CTS Corporation (CTS) Q3 2010 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the CTS Corporation third quarter earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will be given at that time. (Operator Instructions) I would like to now turn the conference over to your host, Mr. Mitch Walorski, Director of Investor Relations. Please go ahead, sir.

Thank you, Carolyn. I'm Mitch Walorski, Director of Investor Relations, and I will host the CTS Corporation third quarter 2010 earnings conference call. Thank you for joining us today. Participating from the company today are Vinod Khilnani, Chairman of the Board and CEO, and Donna Belusar, Senior Vice President and Chief Financial Officer. Before beginning the business discussion, I would like to remind our listeners that the conference call contains forward-looking statements. These statements are subject to a number of risks and uncertainties that could cause actual results to 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 Chairman and CEO, Vinod Khilnani.

Thanks, Mitch, and good morning, everyone. Last evening, we released our third quarter financial results for 2010. I'm pleased to report that total sales and earnings in the third quarter improved sequentially and year-over-year from the third quarter of 2009. As expected, stronger growth in our Components and Sensors segment sales resulted in higher gross margins in the quarter compared to last year, driven primarily by favorable segment mix, with Components and Sensors segment representing 51% of total CTS sales in the third quarter of 2010 versus 44% in the same quarter last year. Earnings per share also came in better than expected. Overall, it was an excellent quarter with strong financial results, increased level of research and development activities, higher number of patent filings and grants of new patents, new business awards and design wins, and on schedule launch and new product testing activities for major programs like Smart Actuators for diesel engines and new piezoceramic products for high density disk drive markets. We continue to diversify our business model with new products, new customers and a presence in new growth markets like India. Total sales in the third quarter of 2010 at $139.4 million went up 10% from the third quarter of 2009, driven by a strong 29% year-over-year increase in our Components and Sensors segment sales. Within this segment, sales of automotive sensors and actuators, which represent 31% of total CTS sales, increased by 20% from the third quarter of 2009. Automotive industry's global vehicle production volumes in the third quarter were up only 10.5% year-over-year. New products and increased market share with customers like Nissan and Honeywell turbochargers allowed us to grow our sensors and actuator sales at roughly twice the underlying market growth rate. Our success in turbocharger sensors arena is also beginning to contribute…

Thank you, Vinod, and welcome to all of you for joining us today. I will now discuss further details on our 2010 third quarter financial results. Our 2010 third quarter financial performance reflects revenue growth, expanded gross and operating margins, and delivered earnings per share of $0.20, up 54% year-over-year. We achieved all of this while continuing to invest to drive future growth. Total sales for the third quarter of 2010 were $139.4 million, up 10.1% from the third quarter a year ago. The double-digit year-over-year revenue increase was driven by our Components and Sensors segment sales, which were up 28.6% from the same period last year. With year-over-year revenue growth more pronounced in our Components and Sensors segment, the overall segment mix remains more heavily weighted towards Components and Sensors coming in at 51.5% of total sales. This is up from 44.1% in the third quarter of last year, and down slightly from 52% of total sales in the second quarter of 2010. Our third quarter 2010 gross margin percentage was 21.5% of sales, up from 20.7% in the same quarter last year, though down slightly from 21.9% in the second quarter. The year-over-year improved gross margin, as a percentage of sales was due to several factors, including the shift in segment mix towards higher margin products, increased capacity utilization and the impact of our global manufacturing footprint. Substantially most of the year-over-year gross margin increase can be attributed to better segment mix from a higher level of Components and Sensors sales and higher gross margin within the Components and Sensors segment. The slight sequential decline in gross margin percentage from the second quarter was expected due to the slightly higher EMS sales, resulting in a return to a more balanced segment sales mix. Now turning to expenses, selling,…

(Operator Instructions) Our first question comes from the line of John Franzreb, please go ahead. John Franzreb - Sidoti & Company: Good morning, Donna. My first question is, I guess, what's going on in the EMS segment. Kind of disappointed, I guess, in how the business played out in the quarter. I was kind of hoping it would rebound better, but then again you guys have signaled that the business is improving, and in fact you're expanding one of your facilities to accommodate, I assume, perceived growth in 2011. Could you talk a little bit about the dynamics of the EMS business and how you see it unfolding?

Sure. John, as we have said in the past that we have had several key customers who had program refreshes, which have had impact on our sales in the last several quarters from a year-over-year growth point of view. Those are factors outside of our control. They are driven by our customers and therefore last several quarters we have seen EMS growth to be fairly weak. We expect that to begin to turn around and that's why we are indicating a reasonable amount of comfort that sequentially our sales in EMS should grow approximately 10% in the fourth quarter compared to Q3, the combination of the programs turning around and frankly, new business. Same reason, we expect our EMS business to grow 7% to 10% next year compared to this year. That is a higher percent of growth than we have talked about in our investor presentations in the past, where we have said our longer term EMS growth targets are maybe 5% to 6% range and our Component and Sensor growth targets are twice or three times that number, thereby changing the mix inside the company, which is more by design. But because the EMS business has been lower than our expectations, we expect the EMS business to catch up with a higher than our longer term growth projections in fourth quarter and next year. As the sales increase, we expect our capacity utilization in EMS to improve, and our margins as a result will continue to increase and we expect to go back up to the normal margin levels of the next phase will take us back to the 2% to 3% target margins, operating margin, EMS and our medium to long-term target remains 4% to 5% in our EMS beyond 2011. John Franzreb - Sidoti & Company: That's a perfect answer, Vinod. Thank you very much, that is exactly what I was looking for. Secondly, the SG&A line. On a sequential basis Q3 versus Q2 kind of dipped meaningfully. Is that a sustainable drop? Could you just talk a little bit about the puts and takes on what happened there?

You're looking at SG&A Q3 versus Q2? John Franzreb - Sidoti & Company: Correct. In Q3 it's $17.1 and in Q2 is $18.3, just rounding.

That's a tough question because a lot of expenses may be timing related. I would rather, John, I would rather look at full year number. If you're looking for guidance from a full year 2010 versus full year 2011, I would expect that higher sales will allow us to leverage that number in 2011 compared to 2010. So, on a four quarter run rate point of view, you can probably expect improvement in 2011 compared to 2010. Within quarters you can have some fluctuations because of timing and adjustments. John Franzreb - Sidoti & Company: Okay. I guess similarly, just on one of down a line, the R&D number jumped up as you noted that you have a lot of program development going to north of $5 million. Is that number going to be elevated at that level for some time or is that a near-term spike?

We have been steadily increasing our R&D expenses in the company, as we take this company more towards component intensive and we penetrate new markets and brand new applications. So, we have a couple of meaningful increases in our R&D expenses, the biggest being our Smart Actuator initiative, which is taking our component and sensors from a traditional automotive market to diesel engines. That is a very exciting development. As you know, we have one large high margin brand new business from diesel engine manufacturers, which is going to take this corporation from automotive centric sensors and actuator business to more towards diesel engines, on and off highway applications, which takes us into construction and mining equipment that takes us into agriculture and all that. That business will add up to close to $60 million, $70 million in annual sales by the time it fully gears up in 2015 and 2016 timeframe. Now, that's a huge, meaningful, brand new business and the company chose to develop it organically by investing something like $3 million of R&D per year, let's say, for a period of five years instead of spending close to $50 million to go buy or do an acquisition of that magnitude. Because of that reason and because of by design we are taking our electronic components into high density disk drives and some other medical and defense application, overall, I would think that our R&D expense will sustain at these levels in 2011 and probably early 2012. Again, I will not look at one quarter in isolation. I would probably look at a four quarter average and that will give you a pretty good indication of 2011. I don't expect it to rise beyond the current levels but I also don't by design want this number to go down meaningfully in 2011. John Franzreb - Sidoti & Company: Okay, thanks a lot, Vinod, I'll get back into queue.

Okay, thanks.

Thank you for that question. And the next question comes from the line of Hendi Susanto from Gabelli & Company. Please go ahead. Hendi Susanto - Gabelli & Company: Good morning, everyone, and thank you for taking my questions. My first question is in July management was expecting free cash flow of $20 million to $25 million for the year and you raised the earnings guidance for the year, and I wonder whether you're still targeting $20 million to $25 million of free cash flow for 2010?

Hendi, we are still forecasting free cash flow roughly in the same range. Now, I would say probably is slightly lower than that. I think we have--

$17 million to $22 million.

$17 million to $22 million, so that is slightly lower. I won't read anything in that I think it all depends on the timing of shipments in the fourth quarter and it's really working capital swing between one month and second month. Fundamentally, the component of free cash flow, which comes from higher cash earnings, that number continues to improve. And the number, which swings back and forth, is working capital and that is the reason why year-to-date our free cash flow is lower, but that can be easily flip. As we saturate investments and working capital I think you'll see the increased profit flow through the free cash flow. So, broadly speaking, we're still on the same page of generating approximately $20 million in cash flow, and whatever shortfall you will see in the fourth quarter, the chances are you'll pick them up in the month of January next year. Hendi Susanto - Gabelli & Company: And then, I think the last conference, in the last earnings call Donna also mentioned that she expected the debt to decrease by $10 million to $15 million by year end. And I'm wondering whether that's still the target as well?

Yes. I mean, if you look at our earnings performance we have debt of $77.1 million which is slightly higher from our second quarter. And so when I was talking in terms of the debt increasing it was from the 2Q and you did see a slight increase of it in the third quarter. Hendi Susanto - Gabelli & Company: Okay. So some increase, not a decrease?

Yes, it was an increase.

Hendi, between now and year end, you're exactly right. You'll see the debt levels go down. Hendi Susanto - Gabelli & Company: Okay. And then, CTS is expanding its manufacturing capacity in Thailand. Could you give us more insight into what drives the capacity expansion, how significant or how much revenue the Thailand facility is currently generating and other information that may be helpful for us?

Hendi, we have our own facility, EMS facility in Bangkok and I'm trying to think about how much square footage we have there today. I think we have roughly 40,000 square feet building. It is pretty much full capacity wise and we have had several instances where we had new customers, EMS customers, who toured the facility, were interested in giving us new business, but they wanted their product to be made in Thailand but they did not see a lot of excess capacity. So, it's a very popular EMS location for CTS because of its cost structure. And we found out that we had some excess land right behind our building, existing building, and so with only a moderate expense of maybe $1.5 million we think we can double our manufacturing capacity by adding an extension to our existing facility, and so that's what we are doing. We are just getting started on that. We hope to do ground breaking in the next 30 to 60 days and the building should be completed by mid-2011 and that would essentially increase our capacity or double our capacity in Bangkok from 40,000 square feet to maybe 75,000 to 80,000 square feet. Hendi Susanto - Gabelli & Company: And what was the amount of sales of piezoelectronics in the third quarter?

The piezoelectronics, Donna, do you have that information?

Yes, it's right there. Piezo technology for the quarter was roughly $5.5 million in total and that crosses all of our markets that we serve in whether defense or medical or aerospace. Hendi Susanto - Gabelli & Company: Okay. Do you still have sales to HP in the third quarter, by the way?

Very, very small, to be in the significant, so we don't have any year-over-year deterioration in our growth because of that business ramping down. Hendi Susanto - Gabelli & Company: My last question, do you have updates on Smart Actuator progress, Vinod?

Yes, we continue to work with the customer. They are going through various levels of testing of the product on their various engine families. We are on light duty diesel and we are being tested on their medium duty diesel programs. And so the program is on track and I believe we begin shipments in late 2012, and we continue to make prototype and testing and the program is on track. Hendi Susanto - Gabelli & Company: Thank you.

Okay. We have a follow-up question from John Franzreb from Sidoti & Company. Please go ahead. John Franzreb - Sidoti & Company: Yes, Donna, the $73 million in cash, can you just talk about where it's domiciled?

Our cash, as we have shared before in our calls, is predominantly in our foreign jurisdictions. John Franzreb - Sidoti & Company: And is that why your debt levels are going up because you can't access it? Could you just talk about that dynamic?

Well, in any company that has cash in foreign jurisdiction, it's the cost of accessing it, right? John Franzreb - Sidoti & Company: Right.

But predominantly, I mean, our debt is driven by our near-term working capital needs, particularly in our EMS and Components and Sensors, but it's just a choice you make in terms of accessing the cash versus the current revolver that I have. John Franzreb - Sidoti & Company: And I heard Vinod say that you're targeting lowering debt by year-end. What kind of amount are you thinking about paying down?

5 to 10.

Yes. John Franzreb - Sidoti & Company: 5 to 10?

As Hendi talked about as a previous comment. John Franzreb - Sidoti & Company: Right, okay. And one last question, when we start to think about the incremental revenue from new programs, is the end of 2012 still reasonable start time, or some of the push outs that we talked about, has that impacted some of the start time in some of the programs we were looking for?

I'm not aware of any material changes in the program time because of the push outs. I think when we talk about push outs, those are all existing business where the customers are doing some pulling and pushing because of inventory levels and the economy. These large programs we have, whether they are Smart Actuator driven, I think it's still scheduled for fourth quarter 2012. The other interesting program, it's not of that magnitude but it is significant because it is new product, new customer, new industry, is our piezo application going into high density disk drive. That actually starts first quarter 2011 and actually I have heard nothing with pushes it out. Actually, I have heard that they are pushing us to pull it up if we can pull it up. So, we are moving very quickly to put some additional capacity and the testing and qualifications are going on, as we speak on those programs. John Franzreb - Sidoti & Company: Okay. And that $1.7 million, that was all currency, Donna?

Yes. Well, are you talking in terms of the other income, other expense? John Franzreb - Sidoti & Company: Yes.

Primarily was driven by our currency, yes, $1.7 million. John Franzreb - Sidoti & Company: Okay, I think that's everything. Nice quarter, guys.

Thank you.

Thanks, John.

(Operator Instructions) Okay. At this time, we don't have anyone showing any questions. So, please continue.

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 to 11:59 am on Thursday, November 4th, 2010. 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 173579. Thank you for joining us today.

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