KEY TRONIC CORPORATION FORWARD-LOOKING STATEMENTS References in this report to "the Company," "Key Tronic ," "we," "our," or "us" meanKey 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 theSecurities 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 inthe United States ,Mexico ,China andVietnam . 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. 18 -------------------------------------------------------------------------------- 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 toNorth America . With our recent investments in new capacity in bothNorth America andVietnam , 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 ofOctober 2, 2021 . Total cash used in operating activities as defined on our cash flow statement was$14.6 million for the three months endedOctober 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 atOctober 2, 2021 . 19 -------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES AND ESTIMATES Preparation of our consolidated financial statements in conformity with accounting principles generally accepted inthe 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 endedJuly 3, 2021 , for further details. 20
-------------------------------------------------------------------------------- RESULTS OF OPERATIONS Comparison of the Three Months EndedOctober 2, 2021 with the Three Months EndedSeptember 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 endedOctober 2, 2021 as compared to the three months endedSeptember 26, 2020 . It is provided to assist in assessing differences in our overall performance (in thousands): Three Months Ended October 2, % of September 26, % of % point 2021 net sales 2020 net sales $ change 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 endedOctober 2, 2021 was 7.6 percent compared to 8.1 percent for the three months endedSeptember 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 endedOctober 2, 2021 andSeptember 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. 21 -------------------------------------------------------------------------------- Operating Expenses Total research, development, and engineering (RD&E) expenses were$2.4 million during the three months endedOctober 2, 2021 and$2.2 million during the three months endedSeptember 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 endedOctober 2, 2021 and the three months endedSeptember 26, 2020 . Total selling, general and administrative (SG&A) expenses were$5.6 million during the three months endedOctober 2, 2021 compared to$5.0 million for the three months endedSeptember 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 endedOctober 2, 2021 and 4.0 percent for the three months endedSeptember 26, 2020 . Interest Interest expense was$1.0 million during the three months endedOctober 2, 2021 and$0.7 million during the three months endedSeptember 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 endedOctober 2, 2021 was 26.0 percent compared to 18.7 percent for the three months endedSeptember 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 OnOctober 2, 2021 , we had an order backlog of approximately$320.9 million . This compares with a backlog of approximately$201.9 million onSeptember 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 endedOctober 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 endedOctober 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 endedSeptember 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. 22 -------------------------------------------------------------------------------- Investing Cash Flow Cash provided by investing activities was$1.8 million during the three months endedOctober 2, 2021 as compared to cash used in investing activities of$3.2 million during the three months endedSeptember 26, 2020 . Our primary investing activity during the three months endedOctober 2, 2021 andSeptember 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 endedOctober 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 endedOctober 2, 2021 and three months endedSeptember 26, 2020 , were borrowings and repayments under our revolving line of credit facility and term loans. As ofOctober 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 ofOctober 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 ofOctober 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 endedJuly 3, 2021 . There have been no material changes in contractual obligations outside the ordinary course of business sinceJuly 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 inMexico ,China ,Vietnam andthe 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. 23 -------------------------------------------------------------------------------- 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 theU.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 inthe 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 theU.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 in certain industries could affect future quarterly results. Additionally, our customers could be adversely impacted by illiquidity in 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. Conversely, our customers may abruptly lower or cancel production which may lead to a sudden, unexpected increase in inventory or accounts receivable for which we may not be reimbursed even when under contract with customers. 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 a 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, stock-based compensation, the valuation allowance on deferred tax assets, impairment of long-lived assets, long-term incentive compensation accrual, the provision for warranty costs, and the impact of hedging activities. Due to the COVID-19 pandemic, we have seen extreme shifts in demand from our customer base. The possibility of future temporary closures and labor constraints, as well as the inability to predict customer demand, costs, and future supply chain disruptions during the rapidly changing COVID-19 environment can materially impact operating results. We are exposed to general economic conditions, which could have a material adverse impact on our business, operating results and financial condition. Adverse economic conditions and uncertainty in the global economy such as unstable global financial and credit markets, inflation, and recession can negatively impact our business. Unfavorable economic conditions could affect the demand for our customers' products by triggering a reduction in orders as well as a decline in 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 effect on our financial results. Adverse macroeconomic conditions as a result of COVID-19 have and may continue to affect our business. The conditions affect the Company's ability to predict and plan for future supply chain disruptions, fluctuations in customer demand and costs, and the ability to operate as there is uncertainty over future temporary closures. The majority of our sales come from a small number of customers and a decline in sales to any of these customers could adversely affect our business. At present, our customer base is concentrated and could become more or less concentrated. 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, typically 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. The contraction in demand from certain industries could impact our customer orders and have a negative impact on our operations over the foreseeable future. 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. 24 -------------------------------------------------------------------------------- We depend on a limited number of suppliers for certain components that are critical to our manufacturing processes. A shortage of these components or an increase in their price could interrupt our operations and result in a significant change in our results of operations. We are dependent on many suppliers, including sole source suppliers, to provide key components and raw materials used in manufacturing customers' products. We have seen supply shortages in certain electronic components. In addition, our suppliers' facilities may also experience earthquakes, tsunamis and other natural disasters which may cause a shortage of components. This can result in longer lead times and the inability to meet our customers request for flexible production and extended shipment dates. If demand for components outpaces supply, capacity delays could affect future operations. Delays in deliveries from suppliers or the inability to obtain sufficient quantities of components and raw materials have and may continue to cause delays or reductions in shipment of products to our customers which could adversely affect our operating results and damage customer relationships. Key Tronic continues to work closely with its employees and key suppliers to ascertain delays attributable to the COVID-19 pandemic. Delays in production and extended transit times of critical parts have and may continue to cause a shortage of components. We operate in a highly competitive industry; if we are not able to compete effectively in the contract manufacturing industry, our business could be adversely affected. 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 and processes 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. Fluctuations in foreign currency exchange rates could increase our operating costs. We have manufacturing operations located inMexico andChina . A significant portion of our operations are denominated in the Mexican peso and the Chinese currency, the renminbi ("RMB"). Currency exchange rates fluctuate daily as a result of a number of factors, including changes in a country's political and economic policies. Volatility in the currencies of our entities andthe United States dollar could seriously harm our business, operating results and financial condition. The primary impact of currency exchange fluctuations is on the cash, receivables, payables and expenses of our operating entities. As part of our hedging strategy, we currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. We currently do not hedge expenses denominated in RMB. Unexpected losses could occur from increases in the value of these currencies relative tothe United States dollar. As a result of COVID-19, significant currency exchange fluctuations can occur causing unexpected losses. Future temporary closures of production facilities inMexico could also cause significant changes in our ability to qualify for hedge accounting treatment of our forward contracts to hedge foreign currency fluctuations. However, given the unprecedented nature of the pandemic the FASB staff believes that an entity may apply the exception in paragraph 815-30-40-4 for rare cases caused by extenuating circumstances that are related to the nature of the forecasted transaction and are outside the control or influence of an entity to delays in the timing of the forecasted transactions if those delays are related to the effects of the COVID-19 pandemic and are considered probable to still occur. In addition, the FASB staff believes that it would be acceptable for an entity to determine that missed forecasts related to the effects of the COVID-19 pandemic need not be considered when determining whether it has exhibited a pattern of missing forecasts that would call into question its ability to accurately predict forecasted transactions and the propriety of using cash flow hedge accounting in the future for similar transactions. Our success will continue to depend to a significant extent on our 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 production employees. There can be no assurance that we will be successful in attracting and retaining such personnel, particularly in our manufacturing locales that may be experiencing high demand for similar key personnel. The loss of key employees could have a material adverse effect on our business, operating results and financial condition. 25 -------------------------------------------------------------------------------- Start-up costs and inefficiencies related to new or transferred programs can adversely affect our operating results and such costs may not be recoverable if such new programs or transferred programs are canceled or don't meet expected sales volumes. Start-up costs, the management of labor and equipment resources in connection with the establishment of new programs and new customer relationships, and the need to obtain required resources in advance can adversely affect our gross margins and operating results. These factors are particularly evident in the ramping stages of new programs. These factors also affect our ability to efficiently use labor and equipment. We are currently managing a number of new programs. Consequently, our exposure to these factors has increased. In addition, if any of these new programs or new customer relationships were terminated, our operating results could be harmed, particularly in the short term. We may not be able to recoup these start-up costs or replace anticipated new program revenues. Customers may change production timing and demand schedules which makes it difficult for us to schedule production and capital expenditures and to maximize the efficiency of our manufacturing capacity. Changes in demand for customer products reduce our ability to accurately estimate the future requirements of our customers. This makes it difficult to schedule production and maximize utilization of our manufacturing capacity. We must determine the levels of business that we will seek and accept from customers, set production schedules, commit to procuring inventory, and allocate personnel and resources, based on our estimates of our customers' requirements. Customers can require sudden increases and decreases in production which can put added stress on resources and reduce margins. Sudden decreases in production can lead to excess inventory on hand which may or may not be reimbursed by our customers even when under contract. Continued growth could further lead to capacity constraints. We may need to transfer production to other facilities, acquire new facilities, or outsource production which could negatively impact gross margin. The Company has been able to manage the arrival of components in an effort to control inventory levels of customers that have seen sharp decreases in demand, as a result of COVID-19. Compliance or the failure to comply with current and future environmental and health laws or regulations could cause us significant expense. 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. In addition, increasing governmental focus on climate change may result in new environmental regulations that may negatively affect us, our vendors or our customers. As a result, we may incur additional costs or obligations in complying with any new environmental and reporting requirements, as well as increased indirect costs resulting from our vendors or customers that get passed on to us. 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. If our manufacturing processes and services do not comply with applicable statutory and regulatory requirements, or if we manufacture products containing design or manufacturing defects, demand for our services may decline and we may be subject to liability claims. We manufacture and design products to our customers' specifications, and, in some cases, our manufacturing processes and facilities may need to comply with applicable statutory and regulatory requirements. For example, medical devices that we manufacture or design, as well as the facilities and manufacturing processes that we use to produce them, are regulated by theFood and Drug Administration and non-U.S. counterparts of this agency. In addition, our customers' products and the manufacturing processes that we use to produce them often are highly complex. As a result, products that we manufacture may at times contain manufacturing or design defects, and our manufacturing processes may be subject to errors or not be in compliance with applicable statutory and regulatory requirements. Defects in the products we manufacture or design, whether caused by a design, manufacturing or component failure or error, or deficiencies in our manufacturing processes, may result in delayed shipments to customers or reduced or canceled customer orders. If these defects or deficiencies are significant, our business reputation may also be damaged. The failure of the products that we manufacture or our manufacturing processes and facilities to comply with applicable statutory and regulatory requirements may subject us to legal fines or penalties and, in some cases, require us to shut down or incur considerable expense to correct a manufacturing process or facility. Our customers are required to indemnify us against liability associated with designing products to meet their specifications. However, if our customers are responsible for the defects, they may not, or may not have resources to, assume responsibility for any costs or liabilities arising from these defects, which could expose us to additional liability claims. 26 -------------------------------------------------------------------------------- If we do not manage our growth effectively, our profitability could decline. Our business is experiencing growth which can place considerable additional demands upon our management team and our operational, financial and management information systems. Our ability to manage growth effectively requires us to continue to implement and improve these systems; avoid cost overruns; maintain customer, supplier and other favorable business relationships during possible transition periods; continue to develop the management skills of our managers and supervisors; and continue to train, motivate and manage our employees. Our failure to effectively manage growth could have a material adverse effect on our results of operations. Energy price increases may negatively impact our results of operations. Certain components that we use in our manufacturing process are petroleum-based. In addition, we, along with our suppliers and customers, rely on various energy sources in our transportation activities. While significant uncertainty currently exists about the future levels of energy prices, a significant increase is possible. Increased energy prices could cause an increase to our raw material costs and transportation costs. In addition, increased transportation costs related to certain suppliers and customers could be passed along to us. We may not be able to increase our product prices enough to offset these increased costs. In addition, any increase in our product prices may reduce our future customer orders and profitability. TECHNOLOGY RISKS Our operations are subject to cyberattacks that could have a material adverse effect on our business. We are increasingly dependent on digital technologies and services to conduct our operations. We use these technologies for internal purposes, including data storage, processing and transmissions, as well as in our interactions with vendors and customers. Digital technologies and services are subject to the risk of cybersecurity incidents and some incidents can remain undetected for a period of time. We routinely monitor our systems for cyber threats and have processes in place to detect and remediate vulnerabilities. Nevertheless, we have experienced attempted security breaches, such as phishing emails and other targeted attacks. We expect that our operations will continue to be subject to cyber threats, and any future cybersecurity incident could significantly disrupt our operations. Cybersecurity incidents could also result in the misappropriation of proprietary or confidential information of the Company or that of its customers, employees, vendors or customers. We expect to incur costs in the future to mitigate against cybersecurity incidents as threats are expected to continue to become more persistent and sophisticated. If our systems for protecting against cybersecurity incidents prove not to be sufficient, we could be adversely affected by, among other things, loss of or damage to intellectual property, proprietary or confidential information, or employee, vendor or customer data; interruption of our business operations; and increased costs to prevent, respond to or mitigate cybersecurity incidents. These risks could harm our reputation and our relationships with employees, vendors and customers and may result in claims or enforcement actions and investigations against us. Disruptions to our information systems, including losses of data or outages, could adversely affect our operations. We rely on information technology networks and systems to process, transmit and store electronic information. In particular, we depend on our information technology infrastructure for a variety of functions, including worldwide financial reporting, inventory management, procurement, invoicing and email communications. Any of these systems may be susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and similar events. If we or our vendors are unable to prevent such outages, our operations could be disrupted. If we are unable to maintain our technological and manufacturing process expertise, our business could be adversely affected. The markets for our customers' products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and 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. 27 -------------------------------------------------------------------------------- RISKS RELATED TO CAPITAL AND FINANCING 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. Our ability to secure and maintain sufficient credit arrangements is key to our continued operations. There is no assurance that we will be able to retain or renew our credit agreements in the future. In the event the business grows rapidly or there is uncertainty in the macroeconomic climate, additional financing resources could be necessary in the current or future fiscal years. There is no assurance that we will be able to obtain equity or debt financing at acceptable terms, or at all in the future. In addition, we have restrictive covenants with our financial institution which could impact how we manage our business. If we cannot meet our financial covenants, our borrowings could become immediately payable which could have a material adverse impact on our financial statements. For a summary of our banking arrangements, see Note 4 Long-Term Debt of the "Notes to Consolidated Financial Statements." An adverse change in the interest rates for our borrowings could adversely affect our financial condition. We are exposed to interest rate risk under our revolving line of credit and term loan. We currently hedge a portion of our term loan with an interest rate swap. We have not historically hedged the interest rate on our credit facility; therefore, unless we do so, significant changes in interest rates could adversely affect our results of operations. Refer to the discussion in note 4, "Long-Term Debt" to the consolidated financial statements for further details of our debt obligations. In addition, theU.K.'s Financial Conduct Authority , which regulates LIBOR, announced that it intends to phase out LIBOR by the end of 2021, though theICE Benchmark Administration , the administrator of LIBOR, announced that it would consider ceasing the publication of the one-week and two-monthU.S. dollar LIBOR settings at the end of 2021 and phase out the remainingU.S. dollar LIBOR settings byJune 30, 2023 . The transition from LIBOR to a new replacement benchmark is uncertain at this time and the consequences of such developments cannot be entirely predicted but could result in an increase in the cost of our borrowings, which could adversely affect our financial condition. Our stock price is volatile. Our stock price has and may continue to 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 our stock's thinly traded nature, variations in quarterly operating results, changes in earnings estimates, or the Audit Committee's internal investigation, or to factors relating to the contract manufacturing 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. In addition, holders of our common stock will suffer immediate dilution to the extent outstanding equity awards are exercised to purchase common stock. RISKS RELATED TO OUR CONTROLS AND PROCEDURES AND THE INTERNAL INVESTIGATION We identified a material weakness in our internal control over financial reporting and concluded that our disclosure controls and procedures were not effective as ofDecember 26, 2020 andApril 3, 2021 . If we fail to properly remediate any future deficiencies or material weaknesses or to maintain proper and effective internal controls, our business and financial condition could be materially adversely impacted. As described in Item 4, "Controls and Procedures," of this Quarterly Report on Form 10-Q, we concluded that our disclosure controls and procedures were not effective as ofDecember 26, 2020 andApril 3, 2021 , due to the existence of a material weakness in our internal control over financial reporting. While we have undertaken remediation efforts to address the identified deficiencies and have concluded that the material weakness was remediated as ofJuly 3, 2021 , we cannot provide assurance that we will be able to conclude that our controls will be effective in the future. We also cannot assure you that additional significant deficiencies or material weaknesses in our internal control over financial reporting will not arise or be identified in the future. We intend to continue our control remediation activities. In doing so, we will continue to incur expenses and expend management time on compliance-related issues. 28 -------------------------------------------------------------------------------- If additional deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results. Moreover, because of the inherent limitations of any control system, material misstatements due to error or fraud may not be prevented or detected on a timely basis, or at all. If we are unable to provide reliable and timely financial reports in the future, our business and reputation may be further harmed. Restated financial statements and failures in internal controls may also cause us to fail to meet additional reporting obligations, negatively affect investor confidence in our management and the accuracy of our financial statements and disclosures, or result in adverse publicity and concerns from investors, any of which could have a negative effect on the price of our common stock, subject us to regulatory investigations and penalties or stockholder litigation, and materially adversely impact our business, financial condition, results of operations and cash flows. Matters relating to or arising from the subject of the Audit Committee's internal investigation, including expenses and diversion of personnel and resources, regulatory investigations, and proceedings and litigation matters, could have an adverse effect on our business, results of operations and financial condition. We have incurred, and may continue to incur, significant expenses related to legal, accounting and other professional services in connection with matters relating to or arising from the subject of the Audit Committee's internal investigation. As described in Item 4, "Controls and Procedures," of this Quarterly Report on Form 10-Q, we have taken and continue to take a number of steps in order to remediate identified deficiencies in our internal control over financial reporting and attempt to reduce the risk of future recurrence. The validation of the efficacy of these remedial steps will result in us incurring additional near term expenses, and to the extent these steps are not successful, we may incur significant additional time and expense. In addition, we are cooperating with theSecurities and Exchange Commission (the "SEC") regarding matters related to the internal investigation. The completion of the internal investigation will not automatically resolve theSEC's inquiries. If theSEC or any other regulator were to commence legal action against us, we could be required to pay significant penalties and become subject to injunctions, cease and desist orders or other remedies. We can provide no assurances as to the outcome of any governmental inquiry or investigation. Further, we, our officers and members of our board of directors could be named as defendants in lawsuits asserting claims arising out of the subject matter of the Audit Committee's internal investigation. As a result of any legal proceedings and any related indemnification requirements to our officers and directors, we could be required to pay monetary damages that may be in excess of our insurance coverage or may have additional penalties or other remedies imposed against us or our officers and directors. All of these expenses, the delay in timely filing our periodic reports and the diversion of the attention of management and other personnel that has occurred and is expected to continue, could adversely affect our business, financial condition, results of operations and cash flows. Due to inherent limitations, there can be no assurance that our system of disclosure and internal controls and procedures will be successful in preventing all errors, theft and fraud, or in informing management of all material information in a timely manner. Management does not expect that our disclosure controls and procedures and internal controls over financial reporting 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. LEGAL AND ACCOUNTING RISKS We are involved in various legal proceedings. In the past, we have been notified of claims relating to various matters including contractual matters, intellectual property rights or other issues arising in the ordinary course of business. In the event of such a claim, we may be required to spend a significant amount of money to defend or otherwise address the claim. Any litigation or dispute resolution, even where a claim is without merit, could result in substantial costs and diversion of resources. Accordingly, the resolution or adjudication of such disputes, even those encountered in the ordinary course of business, could have a material effect on our business, consolidated financial conditions and results of operations. 29 -------------------------------------------------------------------------------- Changes in securities laws and regulations will increase our costs and risk of noncompliance. We are subject to additional requirements contained in the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) and more recently theDodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The Sarbanes-Oxley and Dodd-Frank Acts required or will require changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of the Sarbanes-Oxley and Dodd-Frank Acts, theSEC and NASDAQ promulgated new rules and additional rulemaking is expected in the future. Compliance with these new rules and future rules has increased and may increase further our legal, financial and accounting costs as well as a potential risk of noncompliance. Absent significant changes in related rules, which we cannot assure, we anticipate some level of increased costs related to these new regulations to continue indefinitely. We also expect these developments to make it more difficult and more expensive to obtain director and officer liability insurance, and we may be forced to accept reduced coverage or incur substantially higher costs to obtain coverage. Likewise, these developments may make it more difficult for us to attract and retain qualified members of our Board of Directors or qualified management personnel. Further, the costs associated with the compliance with and implementation of procedures under these and future laws and related rules could have a material impact on our results of operations. In addition, the costs associated with noncompliance with additional securities laws and regulations could also impact our business. Changes in financial accounting standards may affect our reported financial condition or results of operations as well increase costs related to implementation of new standards and modifications to internal controls. Our consolidated financial statements are prepared in conformity with accounting standards generally accepted inthe United States , orU.S. GAAP. These principles are subject to amendments made primarily by theFinancial Accounting Standards Board (FASB) and theSecurities and Exchange Commission (SEC). A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions which are completed before a change is announced. Changes to accounting rules or challenges to our interpretation or application of the rules by regulators may have a material adverse effect on our reported financial results or on the way we conduct business. GENERAL RISKS Our levels of insurance coverage may not be sufficient for potential damages, claims or losses. We have various forms of business and liability insurance which we believe are appropriate based on the needs of companies in our industry. As a result, not all of our potential business risks or potential losses would be covered by our insurance policies. If we sustain a significant claim or loss which is not covered by insurance, our net income could be negatively impacted. We may encounter complications with acquisitions, which could potentially harm our business. Any current or future acquisitions may require additional equity financing, which could be dilutive to our existing shareholders, or additional debt financing, which could potentially affect our credit ratings. Any downgrades in our credit ratings associated with an acquisition could adversely affect our ability to borrow by resulting in more restrictive borrowing terms. To integrate acquired businesses, we must implement our management information systems, operating systems and internal controls, and assimilate and manage the personnel of the acquired operations. The integration of acquired businesses may be further complicated by difficulties managing operations in geographically dispersed locations. The integration of acquired businesses may not be successful and could result in disruption by diverting management's attention from the core business. In addition, the integration of acquired businesses may require that we incur significant restructuring charges or other increases in our expenses and working capital requirements, which reduce our return on invested capital. Acquisitions may involve numerous other risks and challenges including but not limited to: potential loss of key employees and customers of the acquired companies; the potential for deficiencies in internal controls at acquired companies; lack of experience operating in the geographic market or industry sector of the acquired business; constraints on available liquidity, and exposure to unanticipated liabilities of acquired companies. These and other factors could harm our ability to achieve anticipated levels of profitability at acquired operations or realize other anticipated benefits of an acquisition, and could adversely affect our consolidated business and operating results. 30
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