ktcc-20211002

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

____________________________________________________________

FORM 10-Q

____________________________________________________________

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED OCTOBER 2, 2021

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE PERIOD FROM TO .

Commission File Number 0-11559

____________________________________________________________

KEY TRONIC CORPORATION

(Exact name of registrant as specified in its charter)

____________________________________________________________


Washington			91-0849125
(State of Incorporation)			(I.R.S. Employer Identification No.)

N. 4424 Sullivan Road

Spokane Valley, Washington 99216

(509) 928-8000

(Address of principal executive offices and registrant’s telephone number)

____________________________________________________________

Securities registered pursuant to Section 12(b) of the Act:


Title of each class	Trading Symbol	Name of each exchange on which registered
Common Stock, no par value	KTCC	NASDAQ Global Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements during the past 90 days. Yes ☒ No ¨

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulations S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated Filer

☐

Accelerated Filer

☒

Non-accelerated Filer

☐

Smaller reporting company

☒

Emerging growth company

☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

As of November 9, 2021, 10,761,871 shares of common stock, no par value (the only class of common stock), were outstanding.

KEY TRONIC CORPORATION

Index


		Page No.

PART I.	FINANCIAL INFORMATION:

Item 1.	Financial Statements (Unaudited):	3

	Condensed Consolidated Balance Sheets	3

	Condensed Consolidated Statements of Income	4

	Condensed Consolidated Statements of Comprehensive Income (Loss)	5

	Condensed Consolidated Statements of Cash Flows	6

	Condensed Consolidated Statements of Shareholders’ Equity	7

	Notes to Condensed Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	31

Item 4.	Controls and Procedures	31

PART II.	OTHER INFORMATION:

Item 1.	Legal Proceedings	31

Item 1A.	Risk Factors	31

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds*

Item 3.	Defaults upon Senior Securities*

Item 4.	Mine Safety Disclosures*

Item 5.	Other Information*

Item 6.	Exhibits	32

Signatures		33

* Items are not applicable

“We,” “us,” “our,” “Company,” and “Key Tronic,” unless the context otherwise requires, means Key Tronic Corporation and its subsidiaries.

PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands; except share data)


	October 2, 2021		July 3, 2021
ASSETS
Current assets:
Cash and cash equivalents	$	1,544	$	3,473
Trade receivables, net of allowance for doubtful accounts of $303 and $275	126,453		110,324
Contract assets	23,651		24,781
Inventories, net	143,131		137,329
Other	29,554		23,345
Total current assets	324,333		299,252
Property, plant and equipment, net	31,198		35,735
Operating lease right-of-use assets, net	18,994		15,745
Other assets:
Deferred income tax asset	10,252		9,656
Other	6,554		1,458
Total other assets	16,806		11,114
Total assets	$	391,331	$	361,846
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	111,659	$	92,823
Accrued compensation and vacation	8,476		11,471
Current portion of debt, net	3,951		2,143
Other	17,938		20,268
Total current liabilities	142,024		126,705
Long-term liabilities:
Term loans	7,463		7,906
Revolving loan	100,760		90,362
Operating lease liabilities	13,727		11,428

Other long-term obligations	4,300		1,740
Total long-term liabilities	126,250		111,436
Total liabilities	268,274		238,141
Commitments and contingencies (Note 8)
Shareholders’ equity:
Common stock, no par value—shares authorized 25,000; issued and outstanding 10,762 and 10,762 shares, respectively	47,249		47,181
Retained earnings	75,267		74,452
Accumulated other comprehensive income	541		2,072
Total shareholders’ equity	123,057		123,705
Total liabilities and shareholders’ equity	$	391,331	$	361,846

See accompanying notes to consolidated financial statements.

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited, in thousands, except share and per share amounts)


	Three Months Ended
	October 2, 2021		September 26, 2020
Net sales	$	132,762	$	123,207
Cost of sales	122,624		113,192
Gross profit	10,138		10,015
Research, development and engineering expenses	2,449		2,245
Selling, general and administrative expenses	5,595		4,974
Total operating expenses	8,044		7,219
Operating income	2,094		2,796
Interest expense, net	992		681
Income before income taxes	1,102		2,115
Income tax provision	287		396
Net income	$	815	$	1,719
Net income per share — Basic	$	0.08	$	0.16
Weighted average shares outstanding — Basic	10,762		10,760
Net income per share — Diluted	$	0.07	$	0.16
Weighted average shares outstanding — Diluted	11,052		11,040

See accompanying notes to consolidated financial statements.

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited, in thousands)


	Three Months Ended
	October 2, 2021		September 26, 2020
Comprehensive income (loss):
Net income	$	815	$	1,719
Other comprehensive income (loss):
Unrealized gain (loss) on hedging instruments, net of tax	(1,531)		1,268
Comprehensive income (loss)	$	(716)	$	2,987

Other comprehensive income (loss) for the three months ended October 2, 2021 and September 26, 2020, is reflected net of tax expense (benefit) of approximately $(0.3) million and $1.5 million, respectively.

See accompanying notes to consolidated financial statements.

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW

(Unaudited, in thousands)


	Three Months Ended
	October 2, 2021		September 26, 2020
Operating activities:
Net income	$	815	$	1,719
Adjustments to reconcile net income to cash used in operating activities:
Depreciation and amortization	1,335		1,752
Amortization of interest rate swap	75		—
Amortization of deferred loan costs	32		13
Provision for obsolete inventory	138		178
Provision for warranty	75		19
Provision for doubtful accounts	26		—

Share-based compensation expense	68		63
Deferred income taxes	(220)		(81)
Changes in operating assets and liabilities:
Trade receivables	(16,155)		(5,449)
Contract assets	1,130		(705)
Inventories	(5,940)		(4,949)
Other assets	(7,092)		292
Accounts payable	18,835		(1,059)
Accrued compensation and vacation	(2,995)		(2,787)
Other liabilities	(4,753)		1,555
Cash used in operating activities	(14,626)		(9,439)
Investing activities:
Purchase of property and equipment	(1,791)		(3,186)


Cash used in investing activities	(1,791)		(3,186)
Financing activities:
Payment of financing costs	(80)		(307)
Proceeds from issuance of long term debt	5,055		5,000
Interest rate swap termination fee	—		(925)
Repayments of long term debt	(532)		(10,842)
Borrowings under revolving credit agreement	151,916		45,975
Repayments of revolving credit agreement	(141,470)		(25,358)
Principal payments on finance leases	(401)		—
Cash provided by financing activities	14,488		13,543
Net (decrease) increase in cash and cash equivalents	(1,929)		918
Cash and cash equivalents, beginning of period	3,473		553
Cash and cash equivalents, end of period	$	1,544	$	1,471
Non-cash investing activities:
Beneficial interest in transferred receivables	—		(9)
Supplemental cash flow information:
Interest payments	$	999	$	578
Income tax payments, net of refunds	$	210	$	351
Recognition of operating lease liabilities and right-of-use assets	$	4,695	$	—
Recognition of financing lease liabilities and right-of-use assets	$	4,456	$	—

See accompanying notes to consolidated financial statements.

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Unaudited, in thousands; except share data)


	Three Months Ended
	October 2, 2021		September 26, 2020
Total shareholders’ equity, beginning balances	$	123,705	$	115,557

Common stock (shares):
Beginning balances	10,762		10,760
Exercise of stock appreciation rights	—		—
Ending balances	10,762		10,760

Common stock:
Beginning balances	$	47,181	$	46,946
Share-based compensation	68		63

Ending balances	47,249		47,009

Retained Earnings:
Beginning balances	$	74,452	$	70,111
Net income	815		1,719
Ending balances	75,267		71,830

Accumulated other comprehensive income:
Beginning balances	$	2,072	$	(1,500)
Unrealized gain (loss) on hedging instruments, net	(1,531)		1,268
Ending balances	541		(232)
Total shareholders’ equity, ending balances	$	123,057	$	118,607

See accompanying notes to consolidated financial statements.

KEY TRONIC CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.Basis of Presentation

The consolidated financial statements included herein have been prepared by Key Tronic Corporation and subsidiaries (the Company) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The year-end condensed consolidated balance sheet information was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The financial statements reflect all normal and recurring adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods presented. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The results of operations for the periods presented are not necessarily indicative of the results to be expected for the full year. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 3, 2021.

The Company’s reporting period is a 52/53 week fiscal year ending on the Saturday closest to June 30. The quarters ended October 2, 2021 and September 26, 2020 were 13 week periods, respectively. Fiscal year 2022 will end on July 2, 2022, which is a 52 week year. Fiscal year 2021 which ended on July 3, 2021, was a 53 week year.

Certain Significant Risks and Uncertainties Related to Outbreak of Coronavirus Disease 2019 (“COVID-19”)

Due to the COVID-19 pandemic, the Company has seen extreme shifts in demand from its customer base, and shifts in supply chain and logistics risks. The possibility of future temporary closures, as well as adverse fluctuations in customer demand, freight and expedite costs, precautionary safety expenses and labor shortages, collectability of accounts, and future supply chain disruptions during the rapidly changing COVID-19 environment can materially impact operating results. Additionally, continued adverse macroeconomic conditions and significant currency exchange fluctuations can also materially impact operating results.

2.Significant Accounting Policies

Earnings Per Common Share

Basic earnings per common share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the combination of other potentially dilutive weighted average common shares and the weighted average number of common shares outstanding during the period using the treasury stock method. The computation assumes the proceeds from the exercise of equity awards were used to repurchase common shares at the average market price during the period. The computation of diluted EPS does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an anti-dilutive effect on EPS.

Derivative Instruments and Hedging Activities

The Company has entered into foreign currency forward contracts that are accounted for as cash flow hedges in accordance with ASC 815, “Derivatives and Hedging”. The effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI) and is reclassified into earnings in the same period in which the underlying hedged transaction affects earnings. The derivative’s effectiveness represents the change in fair value of the hedge that offsets the change in fair value of the hedged item.

The Company uses derivatives to manage the variability of foreign currency fluctuations of expenses in our Mexico facilities. The foreign currency forward contracts have terms that are matched to the underlying transactions being hedged. As a result, these transactions fully offset the hedged risk and no ineffectiveness has been recorded.

The Company’s foreign currency forward contracts potentially expose the Company to credit risk to the extent the counterparty may be unable to meet the terms of the agreement. The Company minimizes such risk by utilizing a counterparty with a strong credit rating. The Company’s counterparty to the foreign currency forward contracts is a major banking institution. This institution does not require collateral for the contracts, and the Company believes that the risk of the counterparty failing to meet their contractual obligations is remote. The Company does not enter into derivative instruments for trading or speculative purposes.

Income Taxes

We compute our interim income tax provision through the use of an estimated annual effective tax rate (ETR) applied to year-to-date operating results and specific events that are discretely recognized as they occur. In determining the estimated annual ETR, we analyze various factors, including projections of our annual earnings, taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and available tax planning alternatives. Discrete items, including the effect of changes in tax laws, tax rates, and certain circumstances with respect to valuation allowances or other unusual or non-recurring tax adjustments, are reflected in the period in which they occur as an addition to, or reduction from, the income tax provision, rather than included in the estimated annual ETR.

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences and benefits attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as tax credit and net operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized.

We utilize a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments based on new assessments and changes in estimates and which may not accurately forecast actual outcomes. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense. The tax years 1998 through the present remain open to examination by the major U.S. taxing jurisdictions to which we are subject. Refer to Note 6 for further discussions.

Recently Issued Accounting Standards

In January 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2021-01, Reference Rate Reform (Topic 848) to identify alternative reference rates that are more observable or transaction based and less susceptible to manipulation. The Company is currently assessing the effects on its consolidated financial statements, and if it will elect this optional standard.

In March of 2020, the FASB issued ASU 2020-03, Codification Improvements to Financial Instruments, which clarifies specific issues raised by stakeholders. Specifically, the ASU clarifies the following: 1) that all entities are required to provide the fair value option disclosures in ASC 825, Financial Instruments 2) clarifies that the portfolio exception in ASC 820, Fair Value Measurement, applies to nonfinancial items accounted for as derivatives under ASC 815, Derivatives and Hedging; 3) clarifies that for purposes of measuring expected credit losses on a net investment in a lease in accordance with ASC 326, Financial Instruments - Credit Losses, the lease term determined in accordance with ASC 842, Leases, should be used as the contractual term; 4) clarifies that when an entity regains control of financial assets sold, it should recognize an allowance for credit losses in accordance with ASC 326; and 5) aligns the disclosure requirements for debt securities in ASC 320, Investments - Debt Securities, with the corresponding requirements for depository and lending institutions in ASC 942, Financial Services - Depository and Lending. The amendments in the ASU have various effective dates and transition requirements which are dependent on timing of adoption of ASU 2016-13. The Company is currently assessing the effects on its consolidated financial statements, and it intends to adopt the guidance as they become effective.

In December 2019, the FASB issued ASU 2019-12, Simplifying the Accounting for Income Taxes (Topic 740), which modifies certain provisions of ASC 740, Income Taxes, in an effort to reduce the complexity of accounting for income taxes. ASU 2019-12 became effective for the Company during the first quarter of fiscal year 2022. Implementation of this standard does not have a material impact on our consolidated financial position, results of operations, or cash flows.

In June 2016, the FASB issued ASU 2016-13 “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” and also issued subsequent amendments to the initial guidance: ASU 2018-19, ASU 2019-04 and ASU 2019-05, which replaces the existing incurred loss impairment model with an expected credit loss model and requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected. The guidance is effective for the Company beginning in the first quarter of fiscal year 2024 with early adoption permitted. The Company is currently assessing the impact on its consolidated financial statements, and it intends to adopt the guidance when it becomes effective in the first quarter of fiscal year 2024.

3.Inventories

Total inventory as of October 2, 2021 is $143.1 million which is net of $23.9 million of reserves, customer payments, and customer deposits compared to $137.3 million which is net of $14.9 million in reserves, customer payments, and customer deposits as of July 3, 2021. Substantially all of the Company’s inventory balances are raw materials.

4.Long-Term Debt

On September 3, 2021, the Company entered into an amendment to the Company’s current loan agreement with Bank of America. The amendment increases the Company’s current credit facility of $93 million to $120 million, subject to the Company’s borrowing base, maturing on September 3, 2026. As of October 2, 2021, the Company had an outstanding balance under the asset-based revolving credit facility of $101.3 million, $0.3 million in outstanding letters of credit and $12.0 million available for future borrowings.

As of July 3, 2021, the Company had an outstanding balance under the credit facility with Bank of America of $90.9 million, $0.3 million in outstanding letters of credit and $2.1 million available for future borrowings.

Generally, the interest rate applicable to loans under the Bank of America loan agreement will be, at the Company’s option: (i)(A) the base rate which is the highest of (1) the prime rate for the applicable day (as such rate is determined from time to time by the Bank), (2) the federal funds rate for the applicable day plus 0.50%, and (3) LIBOR for a 30-day interest period as of the applicable day plus 1.00% (provided that in no event shall the base rate be less than zero), plus the applicable interest margin for base rate loans; and (B) LIBOR rate for an applicable interest period (provided that in no event shall the LIBOR rate be less than 0.50%), plus the applicable interest margin for LIBOR rate loans. Depending on average daily excess borrowing availability over applicable periods under the Credit Facility, applicable interest margins on: (x) base rate loans will be 1.25-1.75%; and (y) LIBOR rate loans will be 2.25-2.75%, resetting on a quarterly basis beginning in early 2021. If there is an event of default under the loan agreement, all loans and other obligations will bear interest at a rate of an additional 2.00% on the otherwise applicable interest rates. In addition to interest charges, the Company is required to pay a fee of 0.25% per annum on the unused portion of the Credit Facility, monthly in arrears.

Under the new loan agreement with Bank of America, the asset-based revolving credit facility bears interest at LIBOR plus 2.5%, as elected by the Company.

On August 14, 2020, the Company also entered into a $5.0 million equipment financing facility relating to the Company’s existing U.S. manufacturing equipment that bears interest at 4.85% and matures on August 14, 2025. Under this loan agreement, equal monthly payments of approximately $94,000 commenced on September 14, 2020 and will continue through the maturity of the equipment financing facility on August 14, 2025. As of October 2, 2021, the Company had an outstanding balance of $4.0 million. As of July 3, 2021, the Company had an outstanding balance of $4.2 million under the Bank of America equipment term loan agreement.

On November 24, 2020, the Company entered into a $6.0 million equipment financing facility related to the Company’s existing manufacturing equipment that bears interest at 5.52% and matures on April 24, 2026. Under this loan agreement, equal monthly payments of $100,000 commenced on May 24, 2021 and will continue through the maturity of the equipment financing facility on April 24, 2026. As of October 2, 2021, the Company had an outstanding balance of $5.5 million. As of July 3, 2021, the Company had an outstanding balance of $5.8 million.

The interest rates on outstanding debt as of October 2, 2021 range from 3.25% - 5.52% compared to 3.25% - 5.52% as of July 3, 2021.

Debt maturities as of October 2, 2021 for the next five years and thereafter are as follows (in thousands):


Fiscal Years Ending	Amount
2022 (1)	$	1,611
2023	2,190
2024	2,239
2025	2,290
2026	1,187
Thereafter	101,332
Total debt	$	110,849
Unamortized debt issuance costs	(572)
Long-term debt, net of debt issuance costs	$	110,277

(1) Represents scheduled payments for the remaining nine-month period ending July 2, 2022.

The Company must comply with certain financial covenants, including a fixed charge coverage ratio and a cash flow leverage ratio. The credit agreement requires the Company to grant certain inspection rights to Bank of America, limit or restrict the Company’s cash management; limit or restrict the ability of the Company to incur additional liens, make acquisitions or investments, incur additional indebtedness, engage in mergers, consolidations, liquidations, dissolutions, or dispositions, pay dividends or other restricted payments, prepay certain indebtedness, engage in transactions with affiliates, and use proceeds. The Company was in compliance with all financial covenants as of October 2, 2021.

5.Income Taxes

The Company expects to repatriate a portion of its foreign earnings based on increased net sales growth driving additional capital requirements domestically, cash requirements for potential acquisitions and to implement certain tax strategies. The Company currently expects to repatriate approximately $7.5 million of foreign earnings in the future. All other unremitted foreign earnings are expected to remain permanently reinvested for planned fixed assets purchases and improvements in foreign locations.

Repatriations of cash will generally be tax-free in the U.S. However, withholding taxes in China may still apply to any such future repatriations. Management has not changed its indefinite investment assertions with regard to the portion of accumulated earnings and profits in China that may be repatriated in the future. Accordingly, management estimates that future repatriations of cash from China may result in approximately $0.7 million of withholding tax. We do not anticipate there would be any offsetting foreign tax credits in the U.S. and as such, this potential liability is a direct cost associated with actual repatriations. Withholding taxes would not apply to future repatriations from Mexico or Vietnam.

The Company has available approximately $6.4 million of gross federal research and development tax credits as of October 2, 2021. ASC 740 requires the Company to recognize in its financial statements uncertainties in tax positions taken that may not be sustained upon examination by the taxing authorities. Accordingly, as of October 2, 2021, the Company has recorded $2.6 million of unrecognized tax benefits associated with these federal tax credits, resulting in a net deferred tax benefit of approximately $3.8 million.

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted in response to the COVID-19 pandemic. The CARES Act is not expected to have a material impact on the provision or timing of cash payments for income taxes. However, under the CARES Act, AMT credits not previously refunded for the 2018 tax year became refundable in the 2019 taxable year rather than in years 2019-2021, and taxpayers could elect to claim 100% of the AMT credits in the first taxable year beginning in 2018 by applying for a tentative refund claim on or before December 31, 2020. The Company made this election by applying for a tentative refund claim in the fourth quarter of fiscal year 2020. The Company is continuing to evaluate the impacts of other aspects of the CARES Act, and at this time the Company does not believe they will have a material impact on our consolidated financial position, results of operations, or cash flows.

The Company is evaluating tax law changes and regulatory guidance issued through the quarter. Such changes and regulations include guidance under Sec. 162(m), Sec. 245A, Sec. 951A, foreign tax credits, and rules relating to consolidated NOL carryback claims. The Company is still evaluating the ongoing impact of these law and regulatory changes, and does not expect them to have a material impact on its provision for income taxes.

On January 27, 2021, the Company received official notice from the Vietnamese tax authorities, confirming tax benefits awarded (the “Tax Holiday”) related to the Company’s principal product line in Vietnam. The tax rate related to this product line will be zero percent for four years beginning with fiscal year 2021, then five percent for nine years, then ten percent for one year (as opposed to the normal twenty percent each year). Consequently, Management determined that the net operating loss in Vietnam more likely than not would result in minimal, if any, tax benefit, and the Company recorded a valuation allowance against the entire Vietnam net operating loss deferred tax asset ($0.2 million) in the third quarter of fiscal year 2021.

6.Earnings Per Share

The following table presents a reconciliation of the denominator in the basic and diluted EPS calculation and the number of antidilutive common share awards that were not included in the diluted earnings per share calculation. These antidilutive securities occur when equity awards outstanding have an option price greater than the average market price for the period.


	Three Months Ended
	(in thousands, except share and per share information)
	October 2, 2021		September 26, 2020
Net income	$	815	$	1,719
Weighted average shares outstanding—basic	10,762		10,760
Effect of dilutive common stock awards	290		280
Weighted average shares outstanding—diluted	11,052		11,040
Net income per share—basic	$	0.08	$	0.16
Net income per share—diluted	$	0.07	$	0.16
Antidilutive SARs not included in diluted earnings per share	629		329

7. Share-based Compensation

The Company’s incentive plan provides for equity and liability awards to employees and non-employee directors in the form of stock options, stock appreciation rights (SARs), restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based or cash-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is recorded as employee compensation expense in cost of goods sold, research, development and engineering, and selling, general and administrative expenses. Share-based compensation is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on historical experience and future expectations.

In addition to service conditions, SARs contain a performance condition. The additional performance condition is based upon the achievement of Return on Invested Capital (ROIC) goals relative to a peer group. All awards with performance conditions are evaluated quarterly to determine the likelihood that performance metrics will be achieved during the performance period. These awards are charged to compensation expense over the requisite service period based on the number of shares expected to vest. The SARs cliff vest after a three-year period from date of grant and expire five years from date of grant.

The grant date fair value for the awards granted below were estimated using the Black Scholes option valuation method:


	August 9, 2021		July 23, 2020
SARs Granted	165,000		155,000
Strike Price	$	7.17	$	6.94
Fair Value	$	2.73	$	2.32

Total share-based compensation expense recognized during the three months ended October 2, 2021 and September 26, 2020 was approximately $68,000 and $64,000, respectively.

As of October 2, 2021, total unrecognized compensation expense related to unvested share-based compensation arrangements was approximately $0.6 million. This expense is expected to be recognized over a weighted average period of 2.39 years. No SARs were exercised during the three months ended October 2, 2021 or September 26, 2020.

8.Commitments and Contingencies

Litigation and Other Matters

The Company is party to certain lawsuits or claims in the ordinary course of business. The Company does not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on the financial position, results of operations or cash flow of the Company.

Warranties

The Company provides warranties on certain product sales. Allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. If actual return rates and/or repair and replacement costs differ significantly from management’s estimates, adjustments to recognize additional cost of sales may be required in future periods. The Company’s warranty reserve was approximately $32,000 as of October 2, 2021 and $25,000 as of July 3, 2021, respectively.

9.Derivative Financial Instruments

As of October 2, 2021, the Company had outstanding foreign currency forward contracts with a total notional amount of $19.1 million. The maturity dates for these contracts extend through June 2022. For the three months ended October 2, 2021, the Company entered into $13.9 million of foreign currency forward contracts and settled $5.5 million of contracts. During the same period of the previous year, the Company did not enter into any foreign currency forward contracts and settled $6.7 million of contracts.

As of October 2, 2021, the aggregate notional amount of the Company’s outstanding foreign currency contracts along with their unrealized gains (losses) are expected to mature as summarized below (in thousands):


Quarter Ending	Notional Contracts in MXN		Notional Contracts in USD		Estimated Fair Value
January 1, 2022	$	137,973	$	5,129	$	1,586
April 2, 2022	$	149,893	$	7,224	$	(23)
July 2, 2022	$	141,493	$	6,726	$	(23)

On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of September 30, 2022, related to the borrowings outstanding under the term loan with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. On the date of termination this interest rate swap was in a liability position of $148,400, which will be amortized to interest expense over the original term of the swap.

On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of November 1, 2023, related to the borrowings outstanding under the line of credit with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. On the date of termination this interest rate swap was in a liability position of $776,500, which will be amortized to interest expense over the original term of the swap.

The following table summarizes the fair value of derivative instruments in the Consolidated Balance Sheet as of October 2, 2021 and July 3, 2021 (in thousands):


		October 2, 2021		July 3, 2021
Derivatives Designated as Hedging Instruments	Balance Sheet Location	Fair Value		Fair Value
Foreign currency forward contracts	Other current assets	$	1,586	$	3,614

Foreign currency forward contracts	Other current liabilities	$	(46)	$	—

The following tables summarize the gain (loss) on derivative instruments, net of tax, on the Consolidated Statements of Income for the three months ended October 2, 2021 and September 26, 2020, respectively (in thousands):


Derivatives Designated as Hedging Instruments	Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)	AOCI Balance as of July 3, 2021		Effective Portion Recorded In AOCI		Effective Portion Reclassified From AOCI Into Income		AOCI Balance as of October 2, 2021
Forward contracts	Cost of sales	$	2,721	$	224	$	(1,830)	$	1,115
Interest rate swap	Interest expense	(649)		—		75		(574)
Total		$	2,072	$	224	$	(1,755)	$	541

Derivatives Designated as Hedging Instruments	Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)	AOCI Balance as of June 27, 2020		Effective Portion Recorded In AOCI		Effective Portion Reclassified From AOCI Into Income		AOCI Balance as of September 26, 2020
Forward contracts	Cost of sales	$	(759)	$	1,043	$	359	$	643
Interest rate swap	Interest expense	(741)		(223)		89		(875)
Total		$	(1,500)	$	820	$	448	$	(232)

As of October 2, 2021, the net amount of unrealized gain expected to be reclassified into earnings within the next 12 months is approximately $1.2 million. As of October 2, 2021, the Company does not have any foreign exchange contracts with credit-risk-related contingent features.

10.Fair Value Measurements

The Company currently has forward contracts to hedge known future cash outflows for expenses denominated in the Mexican peso. These contracts are measured on a recurring basis based on the foreign currency spot rates and forward rates quoted by banks or foreign currency dealers. There are three levels of fair value hierarchy inputs used to value assets and liabilities which include: Level 1 – inputs are quoted market prices for identical assets or liabilities; Level 2 – inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3 – inputs are unobservable inputs for the asset or liability. These contracts are marked to market using level 2 input criteria every quarter with the unrealized gain or loss, net of tax, reported as a component of shareholders’ equity in accumulated other comprehensive gain (loss), as they qualify for hedge accounting.

The following table summarizes the fair value of assets (liabilities) of the Company’s derivatives that are required to be measured on a recurring basis as of October 2, 2021 and July 3, 2021 (in thousands):


	October 2, 2021
	Level 1		Level 2		Level 3		Total Fair Value
Financial Assets:

Foreign currency forward contracts	$	—	$	1,586	$	—	$	1,586
Financial Liabilities:

Foreign currency forward contracts	$	—	$	(46)	$	—	$	(46)


	July 3, 2021
	Level 1		Level 2		Level 3		Total Fair Value
Financial Assets:

Foreign currency forward contracts	$	—	$	3,614	$	—	$	3,614

The carrying values of cash and cash equivalents, accounts receivable and current liabilities reflected on the balance sheets at October 2, 2021 and July 3, 2021, reasonably approximate their fair value. The Company’s long-term debt, which is measured at amortized cost, primarily consists of an asset-based revolving credit facility, lease liability, and an equipment loan. These borrowings bear interest at LIBOR plus 2.5% per the loan agreement. Each of these rates is a variable floating rate dependent upon current market conditions and the Company’s current credit risk as discussed in Note 4.

As a result of the determinable market rates for our asset-based revolving credit facility and equipment loan, they are classified within Level 2 of the fair value hierarchy. Further, the carrying value of each of these instruments reasonably approximates their fair value as of October 2, 2021 and July 3, 2021.

11.Revenue

Revenue Recognition

The Company specializes in services ranging from product manufacturing to engineering and tooling services. The first step in its process for revenue recognition is to identify the contract with a customer. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied. The Company generally enters into manufacturing service agreements (“MSA”) with its customers that outline the terms of the business relationship between the customer and the Company. This includes matters such as warranty, indemnification, transfer of title and risk of loss, liability for excess and obsolete inventory, pricing, payment terms, etc. The Company will also bid on a program-by-program basis for customers in which an executed MSA may not be in place. In these instances, as well as when we have an MSA in place, we receive customer purchase orders for specific quantities and timing of products. As a result, the Company considers its contract with a customer to be the combination of the MSA and the purchase order. The transaction price is fixed and set forth in each purchase order. In the Company's normal course of business, there are no variable pricing components, or material amounts refunded to customers in the form of refunds or rebates.

The Company assesses whether control of the product or services promised under the contract is transferred to the customer at a point in time (shipment) or over time (as we manufacture the product). The Company is first required to evaluate whether its contracts meet the criteria for 'over-time' or 'point-in-time' recognition. The Company has determined that for the majority of its contracts the Company is manufacturing products for which there is no alternative use due to the unique nature of the customer-specific product, IP and other contract restrictions. The Company has an enforceable right to payment including a reasonable profit for performance completed to date with respect to these contracts. As a result, revenue is recognized under these contracts 'over-time' based on the input cost-to-cost method as it better depicts the transfer of control. This input method is based on the ratio of costs incurred to date as compared to the total estimated costs at completion of the performance obligation. For all other contracts that do not meet these criteria, such as manufacturing contracts for which the terms do not provide an enforceable right to payment for performance completed to date, the Company recognizes revenue when it has transferred control of the related manufactured products which generally occurs upon shipment to the customer. Revenue from engineering services is recognized over time as the services are performed.

The Company’s sales arrangements do not contain any significant financing component for its customers.

The Company generally provides a warranty for workmanship on its manufacturing contracts. Historically, the amount of returns for workmanship issues has been de minimis under the Company’s warranties.

The Company elected to not disclose information about remaining performance obligations as they are part of contracts that that have expected durations of one year or less.

During the first three months of fiscal year 2022, no revenues were recognized from performance obligations satisfied or partially satisfied in previous periods.

Contract Balances

A contract asset is recognized when the Company has recognized revenue, but has not issued an invoice for payment. Contract assets are classified separately on the condensed consolidated balance sheet and transferred to receivables when the right to payment becomes unconditional. The following table summarizes the activity in the Company’s contract assets during the three months ended October 2, 2021 (in thousands):


	Contract Assets
Beginning balance, July 3, 2021	$	24,781
Revenue recognized	129,481
Amounts collected or invoiced	(130,611)
Ending balance, October 2, 2021	$	23,651

Disaggregation of Revenue

The following table presents the Company’s revenue disaggregated for the three months ended October 2, 2021 and September 26, 2020 (in thousands):


	Revenue
Recognition	Three Months Ended
	October 2, 2021		September 26, 2020
Over-Time	$	129,481	$	120,836
Point-in-Time	3,281		2,371
Total	$	132,762	$	123,207

12.Leases

The Company has several commitments under operating and financing leases for warehouses, manufacturing facilities, office buildings, and equipment with initial terms that expire at various dates during the next 1 year to 10 years.

The components of lease cost for the three months ended October 2, 2021 were (in thousands):


Lease cost	Classification	Three Months Ended
Operating lease cost	Cost of sales	$	1,433
Operating lease cost	Selling, general and administrative expenses	$	308

Financing lease cost	Cost of sales	$	434
Financing lease cost	Selling, general and administrative expenses	$	10

Total lease cost		$	2,185

Fixed lease cost		$	1,777
Short-term lease cost		$	408
Total lease cost		$	2,185

Amounts reported in the Consolidated Balance Sheet as of October 2, 2021 were (in thousands, except weighted average lease term and discount rate):


	October 2, 2021
Operating Leases:
Operating lease right of use assets	$	18,994
Operating lease liabilities (1)	$	18,953

Weighted-average remaining lease term (in years)
Operating leases	5.73

Weighted-average discount rate
Operating leases	4.0		%

Financing Leases (2):
Financing lease right of use assets	$	4,948
Financing lease liabilities	$	4,456

Weighted-average remaining lease term (in years)
Financing leases	2.83

Weighted-average discount rate
Financing leases	8.7		%

(1) The current portion of the total operating lease liabilities of $5.2 million is classified under Other Current Liabilities, resulting in $13.7 million classified under Operating Lease Liabilities in the Long-term Liabilities section of the condensed consolidated balance sheet.

(2) The total finance lease right of use assets of $4.9 million is classified under Other Long-term Assets. The current portion of the total finance lease liabilities of $1.9 million is classified under Current portion of debt, net, resulting in $2.6 million classified in Other Long-term Liabilities section of the condensed consolidated balance sheet.

Other information related to leases was as follows (in thousands):


	Three Months Ended
	October 2, 2021
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases	$	1,446
Financing cash flows used in financing leases	$	401

Future lease payments under non-cancellable leases as of October 2, 2021 are as follows (in thousands):


Fiscal Years Ending	Operating Leases		Finance Leases
2022 (1)	$	4,026	$	1,477
2023	4,398		1,969
2024	3,811		1,642
2025	3,462		—
2026	2,667		—
Thereafter	4,521		—
Total undiscounted lease payments	22,885		5,088
Less: present value discount	(3,932)		(632)
Total lease liabilities	$	18,953	$	4,456

(1) Represents estimated lease payments for the remaining nine-month period ending July 2, 2022.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

References in this report to “the Company,” “Key Tronic,” “we,” “our,” or “us” mean Key Tronic Corporation together with its subsidiaries, except where the context otherwise requires.

This Quarterly Report contains forward-looking statements in addition to historical information. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Risks and uncertainties that might cause such differences include, but are not limited to those outlined in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risks and Uncertainties that May Affect Future Results.” Readers are cautioned not to place undue reliance on forward-looking statements, which reflect management’s opinions only as of the date hereof. The Company undertakes no obligation to update forward-looking statements to reflect developments or information obtained after the date hereof and disclaims any obligation to do so. Readers should carefully review the risk factors described in this report and other periodic reports the Company files from time to time with the Securities and Exchange Commission, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

Overview

Key Tronic is a leading contract manufacturer offering value-added design and manufacturing services from its facilities in the United States, Mexico, China and Vietnam. The Company provides its customers full engineering services, materials management, worldwide manufacturing facilities, assembly services, in-house testing, and worldwide distribution. Its customers include some of the world’s leading original equipment manufacturers. Our combined capabilities and vertical integration are proving to be a desirable offering to our expanded customer base.

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, capabilities and logistical advantages to continue to win new business. The following information should be read in conjunction with the consolidated financial statements included herein and with Part II Item 1A, Risk Factors included as part of this filing.

Our mission is to provide our customers with superior manufacturing and engineering services at the lowest total cost for the highest quality products, and create long-term mutually beneficial business relationships by employing our “Trust, Commitment, Results” philosophy.

Executive Summary

For the first quarter of fiscal year 2022, the Company reported total revenue of $132.8 million, up 7.8% from $123.2 million in the same period of fiscal year 2021. While demand has remained strong from both new and existing customers, revenue for the first quarter of fiscal year 2022 continued to be significantly constrained by challenges related to the global materials supply chain, transportation, logistics and the pandemic.

The concentration of our top three customers’ net sales decreased to 33.0 percent of total sales in the first quarter of fiscal year 2022 from 34.7 percent in the same period of the prior fiscal year.

Net sales to our largest customers may vary significantly from quarter to quarter depending on the size and timing of customer program commencement, forecasts, delays, and design modifications. We remain dependent on continued net sales to our significant customers and most contracts with customers are not firm long-term purchase commitments. We seek to maintain flexibility in production capacity by employing skilled temporary and short-term labor and by utilizing short-term leases on equipment and manufacturing facilities. In addition, our capacity and core competencies for printed circuit board assemblies, precision molding, sheet metal fabrication, tool making, assembly, and engineering can be applied to a wide variety of products.

Gross profit as a percent of net sales was 7.6 percent for the first quarter of fiscal year 2022 as compared to 8.1 percent for the same quarter of the prior fiscal year. The global supply chain, transportation and logistics issues and the pandemic continued to disrupt production during the quarter. Intermittent parts supply required both factory downtime and overtime expenses, which had an adverse impact on the Company’s margins.

Operating income as a percentage of net sales was 1.6 percent for the first quarter of fiscal year 2022 compared to 2.3 percent of operating income as a percentage of net sales for the first quarter of fiscal year 2021. The decrease in operating income as a percentage of net sales was primarily driven by the decrease in gross profit as discussed above.

Net income for the first quarter of fiscal year 2022 was $0.8 million or $0.07 per diluted share, as compared to net income of $1.7 million or $0.16 per diluted share for the first quarter of fiscal year 2021. Net income for the first quarter of fiscal 2022 was also impacted by legal and other professional service expenses related to the subject of the previously disclosed internal investigation and related matters of approximately $0.4 million during the quarter.

During the first quarter of fiscal 2022, we won new programs involving industrial testing equipment, medical diagnostic products, and pharmaceutical water treatment.

Moving into the second quarter of fiscal 2022, component shortages, logistic delays and the COVID-19 crisis continue to present multiple business challenges, but we continue to see the favorable trend of contract manufacturing returning to North America. With our recent investments in new capacity in both North America and Vietnam, the Company is well-prepared for long term growth when supply chains improve.

To protect the health of its employees, the Company has implemented the recommendations of WHO and the CDC including wearing of face masks and shields, workstation arrangements to provide social distancing, temperature monitoring, enhanced worksite disinfection, spacing in cafeterias and break areas, contact management and other precautions. The Company is also in compliance with government regulations related to COVID-19.

From time to time, we have experienced shortages in electronic components. These shortages can result from strong demand for those components or from problems experienced by suppliers, such as shortages of raw materials. We have also experienced, and expect to continue to experience, such shortages due to the effects of the COVID-19 pandemic. These unanticipated component shortages have resulted and could continue to result in curtailed production or delays in production, which may prevent us from making scheduled shipments to customers. Our inability to make scheduled shipments could cause us to experience a reduction in sales, increase in inventory levels and costs, and could adversely affect our operating results. We are carefully monitoring potential supply chain disruptions due to ongoing tightness in the overall component environment and are working to mitigate supply chain constraint risks.

We maintain a strong balance sheet with a current ratio of 2.3 and a debt to equity ratio of 0.9 as of October 2, 2021. Total cash used in operating activities as defined on our cash flow statement was $14.6 million for the three months ended October 2, 2021. We maintain sufficient liquidity for our expected future operations and had $101.3 million in borrowings on our revolving credit facility of which $12.0 million remained available at October 2, 2021.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. These estimates and assumptions are based on historical results as well as future expectations. Actual results could vary from our estimates and assumptions.

The accounting policies and estimates listed below are those that we believe are the most critical to our consolidated financial condition and results of operations. They are also the accounting policies that typically require our most difficult, subjective and complex judgments and estimates, often for matters that are inherently uncertain.

•Revenue Recognition

•Inactive, Obsolete, and Surplus Inventory Reserve

•Allowance for Doubtful Accounts

•Accrued Warranty

•Income Taxes

•Share-Based Compensation

•Impairment of Long-Lived Assets

•Derivatives and Hedging Activity

•Long-Term Incentive Compensation Accrual

Please refer to the discussion of critical accounting policies in our most recent Annual Report on Form 10-K for the fiscal year ended July 3, 2021, for further details.

RESULTS OF OPERATIONS

Comparison of the Three Months Ended October 2, 2021 with the Three Months Ended September 26, 2020

The financial information and discussion below should be read in conjunction with the Consolidated Financial Statements and Notes.

The following table sets forth certain information regarding the components of our condensed consolidated statements of income for the three months ended October 2, 2021 as compared to the three months ended September 26, 2020. It is provided to assist in assessing differences in our overall performance (in thousands):


	Three Months Ended
	October 2, 2021		% of net sales		September 26, 2020		% of net sales		$ change		% point change
Net sales	$	132,762	100.0	%	$	123,207	100.0	%	$	9,555	—	%
Cost of sales	122,624		92.4	%	113,192		91.9	%	9,432		0.5	%
Gross profit	10,138		7.6	%	10,015		8.1	%	123		(0.5)	%
Research, development and engineering	2,449		1.8	%	2,245		1.8	%	204		—	%
Selling, general and administrative	5,595		4.2	%	4,974		4.0	%	621		0.2	%
Total operating expenses	8,044		6.0	%	7,219		5.8	%	825		0.2	%
Operating income	2,094		1.6	%	2,796		2.3	%	(702)		(0.7)	%
Interest expense, net	992		0.7	%	681		0.6	%	311		0.1	%
Income before income taxes	1,102		0.8	%	2,115		1.7	%	(1,013)		(0.9)	%
Income tax provision	287		0.2	%	396		0.3	%	(109)		(0.1)	%
Net income	$	815	0.6	%	$	1,719	1.4	%	$	(904)	(0.8)	%

Net Sales

Net sales of $132.8 million for the first quarter of fiscal year 2022 increased by 7.8 percent as compared to net sales of $123.2 million for the first quarter of fiscal year 2021.

The $9.6 million increase in net sales from the prior year period was driven by an increase in new program wins and demand for current programs. However, partially offsetting the increase in revenue during the first quarter of fiscal year 2022, the Company’s revenue was constrained by tightening worldwide supply chain and transportation and logistics issues which delayed the arrival of key components, causing factory downtime.

Gross Profit

Gross profit as a percentage of net sales for the three months ended October 2, 2021 was 7.6 percent compared to 8.1 percent for the three months ended September 26, 2020. This 0.5 percentage point decrease was primarily a result of supply chain constraints and continued but lessening expenses related to COVID-19.

The level of gross margin is impacted by facility utilization, product mix, timing, severity and steepness of new program ramps, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter.

Included in gross profit are charges related to reductions in the carrying value of our inventory due to obsolescence. We recorded a provision of approximately $138,000 and $178,000 for obsolete inventory during the three months ended October 2, 2021 and September 26, 2020, respectively. We adjust the carrying value for estimated obsolescence as necessary in an amount equal to the difference between the cost of inventory and its net realizable value based on assumptions as to future demand and market conditions. The provisions are established for inventory that we have determined customers are not contractually responsible for and for inventory that we believe customers will be unable to purchase.

Operating Expenses

Total research, development, and engineering (RD&E) expenses were $2.4 million during the three months ended October 2, 2021 and $2.2 million during the three months ended September 26, 2020, respectively. The increase in RD&E expenses relate to an increase in engineering payroll expenses. Total RD&E expenses as a percent of net sales were 1.8 percent during the three months ended October 2, 2021 and the three months ended September 26, 2020.

Total selling, general and administrative (SG&A) expenses were $5.6 million during the three months ended October 2, 2021 compared to $5.0 million for the three months ended September 26, 2020. The increase in SG&A expenses relate to an increase in legal expenses related to the subject of the previously disclosed internal investigation and related matters. Total SG&A expenses as a percentage of net sales were 4.2 percent for the three months ended October 2, 2021 and 4.0 percent for the three months ended September 26, 2020.

Interest

Interest expense was $1.0 million during the three months ended October 2, 2021 and $0.7 million during the three months ended September 26, 2020. The increase in interest expense is primarily related to an increase in the average balance outstanding on our line of credit and increased interest rates.

Income Taxes

The effective tax rate for the three months ended October 2, 2021 was 26.0 percent compared to 18.7 percent for the three months ended September 26, 2020. The increase was primarily due to the non-cash tax expense impact of expired stock appreciation rights in the first quarter of fiscal year 2022. For further information on taxes see Note 6 of the “Notes to Consolidated Financial Statements.”

Our judgments regarding deferred tax assets and liabilities may change due to changes in market conditions, changes in estimates, changes in tax laws or other factors. If assumptions and estimates change in the future the deferred tax assets and liability will be adjusted accordingly and any increase or decrease will result in an additional deferred income tax expense or benefit in subsequent periods.

BACKLOG

On October 2, 2021, we had an order backlog of approximately $320.9 million. This compares with a backlog of approximately $201.9 million on September 26, 2020. The increase in order backlog was related to the Company’s increases in demand from programs for home-consumer products, healthcare and home exercise equipment and increasing supply chain issues that have delayed production. Order backlog consists of purchase orders received for products expected to be shipped within the next 12 months, although shipment dates are subject to change due to design modifications or changes in other customer requirements. Order backlog should not be considered an accurate measure of future net sales.

CAPITAL RESOURCES AND LIQUIDITY

Operating Cash Flow

Net cash used in operating activities for the three months ended October 2, 2021 was $14.6 million, compared to $9.4 million during the same period of the prior fiscal year.

The $14.6 million of net cash used in operating activities for the three months ended October 2, 2021 is primarily related to $0.8 million in net income for the period adjusted for $1.3 million of depreciation and amortization, a $16.2 million increase in accounts receivable, a $7.0 million increase in other assets, a $5.9 million increase in inventory, a $3.0 million decrease in accrued compensation and vacation partially offset by a $18.8 million increase in accounts payable and a $1.1 million decrease in contract assets.

The $9.4 million of net cash used in operating activities for the three months ended September 26, 2020 is primarily related to $1.7 million in net income for the period adjusted for $1.8 million of depreciation and amortization, a $5.4 million increase in accounts receivable, a $4.9 million increase in inventory, a $2.8 million decrease in accrued compensation and vacation, a $1.1 million decrease in accounts payable, and $0.7 million increase in contract assets. The $5.4 million increase in accounts receivable is a direct result of the Company not factoring receivables during the first quarter fiscal year 2021.

Accounts receivable fluctuates based on the timing of shipments, terms offered and collections that occurred during the quarter. While overall net sales are not typically seasonal in nature, we ship the majority of our product during the latter half of the quarter. We purchase inventory based on customer forecasts and orders, and when those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable fluctuates with changes in inventory levels, volume of inventory purchases, negotiated supplier terms and taking advantage of early pay discounts.

Investing Cash Flow

Cash provided by investing activities was $1.8 million during the three months ended October 2, 2021 as compared to cash used in investing activities of $3.2 million during the three months ended September 26, 2020. Our primary investing activity during the three months ended October 2, 2021 and September 26, 2020, was purchasing equipment to support increased production levels for new programs.

Leases are often utilized when potential technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds as well as our revolving line of credit facility and equipment term loan.

Financing Cash Flow

Cash provided by financing activities was $14.5 million during the three months ended October 2, 2021 as compared to $13.5 million in the same period of the previous fiscal year. Our primary financing activities during the three months ended October 2, 2021 and three months ended September 26, 2020, were borrowings and repayments under our revolving line of credit facility and term loans.

As of October 2, 2021, approximately $12.0 million was available under the asset-based revolving credit facility.

Our cash requirements are affected by the level of current operations and new programs. We believe that projected cash from operations, funds available under the revolving credit facility and leasing capabilities will be sufficient to meet our working and fixed capital requirements for the foreseeable future. The Company further notes projected cash from operations from increased demand from certain customers will be partially offset by an anticipated slowdown in collections from other customers and increasing inventory levels in efforts to mitigate supply chain constraint risks. As of October 2, 2021, we had approximately $1.5 million of cash held by foreign subsidiaries. If cash is to be repatriated in the future from these foreign subsidiaries, the Company would be subject to certain withholding taxes in the foreign jurisdictions. The total amount of tax payments required for the amount of foreign subsidiary cash on hand as of October 2, 2021 would approximate $16,000. We have accrued withholding taxes for expected future repatriation of foreign earnings as discussed in Note 6 of the “Notes to Consolidated Financial Statements.”

OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS

We have included a summary of our Contractual Obligations in our annual report on Form 10-K for the fiscal year ended July 3, 2021. There have been no material changes in contractual obligations outside the ordinary course of business since July 3, 2021.

RISKS AND UNCERTAINTIES THAT MAY 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 other similar expressions are intended to identify forward-looking statements.

RISKS RELATED TO OUR BUSINESS AND STRATEGY

Our operations may be subject to certain risks.

We manufacture product in facilities located in Mexico, China, Vietnam and the United States. These operations may be subject to a number of risks, including:

•difficulties in staffing, turnover and managing onshore and offshore operations;

•political and economic instability (including acts of terrorism, pandemics, civil unrest, forms of violence and outbreaks of war), which could impact our ability to ship, manufacture, 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; subject to trade wars and tariffs;

•our locations may be impacted by hurricanes, tornadoes, earthquakes, water shortages, tsunamis, floods, typhoons, fires, extreme weather conditions and other natural or man-made disasters; and

•our locations may also be impacted by future temporary closures and labor constraints as a result of COVID-19.

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 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.

We may experience fluctuations in quarterly results of operations.

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

SEC Form 10-Q filed by Key Tronic Corporation