval of the 2010 Plan at the Annual Meeting, or the cash-settled SARs issued under the 2010 Plan that may be settled in shares of Common Stock, subject to shareholder approval of the 2010 Plan. See “Proposal 3: Approval of the Key Tronic Corporation 2010 Incentive Plan” for further information about the 2010 Plan.
Information under the caption “Beneficial Ownership of Securities” in the Company’s 2010 Proxy Statement is incorporated herein by this reference.
Item 13:
Item 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information appearing under the caption “Related Person Transactions”, “Compensation Committee Interlocks and Insider Participation”, and “Directors’ Independence” in the Company’s 2010 Proxy Statement is incorporated herein by this reference.
Item 14:
Item 14: PRINCIPAL ACCOUNTING FEES AND SERVICES
Information appearing under the caption “Principal Accountant Fees and Services” in the Company’s 2010 Proxy Statement is incorporated herein by this reference.
PART IV
Item 15:
Item 15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) 1. FINANCIAL STATEMENTS
2. SCHEDULES
II. Consolidated Valuation and Qualifying Accounts
Other schedules are omitted because of the absence of conditions under which they are required, or because required information is given in the financial statements or notes thereto.
3. EXHIBITS
* Management contract or compensatory plan or arrangement
PART IV
SCHEDULE II
KEY TRONIC CORPORATION AND SUBSIDIARIES
CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS
FISCAL YEARS ENDED JULY 3, 2010, JUNE 27, 2009, AND
JUNE 28, 2008
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: September 13, 2010
KEY TRONIC CORPORATION
By:
/S/ CRAIG D. GATES
Craig D. Gates,
President and Chief Executive Officer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: