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CTS Corporation (NYSE:CTS)

Q3 2008 Earnings Call

October 29, 2008 11:00 am ET

Executives

Vinod M. Khilnani – President and Chief Financial Officer

Donna L. Belusar – Senior Vice President and Chief Financial Officer

Mitchell J. Walorski – Director of Investor Relations

Analysts

John Franzreb – Sidoti & Company

Kevin Kessel – J.P. Morgan

[Handy Sasanto] – Gabelli & Company

Greg Weaver – Invicta Capital

Brett Evans - Hartland

Operator

Welcome to the CTS third quarter 2008 earnings call. (Operator Instructions). With that being said, I will turn the conference now to the Director of Investor Relations, Mr. Mitch Walorski.

Mitchell J. Walorski

I am Mitch Walorski, Director of Investor Relations, and I will host the CTS Corporation third quarter 2008 earnings conference call. Thank you for joining us today. Participating from the company today are Vinod Khilnani, President and CEO, and Donna Belusar, Senior Vice President and Chief Financial Officer. Before beginning the business discussion, I would like to remind our listeners that the conference call contains forward-looking statements.

These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. Additional information regarding these risks and uncertainties was set forth in last evening’s press release and more information can be found in the company's SEC filings.

To the extent that today’s discussion refers to any non-GAAP measures relative to Regulation G, the required explanations and reconciliation are available on our website in the investor relation section. I will now turn the discussion over to our CEO, Vinod Khilnani.

Vinod M. Khilnani

Last evening we released our third quarter financial results for 2008. I am pleased to report that despite an extremely challenging economic environment, our earnings per share met consensus estimates and our internal forecast. Our increasingly diversified business models help soften sharp declines in automotive sales worldwide, plant closings by our customers, program push outs affecting our electronic components and EMS business.

Sales had earned $70 million were down 2.7% from the third quarter of 2007 primarily due to reduced EMS segment sales to Hewlett Packard of the end-of-life program, which we have discussed many times in the past. EMS sales excluding Hewlett Packard were actually up 6.6% and component intensive segment sales was up 5.4% year-over-year. GAAP earnings per share were $0.21, excluding the tax credit and a proactive restructuring initiative, which Donna will discuss in greater detail. Adjusted earnings per shares of $0.16 matched consensus estimate for the quarter.

Please note that our last earning’s conference call, we had indicated that second quarter diluted earnings per share had benefited by $0.02 from sales and production pull up from the third quarter into the second quarter this year. On a segment basis components and sensor sales were $72.5 million, up 5.4% from the third quarter of last year. Within this segment since sales of automotive sensor and actuator products went up 5.4% despite a very tough automotive environment deflected by steep year-over-year declines in the light vehicle sales in North America and Western Europe, up 18% and 10% respectively.

Plans for closing and extended summer plant shutdown by many automotive customers made it a tough quarter. Our automotive sensor and actuator product sales in Asia Pacific grew 53% to $12.6 million. Despite the fact that China, one of the fastest growing markets, had essentially flat sales in third quarter compared to the same quarter last year. Our global sales to Toyota and Honda almost doubled as we increased our penetration and are awarded new platforms.

In the third quarter, we won four new sensor programs, including a generation three pedal module award from our largest Japanese automotive [inaudible], insuring our continued strong relationship with this prestigious customer well into 2015 and beyond. We also continue to make inroads into new commercial markets with our sensor and actuator application. This will take our products into non-passenger vehicle applications with opportunities to generate new sales in 2010 and beyond.

We are experiencing a significant increase in the quest for samples and quotations for both existing and new sensor products driven by emission regulations and need for advance engine control. Needless to say, these initiatives are keeping our engineering and new product development group extremely busy. Continuing with the component and sensor segment, our electronic component sales in the third quarter were also up 5.4% year-over-year.

These demands from our communication infrastructure market and distribution channels was more than offset by sales of our electromagnetic and piezoceramic products. Piezoceramic products are a profitable and growing part of our electronic components, with third quarter growth driven primarily by medical ultrasound and defense and aerospace applications.

In communication infrastructure, we recorded 58 new frequency ceramic filtered design wins, an increase of 23% from 47 design wins in the third quarter of last year. These wins were in 3G wireless, WiMAX, satellite and wireless receiver applications among others. We believe design wins are the leading indicator of future program [ramps].

Our EMS sales in the third quarter were $97.5 million, down $8.5 million from the third quarter of 2007. Hewlett Packard sales, as expected, declined by $13.5 million due to the previously discussed end-of-life process which started in early 2007. Excluding Hewlett Packard, EMS sales were up 6.6% primarily due to increased sales in the defense and aerospace market.

EMS business reported four new wins, one each in medical, defense, industrial and computing areas. Financial constraints on smaller tier three and tier four competitors are presenting new business opportunities for our EMS business. However, we remain very selective in pursuing new EMS opportunities to ensure our strategic focus and financial target. Looking ahead, fourth quarter continues to be a challenge from a macro economic perspective.

Many of our customers, mostly in the U.S. and Europe are lowering their sales projections and reducing their demand to further tighten their inventory levels. Forward visibility of revenue projections from some of our customers and industry forecast groups, especially in automotive, is very limited. However, progress in our business diversification efforts and continued success in business development activities in Asia have helped to partially offset the negative impact from the global economy slowdown.

Although we are taking proactive action to further improve our core structure, program push outs and extended production shutdowns by our customers will adversely impact our financials in the fourth quarter if we see a 4% to 8% sequential drop in our fourth quarter sales, primarily driven by macro economic issues and end-of-life Hewlett Packard sales. This will put our full year sales at the same level or slightly higher than last year. Our electronic components and sensor and actuator sales in Asia are projected to continue their year-over-year growth in the fourth quarter.

Full year diluted earnings per share are now expected to be in the range of $0.71 to $0.76 per share excluding the tax credit both in this quarter and the restructuring and related costs. We are continuing to move forward and stay focused on generating positive earnings and free cash flow on the one hand, and judiciously investing in growth initiatives through design and development activities on the other.

This we believe will further strengthen CTS’s position and the global economic environment begins to improve and our new programs and designs will begin to come unstrained, and now I will turn the meeting over to Donna Belusar, our CFO, who will provide further details regarding our financial results.

Donna L. Belusar

Welcome to everybody on the call. Our third quarter 2008 finished with sales of $170 million, down 2.7% from sales in third quarter 2007 and net earnings are $7.6 million which are slightly lower than the net earnings of $7.8 million in third quarter 2007.

We had two independent actions in the third quarter 2008 which impacted our financial results. The first was a recognition of a non-cash tax benefit of $4 million, resulting from the release of a valuation allowance at one of our Asian facilities, and the second came from the initiating of certain restructuring actions of $3.5 million pre-tax charge in the third quarter. Bottom line, we delivered $0.21 per diluted earnings per share in third quarter 2008, up from $0.20 in the third quarter 2007.

Now, let me provide you some further insight into our third quarter 2008 details. As mentioned, our top line sales were $170 million. Gross margin as a percent of sales was 19.6% in the third quarter of 2008 compared to 19.3% in the third quarter of 2007.

This improvement in gross margins was due to favorable segment sales mix, as a higher percentage of total sales was in the components and sensor segment, which inherently has higher gross profit margins than the EMS segment.

Sales and components and sensor segment was 43% of our total sales compared to 39% in third quarter last year, whereas sales in the EMS segment represented 57% of total sales compared to 61% in the third quarter of 2007.

Selling, general, and administrative expenses or SG&A were $20.8 million, or 12.2% of sales in the third quarter of 2008 verses $19.8 million or 11.3% of sales in the third quarter of 2007. Research and development, or R&D, expenses of $4.5 million or 2.7% of sales in the third quarter 2008 increased $500,000 year-over-year. The SG&A expenses were up from third quarter 2007 primarily to support slightly higher year-over-year sales in the components and sensor segments.

And the R&D expenses were higher verses the third quarter 2007 primarily due to engineering and development spending devoted to the development and margin of new commercial growth initiatives. Overall, we continue to focus on expanding applications and new product opportunities, as well as current product and process enhancements.

As mentioned in September 2008, we initiated certain restructuring actions to transfer and consolidate specific operations to further improve our cost structure. These restructuring and restructuring related pre-tax charges incurred in the third quarter were $3.5 million, or approximately $0.06 per diluted share. The remaining fourth quarter 2008 restructuring charge is expected to be approximately $1 million or $0.02 per share in the fourth quarter 2008.

The resulting operatings were $4.9 million, or 2.9 % of sales in the third quarter 2008 compared to $9.9 million, or 5.7 % of sales in third quarter 2007. The decrease in operating earnings resulted primarily from restructuring and related charges in the current period and higher components and sensor resources requirements as previously stated.

Excluding the restructure and related costs adjusted operated earnings were $8.4 million or 4.9% of sales in the third quarter 2008. Total interest and other expenses in the current quarter were $0.9 million, approximately $0.9 million higher than the same period last year primarily due to unfavorable foreign currency translation impacts, lower interest income and slightly higher interest expense associated with increased debt.

During the third quarter 2008, we recognized a discrete non-cash tax benefit of $4 million or approximately $0.11 per diluted share related to the release of a deferred tax asset valuation loans as we have had continued sustained profitability of one of our Asian locations.

Also during the third quarter, we changed our expected full year effective tax rate. Excluding the discrete tax benefit just mentioned from a previous estimated full year rate of approximately 22% to a lower rate of 19.8% for the full year. The 2.2% tax rate change decrease is driven by a combination of higher earnings in lower tax jurisdictions and lower earnings in higher tax jurisdictions.

Our overall business performance resulted in net earnings of $7.6 million or $0.21 per diluted share in the third quarter of 2008 compared to $7.8 million or $0.20 per diluted share in the third quarter of 2007. Adjusted diluted earnings per share, which excludes the restructuring and related charges of a negative $0.06 per share, and a positive benefit of $0.11 per share from the discrete tax benefit is $0.16 per diluted share.

Now, let’s please shift our focus to CTS’s balance sheet performance and the strength of our financial conditions. As the financial crisis grips global economies our balance sheet remains strong. Our debt levels are conservative and we have available capacity in our existing line of credit.

In addition, our business units continue to generate positive cash flow, which allows us flexibility during these challenging economic conditions. Since the beginning of the year, we funded several important strategic activities and operational improvements. These include $21 million during the first quarter of 2008 for our true strategic acquisitions, Tusonix and Orion, about $14 million year-to-date for capital expenditures as we continue to invest in future growth initiatives and we completed $7 million of stock purchase programs.

With positive net cash provided from operating activities, as of September 28, 2008 we had nearly $54 million of cash and cash equivalent. Our debt structure consists of two primary elements, $100 million unsecured revolving credit agreement of which we had $40 million drawn upon at the end of the third quarter 2008, and a $60 million convertible senior subordinate debenture.

As of third quarter, we are well within all debt covenants of a maximum total leverage ratio and a minimum fixed charge coverage ratio. Subsequent to the third quarter close, we recently purchased through open market transactions at a discount $24 million of the $60 million convert. These negotiated discounted purchases will be reflected in the fourth quarter 2008 results. Therefore, the convert now has a projected remaining balance of $36 million.

In this tough economic environment we continue our focus on managing controllable working capital, which includes accounts receivable and inventory less accounts payable. At the end of third quarter controllable working capital at $112.6 million or 17% of annualized sales was higher than our objective and we are taking actions and have been currently under way to lower it as we go forward. This is approximately a $22 million increase verses the year end 2007 and is primarily due to the inventory growth from our recent acquisitions along with slightly lower payables.

Accounts receivable is in line with our expectations despite the tightening of the financial market. Considering the challenging economic environment, we expect our full year free cash flow, which is net cash from operations less capital expenditures, to be in the range of $15 to $19 million, which is lower than our prior estimate.

We will continue investing in selective high return capital expenditures and anticipate the full year 2008 spending to be approximately $17 million. We finished the third quarter with a strong balance sheet and positive results overall.

With that, I would like to open the call now for your questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from John Franzreb – Sidoti & Company.

John Franzreb – Sidoti & Company

My first question is regarding the accelerated spending in the R&D line to support some of the programs you would want to use for growth next year. In light of market conditions, is there any plans maybe to scale back that spend? Can you just talk about what you are spending, what your expectations are for next year and maybe also update us on what your CapEx expectations are for 2009?

Vinod M. Khilnani

John, we have continued to look at all of our expenditures and we believe we can lower the expenditures without hurting our future growth prospects we are doing them. In R&D, if there are expenditures which are being incurred to launch specific programs for either the diesel commercial markets which we have won because the sales are going to start in mid-2010 timeframe, or programs which we are working very actively with key customers like Toyotas and Hondas of the world, we are going to continue to incur that to make sure that we have really strong growth in 2010 when those programs will be launched.

Other than that, we are looking at every expense and every category to see if we have room to further improve that. Commenting on your capital expenditures, we are going through that process right now. We believe we will be able to bring our capital expenditures down in 2009 compared to 2008, more in line with what we have done in 2006 and 2007.

John Franzreb – Sidoti & Company

So the R&D takeaway, it's too much to spend based on the visibility of the project and maybe something that you didn’t have lined up you will be scaling back a little bit on that? Is that the right read there, Vinod?

Vinod M. Khilnani

That’s the right read. That's the right read. If you look at, John, we are continuing to be very optimistic about the new business we are winning and increase penetration in the market share. The slowdown we see in fourth quarter and early 2009 is primarily macro economic driven. So we want to keep that in mind and aggressively reduce our costs, but we want to also be mindful that the business which we are winning that we are able to launch those projects successfully in 2010.

John Franzreb – Sidoti & Company

Could you update us on what you are hearing form the EMS customers particularly in the aerospace sectors, if you know what is going on there?

Vinod M. Khilnani

In the aerospace sector what we are hearing is that the piece of the business which is on the defense and military side is staying strong, but the side of the business which is more commercial side of the business that is weak and partly because of the Boeing strike and as that settles we expect some improvement in that side of the business going forward.

John Franzreb – Sidoti & Company

Regarding the repurchase of the converts, A, could you give me what the impact that will be on our EPS of specifically, for the fourth quarter in the guidance, and B, just talk a little bit about your expectations on refinancing the debt when it matures next year? Or do you expect to retire it all. What are your thoughts there?

Donna L. Belusar

John, let me answer that for you but I’d like to do it in conjunction with currency. When we look into the full year and we address specifically the fourth quarter looking ahead, we see the volatility in the currency arena which is going to be impacting us in the fourth quarter. That impact is offset with the transactions that we recently did within the convert in terms of buying these open market transactions.

So as I said in my current discussion, we did have a convert of $60 million recently as subsequent to the third quarter closed in open market transactions. We bought back some of those and we currently have a balance of $36 million. The benefit we will see in the fourth quarter will help mitigate the pending translation impact that we see in the fourth quarter.

John Franzreb – Sidoti & Company

So, for modeling purposes can you separate the two for me then?

Vinod M. Khilnani

John, it’s in the $0.04 or $0.05 per share magnitude, the discount and the currency translation negative forecast. So if you look at those things as offsetting each other of the guidance, we believe truly deflects the operating environment.

John Franzreb – Sidoti & Company

I’m just saying that say currency switches on us I wanted to know what the EPS impact was to reduce share count.

Vinod M. Khilnani

It’s in the $0.04 or $0.05 per share range.

John Franzreb – Sidoti & Company

And your thoughts about the debts next year?

Vinod M. Khilnani

As Donna indicated, we only have $36 million left on the convert and we obviously are going to watch the market, but between our unutilized portion of the revolver and the cash available in the company, we believe we should be able to take care of that remaining $36 million next year in the May timeframe.

Operator

The next question comes from Kevin Kessel – J.P. Morgan.

Kevin Kessel – J.P. Morgan

Donna, I might have missed this but did you provide for the quarter the cash flow from operations and the CapEx?

Donna L. Belusar

In terms of the CapEx we had approximately $4 million CapEx within the quarter. I know we typically get the question of how much was our deprecation and amortization within the quarter which is approximately, but $5.7 million was our depreciation and amortization for the quarter. CapEx was $4 million.

Vinod M. Khilnani

Cash from operations was $8.7 million.

Kevin Kessel – J.P. Morgan

$8.7 million, okay, and then when you said, I think you said what for the year you were expecting cash flow from operations to be 15 to 19?

Donna L. Belusar

Our free cash flow is –

Vinod M. Khilnani

No, that was free cash flow.

Kevin Kessel – J.P. Morgan

That was free cash flow, okay that's what I thought. I just thought I heard it as cash flow.

Donna L. Belusar

No, free cash flow would be $15 to $19 million and that would include a CapEx of around $17 million there.

Kevin Kessel – J.P. Morgan

Again, when you look at the convert that you started to take out during the quarter, can you say what the average discount was that you were able to buy back the 24 million at?

Vinod M. Khilnani

It was 7%, 8% range.

Kevin Kessel – J.P. Morgan

In terms of overall balance sheet, once this convert comes off the balance sheet and it either be, anywhere between now and the end of I guess May of next year, what's your thinking in terms of the overall right leverage for the company? Would you still want it to eventually get back a kind of 25% to 30% debt-to-capital ratio or would you be comfortable running it much less levered if the credit markets weren’t accommodating, let's say, when it comes time for that to disappear entirely?

Vinod M. Khilnani

Kevin, that's a tough one to answer because our answer on the one hand depends on the credit market, but frankly on the other hand depends on what’s the use for that cash. If we find growth opportunities, whether they are organic or acquisition related, which we find very attractive then obviously we have said in the past that the [fishing] frontier for our capital structure probably indicates that we should have debt-to-capital ratio around 25% range, but that all depends on what are the growth opportunities and we will consider them to determine whether we want to lever up from that point or not.

Kevin Kessel – J.P. Morgan

Vinod, you had mentioned I think in your prepared remarks that you guys have doubled the Toyota and Honda sales?

Vinod M. Khilnani

That's correct.

Kevin Kessel – J.P. Morgan

Can you provide us what is the reference point? You've doubled them – is it year-over-year and then can you give us a sense of what the absolute number is on a combined basis for those two in terms of what we are looking at here for dollar-wise exposure?

Vinod M. Khilnani

I think the total Honda and Toyota sales in the third quarter was approximately in the range of $7 million range, $6.5, $7 million range and I think what I want to highlight with that is automotive markets in 2008 are running 10% to 20% somewhere in between 10% to 20% lower than last year, and we expect our automotive sensor and actuators to be up on a full year basis probably close to 6% to 7%.

So we’re offsetting a decline of 15%, 16% in the market and are still able to report a 6% to 7% year-over-year growth and that is primarily because on the one hand we are penetrating new customers, and on the other hand we are continuing to launch programs.

So there were new programs which were launched throughout '07 which we are benefiting this year because there are more annualized sales coming from them, and I think that's one thing we would like to highlight that although we are operating in a very tough industry like automotive, CTS is still able to grow the top line despite an extremely difficult market because we are feeling pretty good about our new products and customer penetration.

Kevin Kessel – J. P. Morgan

And the doubling, was that a doubling from a year ago so the two combined were in the $3 to $4 million range?

Vinod M. Khilnani

Yes, I was looking at the sales in Q3 of last year versus Q3 of this year.

Kevin Kessel – J. P. Morgan

Okay on a quarterly basis. So, then if I do the math in my head right based on auto being about a quarter of your business, I guess that would imply that these two customers that obviously you're done a good job growing share with are about 15% of the total automotive exposure? Is that right?

Vinod M. Khilnani

Say that again?

Kevin Kessel – J. P. Morgan

I’m looking at the $7 million and then I’m taking what your total automotive exposure likely is for the company. I’m just using 25% on a 170 and then I’m seeing about 15% exposure of Toyota Honda overall, like they account for 15% of your total automotive business today from probably –

Vinod M. Khilnani

That’s probably not too far from the numbers, but again as we win new platforms we hope that number to grow. The other thing since we are talking about customer concentration, I believe this is the first quarter ever in our history that no one customer of CTS is more than 10% of our sales.

And so the other story here is that the company is dramatically more diversified today than it has ever been in its history and that is one of the reasons which is providing us a floor so to speak against the volatility of the economic conditions.

Kevin Kessel - J. P. Morgan

Okay, that was actually my next question on HP. I know that you decided that they were what they were down. So in the quarter then they fell what, $4 million sequentially?

Vinod M. Khilnani

Yes.

Kevin Kessel – J. P. Morgan

So that brings their overall exposure to, I don't think I have it in front of me, they were 20 million right last, was it 20 million?

Vinod M. Khilnani

Yes.

Kevin Kessel – J.P. Morgan

Okay so they are 16 give or take and Motorola has remained below 10%.

Vinod M. Khilnani

Right, and so HP this was the first quarter HP as a percent of total company was just below 10%.

Kevin Kessel – J.P. Morgan

This is for Donna, the overall inventory exposure that CTS has in inventory reserves, there has been a couple of companies that have had to come out so far particularly on the EMS side and increase their inventory reserves because of weekend customer states and conditions.

Is that at all a concern right now of yours or do you feel right now that the reserves are accurately reflecting the current environment? Lastly on taxes I just wanted to clarify that you said 19.8% going forward for the tax rate.

Donna L. Belusar

Okay. Let me do the tax rate first, yes it was 19.8% for the full year 2008 going forward. In regards to the reserves, we have no exposures on our inventory reserve. I’ll tell you, Kevin, we have a very tight process in terms of focusing on the liquidity and our balance sheet within the company. I have weekly updates overall on many of these topics and particularly on inventory because we do keep ahead of what’s happening without competitors out there, but there are no exposures on our inventory.

Kevin Kessel – J.P. Morgan

What about stock option expense. I didn’t hear what that was in the quarter.

Donna L. Belusar

Stock option expense was $18,000.

Kevin Kessel – J.P. Morgan

That’s primarily in SG&A.

Donna L. Belusar

Yes it is.

Operator

The next question is from [Handy Sasanto] – Gabelli & Company.

[Handy Sasanto] – Gabelli & Company

Can you elaborate more on your visibility into EMS market and what kind of health decline estimate do you bake into the fourth quarter outlook?

Vinod M. Khilnani

The visibility is probably several notches less these days than historically we have experienced, but as we have focused more and more on non-communication, non-computer market we believe our volatility in that market would be less and less because we tend to believe that shipments into defense and medical tend to be a little bit more predictable than industrial and computers and communication market. So, compared to our other markets EMS probably is more stable in the fourth quarter.

The only exception I would say is Hewlett Packard where the exact timing of the shipment becomes less predictable but excluding HP end-of-life products we have probably more stable sales going on forward into Q4 and EMS than other markets.

Operator

The next question comes from Greg Weaver – Invicta Capital.

Greg Weaver – Invicta Capital

In terms of HP, I’m sorry I’ve been away from the story a little while, what does the tail off look like there and it is going to zero or just one reduced level?

Vinod M. Khilnani

No, I think it’s not going to go to zero we’ll continue to keep some higher margins maintenance and support kind of sales with them and we continue to talk to them that if they have any opportunities which fits with our model which is lower volumes and more variety kind of products then we will continue to bid on that kind of business, but this particular business we had was lower margin and did not fit our EMS model. So we have been talking about this for the last couple of years that it’s continuing to gradually ramp down.

Greg Weaver – Invicta Capital

So for calendar '08 how much of that were their businesses in your mix here at about 70 millionish?

Vinod M. Khilnani

Yes, I think in 2008 the number is probably close to 70 million.

Greg Weaver – Invicta Capital

So, for next year how much do you think that will tail off?

Vinod M. Khilnani

Well if I look at the run rate for between '07 and '08 my expectation would be that we will probably do close to $30 million in HP, and then we will continue to grow our target areas like we have been doing which are industrial, medical and defense and communication.

Greg Weaver – Invicta Capital

Right, Vinod, can you give me a sense how the mix is there in your EMS business now with some of these new target areas, the percent?

Vinod M. Khilnani

Yes, I think the target areas are probably approximately half of our business today, three, four years back they were zero. So target areas are probably half and our other half is a combination of communication and computers.

Greg Weaver – Invicta Capital

Okay, that’s helpful, and on the component side of your business. You’ve made a few acquisitions here. I guess I’m just trying to get a handle on what's the organic growth rate there year-over-year if at all?

Vinod M. Khilnani

Good point. We had on the automotive sensors and actuators that everything we deport is organic and I believe that for the full year automotive business will be up 2.5% to 5% range and it’s all organic. As I was commenting earlier that despite a 15%, 18% drop year-over-year in automotive we will still be able to deport a 2.5% to 4% kind of organic growth despite extremely difficult market in the automotive sensors and actuators.

If you look at electronic components and that's where we made the acquisitions, our growth there is close to 18%, 17% and probably 70% of that is acquisition and the remaining is organic.

Greg Weaver – Invicta Capital

Okay, so the segment as a whole year-over-year is organically growing so.

Vinod M. Khilnani

Absolutely, and that's exactly I was trying to highlight that if you look at that segment year-over-year we’re growing probably 8% and little less than 5% of that 8% is acquisition and the remaining approximately 3.5%, 4% is organic, despite the fact the industry is down 15% year-over-year.

Operator

We do have a follow-up from Kevin Kessler – J.P. Morgan

Kevin Kessel – J.P. Morgan

I just wanted to clarify the [NODIA]. I think last quarter you had said that the Big Three were $18.5 million in revenue for CTS. I just wanted to get first of all an update to what that was now here in the third quarter.

Vinod M. Khilnani

Kevin, I’ll have to cycle back to you. I know that number continuing to go down but I don’t have that information handy. Can we call you back after this call? Mitch will call you back and give you that.

Kevin Kessel – J.P. Morgan

Yes of course. Do you have what automotive was as a percentage of sales or maybe you have just the overall breakdown as a percentage of sales for the segment?

Vinod M. Khilnani

Yes, I think we have automotive as a percent of sales. Automotive in the third quarter is 26% of the total company compared to 24% of the company in the third quarter of last year.

Kevin Kessel – J.P. Morgan

Okay, so auto is 26 and what about the remaining?

Vinod M. Khilnani

Communication is 22%, computer is at 12%, industrial is 13%, medical is 8%, and defense has moved up to 13%, and the remaining 6% is just other.

Kevin Kessel – J.P. Morgan

So, looking at that I guess at the end of the day just assume that the Big Three maybe they declined I'm just going to use them as a constant, them plus Honda and Toyota is about $25 million or so and your auto in total was closer to $44 million. So, I’m just trying to think the remaining 40% plus or 50% plus of the automotive exposure is that just very diversified across you know numerous companies?

Vinod M. Khilnani

That is another thing that we have tried to highlight that we are extremely diversified in that area. We have customers like Nissan and we have now started penetrating Chinese automotive manufacturers like Cheri and so it’s an extremely diversified group.

We also are now taking as you know our product to motorcycle manufactures, small engines TPS and I would say that our small engine TPS sales were down most of the last 12 months because of our wonderful key customer, Makuni, had stopped buying form us and we kept hearing that they are bleeding inventory, they had too much inventory.

I’m pleased to report that this last week order board from Makuni jumped up and we got a confirmation that they have finally finished all their excess inventory and they have come back on stream with their regular orders, and so you know, we do go beyond passenger vehicles and do some other applications and we have recently won business.

And we’re very optimistic about our products going on turbo chargers and these turbo chargers are not only light vehicles or passenger cars, but potentially on the heavy duty applications are diesel engines too. So, as we go forward we would be even less dependent on the passenger car per say when we talk about our sensors and actuator business.

Kevin Kessel – J.P. Morgan

That’s very helpful, and then just again I guess going back to the customer question I was asking Donna earlier about EMS, at the end of the day here there is always speculation amongst the Big Three and the overall outcome for that, what will happen with them whether it’s mergers or who knows what, but at the end of the day if worse comes to worse and one of them does end up filing bankruptcy, Is CTS protected in that event? Is there any exposure?

Vinod M. Khilnani

Well there may be some exposure but a lot of our Big Three sales have begun to go, instead of directly to Big Three, it goes to a tier one, so our receivables are actually in that case will be from tier one and not Big Three but we will have some Big Three exposure obviously.

Kevin Kessel – J.P. Morgan

But it is key – you're saying it would be the majority of the receivables exposure? Like the tier one you're talking about strong suppliers?

Vinod M. Khilnani

It may be beyond that. It may be people like BorgWarner and maybe [Pierpert] in Europe, people like that.

Kevin Kessel – J.P. Morgan

Okay but numerous suppliers enter them as opposed to them vertically?

Vinod M. Khilnani

That’s right. Really our concentration, we really don’t’ have much concentration and as you know that beyond the top two customers we frankly don’t even have a customer which adds up to even 5%. It really falls very quickly after Motorola and Hewlett Packard it really falls at 5% or below category.

Kevin Kessel - J. P. Morgan

I just want to understand here, in your fourth quarter guidance that you’ve provided, what is the importance of expectation and for your largest customer in terms of where that will go, so if it's down to 16 million now and I think that you just said you expect it to kind of be at a 30 million run rate in 2009. Does that imply that we’re getting there in the fourth quarter like it should drop pretty meaningfully? Or do you just expect, I’m just wondering kind of what range you have for them as part of this guidance so I can understand how the rest of the business is performing.

Vinod M. Khilnani

Kevin, honestly I don’t have further breakdown by customer of my guidance.

Kevin Kessel – J.P. Morgan

Okay, but you would expect them to be down I guess?

Vinod M. Khilnani

Not necessarily. I mean I don’t know that because some of these customers the quarters can be uneven, so directionally it will be down but I can’t definitively say that where that number will be. I guess it will be a fair estimate to say they will be down.

Kevin Kessel – J.P. Morgan

But I guess in terms to what you said earlier you were looking for kind of a $7.5 million per quarter sort of a run rate in 2009 so that customer they're going to run at 30.

Vinod M. Khilnani

That is correct.

Kevin Kessel – J.P. Morgan

Okay, that’s less than half of where we’re at now and that’s why I’m just trying to figure out how fast it ramps down to that.

Operator

We have a question from Brett Evans – Hartland.

Brett Evans – Hartland

Vinod, I’m just curious if you could just I guess looking at the third quarter here, your SG&A and R&D ran at $25.3 million. What are your thoughts on how that number looks fourth quarter or first quarter as we start to benefit from the restructuring?

Vinod M. Khilnani

I can tell you, Brett, that directionally we will take that number down given the economic environment and the restructuring we have done. It’s difficult for me to quantify the drop in Q4 and Q1 but I can tell you we will expect that number to go down.

Brett Evans – Hartland

I’m sorry if I missed this number, did you give an annualized savings that you expect to benefit from that restructuring charge?

Vinod M. Khilnani

I believe we said that the payback is a two-year payback, so it’s approximately a two-year payback. We’re still looking to expedite that and obviously some of the savings will fall in cost of goods sold and some of the savings would fall in the operating expense.

Brett Evans – Hartland

So just to be clear, the dollars savings you expect in the $3.5 million charge is basically one for one and you expect to realize it over the next two years?

Vinod M. Khilnani

Right, so you can assume that the annual savings will be $1.8 million range to $2 million range, half of it. So it’s a two-year pay back, means roughly half of that would be the annual savings.

Brett Evans – Hartland

So how much of that charge is associated with people versus the leasehold. I’m a little confused as to why you wouldn’t get more of it immediately as it looks like, I mean 60 people I guess is a pretty big number.

Vinod M. Khilnani

$1.9 million of the charge is people related, and the people will exit over a period of time so it’s not a set date when everybody is affected and the remaining is mostly legal, or we also have a small location which we are closing in California and consolidating that operation into our Tucson operation.

What we are not counting, Brett, is that it also frees up a facility in California which we own and essentially a fully depreciated facility, so whenever we can completely clear out from there and sell it we’ll expect some gain on the sale from that which we don’t normally count those kind of things when we talk about payback.

Brett Evans – Hartland

Just shifting gears for a second, the convertible redemption, did you redeem that with cash or did you draw on the revolver for that?

Donna L. Belusar

Given the timing of it and responding to the request, we drew upon our revolver.

Brett Evans – Hartland

So can you just paint a picture of how we should think about the fourth quarter balance sheet? I mean I know it could be, if you want to give us a range that’d be great, but can you talk about where you'd expect cash and revolver borrowing come December 31st?

Vinod M. Khilnani

Hard to do, I’ll add to the comment here. We don’t really distinguish between revolver and cash because what really happens is that in U.S. the excess cash just flows in to the revolver and the revolver goes down and then when we pull it, it goes up, so the revolver and cash become kind of combined. It’s obvious that our convert will be no higher than $36 million. Exactly where the revolver would be I guess we can add up the free cash flow and take out the dividend payments and give you probably a rough estimate of where the revolver and debt will be.

I expect it to be better than where it is. The total debt obviously is going to be lower in my opinion at the end of the year than where it is at the end of the third quarter because we will be generating free cash flow.

Brett Evans – Hartland

I know there was a discussion on inventories, but just in general in terms of working capital it would seem like you have an opportunity here. I mean your cash conversion cycle has just come up from 46 days a year ago to 62 days in the third quarter here. I imagine you have got a full core press on working capital and it looks like it could be a somewhat meaningful source of cash. Can you quantify what you think you might be able to liquidate off the balance sheet from cash flow perspective?

Vinod M. Khilnani

I tend to agree with you that that can be a meaningful source of cash in 2009. I would like to think that a lot of inventory buildup is short-term in nature and I would define short-term as three to four months kind of a timeframe.

Some of the inventory the customers have committed. They will have to take it from us, but they have the flexibility whether they take it now or whether they take it in a few months and as some of the customers pushed out their orders we did end up with a little bit more inventory than we were expecting. And so yes, I expect working capital to be a source of cash flow in 2009 for us.

Brett Evans – Hartland

I realize that visibility isn’t good right now. I guess we're staring into the abyss here with this credit crisis and I don’t think many people expect the economy to get better any time soon, but considering the fiscal and monetary stimulus globally that's being applied to the global economy, I guess there might be hope that the economy might start to get a little better come maybe the latter part of the first quarter into the second quarter maybe.

If that were to be a working proposition or thesis, how would you gauge CTS as a consolidated entity's ability to grow revenues and earnings in 2009, Vinod?

Vinod M. Khilnani

Yes, it’s a big if that you talk about, about macro economics. Everybody we talk to tells us that don’t expect a lot in the first half of 2009 and people generally expect improvement in the second half of 2009. If I step back from just the quarter-over-quarter and the credit markets and all the turmoil, I personally feel very positive as to what the corporation has done from a top line growth and the bottom line profitability despite everything. I mean people tell me that you are in markets which are just absolutely horrible markets like automotive.

One of our analysts commented this morning that we work in automotive industry, which is horrible. Well with that horrible industry dynamics which lowered the production volumes by 15%, 16%, 17%, CTS has been able to demonstrate organic growth at the top line. So I feel very good about that. I feel very good about the inquiries we get from of our OEMs who are inviting engineers to come work with them to deliver up the next generation of engines and platforms.

Our research and design and development groups are more busy today than they were any time in the last 12 months. So I feel very positive about the new business generation, relationship with the customers and the future of this company.

What is difficult for us to put our finger on is the exact timing of the economy turning around and to some extent we are a little bit less certain about the exact timing of the program launches by the customer. So if you can, Brett, if you can broaden that timeframe to include 2010 in it, I will tell you that we will be on more platforms and very exciting opportunities in our sensors and actuator business, but we do have the risk that some of the program launches the customers may push them out. But we are designed in so when they launch them we know we will be there.

However, it's difficult for us to sometimes predict whether the customer would launch their platforms in the quarter when they originally thought they would or they may push it out a quarter or two given the economic conditions.

Brett Evans – Hartland

I know that in the past I think it’s evident that there aren’t great synergies between the components and sensors and EMS business, and I just wonder with the way the market is, I realize we're in a tough environment, but looking at the way the stock is reacting today, I guess we're, I mean the stock really hasn’t performed for a long time and not sustain.

The fact that you have done a great job of repositioning the EMS business as such with the HP exposure there coming down and the [inaudible] spec business I think is obviously much stronger that it has been in the past and clearly your efforts on the components and sensor side speak for themselves. But does at some point does the board reconsider the merits of having these two businesses that the other when there is lack of synergies are fairly evident?

Vinod M. Khilnani

Brett, the board looks at strategy on an ongoing basis and they measure us and we have the targets, not only from free cash flow point of view, but from return on invested capital point of view. So that’s a discussion; it's a dynamic subject and it is always in front of the management and the board and so it will continue to be evaluated as we go forward.

Operator

You have a follow-up from [Handy Sasanto] – Gabelli & Company.

[Handy Sasanto] – Gabelli & Company

You mentioned about the turbo smart actuator again and based on the last information you think that the shipment may happen in early 2010? Do you have any updates on that, and do you expect that to be out in early 2010?

Vinod M. Khilnani

[Handy], we will actually probably start shipping some turbo charger sensors in 2009, in late 2009, but we are pursuing some even larger opportunities and working very closely with a couple of turbo charger manufacturers, which we continue to be very optimistic about begin shipments on a larger scale in 2010.

Operator

No further questions.

Mitchell J. Walorski

I would like to remind our listeners that a replay of this conference call will be available from 1:30 pm Eastern Daylight time today through 11:59 pm on Wednesday, November 5, 2008. The telephone number for the replay is 800-475-6701 or 320-365-3844 if calling from outside the U.S. The access code is 963049 and thank you for joining us today.

Operator

Ladies and gentlemen that does conclude your conference. Thank you for your participation.

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Source: CTS Corporation Q3 2008 Earnings Call Transcript
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