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Executives

Mitch Walorski – Director, Planning and IR

Vinod Khilnani – Chairman, President and CEO

Donna Belusar – SVP and CFO

Analysts

John Franzreb – Sidoti & Company

Jim McIlree – Neuberger Berman

Hendi Susanto – Gabelli & Company

CTS Corporation (CTS) Q2 2010 Earnings Call July 27, 2010 11:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by and welcome to the CTS Corporation’s Second Quarter Fiscal 2010 Earnings Conference Call. (Operator Instructions)

As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Director of Investor Relations, Mr. Mitch Walorski. Please go ahead.

Mitch Walorski

Thank you, Greg. I’m Mitch Walorski, Director of Investor Relations. And I will host the CTS Corporation’s Second Quarter, 2010 Earnings Conference Call.

Thank you for joining us today. Participating from the company today are Vinod Khilnani, Chairman of the Board 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 different 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 the website in the Investor Relation’s section.

I will now turn the discussion over to our chairman and CEO, Vinod Khilnani.

Vinod Khilnani

Thanks Mitch. And good morning everyone. Last evening we released our second quarter financial results for 2010. I’m pleased to report that total sales and earnings in the second quarter of 2010 improved year over year from the second quarter of last year, and sequentially from the first quarter of 2010.

Our components and sensor segment sales went up 46% year over year, EMS sales were lower 5.9% year over year, but they were up 19% sequentially; and excluding end-of-life Hewlett-Packard products, increased 3% year over year.

Favorable segment sales mixed with component and sensor representing 52% of total CTS sales, again, allowed us to post a stronger gross margin of 21.9% in the quarter, versus 18.2% in the same quarter last year.

We continue to increase our R&D activities and investment and new products prudentially, but at the same time, are keeping our expense base and cash flow tightly managed given the lingering, uncertain global economic conditions.

Total sales in the second quarter of 2010 at $138.9 million, went up 15% from the second quarter of 2009, driven by a strong 46% year-over-year increase in our component and sensor segment sales.

Within this segment, sales of automotive sensors and actuators increased by 42 % from the second quarter of 2009, as demand for light vehicles improved from the depressed 2009 levels.

Year over year, vehicle production volumes in the second quarter were up 71% in North America, but only 6% higher in Western Europe, and up approximately 22% in China, reflecting increased vehicle sales and inventory replenishment.

North America light-vehicle inventory levels at the end of June, at 48 days, were fairly reasonable and somewhat lower than historical levels. This is a good sign, and reduces the risk of sharp product curtailment in the second half of 2010, apart from the normal seasonality of the third quarter when most orients schedule their summer plant shutdowns.

Continuing with the component and sensor segment, sales of electronic components representing 20% of our total sales in the second quarter 2010 were up a strong 52% year over year as we saw a broad base of economy continue in our third markets.

Wireless and infrastructure sales went up 24% and Piezoceramic sales more than doubled as key third markets of medical ultrasound, commercial inkjet printers and hydrophone all recorded strong sales driven by improved demand and favorable impact from our new product introductions.

Distribution channel sales of electronic and electro components were up 53% and the demand seems to be staying fairly robust going into the third quarter with a 1.1 book-to-bill ratio.

Sales in other components and sensor business overall reflects not only improved macro economic conditions worldwide, but also the impact of our increased R&D initiatives, which are helping new product introductions and improved market share.

We filed 20 new patent applications in the second quarter this year, versus only nine last year. And we were granted 11 new patents in the second quarter of 2010, versus seven last year.

Our increased filings and patent grants are indicative of the effectiveness of our R&D initiatives and our future growth opportunities. And at the same time, helped protect our market position.

Our EMS segment sales were 48% of total CTS sales in the second quarter, compared to 59% in the same period last year.

EMS sales in the second quarter of 2010 at $66.6 million, went up 19% sequentially, but down approximately 6% year over year.

As I said earlier, if we exclude the end-of-life HP volumes of approximately $6 million from second quarter 2009, EMS sales were also up year over year by 3%.

EMS sales were helped by strong communication infrastructure markets.

On the design wins and business development front, we won four new programs in the automotive sensor and actuator arena, and captured five new customers in the EMS business in the second quarter of 2010.

Automotive programs were split equally between Japanese and U.S. customers. EMS awards were captured and there were target focus areas of medical, defense and industrial markets.

In electronic components, our new design wins are the best indicator of our future revenue growth. Design activities continue to be strong as we recorded 65 new wireless infrastructure design wins compared to 51 in the first quarter of 2010 and 59 in the second quarter last year.

Looking forward, in the short term, the order board looks reasonably firm for the third quarter. Fourth quarter visibility is less clear, but we remain cautiously optimistic. Assuming no significant economic events, we expect our full year 2010 sales to grow 10% to 15% year over year, although this reflects a small reduction in our top-line growth from our previous guidance.

Due to some EMS sales push outs from forth quarter and some leveling off in the global economic activity, we are increasing our full-year EPS guidance range from $0.52 to $0.60 to $0.55 to $0.62 due to slightly higher gross margin expectations.

Overall, we continue to transform the company with an increasingly diversified base of customers, third market and geographic footprint.

We continue to enlist in exciting new products to increase our organic sales growth.

A sharply increased focus on research and development driven new product, are helping to grow our higher margin components and sensor business.

We are currently spending approximately $3 million, or $0.06 per share, per year, on special R&D and new product launch activities to broaden our product offerings and penetrate new markets like Smart Actuators for advanced diesel engine applications and commercial vehicles, and piezoceramic product for new high-density disk drive applications.

These new growth opportunities are positioning CTS to grow its top and bottom lines significantly in 2012, 2013, and beyond.

Now, I will turn the meeting over to Donna Belusar, our Chief Financial Officer who will provide further details regarding our financial results. Donna?

Donna Belusar

All right. Thank you Vinod. And good morning to everyone. I am pleased to present to you further details on our 2010 second quarter financial results.

Our 2010 second quarter results continue to show improved sales revenue, strong gross margin performance, and increased operating earnings. Total sales for the second quarter 2010 were $138.9 million, up 7.3% from the prior year, and up 15.3% from the second quarter a year ago.

The double digit year-over-year revenue increase was driven by significant demand improvement from components and sensor customers.

Our components and sensor segment sales were $72.2 million, an increase of 45.6% from the same period last year as we saw overall production requirements increase across the globe, while down slightly by 1.7% from the prior quarter.

EMS sales were $66.6 million, down 5.9% from the prior year. However, up significantly, 19.1%, from the first quarter, primarily due to the generally improved macroeconomic condition.

With year-over-year revenue growth more pronounced in the components and sensor segments, the overall segment mix remained more heavily weighted towards components and sensors coming in at 52% of total sales.

This is up from 41% in the second quarter of last year, and down from a high point of 57% of total sales in the first quarter of 2010. The year-over-year shift in segment mix, the improving product mix, increased capacity utilization as well as the impact of our global manufacturing footprint, all contributed to the improved gross margin as a percentage of sales.

Our second quarter 2010 gross margin percent was 21.9% of sales, up from 18.2% in the same quarter of last year, and down from the record 23.6% in the first quarter.

Roughly 2/3s of the year-over-year gross margin increase can be attributed to the better segment mix from a higher level of components and sensor sales. The slight sequential declining gross margin from the first quarter was expected due to EMS sales rebounding, resulting in the return to a more-balance segment sales mix.

Second quarter 2010 had $18.3 million of selling, general and administrative expenses, or 13.2% of sales, compared to 12.7% in the second quarter of 2009, and 15.1 percent of sales in the first quarter of this year.

The year-over-year increase reflects increased spending to support higher sales as well as the reinstatement of certain compensation-related items that were temporarily suspended during 2009.

The decline from first quarter was primarily due to lower spending across a higher sales level.

Research and Development expenses were $4.3 million, or 3.1% of total sales, and were substantially all in the components and sensors segment as we continue our investment and growth initiative in this space.

Total other expenses, which include interest expense, interest income, and currency translation gain and loss, and other non-operational expenses and gains were $0.5 million, which is essentially flat year over year.

And despite the recent volitility in the currency markets, there was no significant impact from any one currency on the company’s financial, including the European currencies.

Earnings Before Income Tax were $7.3 million, up from $2.7 million from the prior year. The effective tax rate was 20.2% and we expect the full year effective tax rate to be in the range of 21% to 23%.

Second quarter net earnings were $5.9 million, or $0.17 per share. This continues the trend of positive earnings performance.

Now, I would like to move the discussion to a review of our balance sheet.

CTS ended the quarter with $65.2 million in total cash and cash equivalence, up $14.1 million from year end 2009, and up $6.5 million from the first quarter 2010.

Cash flow from operations for the quarter was $1 million as we increase our working capital to support higher sales.

This brings net cash provided by operating activities for year to date 2010 to $6.3 million. Including capital expenditures of $6.2 million, year to date 2010 free cash flow was break even.

We expect global cash from operations to improve through the second half of 2010, and to generate positive free cash flow in the range of $20 to $25 million.

Capital expenditures are anticipated to be approximately $15 to $17 million, which is within our target range of 2 1/2% to 3% of total sales.

At the end of second quarter 2010, long-term debt was $65.9 million versus $56 million at the end of the first quarter.

This increase of $9.9 million resulted in a debt-to-capitalization ratio of 20.4%, up from 18.2% in the prior quarter.

From its current level, we expect debt to be increased by $10 to $15 million by year end.

Finally, a concluding comment on controllable working capital, which includes accounts receivable, plus inventory, less accounts payable.

As a percentage of annualized sales, controllable working capital was 15.3%. This is up slightly from first quarter 2010 of 14.4% primarily due to the timing of our sales, as accounts receivable increased in line with higher sales occurring towards the end of the quarter.

However, it is lower than the 17.1% in the second quarter of 2009 as we tightly managed these overall processes.

CTS remains well positioned to deliver our full-year guidance on sales, earnings per share, and positive free cash flow.

With that, I will now open the call for questions. So Greg, you can take it from there. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions)

Your first question comes from the line of John Franzreb from Sidoti. Please go ahead.

John Franzreb – Sidoti & Company

Good morning Vinod, and Donna. Vinod, you mentioned that you pulled down your revenue guidance due to push outs in EMS business. Could you provide a little color into what end markets are pushing out?

And could you also discuss if the pricing in the EMS business in general has gotten more competitive such that maybe we should think different about operating margin contributions from that segment?

Vinod Khilnani

You know, the pricing environment is no more challenging today than it has always been. So I will not say pricing is necessarily anymore difficult today. We did experience some push out from Q2 to Q3 and expect those push outs to continue. They are happening primarily in medical and defense, timing-related items. That combined with some delays in the supply chain product component availability made us become a little bit more cautious and push out the sales from the EMS from 2010 to 2011 timeframe.

John Franzreb – Sidoti & Company

Okay. And looking at components and sensors on a sequential basis, revenues in the quarter were down roughly $1 million from June versus March. Okay, but we’ve also [inaudible] $1 million and change on the operating profit line. Could you talk a little bit about that? What happened there?

Vinod Khilnani

Okay. Component and sensor segment is continuing to stay fairly strong. The sequential decline partially came from the fact that in the first quarter, we had some unusual one-time service-oriented shipments to Toyota, which we talked about and said that is – there’s a one-time element in that and will not be repeated.

So if I take that element out, and automotive components are staying at a very strong level – stay at a very strong level in Q2, and we hope that that business will continue to stay fairly robust, tempered by the seasonality, which comes from the third quarter shutdowns.

Electronic components are staying really strong, as I mentioned, book-to-bill is above 1, and order board is looking fairly strong for the third quarter. We don’t have the visibility of the fourth quarter, obviously, at this point but it’s staying stronger than our expectations.

John Franzreb – Sidoti & Company

Okay. Since you mentioned it, I am hearing that some of the automakers may actually have production through their normal shutdown periods. Are you hearing that from any of your customers?

Vinod Khilnani

Nothing definitively. So we are planning that they will continue to schedule their summer shutdowns as scheduled. We are encouraged by the inventory levels, especially in North America. They are lower at the end of June than where they were in March, April and May, actually.

So that gives us some opportunity that maybe some audience will not extend their summer shutdowns, or may actually tweak their productive volumes up.

John Franzreb – Sidoti & Company

Great. That’s good news. And Donna, for you, a couple of balance sheet items. If I did the math right, it looks as if there’s a working capital outflow in the quarter. I think you attributed that probably to the higher sales level.

But I also noticed that you – the cash went up and so did the borrowings, long-term borrowings go up in the quarter. I just wanted to walk through what was going on with those three items. Can you just talk a little bit about that?

Donna Belusar

If you look at quarter over quarter, indeed, or cash position did improve where our cash went up by $7 to $8 million over the quarter, as well as our debt going up quarter to quarter.

The debt increase is really driven by driving working capital requirements, whether it’s in inventory to support future sales, as well as be accounts receivable going up. And then on a cash balance, as we’ve talked before, predominantly a lot of our cash across the global is more balanced towards our foreign where we have over the bulk of our manufacturing facilities.

But nothing fundamentally has changed in terms of the operating flow of it.

John Franzreb – Sidoti & Company

Okay. I was just curious to see the cash flow, if the debt goes up. And especially so much cash. What percent of cash is overseas?

Donna Belusar

The predominant amount of it is overseas.

John Franzreb – Sidoti & Company

Okay. Thanks. I’ll let somebody else get in.

Donna Belusar

Yeah. Well, I will close though with one of the things I did say, though is we expect our debt to go down by $10 to $15 million by year end. So that should help you.

John Franzreb – Sidoti & Company

You know, since you brought it up. Donna, down $10 to $15 million, but did you also say free cash flow of $20 to $25?

Donna Belusar

Yeah.

John Franzreb – Sidoti & Company

Now, if you’re at free cash flow for the first half of the year, probably 100,000 or so if I did the math right. That’s substantial improvement in the second half. Could you just discuss how you’re going to get from, you know, essentially a break-even free cash flow first half to a $20 million in the second half? Can you just talk about that?

Vinod Khilnani

John, it’s primarily timing of how your cash increases in your working capitals. The profitability was high in the first half, but because we were ramping up sales predominately all your cash goes towards funding your working capital.

Once your sales levels are high and sustained with relatively small uptick in your growth, and depending on where it is, your working capital should begin to generate.

We also had unusually low accounts payable at the end of the second quarter, lower than normal. And so we think there will be a positive impact on that. So it’s really timing between quarters.

John Franzreb – Sidoti & Company

Okay. So it’s the function of the payables, I guess some inventory drawdown because you’re probably building, you mentioned the components shortage, right?

Vinod Khilnani

Yes.

Donna Belusar

Yes.

John Franzreb – Sidoti & Company

And obviously, receivables have to come down substantially.

Donna Belusar

Yep.

John Franzreb – Sidoti & Company

Okay. All right. Thank you.

Donna Belusar

Thank, John.

Operator

Your next question comes from the line of Jim McIlree from Neuberger Berman. Please go ahead.

Jim McIlree – Neuberger Berman

Hey, Vinod. I just appreciate the balance sheet review. I wanted to get a little better understanding. You’ve generated some nice wins in the [inaudible] of particularly some turbo-related ones. And if there’s any other – can you expand on that a little more. Are there some other areas that we should be looking at where you feel the company is well positioned with some new technology?

Vinod Khilnani.

I think the really three different things I would like to highlight; the first one is historically, we have sensing technology and we really want to diversify our base, and we are going beyond the traditional pedal-modules of position sensors and we were on a path to go convince our customers that they should be looking at a broader array of sensors from the company.

And the most recent appraisal we did on a brand new sensor application, although the volumes were small, but what was significant about that was we’re beginning to succeed in taking our sensing technology to newer application. And that’s an advance engine management system we have our sensors [inaudible].

So that one aspect there, we are talking ours sensors in brand new areas. The second huge opportunity, which we didn’t talk about in this quarter, but we have talked in the past is whereby we are going into diesel engines, which are taking us, on-and-off highway diesel engines and trucks. But it also takes us in the commercial application, other commercial applications like conception, and mining, and ag. And that’s a huge opportunity.

We announced some fairly large wins in 2009, $100 million plus. That product will start rolling out and begin to benefit our top line tail end of 2012 timeframe. And right now we are actually, as I pointed out, investing close to $3 million per year, which is an investment in our new products and new technology, which will help us tremendously going forward, and broaden our product offering. So that’s the second major thrust.

In electronic components, similar strategy. We are taking our piezoceramic product, which traditionally we have only talked about ultrasonic medical application, or commercial inkjet applications, or obviously, energy exploration. We have the new business line where we are taking our piezoceramic product on high-density disc-drive actuation application.

So those are some examples similar to Turbo applications where CTS will not only enjoy the normal economic activity-driven growth, but we are actually going into brand-new markets. So even if we are able to get smaller penetration, or reasonable amount of market shares, that will all be incremental growth to the top line.

Jim McIlree – Neuberger Berman

Okay. Can I – a follow up on this, if I can. You had some success expanding into say a subsystems application on a few things. And this sounds like these are, you know, discreet sensor components. Are there any sort of sub-system type of applications as you look at the engine, whether it’s gasoline or diesel sort of thing?

Vinod Khilnani

Yes. In some areas where we are looking to approach it from a sub-system point of view is where we are beginning to combine sensing and actuation. And we give it a term, Smart Actuator, but it essentially is taking it up the food chain whereby just sensing and activity are an event, we are sensing them as an actuation component in that vehicle.

Jim McIlree – Neuberger Berman

Okay. Great. Thank you.

Operator

Your next question comes from the line of Hindi Susanto from Gabelli & Company. Please go ahead.

Hindi Susanto – Gabelli & Company

Good morning, all. First off, I looked back to the guidance, you mentioned that the W5 guidance reflects the push out in part of your EMS business. Are there any reasons in the compound business that influences the revised guidance?

Vinod Khilnani

No, actually component and sensor business is equal to or better than our expectations in the second quarter. And we have no reason to believe that the component and sensor business will be less than what we expected before.

Hindi Susanto – Gabelli & Company

Okay. And historically, Motorola is a major customers of CTS, the EMS business, may I know what your current business relationship with Motorola at this point?

Vinod Khilnani

Yeah, Motorola as a key customer, we not only do business with Motorola on the EMS side, Hindi, but we also do business with Motorola on the electronic component side.

Both the sides combined, Motorola probably runs 8% of our sales, approximately. And very roughly, you know, I would assume it’s probably split half and half, maybe a little bit more on the EMS side than components.

Hindi Susanto – Gabelli & Company

And do you have any footprint in there one the new smartphone product line up?

Vinod Khilnani

We do very little from a component in the cell phone side. Our sales to them are primarily focused on their wireless infrastructure footprint. And there, we are willing, with Motorola and others design wins beyond the 3G. So we are an LTE, which is sort of the 4G kind of technology. So we are getting design wins on the future technology.

Hindi Susanto – Gabelli & Company

Do you expect any impact coming from Motorola sales of the majority of its network, as such to Nokia or Kyocera’s, network?

Vinod Khilnani

The Kyocera network is also a good customer of CTS, the component side. And you know, I’m not aware of any market-share changes between Motorola and NFM, but we look at both of them as important customers.

Hindi Susanto – Gabelli & Company

CTS has four smart-actuator awards. Would you provide updates on those awards, especially with regard to timing? I would like to know which one is on track and which one has experienced some delay.

Vinod Khilnani

Overall, I would say when we talked about it a couple of quarters back, we’re on track. The programs are on track. The volumes for the application sometimes change as the OEMs win larger orders on one program versus another, but they normally keep that fairly confidential. So the pieces may move within the program, but from our point of view, the overall timing stays the same.’

Hindi Susanto – Gabelli & Company

Okay. Thank you.

Operator

(Operator Instructions) Next, you have a followup from John Franzreb from Sidoti. Please go ahead.

John Franzreb – Sidoti

Yes, Vinod, you said that distribution sales were up 53% in your prepared remarks.

Vinod Khilnani

That’s correct.

John Franzreb – Sidoti

How much of that is distribution of total sales?

Vinod Khilnani

Distribution as a percent of total sales, that’s a good question. I’m looking at it here. Distribution of the percent of total CTS sales are probably around 7-8%, it fluctuates between 7% and 10% I would think.

John Franzreb – Sidoti

Okay. I just wanted to get a feel. And I guess to kind of follow up on some of the previous questions, essentially, with wireless infrastructure up 24%, could you give us a sense, just a sense directionally what your expectations are for the balance of this year and into next year of wireless infrastructure volumes? Just give us a sense of what your customers are telling you.

Vinod Khilnani

Wireless infrastructure volumes, I would say, are a little tricky because they are a little lumpy. So we do look at our total electronic components, which includes wireless infrastructure and piezoceramic, and distribution combined. If I combine all of them, if you allow me to give you kind of a macro answer to that, then we overall are looking at volumes to continue to stay strong in the third quarters based on what we are hearing.

We sense from our customers that they still are seeing some pent-up demand. We are sensing from the customers that they would have actually pulled a little bit more from us, but they couldn’t because they were experiencing some sporadic component shortages. I saw actually in the earnings release of AlcaTel Lucent, and Erickson, I believe, that their shipments were effected, and we are hearing a little bit of the same kind of news from our EMS people, the normal 15-16 week lead times are becoming more like 20-25 week lead times.

So in some pockets there’s a pent-up demand, and because of that, we feel pretty upbeat on our electronic components going forward, at least in the short-medium term.

John Franzreb – Sidoti

Okay. Perfect. Thank you very much, Vinod.

Operator

And at this time, there are no further questions.

Mitch Walorski

I would like to remind our listeners that a replay of this conference call will be available from 1:30 p.m. Eastern Daylight Time today, to 11:59 p.m. on Tuesday, August 3rd, 2010.

The number for the replay is 1-800-475-6701, or 320-365-3844 if calling from outside the U.S. The access code is 164863.

Thank you for joining us today.

Operator

Ladies and Gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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