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CTS Corporation (NYSE:CTS)

Q1 2008 Earnings Call Transcript

April 30, 2008 11:00 am ET

Executives

Mitch Walorski – Director of IR

Vinod Khilnani – President and CEO

Donna Belusar – SVP and CFO

Analysts

Kevin Kessel – Bear Stearns

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Q1 2008 earnings conference call. (Operator instructions) As a reminder, this conference is being recorded. I would now like to the conference over to our host, Mr. Mitch Walorski. Please, go ahead.

Mitch Walorski

Thank you, Kathy. I'm Mitch Walorski, Director of Investor Relations, and I will host the CTS Corporation first 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 were 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 Web site in the Investor Relations section. I will now turn the discussion over to our CEO, Vinod Khilnani.

Vinod Khilnani

Thanks, Mitch, and good morning, everyone. Last evening we released our first quarter financial results for 2008. I'm pleased to report that despite the challenging economic environment both sales and earnings per share were better than our expectations for the quarter.

Sales at $172.8 million were up 5.8% over the first quarter last year, driven by strong revenue growth in our components and sensors segment. Diluted earnings per share were $0.18, up 64% from $0.11 in the first quarter of last year. The first quarter last year reflected $0.02 per share negative impact from unusual audit and professional fees.

First quarter 2008 earnings, on the other hand, were helped by a favorable segment mix as our components and sensor sales increased to 45% of our total sales in the first quarter of 2008 versus 42.6% in the same quarter last year. In addition, both the EMS business and component and sensors business improved their operating margins in the first quarter of 2008 versus first quarter last year. On a segment basis, component and sensor sales were $77.8 million, up 12% from the first quarter of 2007. Within that segment, automotive sensor and actuator products were up 2.6%, despite 9% drop in North American light vehicle production from approximately 4 million units in the first quarter of 2007 to approximately 3.6 million in the first quarter of 2008.

Year over year, light vehicle production in Europe was also down approximately 4% in the first quarter. Electronic component sales were up a strong 31% year over year. Communication infrastructure and piezo material product shipments were up 46% and 43% respectively in the first quarter of 2008 versus last year.

Our distribution channel sales were also up 9% in the first quarter compared to last year. In total, organic growth in electronic component sales was approximately 18.5% with the remaining 12.5% growth in sales coming from the Tusonix acquisition. Strength in our component and sensor business overall was reflective of our diversification and increased market share, driven by new customers and new products.

Our automotive sensors and actuator products continue to diversify away from the big three U.S. OEMs as we grow our business with customers like Toyota, Nissan and Honda. Continuing growth of our sales in the Asia Pacific region and new product introductions especially for communication infrastructure applications are examples of customer, geographical and product line diversification.

EMS sales in the first quarter were $95 million, up 1.3% from last year. Sales in our focus areas of medical, industrial and defense and aerospace in total were up 6.5% year over year. EMS sales to Hewlett-Packard were approximately $28.6 million in the quarter, down 6.5% from the same quarter last year, as expected and in line with our earlier comments.

Gross and operating margins were both better than last year, helped by improved segment mix as our component and sensor segment grew faster, success in negotiating some price increases and improved operations overall. Some other highlights for the quarter are, in automotive, we received six new sensor and actuator business awards. The most noteworthy of them was $75 million over six-year supply agreement with a major North American diesel engine manufacturer to develop a smart actuator for a light-duty diesel engine to be launched in the fourth quarter of 2009.

This new customer, new product and new application is helping CTS establish its foothold in the commercial market, which is an important growth opportunity for our sensor and actuator technology to grow into. In the electronic components arena, we had 45 new design wins for RF components, up 15% from 39 design wins in the same quarter last year. Most of the new design wins were in the military and aerospace, 3G wireless and WiMAX areas.

On the mergers and acquisition front, we completed two small strategic acquisitions in the first quarter. In January, we completed the acquisition of Tusonix, a $15 million revenue company that manufactures ceramic filters, capacitor assemblies and related components. The acquisition expanded our technology and customer base and will be accretive in 2008.

In March, we completed the acquisition of Orion Manufacturing, a San Jose based EMS company with annual revenues of approximately $26 million, focused on defense and aerospace, industrial and medical markets. We are currently in the process of consolidating our Santa Clara and Orion, San Jose, operations both currently in a leased facility into a single leased facility in the same area.

From a macro economic perspective, we did see some weakness primarily in the automotive and communication industries. However, we were able to offset the impact of the weak economic environment in the U.S. with new products, new customers and a strong presence in the Asian markets. Fully 35% of our total sales in the first quarter were in the Asia Pacific region. We nevertheless remain cautious, given the uncertainties caused by the turmoil in the credit and housing markets here at home.

Given our first quarter performance and diversified business model, we are comfortable with reiterating our full year sales growth guidance in the range of 5% to 8% and full year diluted earnings per share guidance of $0.78 to $0.83. And now, I will turn the meeting over to Donna Belusar, our Chief Financial Officer, who will provide further details regarding our financial results.

Donna Belusar

Thank you, Vinod, and a welcome to all of you. Our first quarter financial results are a good, solid start to 2008 with growth in revenue and earnings per share. As you will see the performance reflects the strength of our global footprint. By leveraging our manufacturing capabilities and the opportunities of a global economy, we delivered in the first quarter $172.8 million in sales, a growth of 5.8% from sales in first quarter 2007.

We maintained our focus on cost and expense management, while continuing to invest for growth in key markets via acquisitions and increasing to a slightly higher level of research and development expense. With this operating leverage, net earnings came in at $6.7 million, up $2.6 million from first quarter 2007. Bottom line, our CTS business delivered earnings of $0.18 per diluted share, up 64% compared to $0.11 per diluted share in first quarter 2007.

Now, let me provide you some further insight into the first quarter details staring with revenue. As mentioned, total first quarter 2008 sales were $172.8 million, nearly 6% revenue growth year over year from the first quarter of 2007. With this revenue growth our operating earnings margin as a percentage of sales improved nearly two percentage points year over year to 4.9%, up from 3% in the first quarter of 2007.

Peeling back operating margin in the first quarter, gross profit margin percentage improved 100 basis points to 19.6% driven by favorable segment sales mix and favorable product mix. In addition, selling, general and administrative expenses and research and development expenses as a percentage of sales declined 100 basis points to 14.6% of sales in the first quarter of 2008, down from a high of 15.6% in the first quarter of 2007.

Our operational performance is the result of actions taken to manage spending in the current environment, while continuing to invest in areas that will drive growth over time, especially in expanded applications and new product development, as well as current product and process enhancement.

Total interest and other expenses were flat year over year in spite of higher interest expense in the first quarter 2008 associated with increased debt, primarily due to and in support of the first two quarter strategic acquisitions. I will discuss debt a bit more shortly.

Our first quarter 2008 effective tax rate was 22% versus 21% in the same quarter last year. I started our discussion highlighting how our performance reflects the strength of our global footprint. Comparing to the first quarter 2007, the U.S. dollar has weakened against nearly all major foreign currency, approximately 9 to 10% relative to our basket of currencies. This created additional expenses and costs to our business operations. However, on the other hand, as we grew assets with a foreign currency appreciated against the U.S. dollar, the favorable impact helped minimize any potential negative overall currency impact to the bottom line.

Net earnings were $6.7 million or $0.18 per diluted share, in the first quarter of 2008, compared with $4 million or $0.11 per diluted share in the first quarter of 2007. Higher net earnings were the result of improved gross profit margins and overall lower operating expenses in the first quarter of 2008, as other income remained essentially flat.

Now let's turn to CTS’ balance sheet performance. Overall changes in our first quarter 2008 balance sheet reflect the management of our recent strategic acquisitions. Our controllable working capital is $113 million or 16% as a percent of annualized sales. This is up sequentially from year end 2007, driven by an increase in inventory of $10 million and higher accounts receivable of $7.5 million, both of which resulted primarily from acquisitions during the quarter.

Our expectation is to manage the full year controllable working capital to our target objective of 13% of annualized sales. Net cash used by operating activities for the first quarter 2008 was $5.5 million. Three-quarters of the net cash used in the quarter is timing related to payables, driven by our policy to selectively leverage early payment terms and discounts from some of our key suppliers. The remaining is driven by the integration of the acquisitions into our CTS business during the quarter.

As a result, our long-term debt, net of cash and cash equivalents, increased from $19.1 million as of December 31, 2007, to $57.4 million as of March 30, 2008. Roughly half of the debt increase is acquisition-based and the remaining one half is associated with the timing of our working capital.

We expect our full year free cash flow to be on track with early estimates in the range of $28 million to $32 million, with CapEx to be in the range of $22 million to $25 million. CTS repurchased 689,800 shares of stock during the quarter at an average purchase price of $9.87 per share.

So, we finished the first quarter 2008 with a strong operating and financial position. We have a strong portfolio of products and customers. We have a global footprint base of capabilities. Our operating model is in place and executing well. And we are integrating the acquisitions and are being successful in bringing these technologies and business to our customer base. And we have a solid balance sheet. So, with that, I'd like to open it up, the call, for your questions. So, operator, would you please open the lines for questions. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) One moment for the first question. Our first question is from the line of Kevin Kessel. Your line is open. Please go ahead.

Kevin Kessel – Bear Stearns

Sure. Can you hear me?

Vinod Khilnani

Yes.

Donna Belusar

Yes.

Kevin Kessel – Bear Stearns

Great. So, I guess my first question is, Vinod, so, for the full-year guidance that you mentioned today that you reiterated 5% to 8% growth and $0.78 to $0.83, when I look at it and I look at the two tuck-in acquisitions you did so far, based on my math, I don't know if I'm right or not, but I calculate that you might have got as much as $3 million possibly in contribution in the first quarter. And then overall, based on the run rates they were at, it would be close to $35 million for the year, which actually works out to about 5% year-on-year growth versus '07. So, in other words, if the acquisitions never happened, I'm actually curious whether or not the environment is such that you would actually have to be reducing your expectations. And on top of that, you mentioned they are both accretive, yet it's the same EPS range?

Vinod Khilnani

Kevin, first commenting on the top line, you will remember that in January when we gave the guidance for 2008, we did say that – at that time we had one acquisition completed, in fact second acquisition we mentioned was going to be completed. At that time, we said that our growth target on the one hand would reflect what I will call somewhat unusual end of life EMS HP-related product. And so we said that that unusual negative will be offset by non-organic acquisition activity. And so, in our mind those two things offset each other very roughly and so we believe that the top line growth, which we were guiding the Street, was truly reflective of all the focus areas we are driving. Those are sensors and actuators and communication infrastructure components, and in EMS, defense and aerospace, industrial and medical market. As far as the bottom line is concerned, you are exactly right, both of these acquisitions we have done in the first quarter are accretive, approximately one penny each. And so that does give us an upside to our guidance. But as I said, we are still fairly cautious about the rest of the year and we want to watch it. And if the things don't deteriorate, we probably will be on the very top end of our guidance. But we did not feel comfortable to change the guidance at this time, given the fact it's only the first quarter and there were still a few things up in the air from the macroeconomic point of view.

Kevin Kessel – Bear Stearns

So, that makes sense to me. I had forgotten that you'd made that statement regarding the fact that, in other words that they were already contemplated in the 5% to 8%.

Vinod Khilnani

But, I'm glad you asked the question because it allows me to clarify the comment that the top line growth guidance is we believe fully reflective of the increase in our organic business.

Kevin Kessel – Bear Stearns

Then the other question I guess I have is, you say they roughly offset each other. So, you said, HP now is, I think you said, $28.6 million in the actual quarter. Can you just remind us what it was in the previous quarter in December? And then, how that end of life is seen playing out? Is it going to take a year? Is it going to take two years before essentially it becomes almost negligible from a revenue perspective?

Vinod Khilnani

Okay. If you allow me to go back to 2005 an environment, in 2005, for example our total HP sales were in the range of $180 million per year with the first quarter '05 being around $47 million, $48 million. Fast forward to '06, that $180 million came down to $140 million as we went through partial end of life product discussion, which we have done in the past. '07 full year was something like $115 million, $116 million kind of a number and that number in 2008 we are projecting is closer to $70 million. And going forward in '09, we are still not clear that how rapidly that product range will be phased out, but our current estimate is that in 2009 that number will probably go from $70 million to probably $40 million in range. But that's uncertain.

Kevin Kessel – Bear Stearns

I understand. What was it last quarter on that quarterly basis? It was $28.6 million this quarter?

Vinod Khilnani

Sequentially, you mean?

Kevin Kessel – Bear Stearns

Yes. Sequentially, what was the dollar amount in December?

Vinod Khilnani

December quarter was slightly higher. It was $31.7 million.

Kevin Kessel – Bear Stearns

Okay. So, even with end of life, it actually, on a seasonal basis, it doesn't – even though there's some seasonality in that business, it doesn't appear that it really affected it much?

Vinod Khilnani

Yes, actually, the sales were somewhat higher than our projections to HP. And that's why we have said in the past it's very difficult for us to project the quarterly sales because they do fluctuate based on the demand and based on the mix of the product, mix of the HP product from a storage point of view.

Kevin Kessel – Bear Stearns

From a margin perspective, do you feel like, as this program goes end of life, it's being replaced with again, the focus business you mentioned that at a higher or margin accretive, will it be a margin accretive in other words, the revenue that you are backfilling it with in EMS?

Vinod Khilnani

Yes. Overall, if you look at HP business or instead of saying HP business, let me rather say EMS, computer EMS business versus the three focused areas we have talked about, defense and medical and industrial. We clearly have higher gross margins in those markets than computers. So, over the long term, it's definitely benefiting us. But when you break it down by quarters, depending on how the HP business phases out at what speed and at what speed we replace that, you obviously may have some short-term quarter-by-quarter capacity utilization issues, which can swing the margins. But we are clearly seeing, as we grow our focused areas in EMS faster than those areas are growing. So, we have been growing in the last couple of years, those focus areas double digits, which is higher than the market growth. They are bringing in higher margins than our EMS margins in the computer segment.

Kevin Kessel – Bear Stearns

I got it. And then, just last question I guess is just more housekeeping for Donna. One is the tax rate, it came down a little bit below I think what we were expecting of 23.5%. I don't know if the 22% level is sustainable. And secondly, if there's an expectation at all for cash flow and free cash flow for 2008 because I think in the past you used to give it, Vinod, on an annual basis. And then any 10% customers besides HP that you could share with us?

Vinod Khilnani

You asked three questions. Let me start from the reverse, I guess. There are no other customers other than HP which are more than 10%. And as we continue to diversify our customer base, other than maybe one other customer, there aren't any other customers which are even 5% of our sales. So, that process continues very satisfactorily. The cash flow, I think Donna gave the guidance and reiterated the free cash flow. So, that's the same as what we gave last time. We feel reasonably comfortable with that guidance, so that's why Donna reiterated the free cash flow guidance, despite the fact that, due to timing, the first quarter free cash flow was lower than first quarter '07. But that, as she said is primarily timing oriented and she's sticking with the guidance for the full year. Tax rate it fluctuates between the mix, between the profits we captured in the U.S. versus international. I think the guidance we gave at the end of January was similar to 23% 24% number, which you remember. This quarter did come out little bit lower than that and we still think that the full year number may still be in 23%, 24% range. But it can fluctuate, plus, minus, 1%.

Kevin Kessel – Bear Stearns

Thank you very much.

Operator

(Operator instructions) Mr. Kessel, do you have a question again?

Kevin Kessel – Bear Stearns

Yes, just a follow up, if there aren't others in queue. So, then going back to your EMS business, operating margin of 2%, and I think that again the stated goal for a while has been 5%. So, what actually has to happen here? You’ve got HP obviously going end of life on the computing side. You are adding others in these other spaces, but I certainly don't have really a good feel for who those customers are or what those products are that are going to move the needle. So, is it going to be just growing the revenue base? Or is there a cost component here that costs still aren't aligned the way you would like them to be? And how long do you think of a project it would be to get those margins to approach where they should be given the focus that you guys have in the mix?

Vinod Khilnani

Well, the target remains 5% operating margin, as you know. We expect our gross margins, which we don't break out separately, but we expect our gross margins to improve as our mix in favor of defense and medical and our data confirms that. And then, yes, we will get some leveraging off the overhead expenses, SG&A expenses, as the sales grow. But I think bulk of the improvement in the operating margin is expected to come from improved gross margins. The other thing we have also highlighted in our recent presentations is that, since the growth of component and sensor business clearly is going to be higher than EMS business, the other aspect of our margin dynamics is that EMS business, which in the last several years has been 60% of the total company, in the next five years is going to go down to 40% of the company with component and sensors becoming 60% of the company instead of 40%. And that swing in mix, which you began to see a little bit in the first quarter of 2008 is going to help us reach our operating targets overall as we go forward.

Kevin Kessel – Bear Stearns

Okay. And you said that's over the next couple of years.

Vinod Khilnani

The EMS comment was over the next couple of years, yes.

Kevin Kessel – Bear Stearns

I'm talking about the mix comment, like to get to 60,40 components.

Vinod Khilnani

We have actually a presentation recently which is on our Web site, which says that by 2012, we will actually flip our mix and EMS will be 40% and component and sensor will be 60% of the company, and that is simply because of the fact that the growth rates in component and sensors are double digits higher than our EMS business. Combine that with a slight bias we have in favor of acquisitions being done in the component and sensors segment would allow us to get there by 2012.

Kevin Kessel – Bear Stearns

Great. And when you mentioned the large diesel actuator win, did you say that's going to begin production in Q4 '09?

Vinod Khilnani

Yes.

Kevin Kessel – Bear Stearns

Okay. So, It's a little over $10 million a year, I think, if it's linear, is that the way we should be looking at that?

Vinod Khilnani

Yes.

Kevin Kessel – Bear Stearns

As a linear ramp and then just essentially slice and dice it by quarters?

Vinod Khilnani

Exactly.

Kevin Kessel – Bear Stearns

Okay. So, you could maybe see a contribution north of $3 million or $4 million in the fourth quarter of '09?

Vinod Khilnani

Contribution? No, because if it's starting in the fourth quarter of '09 and the full year sales are $10 million, we will probably see a – yes, when you say a contribution, you mean the sales contribution?

Kevin Kessel – Bear Stearns

Yes, I'm sorry, the sales, yes. Because I'm thinking actually revenue is above ten and then I'm looking at it on a quarterly basis, so it's closer to twelve.

Vinod Khilnani

Yes. I think that's a pretty fair estimate that we should see somewhere between $2 million and $3.5 million in sales in Q4 depending on when in Q4 they launch the product.

Kevin Kessel – Bear Stearns

Okay.

Vinod Khilnani

It's a pretty significant opportunity for us, not because of this particular opportunity, but it really gives us credibility to take our sensor and actuator products from our traditional light vehicle applications to really a very, very different set of customers who are in diesel engine and commercial engines and heavy duty and medium duty diesel engine markets.

Kevin Kessel – Bear Stearns

Okay. And is there anything new on the OCS front, or no?

Vinod Khilnani

Nothing new on that one.

Kevin Kessel – Bear Stearns

Okay. And then, just from a SG&A dollars perspective, I think it was a little bit above where I thought it would be for March. And I know that maybe there are some impacts there for currency, as Donna mentioned. But, where from a dollars perspective do you see that trending here over the next, I guess, couple of quarters?

Vinod Khilnani

Hard to comment on the dollars, but we do believe that as a percent of sales we should see improvement as we go forward.

Kevin Kessel – Bear Stearns

Okay.

Vinod Khilnani

We should be able to leverage that, in other words.

Kevin Kessel – Bear Stearns

Okay. And then, in terms of your other large customer in the past, on the communications side, it sounds like they are below 10% of sales. I know they have been for a while. But I just wanted to know if there was any update at all around what was going on there, especially around China, because I know that's where you were focused their products, going into the China telecom market. And I know that the Olympics coming up, I think they are – your customer's end customer is doing a pretty substantial build-out of their infrastructure ahead of the Beijing Olympics. So, is there anything there that's affecting it? Or has that business remained stable? Is it going down? Is it coming up?

Vinod Khilnani

That business is stable and going up in the sense that we believe that our market share with that customer is little bit higher today than it was a year or two years ago. So, we are doing well. We are winning designs with them. And we do business on both sides, on the EMS side and on the component side. And my comment that we probably have a higher market share with them is on the component and sensor side. So, we are doing well with the customer to whatever extent the customer is winning new business, we are participating in that.

Kevin Kessel – Bear Stearns

Do you see the Olympics having any affect whatsoever on the business?

Vinod Khilnani

I haven't seen that in the first quarter.

Kevin Kessel – Bear Stearns

And then, was that correct about the contribution from acquisitions in the quarter that I quoted earlier is about $3 million?

Vinod Khilnani

Yes.

Kevin Kessel – Bear Stearns

Okay. And then just, I guess, the last question for me is, in terms of the stock buyback, if you could just remind us what's left under the authorization?

Vinod Khilnani

We had 2 million authorization, which we did wrap up in the first quarter. And so, we are back doing our same analysis, which any good company should do, on an ongoing basis to see what should be our next step.

Kevin Kessel – Bear Stearns

Okay. So, you would, in other words, need to come back with another authorization to buy further stock?

Vinod Khilnani

Yes.

Kevin Kessel – Bear Stearns

Got it. Okay. I appreciate your time.

Vinod Khilnani

Thanks, Kevin.

Donna Belusar

Thank you.

Operator

(Operator instructions) There are no further questions. Please proceed.

Mitch 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, May 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 917648. And with that, thank you for joining us today.

Operator

That does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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