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CTS Corporation (NYSE:CTS)

Q4 2007 Earnings Call

January 31, 2008 5:00 pm ET

Executives

Mitchell Walorski - Director Planning and Investor Relations

Vinod M. Khilnani – President and Chief Executive Officer

Donna Belusar - Senior Vice President and Chief Financial Officer

Matthew W. Long - Treasurer

Analysts

Analyst – Gabelli

Analyst for Kevin Kessel - Bear Stearns

Sean Hannan – Needham & Company

John Franzreb – Sidoti & Company

Operator

Welcome to the fourth quarter and full year 2007 earnings conference call. (Operator Instructions). As a reminder, today’s conference call is being recorded.

I would now like to turn the conference over to your host, Director of Planning and Investor Relations, Mitchell Walorski.

Mitchell Walorski

Thank you, Anna. I’m Mitchell Walorski, Director of Planning and Investor Relations and I will host the CTS Corporation fourth quarter 2007 earnings conference call. Thank you for joining us today. Participating from the company today are Vinod Khilnani, President and CEO; Donna Belusar, Senior Vice President and Chief Financial Officer; and Matt Long, Treasurer.

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 Relations section.

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

Vinod M. Khilnani

Thank you, Mitch and good morning everyone. Last evening we released our fourth quarter and full year 2007 financial results. I am pleased to report that we recorded a stronger than expected fourth quarter, with earnings per share and free cash flow both exceeding our earlier projections.

Adjusted earnings per share, which excluded the previously announced restructuring charge, were $0.25 versus consensus estimates of $0.20. Full year adjusted EPS was $0.71, versus our previous guidance of $0.65 to $0.68.

Sales in the fourth quarter of $178.3 million were up 3% year-over-year, sales for the full year at $685.9 million were 5% higher than 2006. On a segment basis, component and sensor sales were $71.1 million, up 8.2% from the fourth quarter of 2006.

Automotive sensors and actuator products were up 6.2% despite lower fourth quarter 2007 light vehicle sales and production in the U.S. year-over-year. Strength in CTS sensors and actuator sales were reflective of our growing business with non-big three automotive OEMs, and continuation of double-digit growth of our automotive sales in the Asia Pacific Region.

Sales of Electronic Components were up a strong 11.8%, driven by a 27% increase in sales for communication infrastructure applications. EMS sales in the fourth quarter were essentially flat compared to the same quarter in 2006.

Gross and operating margins were both better than expected, helped by favorable segment mix as a component and sensor segment grew faster, combined with some price increases in our Automotive business and improved operating efficiencies. Free cash-flow was also better than our previous estimates.

Let me now comment on some positive developments in the fourth quarter that will be important as we look ahead. Beginning with the Automotive business, we captured 15 new platforms in the fourth quarter with annual sales potential of approximately $8 million.

Almost all of these wins came from Japanese and other Asian automotive OEMs. On a full year basis, CTS Automotive was awarded 28 new business awards in 2007. Approximately 20% of these new awards came from the North American big three OEMs.

These new awards reflect our progress to successfully broaden and diversify our customer base. Approximately 50% of our total sensor and actuator sales were to North American big three automotive OEMs in 2007. This percentage is projected to go down to roughly 39% in 2008, reflecting our increasing penetration of OEMs like Honeywell, Toyota, Honda and Chery.

In Electronic Components also we had an excellent quarter with 77 new design wins in the fourth quarter, up 6% sequentially and up 24% year-over-year. New design wins were in the arenas of WiFi, WiMax applications, 3G wireless and audit modules for base stations.

In the Telecommunications market, we’ll highlight a few key activities. Electronic Components business established preferred supply relationships with leading OEMs in Europe, China and India.

Nokia Siemens Networks signed a global supply agreement with CTS and began receiving production shipments of radio frequency modules during the year. ZTE, a leading telecom company based in China, signed a supply agreement and began qualifications of CTS oscillators for shipment in 2008. In addition, CTS won new business from a fast growing Indian optical network equipment company.

In our EMS business, four new customers were captured in the fourth quarter. On a full year basis, EMS won 17 new customers. Excluding HP, EMS sales were up 19% in full year 2007 versus 2006.

Our Singapore EMS operations received AS9100 Aerospace Quality certification, only third EMS provider in Singapore to gain such certification. We also received TL 9000, a telecommunication certification at our EMS locations in Thailand and Singapore. These certifications are important for us to win new business at these operations.

In the acquisitions and alliance arena, we have streamlined the process to surface and evaluate potential targets and execute transactions more efficiently. As a result, we have completed two small tuck-in acquisitions: Alpha Ceramics in December 2007 and Tusonix this month.

Both the transactions were in our components and sensor segment. We are now working on two other potential transactions, a small accretive acquisition in U.S., and a small joint venture in India to manufacture sensor and actuator products for that rapidly growing automotive market.

I would also like to mention a major new strategic growth initiative which we have been pursuing aggressively to penetrate commercial markets with our sensor and actuator products. It is a new $1 billion market, and we are targeting to capture 10% of it in the next five-six years.

This is an exciting developing opportunity for us which can accelerate our sensor and actuator sales significantly beginning in late next year and beyond. We will be sharing with you more information on this initiative and our progress in the coming months.

On the organization front, I am delighted to have Donna Belusar join our leadership team as Senior Vice President and Chief Financial Officer. Donna joined CTS after 25 years of leadership experience at IBM and will lead the finance and IT activities at CTS.

In addition, we have added a senior resource from EMC Corporation on my staff to drive corporate wide Six Sigma and Lean Manufacturing and other business profit improvement initiatives.

Looking ahead to 2008, we expect full year sales growth to be in the range of 5% to 8% with some EMS end-of-life sales declines offset by incremental sales from the acquisition activity. Overall, higher growth is expected in our components and sensor segment, making it closer to 45% of the total company in 2008 versus approximately 40% today.

Full year diluted EPS is expected to be in the range of $0.78 to $0.83 which also includes approximately $0.03 to $0.05 per share of engineering and R&D resources or expenses related to those things for the launch of our new commercial market growth initiative which I mentioned earlier.

And now I will turn the meeting over to Matt Long our Treasurer to discuss our financial results in more detail.

Matthew W. Long

Thanks, Vinod. We finished the quarter with sales of $178.3 million, up 3% from last year. Adjusted diluted earnings, which exclude restructuring charge, improved 25% to $0.25 per share, compared to $0.20 per share in the fourth quarter of 2006.

Full year diluted earnings per share increased 5% year-over-year to $0.66 in 2007, from $0.63 in 2006 on a sales increase of 5%. The adjusted diluted earnings per share of $0.71, which excludes the restructuring expense, were equal to the adjusted diluted earnings per share in 2006.

However, please note that 2007 earnings per share were adversely affected by the $0.05 charge related to the accounting investigation.

Fourth quarter gross margins were the best we have seen since the beginning of 2006 at 20%, which was 7/10 of a percent better than the third quarter and 2.8 percentage points higher than a year ago quarter. The year-over-year improvement in gross margins is primarily due to the improvement in operational efficiencies and improved products mixed within the EMS segment.

SG&A and R&D expenses of $23.7 million, or 13.3% of sales in the fourth quarter, improved sequentially from 13.7% in the third quarter, but was 1.3 points higher than the fourth quarter last year. The year-over-year increase is primarily due to certain credits in 2006 and the CEO transition costs in 2007.

On a full year basis, SG&A and R&D expenses were 14.3% versus 13.2% for 2006. Excluding the investigation costs from the 2007 expenses, the normalized SG&A and R&D expenses as a percent of sales were 13.8% in 2007 versus 13.2% in 2006.

Interest and other expenses in the fourth quarter were approximately $500,000 better due to higher interest income from higher tax balance. The full year effective tax rate increased to 21.75% in 2007 from 21% in 2006, primarily due to earnings mix in the various tax jurisdictions where we operate.

From a balance sheet perspective, we are pleased to report excellent performance in the management of working capital. Our controllable working capital as a percent of annualized sales at 12.7% beat our target of 13% while matching our 2006 performance.

Year-over-year, we improved our DSO by three days to 50. Inventory turns at 8 in 2007 were lower than 2006 turns of 11 due to higher than normal product transfer activity and new EMS business that required larger inventory levels at the beginning of the program. We expect inventory turns to improve in 2008 as we work those balances down.

Full year 2007 operating cash flow of $48.6 million further improved from $47.2 million in 2006. Capital expenditure for the full year of 2007 at $16.1 million, or 2.3% of sales, was in line with 2006 at $15.8 million, or 2.4% of sales.

The 2007 free cash flow of $32.5 million beat last year’s record of $31.4 million, and was higher than our guidance for the year of $27 to $29 million. Positive free cash flow is defined as cash flow from operating activities less capital expenditures.

CTS purchased approximately 1 million shares of its stock during the quarter, leaving just over 600,000 shares remaining in the current 2 million share buyback authorization. The debt-to-capital ratio stayed below 20% at 18.4%, compared to the 17.2% last year.

Looking to 2008, we expect the full year effective tax rate to move up further by 1 to 2 percentage points as our profitability in the U.S. further increases. We expect our CapEx to be in the range of $22 to $25 million for the full year 2008 and positive free cash flow therefore is expected to be in the range of $28 to $32 million.

And with that, we will open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Kevin Kessel - Bear Stearns.

Analyst for Kevin Kessel - Bear Stearns

This is (Yeung?) for Kevin. A couple questions; first though some bookkeeping questions. What is the depreciation and amortization for this quarter?

Matthew W. Long

The depreciation was $5.1 million and amortization was $800,000.

Analyst for Kevin Kessel - Bear Stearns

So, what’s the stock expense for this quarter?

Matthew W. Long

It was $53,000.

Analyst for Kevin Kessel - Bear Stearns

My next question is regarding your largest customer HP, what’s the percentage of sales for them this quarter?

Vinod M. Khilnani

I am looking at the full year numbers first, so let me give you full year because the quarters may fluctuate. The full year number for HP was 17.1% for 2007, and the same number for last year was closer to I believe 22%.

Analyst for Kevin Kessel - Bear Stearns

So, going forward for 2008, what’s the percentage range do you expect from HP?

Vinod M. Khilnani

We have stated that due to end-of-life products, we will continue to see that percent come down, and as we have stated before, the focused area in EMS, which are medical, industrial and defense and aerospace, will continue to go down as a percent of total EMS business.

So for example, full year 2007, those three focused areas were close to 26% of the EMS business, while they were close to 20% last year. So we continue to broaden and grow that piece which is our focused area because we have chosen those areas to target.

Analyst for Kevin Kessel - Bear Stearns

So maybe we can switch gears a little bit. Regarding your EMS business we noticed that for this quarter your operating margin is basically flat on a sequential basis, it’s about 3.6%, which we noticed that it is still below your 5% target. So, going forward, can you give us a little bit of color on your margin improvement for your EMS business?

Vinod M. Khilnani

On a full year basis, the EMS margins have improved nicely from I believe approximately 2.5% or so. Actually on a full year basis, EMS has gone from 1.6%, which was fairly low, to 2.5%. If you look at it on a quarterly basis, they have gone from 2.6% last year in the fourth quarter to 3.6% in the fourth quarter of this year.

We have said in the past that our goal is for EMS business to go up to 5% of operating margin, because 5% operating margin in that business makes it equal to our component and sensor business when you look at return on invested capital. Because their capital intensity is lower and they turn their assets more, 5% operating margin in that business, it’s closer to 14% operating margin in the component and sensor business when we look at return on invested capital.

So we move these margins up from 2.5% range to 3.5% to 4% range, our goal will stay at 5% and we have said in the past that we do need to take these margins up to 5%, and the way we intend to take those margins up is a) we need to improve the mix in the EMS business which you’re seeing us do by making defense, medical and industrial as a bigger percent of the EMS business, and b) continuing to improve our capacity utilization in the EMS business.

Analyst for Kevin Kessel - Bear Stearns

You mentioned in 2007, the three focus segments, defense, medical and industrial, accounted for like 26% of your total sales. So, what’s your target percentage for these three focus areas for 2008?

Vinod M. Khilnani

We don’t really have a target per se by year, but I think you would hopefully see us continue to increase that percent and make it a bigger percent of the EMS business.

Analyst for Kevin Kessel - Bear Stearns

My last question is regarding your acquisition, we noticed that you made two small acquisitions over the last few months, especially this Tusonix acquisition which you are at $50 million sales for the year 2008.

Can you give us some margin profile of this business? Compared to your legacy component business, the operating margin or gross margin of this business is higher or lower than your average right now?

Vinod M. Khilnani

The margin profile of this business, with synergies and everything else we expect to achieve, is fairly similar to the margin profile of our overall component and sensors business, maybe a touch better.

The important thing to note as I said earlier is, as we grow this segment of our business faster, our overall segment mix improves. So, if we go from component and sensors segment business from 40% of the total company to 45% of the total company through organic growth and through these targeted small niche acquisitions, you will see an improvement in overall gross margin and operating margin profile of the company because component and sensors is better than EMS from an operating margin and gross margin perspective.

Analyst for Kevin Kessel - Bear Stearns

What’s the motivation for you to make this acquisition? Is it to try to broaden your product offering or enhance your technology capabilities?

Vinod M. Khilnani

Both, actually. We have said historically that we would be very focused in our approach to acquisitions; we will do acquisitions if we believe that they are either broadening our product offering or our technology base. The need to be synergistic, which means accretive in year one, and they also can be done if we are trying to penetrate a strategic customer or we are trying to penetrate a particular region in the world where we think it’s critical for the corporation to have a footprint.

Operator

Our next question comes from Sean Hannan - Needham.

Sean Hannan - Needham

If there’s a way if you could perhaps expand a little bit on your outlook at least as we look into March, what your thoughts are as you look into both your components space as well as EMS; what the different push and pulls are?

There was some commentary you provided last quarter really specific to some OEM plant shutdowns. There was some other challenges I think that you had seen in telecom. If you can just provide a little bit of commentary around that as we look forward?

Vinod M. Khilnani

On the sensor and actuator side which we call our Automotive side of the business, we obviously have some concerns because we continue to see fairly soft markets in North America and the data which has been published indicates that 2008 would have lower production and sales for light vehicle market in North America in 2008 compared to 2007, so that is definitely somewhat a negative for us.

In the case of CTS however, what is offsetting that to a large extent, is the fact that majority of the business we have won in recent months and quarters is focused on non-Big Three North American OEMs, so we are very rapidly diversifying our customer base with penetration at customers like Toyota and Honda and Chery, so that is helping us. Our growth in Asian market is also helping us since our dependence on the North American market continues to go down.

The other thing which is happening and I mentioned that is that if you heard us talk about our customer base in that business, you would have always heard us talk about either Big Three or Toyota or Renault and Peugeot and those kind of people.

You will hopefully begin to hear us talk about names like Honeywell, and what that indicates to you is that we are now beginning to broaden our sales base from the traditional passenger vehicles to more diesel applications or turbocharger sensors, which actually go much broadly beyond the passenger vehicle.

So, I guess to summarize what I’m suggesting is that yes we are concerned and the market is soft and there are indications that Big Three especially will be cutting production and will probably see first and second quarter production levels lower in 2008 compared to 2007.

However, our initiatives would to a large extent protect us from those kinds of negative trends. They will impact us, but we believe at this point that with all the new initiatives underway we will be able to offset those kinds of headwinds.

In the Electronic Components arena you heard me talk about some new customers, some new supply agreements, some new products and so we are fairly optimistic about our prospects in 2008.

We obviously hear some negative news coming from a macroeconomic point of view, but frankly we haven’t seen an impact on us in our order board if I reflect on where we stand in the first quarter of 2008. So we were watching it very carefully, but we are not seeing any negative impact on that side of the business yet.

As far as EMS was concerned I frankly don’t have anything unusual to report and so the markets are pretty stable, maybe because they are so diversified, that we’re not seeing any indication in either direction as to how 2008 will turn.

Sean Hannan - Needham

For EMS, markets stable on the component side. North America, macro-wise, there are concerns, but really your diversification and also your presence in Asia, and it’s a specific CTS story that allows you to be confident in the growth there.

Vinod M. Khilnani

That’s a pretty good summary.

Sean Hannan - Needham

And then separately, if I look to your estimates, I think it’s roughly 5% to 8% of growth in 2008 on the top line. When we pull out the recent deals that you have announced, I think that it is probably about 2 to 2.5 percentage points of that growth. Is that the right way to think about it in terms of organic versus what’s been acquired?

Vinod M. Khilnani

That’s not the way I would like to look at it. The way I look at it is that our basic growth in our base business is going to be in 5% to 8%, and I would like to see acquisitions try to offset some unusual end-of-life kind of activity primarily in the EMS arena, primarily with HP. So if you look at that end-of-life activity offset by acquisitions, then I think in all of our core businesses you will see us grow organically 5% to 8%.

Sean Hannan - Needham

Then when we are talking about $15 million run rate from Tusonix that is added on top? That’s not a part of your 5% to 8%?

Vinod M. Khilnani

No, I am saying that that kind of an incremental acquisition related growth should be offsetting some end-of-life kind of a product activity and I am looking at both of those two things as somewhat unusual.

Sean Hannan - Needham

And further, you have mentioned two other potential acquisitions or deals there in the pipe – one being a JV and another being an actual deal − are those a part of the 5% to 8% growth assumptions?

Vinod M. Khilnani

At this point, I will assume it is, but it’s unclear some of the economic conditions are unclear; the size of those may be unclear; timing may be a little bit unclear. So, it’s possible that if those things turn out to go in the right direction we may be on the high end of the 5% to 8%, and if the economy stays reasonably stable we may exceed that.

On the other hand, it’s possible that we may be on the lower-end of it so, my thinking is that 5% to 8% should be what we will deliver and we would look at these kind of transactions to make sure they are offsetting some the end-of-life products or some unusual economic activity which may be somewhat negative.

Operator

Our next question is from John Franzreb – Sidoti & Company.

John Franzreb - Sidoti

I just wanted to piggy-back on the last question. If I understood you properly, it’s 5% to 8% organic. You are adding $15 million on but in your prepared comments you discussed EMS sales declines. That $15 million offset − is that essentially the HP business going away or is there other EMS sales declines that you were referencing earlier that we should be aware of?

Vinod M. Khilnani

No it’s really primarily HP which we have been talking about it for couple of years. So, I’m frankly looking at this $15 million and potentially a little bit more activity in this area to essentially offset HP’s end-of-life product.

John Franzreb - Sidoti

You mentioned that order trends are still positive. Could you talk a little bit what the order trends are in the Automotive business? Have they pulled back at all? A little bit about what your thoughts are in the automotive cycle especially early in the year?

Vinod M. Khilnani

The order board looks reasonably good on Electronic Components side. We did see some softness on the distribution side in fourth quarter and may continue in the first quarter, but overall Electronic Components is fairly steady to positive.

Automotive, we are watching very closely, we haven’t seen anything in January. So we are cautiously optimistic; however, I continue to hear that Big Three are looking at cutting their productions maybe a little bit deeper in Q2 timeframe than earlier.

I saw one report which said that Big Three will cut production in Q2; year-over-year they will be down 6%. Now it is negative but again as I said earlier, the impact on CTS will be muted because of our diversification and increasingly higher penetration in the non-Big Three OEMs.

John Franzreb - Sidoti

You mentioned also in your prepared remarks about the $0.03 to $0.05 in R&D and launch expenses that will negatively impact the EPS profile going forward. We’re not to take that as any kind of a non-recurring item. Those costs would be embedded in the R&D and selling lines, is that correct?

Vinod M. Khilnani

That is exactly right. We will not talk about them normally. I just wanted to give you a flavor that qualitatively $0.78 to $0.83 is actually better than the way it looks because we are going to start some brand new growth initiatives and going to invest some targeted money in R&D and engineering resources which will benefit the company tremendously a couple of years down the road. We will absorb them and they are already included in our estimates of $0.78 to $0.83.

John Franzreb - Sidoti

And what’s the timing of those expenses?

Vinod M. Khilnani

Probably would be spread throughout 2008.

John Franzreb - Sidoti

So we won’t see any incremental bump ups sequentially in any given quarter?

Vinod M. Khilnani

You hopefully will not see any bump.

John Franzreb - Sidoti

Just a little bit into the nitty-gritty here, in the fourth quarter your other income line was up rather noticeably on a sequential basis, I want you to just walk through what happened there?

Vinod M. Khilnani

You are looking at income?

John Franzreb - Sidoti

The other income number is $1.4 million.

Vinod M. Khilnani

Sequentially, you’re looking at net earnings?

John Franzreb - Sidoti

No, I’m looking at the P&L, the other income line?

Matthew W. Long

It was primarily the interest income that we talked about in the prepared statement, as our cash was increased we gained incremental interest on that. And then we had some favorable translation gain, foreign exchange.

Vinod M. Khilnani

So elaborating on Matt’s comment you see a separate line interest expense, but Matt is saying that interest income is included in other line.

John Franzreb - Sidoti

It’s $1.4 million versus $800,000? Pretty much the run rate you’ve been going at?

Vinod M. Khilnani

Yes, and then we have some small translation gain.

John Franzreb - Sidoti

One last question. Your stock’s take has been pretty weak as of late. Just talk a little bit about your appetite for repurchasing your own stock versus acquisitions?

Vinod M. Khilnani

John we have never commented on forward action on buyback. We hope people will draw their conclusion based on our actions looking back and as Matt pointed out, we were fairly aggressive in the fourth quarter. Obviously the stock was clearly below where it needs to be and it was a tremendous value to us and so we were fairly aggressive in buying back stock.

And the other thing I will repeat, which Matt said, that we have 600,000 left in that program. So, from time-to-time, the Board reviews that along with the whole bunch of other initiatives and they will continue to do that.

Operator

We have a question from [inaudible] - Gabelli.

Analyst – Gabelli

I have a question about the details in the balance sheet. I saw that your inventory rose by $13 million. Can you shed some light on that?

Vinod M. Khilnani

Yes, some of it was activity-related, but as Matt pointed out our inventory turns were not as healthy as they were in the prior years primarily because of some product transfers between our locations and some new program launches and as we indicated we have to build some extra inventory in the front of new program launches.

So, we expect inventory turns to go back to closer to more normal levels I think in the next couple of quarters. Nothing specific; nothing unusual in our mind.

Analyst – Gabelli

And then on the SG&A line, there is an increase of $3 million. And I wonder what kind of trend we should expect for 2008?

Vinod M. Khilnani

Are you looking at full year 2006 versus full year 2007?

Analyst – Gabelli

No, just the fourth quarter of 2007.

Vinod M. Khilnani

Are you looking at selling, general and administration number?

Analyst – Gabelli

Yes.

Vinod M. Khilnani

We’re looking at that number to be the same as Q3.

Analyst – Gabelli

Actually, a year ago?

Vinod M. Khilnani

Yes, it’s a year ago. So, sequentially we are fine. I think year-ago level we are higher. And there are some year-end or timing related things. We’ll look into that and we’ll cycle back to you if there is something unusual.

Operator

And there are no further questions in queue at this time.

Mitchell Walorski

I would like to remind our listeners that a replay of this conference call will be available from 1:00 PM Eastern Standard Time today through 11:59 PM on Thursday, February 7. 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 906728. And thank you for joining us today.

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