CTS Corp (CTS) operates in two segments – EMS (electronic manufacturing services) and C&S (Components and Sensors). A large part of the C&S is for automotive applications, so CTS is operating in two difficult sectors at a time when the business cycle is pointing down.
Nevertheless, the company's strengths make it an attractive buy at Friday's close of 5.53. Based on a strong balance sheet, effective R&D, improving diversification, and favorable macro factors, I expect CTS to to reach a midpoint target price of 13 within two years.
Macro Factors - CTS designs and manufactures sensors and actuators for automotive and other applications. The trend toward requirements for higher fuel efficiency and less pollution can be expected to create increasing demand for these products. CTS has extended their reach into adjacent markets to include light engines and commercial/diesel, recently winning an award from a major diesel engine manufacturer.
Also, many of their electronic components are high tech (non-commodity) used in areas where long-term growth can be expected, such as communications infrastructure, medical, and defense/aerospace.
Diversification – Between 2004 and the present, CTS reduced computer-related business from 35 to 11%, and communications from 28 to 22%, by developing a presence in defense/aerospace (11%), industrial (6%) and medical (13%).
Customer concentration is not bad, with Hewlett-Packard (HPQ) now falling below 10%, followed by Motorola (MOT) less than 10%, and nobody else has much more than 5%: specifically none of the Detroit Three is above 5%. Exposure to these questionable customers is mostly indirect, through Tier 1 suppliers.
R&D – CTS spends about 2.5% of revenue on R&D. Based on the conference call, my sense is that this money is effectively deployed, along the lines of what I call “creativity-to-order.”
R&D can be a troublesome area for investors; the situation in Bio-Tech and Pharmaceuticals is the primary offender. Some companies have massive R&D expenditures, well over 10% of revenue, yet there is no predictability of when something important will come out of the pipeline. The question is, can R&D create a new breakthrough, the next block-buster drug? All too often the answer is, not yet.
Innovation, something new and not previously thought of, is illusive.
Creativity-to-order consists of experienced engineers or scientists extending existing technology in ways both they and their customers know are possible. The customer knows what they need, they know who can reliably produce it, and good things follow. What I read in the conference call suggests that this desirable state of affairs exists between CTS and their customers:
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...
... 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.
So 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.
This makes me think of Harmon (HAR) back before the failed sell-out, where the R&D was mostly development expense for orders that were already booked and was a good tell for future revenues. The linkage here is not as direct for CTS but the asserted activity in working with customers is food for thought.
Balance Sheet & Financials - Debt stood at 18.4% of capitalization as of year end 2007. When looking at cash flow, I like to compute a ratio comparing it to earnings. CTS typically reports EPS that are around 50% of cash flow, leading me to conclude that depreciation and amortization are realistic but not aggressive. Also, the strong cash flow will allow the company to operate through the downturn unimpeded by liquidity constraints.
The last quarter included some restructuring, with more to come in the next quarter. I saw nothing draconian, normal adjustments in the face of a downturn. Payback is estimated at two years.
Wrap-up – Taking all of this together, I see CTS as a reliable growth prospect, developing proven technologies and increasing revenue profitably at a clip of 7% or slightly better over the long-term. Share counts have decreased in recent years. I do not believe the company will cruise through the downturn without any difficulties: however, looking out toward 2010 I see EPS potential of .76. Applying a multiple of 17 (on the low side of its historical average), I arrive at a midpoint target of 13. John Neff used to observe that 7% growth doesn't get a lot of respect, but it adds up.
Valuation Metrics are attractive, with the .5 P/B providing margin of security. They are closing a fully-depreciated facility in California, the sale will generate both profit and cash.
I have taken up a starter position, and plan to accumulate and monitor over the next several quarters. Rather than focus on EPS, I will be looking for continued evidence validating the idea that CTS will diversify along lines supported by macro factors, work capably with their customers on product development, and maintain financial discipline.
Disclosure: Author holds positions in CTS