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Executives

Vinod Khilnani - President and Chief Executive Officer

Donna Belusar - Senior Vice President and Chief Financial Officer

Mitch Walorski - Director of IR

Analysts

Kevin Kessel - J.P. Morgan

John Franzreb - Sidoti & Company

David Feinberg - Goldman Sachs

Gerry Heffernan - Lord, Abbett & Company

CTS Corporation (CTS) Q2 2008 Earnings Call July 30, 2008 11:00 AM ET

Operator

Welcome to the Q2 2008 earnings release conference call. (Operator instructions) I would now like to turn the conference over to Mitch Walorski, Director of Investor Relations.

Mitch Walorski

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 yesterday’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 Khilnani

Yesterday we released our second quarter financial results for 2008. I'm glad to report that both sales and earnings per share were better than our expectations despite a challenging economic environment. Our increasingly diversified business model helps CTS better manage its business in the turbulent economic environment.

Sales at $186.1 million were up 9.7% over the second quarter of last year, primarily driven by strong organic growth in our components and sensors segment and a small acquisition in each of our two segments. Diluted earnings per share of $0.27, in the second quarter were up a strong 80% from $0.15 in the second quarter of last year.

Second quarter 2008 earnings were helped by higher volumes, strong operational execution and a favorable segment mix as our components and sensor sales increased to 45.2% of total sales versus 41.7% in the same quarter last year. In addition, second quarter earnings benefited by approximately $0.02 per share from some sales and production pull up from the third quarter due to Olympics related restrictions in China.

On a segment basis, component and sensor sales were $84.1 million, up 19% from the second quarter of last year. Within that segment, our sales of automotive sensor and actuated products were up 15%, despite of very tough automotive environment reflected by a year-over-year drop in the light vehicle production in North American and Western Europe up 15% and 3% respectively.

Our sales to Asia based OEMs primarily Toyota and Honda, increased from $3.7 million in the second quarter of last year to $8.4 million in the second quarter of 2008 as we increased our Toyota business to eight platforms in the second quarter of this year from four last year and supplied products for three Honda platforms in the second quarter of this year compared to none last year.

Our overall automotive actuator and sensor sale to Asia Pacific was up 58% to $11.5 million in Q2 of this year. Production of passenger vehicles in China, one of the markets we participate in grew by approximately 18% year-over-year in the second quarter. Our second quarter 2008 North American sales to the Detroit victory at $18.5 million represent less than 10% of what total CTS sales are now as we continue to penetrate other global OEMs at a faster pace.

Continuing with the component and sensors segment, our electronic component sales in the second quarter were up 26% year-over-year. 9 percentage points of this growth was organic with the remaining 17% coming from the Tusonix acquisition which we completed in the first quarter. Organic growth was driven by an 80% increase in our Piezoceramic product sales.

Piezo products are a small, but profitable and growing part of our electronic components. In the second quarter, our Piezo sales were approximately $4.9 million with applications in the medical, defense, hydrophone and inkjet printer arena.

Organic growth in our infrastructure components business was also 9% year-over-year. Shipments to customers like Nokia, Siemens for RF Modules and 3G base stations, RACO our military application and CISCO were up double digits from last year. Strength in our total component and sensor business therefore was reflective of our progress in diversifying our customer base and increasing our market share through new product introductions. Our increased presence in Asia and Eastern Europe also contributed to improved performance in the second quarter.

Our EMS sales in the second quarter were $102 million up 3.2% from the second quarter of last year. As expected, lower HP sales were more than offset by growth in sales driven by our recent acquisition which was completed earlier this year in the first quarter. Overall our diversified international sales which approximate half of CTSs of total sales are helping the company reduce volatility due to weak economic activity in any one part of our served global market.

Total CTS gross and operating margins were both higher sequentially and year-over-year. Improved segment mix due to faster growth of our components and sensors segment, success in negotiating some price increases, currency exchange, improved manufacturing performance and tighter expense management were some of the key drivers behind our improved operating earnings in the second quarter.

Some of the highlights for the quarter are as follows: In automotive, we received six new sensors and actuated business awards and five of them were from Asian OEMs and one from a European OEM. In the electronic components arena we captured 49 new infrastructure frequencies and filter design wins up 17% from 42% in the same quarter last year.

Design wins as you known are the strongest leading indicator for the future program revenues in the electronics components business. Most of the design wins in the second quarter, was in the 3G wireless, WiMAX and Repeater arenas with customers like AlcatelLucent, Motorola, Nokia, Siemens, FTM Networks, E-Blink, etc.

Looking forward to the second half of 2008, we seem to have somewhat less visibility given the economic uncertainties and sense continued weakness in demand for automotive products and electronic components in North America and Europe; however, we expect to offset most of these headwinds with our new products, new customer initiatives and increased market share.

We believe that our second quarter results have benefited by approximately $0.02 per share at the expense of the third quarter from sales and production fill-up’s relating to the China Olympics restriction. In addition, third quarter result will reflect seasonal planned and extending shutdowns in the automotive industry, but also seeing some electronic components program push outs based on weaker demand from the soft economy.

As discussed in the earlier conference calls, we expect to incur in the second half of 2008 close to $1.5 million in pre-tax expenses on approximately $0.03 per share in engineering and development activities to support growth of sensor and actuators for the commercial market. This is primarily related to the new $75 million six year supply agreement with the diesel engine manufacture that we announced a few months back.

Taking these factors into consideration, which temper our second half results in general, but Q3 in particular combined with the very favorable first half performance, the company is reiterating it’s full-year 2008 sales guidance of 5% to 8% growth over 2007 and slightly raising its full year earnings per share guidance to a range of $0.79 to $0.84 and now I turn the meeting over to Donna Belusar our CFO who will provide further detail regarding our financial results.

Donna Delusar

Our second quarter 2008 financial results continue on a positive trend with growth in revenue and earnings per share. With a sold customer base and flexibility of our global footprint in manufacturing and sales we delivered in the second quarter $186.1 million in sales, a growth of 9.7% from sales in the second quarter of 2007. We maintained our focus on costs and expense management and successfully integrated our recent strategic acquisition to deliver a strong second quarter.

Second quarter 2008 net earnings came in at $10 million up $4.1 million from the second quarter 2007. Bottom line CTS delivered diluted earnings of $0.27 per share up 80% compared to $0.15 per diluted share in the second quarter 2007. Please note that the prior year diluted earnings per share did include approximately a $0.03 negative impact for unusual audit and professional fees.

Now let me provide you some further insight into the second quarter 2008 details. Starting with top line sales growth, for the second quarter sales were $186.1 million, a 9.7% revenue growth year-over-year from the second quarter of 2007 and up sequentially 7.7% from the first quarter 2008 sales of $172.8 million. We had a strong quarter in components and sensors segment sales, which increased by 18.8% compared to second quarter 2007 while sales in EMS segment increased by 3.2% versus the second quarter in 2007.

Sales growth in both segments contributed to the year-over-year improvement in gross profit margins. In the second quarter of 2008 sales in EMS, in components and sensors segment represented 54.8% and 45.2% of our total sales respectively, compared to 58.3% and 41.7% respectively in the second quarter of 2007. Favorable segment sales mix along with favorable product mix in improved manufacturing performances drove gross profit margin as a percent of sales to a high of 21.6% for the second quarter 2008 up from 19.4% in the second quarter 2007.

Selling, general and administrative expenses and research and development expenses as a percentage of sales declined 70 basis points to 14.1% of sales in the second quarter of 2008, down from 14.8% in the second quarter 2007. Please note that research and development expenses, the loan increased by 16% year-over-year reflecting planned initiatives to drive future growth.

The resulting operating earnings margin as a percentage of sales improved more than two percentage points quarter-to-quarter to 7.4% up from 4.9% in the first quarter of 2008 a nearly three percentage points improvement year-over-year from 4.7% in the second quarter of 2007.

Our operational performance continues to reflect the results of actions taken to manage spending given the uncertainties associated with the global economic condition. We continue to invest in areas including research and development that are expected to drive growth overtime in current product and process enhancements, expanded applications and new product development.

Total interest and other expenses were slightly higher year-over-year primarily due to higher interest expense in the second quarter of 2008 associated with increased debt in support of the recent strategic acquisitions. Our year-to-date 2008 effective tax rate was 22% versus 21% in the same period last year. I highlighted at the beginning of our discussion how our performance reflects the strength of our customer base and our global footprint both in manufacturing and sales.

As we have seen in the first quarter of 2008, the U.S. dollar continues to remain weakened against nearly all major foreign currencies, approximately 8% to 9% relative to our basket of currencies. While, this has created additional expenses and costs to our business operation, we also grew our revenue in countries where we do business in local currencies, which helped minimize any potential negative overall currency impact.

Net earnings were $10 million or $0.27 per diluted share in the second quarter of 2008 compared with $5.9 million or $0.15 per diluted share in the second quarter of 2007. Higher net earnings were the result of increased revenues, improved gross profit margins and overall lower operating expense as a percent of sales in the second quarter of 2008.

Now, let’s discuss CTS’s balance sheet performance. Overall changes in our second quarter 2008 balance sheet reflect the full integration of our recent strategic acquisitions. Our controllable working capital, which includes account receivable and inventory, less account payable is $111 million or 15% of annualized sales. This is down from 15.7% in the first quarter of 2008.

Within the quarter we did realize a slight increase in inventory of several million dollars of which more than half of the increase was due to the required over head of certain production related to the China Olympic restriction. We expect our full-year controllable working capital to come down further towards our long-term target of 13% as a percent of annualized sales.

A strong positive free cash flow of $11.6 million, which is define as cash flow from operating activities as capital expenditures was achieved in second quarter of 2008. This was driven by net cash provided by operating activities for the second quarter of 2008 of $17.8 million, plus our investment in capital expenditures of $6.2 million in the second quarter.

We also reduced our long-term debt sequentially from the first quarter 2008 by $24.4 million to $92.3 million resulting in a current debt to capital ratio of 21.7%. Considering the challenging economic environment we expect our full-year free cash flow to be slightly lower in the range of $26 million to $30 million with CapEx to be in the range of $22 million to $25 million.

We finished the second quarter 2008 with a strong operating and financial position aided by a strong portfolio of products and customers, a global footprint base of capabilities, successful integration of our recent acquisitions and a very solid balance sheet.

With that I would like to open the call now for your questions; thank you.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is from the line of Kevin Kessel from J.P. Morgan. Please go ahead.

Kevin Kessel - J.P. Morgan

The first question actually, Donna you mentioned that your long-term debt was reduced, I think it’s the $24 million in the quarter. So, what exactly were you guys doing there, was that your borrowing facility?

Donna Belusar

The revolver, yes it was.

Kevin Kessel - J.P. Morgan

So that was the reduction in the revolver. So, can you just remind us like where the revolver is in terms of utilization right now?

Vinod Khilnani

Kevin the revolver as you know is $100 million, and.

Donna Belusar

$24 million is our credit utilization out of a 100, yes.

Kevin Kessel - J.P. Morgan

Okay so, with that 48.

Donna Belusar

Yes.

Kevin Kessel - J.P. Morgan

My question is on your convertible, now that it’s coming I think there’s a couple of puts, but the first one I believe is in the beginning of May of next year and so how are you guys thinking about it? Because I know it’s just a little bit over 2%, but it’s $60 million, so based on the current, you can adjust the current cash on the balance sheet, you’d probably have to go quite a bit into the revolver in order to pay it off, because I don’t believe that you guys are looking to have its converted to stocks. I don’t even know if that’s an option at this point.

At the same time, I know that the conversion price, I think its at 15, but if I’m not mistake I think it has to actually go over 18 because of the conditions that are in the convert to actually convert in to stock.

Vinod Khilnani

That is correct. I think Kevin based on what we know today we would guess that we will not convert it in the stock and we will pay it off. The options we are continuing to explore are to refinance it or utilize our revolver to pay down or do a combination, but that’s something which the treasury is continuing to evaluate.

Kevin Kessel - J.P. Morgan

So it’s something that more likely or not I guess it doesn’t have to be decided until some point next year?

Vinod Khilnani

Yes, I mean we’ll obviously not wait until the very last moment to do that, we are beginning to look at it already and hopefully well before the May deadline we would have a solution executed.

Kevin Kessel - J.P. Morgan

Also on the balance sheet here, the other assets, particularly the other I guess long-term assets; they’ve risen something like $13 million, $14 millions since the beginning of the year. What exactly is in that line-item and how much of that could theoretically become liquid?

Vinod Khilnani

I think that’s a category which includes goodwill and intangible and things like that and I suspect that the biggest piece of the increase is due to the two small acquisitions we did this year.

Kevin Kessel - J.P. Morgan

I got it. Okay and then when you look at the overall impact that you mentioned about the Olympics. So, if I understand you said this impacted you by 2% in the quarter positively?

Vinod Khilnani

Two pennies

Kevin Kessel - J.P. Morgan

Two pennies, but didn’t you also quantify the top line impact?

Vinod Khilnani

No, we didn’t.

Kevin Kessel - J.P. Morgan

Okay, so the bottom line is two pennies.

Vinod Khilnani

Yes, that’s a combination of some sales pull-up, because lots of restrictions are from a logistics point of view, so some of the customers we believe have pulled-up some sales, but the bigger positive impact was you pull-up some production into the second quarter, so you get the favorable absorption impact and we wanted to do it to make sure that if there are any supplier restrictions in the third quarter because of the movement of products, truck restrictions and things like that, that we are there with the right inventory to support our customers.

Kevin Kessel - J.P. Morgan

Okay, now that makes sense. So, you needed to get ahead of it, but at the end of the day it’s something that obviously will reverse itself here in the third quarter as some of those. I guess these are your plants within China that are not going to be able to operate as freely as they would have otherwise?

Vinod Khilnani

Yes primarily one plant which is not too far from Beijing and these are restrictions which are pretty much within I think 100 or 150 miles radius of Beijing where the games are taking place and you are exactly right, this is a flip flop between Q2 and Q3.

Kevin Kessel - J.P. Morgan

Okay, but in terms of overall top-line impact, is there anyway to give us a sense for roughly speaking what you might have actually pulled into revenue for the second quarter.

Vinod Khilnani

It wasn’t material at all. It was an extremely small number.

Kevin Kessel - J.P. Morgan

But yet it had a material bottom line impact?

Vinod Khilnani

Yes because of the production and absorption it had the $0.02 bottom line impact, but the top line was very, very small.

Kevin Kessel - J.P. Morgan

Okay and then I did not hear anything regarding the percentage of sales for HP in the quarter; if you could maybe give that as well, how it compare to last quarter?

Vinod Khilnani

Sure, the HP sales in the quarter were approximately $20 million and that compared with close to $25 million in the second quarter of 2007. So HP sales, as a percent of the EMS business this quarter are I would say around 20%, when they were close to 26% in the second quarter last year and so as a percent of the total company, they are probably at 12%, 13% range.

Kevin Kessel - J.P. Morgan

In the last quarter, the dollar amount for HP was what?

Vinod Khilnani

Q1 was actually $28 million.

Kevin Kessel - J.P. Morgan

$28 million, okay

Vinod Khilnani

But the second quarter of last quarter was around $25 million, so if you compare quarter-over-quarter; year-over-year in the second quarter it came down from $25 million to $20 million.

Kevin Kessel - J.P. Morgan

But the sequential decline, is that something that -- I mean at this point I know you thought it would still take more than a year maybe, year and a half, two year before it really kind of ramps down completely. Is it somehow accelerating now?

Vinod Khilnani

No, I won’t read anything in it, because we know that the sequential quarterly changes in HP, they jump all over, so I won’t read anything whether it’s accelerating or slowing down.

Kevin Kessel - J.P. Morgan

Okay and then just lastly, just housekeeping I have for Donna. The tax rate, should we be thinking about that Donna, it’s been 22% the last two quarters. Should we think about it remaining there or is it going to remain more 23.5% or?

Donna Belusar

No, I would hold it to the 22%.

Kevin Kessel - J.P. Morgan

Okay and then the depreciation and amortization in the quarter, I don’t think I heard that or may be I missed it.

Donna Belusar

No, depreciation is running around the same level it has, its around $6 million, that’s specifically $5.9 million as a depreciation and amortization would be about $900,000 and Kevin, I do want it correct myself because I misspoke on -- you was asking about the revolver credit balance, it was $32.3 million as of the end of the quarter.

Kevin Kessel - J.P. Morgan

And then we know this last item in R&D does the clarification; you said that in the second half of the year, CTS will spend $1.5 million on I guess incremental R&D to support the diesel program, which would be about $0.03?

Donna Belusar

Yes.

Operator

Thank you. Our next question is from line of John Franzreb from Sidoti & Company. Please go ahead.

John Franzreb – Sidoti & Company

Could you talk a little bit about the acquisitions Vinod? You mentioned that some of them are going faster than expectations; can you provide a little color there, what’s doing better than you thought originally?

Vinod Khilnani

Yes, the acquisition which we did in component and sensor segment, Tusonix; when we did the acquisition we said that we are buying a company with annual sales of roughly $15 million and my guess is that that company, that division or that acquisition will probably grow during 2008 by 10%.

More importantly the second acquisition, the other acquisition we did in EMS which was primarily driven by their sales into the defense and aerospace; when we did that acquisition, we said we are doing an acquisition with annual sales of $27 million and if I have to guess at this point I would think that that acquisition will probably do closer to $35 million if not even higher than that this year and that’s what I meant that they are growing faster than our expectations and EMS acquisition with its heavy penetration into the defense and aerospace markets is specially performing well.

John Franzreb – Sidoti & Company

Now could you provide for us the sales growth on an organic basis for the companywide and then even further break it down on the component side and the EMS side what the organic top-line growth was versus how much the acquisitions contributed?

Vinod Khilnani

I think component and sensors did a pretty good story because we break it down between automotive and electronic component. Automotive growth 15% is all organic, there was no acquisition there, that was probably very encouraging for us. Frankly our automotive sales, I was discussing with my colleagues that our automotive sensors and actuator sales this quarter is an all-time record, so that was 15% all organic.

Electronic components, I said organic was more or like 9% and so if you combine that segment; component and sensors, the organic growth is roughly 12%, so pretty good performance. EMS on the other hand almost all the growth came due to acquisition. So the organic growth is minimal if any. If you combine the total company, we said our year-over-year growth in the second quarter was 10%. I would say that organic is probably 6.5%, 6.8% range and the organic is more like 3.5% in that range.

John Franzreb – Sidoti & Company

You also mentioned in the press release, that there has been some program push-outs; can you provide a little color on what side of the business and what are the push-outs related to?

Vinod Khilnani

The push outs we are seeing in electronic components are primarily in wireless infrastructure space and we have seen some indication that some of the OEMs maybe pushing out some of the sales from Q3 to Q4 and therefore some of the Q4 sales may fall into first quarter of next year and they have a tendency to change it, John as you know. So, we are watching it very carefully but we have seen indications of some push outs in that space.

John Franzreb – Sidoti & Company

Is this across the board; is there a region of bias involved in those push outs?

Vinod Khilnani

I can’t say definitively, but anecdotally I think that push-outs tend to be more from North American and European markets and Asian markets continue to do very well and that’s probably true with not only electronic components, but automotive sensors and actuators also.

John Franzreb – Sidoti & Company

Okay, you mentioned that the extended shutdowns; the automotive sector is going to have a disproportionate impact on third quarter profitability, could you just talk a little bit about what your thoughts are on the auto sector for the balance of the year, maybe into next year in light of those statements?

Vinod Khilnani

We are watching it. It’s a changing story everyday, but you know that OEMs have continued to announce that some of them are going to extend their shutdowns in the third quarter. We do have a seasonality pattern. We normally have Q3 as our weakest quarter. The shutdowns normally affect sensors and actuator side of the business, the automotive side of the business and as sensors and actuators become a bigger and bigger part of the company you may see a little bit of more seasonal patterns in our performance between the quarters. So, Q3 being a weaker quarter compared to second quarter and the fourth quarter.

If you look at the full year forecast, we are seeing for North American light vehicle production -- last year the numbers were closer to 16.1 million units in North America. This year you will see forecasts all the way from a lower of 14.2 million units to maybe a high of 14.7, 14.8. There is nobody forecasting even a 15 million number for 2008 in North America. So, depending on where those numbers come out we think they will be probably closer to 14.2 million to 14.4 million, that’s the lowest level since 1995.

So we’re watching it very carefully. We are hoping that most of it will be offset by our penetration into OEMs like Toyota and Hondas which continue to do well. Actually Honda was probably the only major automotive OEM which showed an increase in their unit sales in 2008 compared to 2007. So that’s positive, combined with as I indicated in my comment that one of the drivers for our higher sales in automotive sensor was the fact that we are now providing products on several Toyota and Honda platforms, when last year we weren’t supplying in the second quarter any Honda platforms and Toyota platforms were not lower.

So we believe that our increased penetration would help us to offset the impact of the economic weakness, but stepping away from that, the overall North American and European light vehicle market is not looking in the second half. I think the jury is out as to where that number would be for 2009.

John Franzreb – Sidoti & Company

I guess that makes sense Vinod. I guess in the context of the beat that you had in the quarter and assuming the $0.02 and the sales what would have happened in the third quarter as opposed to the second, I am just curious; could you just talk a little bit about your lack of willingness to raise the outlook? Where does the program push-outs versus the weak economy versus the auto sector, rank them or if you can quantify how much are you expecting to be an average impact on the earnings performance in the second half.

Vinod Khilnani

John I can highlight some of the things we have kind of talked about, which will attempt to answer your questions. The first one as you know we talked about is that approximately $0.02 worth of pull-up in Q2 from Q3. That’s pretty straight forward. We can quantify that and…

John Franzreb – Sidoti & Company

But that will also happen in Q3 no matter what, right; this is just a pull-up so..

Vinod Khilnani

Right it’s a pull up, so that says that the $0.27 are more like $0.25 and whatever we will do in Q3 would have been two penny higher if we wouldn’t have had this Olympics phenomena on the timing, but you‘re right it has no impact on the full year numbers, but it does have an impact that those $0.02 are already recorded in the second quarter.

The second comment we made is we are driving a brand new growth initiative around sensors and actuators for adjacent markets or commercial markets as we call them and the announcement of the win we had recently for a diesel engine manufacturer is a very good example of that and as I pointed and Donna pointed out that we have roughly $0.03 per share of impact in the second half, because of that and that’s an investment into our future, that’s an investment in R&D, that’s an investment to drive growth in 2010 and beyond.

So $0.03 there, which is a drain in the second half; $0.02, which will not be there in the second half because that was pulled up in the second quarter; those two things combined with the fact that the overall economic environment and especially in North America and Europe is really still unfolding and those three broad category of things I think combined made us increase our guidance, but not go beyond that.

John Franzreb – Sidoti & Company

Remind me, because I thought the R&D kicked up in the first quarter and that the announcement of the diesel program was already kind of baked into the numbers, by the time we had the next conference call; maybe I’m wrong.

Vinod Khilnani

No, no certain amount of that number was baked into our guidance, but I think that the numbers are probably a little bit higher. When we give the guidance I believe in January we put that number at probably $1.5 million to $2 million, $0.02 to $0.03 and now as we are pointing out we have that magnitude of number in the six months in the second half alone, so that number is a little bit higher.

Frankly that’s good news, because we are finding some very interesting opportunities and discussing with several major new customers in the commercial or diesel engine arena and that is requiring us to chase those opportunities and actually strengthen our R&D resources to drive those growth initiatives.

John Franzreb – Sidoti & Company

Okay, one last question; will these R&D level stay elevated in 2009 or do you expect them just to go end of life at the end of the year?

Vinod Khilnani

I think they will stay there in 2009.

Operator

Thank you. Our next question is from the line of David Feinberg from Goldman Sachs. Please go ahead.

David Feinberg - Goldman Sachs

I’m interested to hear about I think it was a end market that you have. What end markets are you starting to see from growth into this economy and which ones are you starting to see some weakness in?

Vinod Khilnani

It’s an interesting question because all the markets we are seeing growth end for CTS products. Most of them happen to be markets which are actually weak and the reason we’re growing despite the fact that the markets are weak is either because we are introducing new products or because we have added new customers and the clearest example I can give you is automotive.

We all know how difficult that environment is with the volumes down pretty materially in North America and to a smaller extent in Europe. Asia is growing, but as I pointed out that Asian growth in light vehicles was more like 18%. Despite all that, we have grown and the reason we have grown double-digit is because of new customers. So, that’s an example where markets are weak but we’re growing.

The other areas where we are growing, but the market is okay, but not extremely strong is what we call the wireless infrastructure area. Our organic growth there we believe is somewhat higher than the market growth. One area where we are growing and the markets are also strong and I pointed out that as a one of the key drivers in our electronic component sales is the PVT, the Piezo ceramic product and that is probably one example where the markets are growing along with our sales increasing because those markets are either oil and natural gas exploration kind of applications or they are medical applications, so those are examples where the markets are growing and we are growing with them.

Another area where I believe the market is also fairly healthy, and that’s where we’re benefiting also is the defense. That market has not been affected like automobiles or wireless infrastructure kind of market. So here are two examples where markets are weak, but we’re doing well and two examples where we are doing well along with the market strengthening.

David Feinberg - Goldman Sachs

Just to clarify the market is fairly healthy how it benefits CTS is defense and what was the other one?

Vinod Khilnani

One was the Piezo product which goes into medical and oil and gas exploration and the second example was defense.

David Feinberg - Goldman Sachs

Okay and my last question has to do with -- you’re speaking about how the third quarter might be impacted by how the economy is shaping. Are there any particular concerns that you have within the macro economy, whether its inflations or fuel expenses, labor costs, are there any particular areas that you’re particularly cautious on?

Vinod Khilnani

No particular area, which we would like to highlight necessarily. In the past we have talked about the negative impact on CTS because of materials, the pressure for material’s, commodities kind of a things, so that actually we’re hoping that as the economy slows down, that pressure should be less compared to what we saw last year or earlier this year. We also have some flexibility to give price increases to the customer on the backs of higher material increases. So, I won’t point that out as a special concern for Q3, because we think it should actually get better.

In the past, currency was another area where we were very worried that as the dollar weakens dramatically it had a negative impact on CTS because we had more cost base in the foreign currencies outside U.S. than revenue base and when the dollar used to weaken, we used to see a negative impact on CTS.

Now as Donna pointed out, because of our expansion in Czech Republic or we tapping into the local markets in Asia, all of these are creating sales which are denominated in foreign currencies like the euro and Czech and Chinese currency in those countries. So, as we balanced our revenue as an expense even currency has gone away from the radar as a major concern for us. So we have managed currency and balanced it more so that’s not an issue.

I guess if I have to point out what we are worried about, it’s just the overall GDP growth in North America and the overall vitality of the economy in Europe which will obviously have an impact on us. If that weakens further we will see pockets of negative impact on us either because of communication equipment or our automotive applications.

Operator

Thank you. Our next question comes from the line of Gerry Heffernan from Lord, Abbett & Company. Please go ahead.

Gerry Heffernan - Lord, Abbett & Company

In the previous question I think you discussed the R&D spent for the diesel business and I guess that is for not just that diesel contract that you are working on but also other businesses that you maybe able to get in off of that. Can you just review that business win however and give us an idea of when you would actually begin to see revenue ramp from that business?

Vinod Khilnani

Okay, good question. Gerry that business which we announced a couple of three months back was the product is a smart actuator which we are developing by working very closely with the engineering organization of this diesel engine manufacturer and that is $75 million spread over a five, six year period; kind of a business goes on their light-duty diesel engines.

The revenues from that program currently are projected to begin some time around mid 2010, okay. When I commented that it was opening up potential opportunities with others; when we won that business and started putting a lot of effort in developing different versions of that product, since then we have now started discussions with a major turbo charger manufacturer in the United States and we have been working very closely with them to sell them the product and we have also open discussions or have enquires from at least two other very large major OEMs who make diesel engine related products and so we’re finding very interesting opportunities for us.

These opportunities tend to have higher margin than our base business. The only thing we have to point out is that you have to work with the OEM and develop the product for a period of 12 to 18 months before the revenue start, but on the other hand once you are designed into those products, those revenues then become locked in for a very long period of time six to eight years and so it’s a very good opportunity, it’s a higher margin opportunity, but the revenues lag from the expense or design and development phase by 12 to 18 months.

Gerry Heffernan - Lord, Abbett & Company

Okay and that would be for most all of the products that maybe developed in this area, regardless of whether it’s the turbocharger manufacturer or one of these other two diesel engine related OEMs?

Vinod Khilnani

Yes. That is a pretty standard timeframe we talk about.

Gerry Heffernan - Lord, Abbett & Company

The HP business, a previous question you were asked about, the amount of revenues there, I think its being pretty widely discussed that we’re expecting this business to pretty much roll off and go away. Is the roll off of this business happening on a trajectory that is consistent with what you had been expecting one quarter, two quarters ago?

Vinod Khilnani

Yes, absolutely.

Gerry Heffernan - Lord, Abbett & Company

Okay and this is just a kind of a detailed question here. There was some discussion on the free cash flow and what we expected the full-year cash flow and CapEx to be and unfortunately to my wisdom, it weren’t reacting as fast as it was being said, so could you just review that information please?

Donna Belusar

The free cash flow provided a range of $26 million to $30 million and CapEx between $22 million and $25 million for full-year.

Gerry Heffernan - Lord, Abbett & Company

And that 26 to 30 free cash flow, that’s after the 22 to 25 CapEx number, right?

Donna Belusar

Yes, yes it is, yes.

Vinod Khilnani

That’s correct.

Operator

Thank you. Our next question comes from the line of [Hendy Susanto from Gabbali]. Please go ahead.

Hendy Susanto - Gabbali

Actually my question has been answered. Thank you.

Operator

Thank you. We have a follow-up from line of Kevin Carter from J.P. Morgan. Please go ahead.

Kevin Kessel - J.P. Morgan

I just wanted to just clarify one statement I think that was made in the beginning by Vinod. You were talking Vinod about the platforms for Toyota and Honda and I think you said three platforms right now for Toyota by CTS in this quarter versus four a year ago and Honda was three versus zero and then I think you made a mention of some sort of an aggregate sales rate for the two combined, maybe you could just review that, because I heard the big three at $18.5 million.

Vinod Khilnani

Sure and I didn’t necessarily say that number applies to completely for those two, but I said it’s primarily because of those two and that number I’m just going back on my notes, I said our sales to Asia based OEMs increased from $3.7 million in the second quarter of last year to $8.4 million in the second quarter of this year and I said Asia based OEMs are primarily Toyota and Honda.

Kevin Kessel - J.P. Morgan

Okay and on the big three you mentioned you said they’re now less than 10% of sales.

Vinod Khilnani

Total CTS, yes.

Kevin Kessel - J.P. Morgan

Total CTS sales at $18.5 million, what where they a year ago?

Vinod Khilnani

That’s a good question. Let me quickly check my notes to see if I can pull that information out easily.

Kevin Kessel - J.P. Morgan

And you leave us talking big three, you’re talking sales to guys like GM Ford or how are you defining it? I am talking about the (Inaudible).

Vinod Khilnani

Good question, when we talk about that, we would generally include in that category Dell 5 and Esteon, so it’s a pretty safe definition. So, if we sell to Dell 5 and its ending up to GM it will be included in this concept.

Kevin Kessel - J.P. Morgan

But Dell 5, Esteon and then who else would be kind of consider the third one.

Vinod Khilnani

For CTS those are …

Kevin Kessel - J.P. Morgan

Or you’re just saying those won’t sell into those, the big three?

Vinod Khilnani

Those are primarily the two big once where we sale, where we know the product ends up with GM and Ford and Chrysler. In reality they are companies like American Axle, which as you know 70%, 80% of their sales I believe still go to GM and we have very little sales over there. So, we try to go through an analysis and capture everything, which ends up with the Big Three Detroit in North America.

Kevin Kessel - J.P. Morgan

But do you have direct relationships as well with GM, Ford or Chrysler?

Vinod Khilnani

Yes, yes we do.

Kevin Kessel - J.P. Morgan

Okay, so that’s all been incorporate in this $18.5 million.

Vinod Khilnani

It is incorporated in all that. The one question you asked was the sales to this Big Three. I do have some information here that if I compare Q2 ’07 with Q2 ’08, the sales to them actually came down 22%.

Kevin Kessel - J.P. Morgan

Okay, so is 22% higher a year ago?

Vinod Khilnani

Yes.

Kevin Kessel - J.P. Morgan

Now on a sequential basis is it easy; do you have that comparison, I’m just curious, to Q3?

Vinod Khilnani

I don’t have that comparison. We can provide you with that information after this call. I suspect you will see a steady trend of them coming down as a percent, simply because our sale to the non-big three is growing clearly faster. If you remember, we started saying, actually a couple of years back that a very large percent of the new business we are winning is from people like Hondas and Toyotas and so we had projected at least directionally that couple of years down the road, they will play a much bigger role for the corporations and the Detroit big thee as a percent at least would be smaller.

Kevin Kessel - J.P. Morgan

Okay, and then just two last things here; one, is inventory. I think year-over-year, it’s up about 17%, which is almost double the sales growth number and your inventory turns have fallen close to a full turn over the last five quarters, so what’s your expectation there. Is this build up then primarily a raw material build-up or is this a finished goods build-up, are you having to have more inventory or learn to manage more inventory or what exactly is driving the inventory growth?

Vinod Khilnani

One of the things which is distorting that number is the two acquisitions we have made. So what we probably should do is just after this call, provide you the inventory which is apples-and-apples with last year by taking away the acquisition inventory.

Kevin Kessel - J.P. Morgan

Right, but I guess last year you wouldn’t have had those acquisitions in your revenue number so…

Vinod Khilnani

Right, but the way the terms get calculated, I think it does good distort, but I think Donna and Mitch will cycle that to you.

Kevin Kessel - J.P. Morgan

Okay. So, that’s a part of it. Is there any other part of it, besides the acquisitions do you think? I mean….

Vinod Khilnani

No, I think as we said earlier there was probably some extra inventory build up in Q2, because of this China Olympics issue, because that did benefit us from the absorption side in the P&L and so the flip side is that we probably are carrying more inventory than normal in China, but we should be able to believe those by the end of the year.

Operator

There are no further questions.

Mitchell Walorski

Thank you. 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, August 6, 2008. The telephone number for the replay is 800-475-6701 or 320-365-3844, if calling from outside the U.S. The access code is 952939. Thank you for joining us today.

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Source: CTS Corporation Q2 2008 Earnings Call Transcript
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