CTS Corporation (CTS) Q4 2011 Earnings Report, Transcript and Summary

Welcome to the CTS Q4 and full year 2011 conference call. [Operator Instructions] I would now like to turn the conference over to your host, Director of Investor Relations, Mr. Mitch Walorski.

Good morning. I'm Mitch Walorski, Director of Investor Relations, and I will host the CTS Corporation fourth quarter 2011 earnings conference call. Thank you for joining us today. Participating from the company today are Vinod Khilnani, Chairman of the Board and CEO; and Tom Kroll, 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 fourth quarter and full year 2011 financial results. The year was affected by disruptions due to the Japan earthquake and a fire at our EMS facility in Scotland earlier in the year. And again, major flooding in Thailand adversely affected our sensor business, electronic components and EMS operations in the fourth quarter of 2011. Despite these back-to-back events, which materially affected many of our key customers like Toyota, Honda, Western Digital, et cetera, our full year sales were up 6.5% and adjusted earnings per share were up slightly from $0.66 last year to $0.67 in 2011. Some of the sales and earnings impact from these natural disasters is expected to be recovered in 2012. New business awards and new product development activities stayed strong. We also signed an agreement to acquire Valpey-Fisher, an electronic components company with approximately $15 million in annual sales. The transaction did close day before yesterday. We increased the pace of our stock buyback activity in the fourth quarter and announced a 17% increase in our dividends to our shareholders. 2012 should benefit from new business and new customer revenue and some claw-back from 2011 issues. As a result, we expect a strong 2012 with double-digit increase in our top and bottom line compared to 2011. Sales in the fourth quarter of 2011 at $144 million were essentially flat compared to fourth quarter last year due to approximately $11 million to $13 million of adverse impact from Thailand floods, offsetting the increased sales from our new products and programs in the quarter. Full year sales of $588.5 million were up 6.5% despite approximately $22 million to $23 million of headwinds from Japan earthquake and Thailand floods. Our components and sensors segment sales were $70.7 million…

Thank you, Vinod, and welcome everyone. Before I review the financial results in greater detail, I will comment on a couple of unusual items. First, we initiated a fourth quarter restructuring action, costing about $2.4 million with a payback of less than one year. This action will improve efficiencies primarily within our component and sensor business segment with an associated global workforce reduction of approximately 100 employees. Secondly, as discussed in our last conference call, CTS was negatively impacted by the unprecedented floods in Thailand, which began early in the fourth quarter. The impact of the Thailand flood was much more extensive than anticipated during our last conference call in late October. Also during the quarter, we finalized the property damage insurance recovery related to our second quarter 2011 EMS buyer. The $3.4 million recovery or about $0.07 per share is shown separately on our statement of earnings. This amount is essentially in line with our expectations that we discussed during our last conference call. Also recorded in our financials is the insurance recovery for business interruption of $2.2 million, for both the Scotland fire and the Thailand floods. This amount is primarily a reimbursement of fixed burden expenses shown in cost of sales. Therefore, if we include this amount in our cost of sales, the fourth quarter adjusted gross margins were at 19.6%. We also recorded approximately $1 million of EMS incremental flood related burden expense that negatively affected gross margins by about 70 basis points. This $1 million is expected to be recovered via our business interruption policy in 2012. Now, I'm going to discuss the results. Our consolidated fourth quarter 2011 sales were $144 million, a 1% decrease from both prior year and prior quarter. Our adjusted gross margins were 19.6% versus 20.3% last year and 19.4%…

[Operator Instructions] I will go to the line of John Franzreb of Sidoti.

Vinod, regarding your guidance, it sounds like embedded in it is continued insurance recoveries, not only in the first quarter, but sounds like you're expecting it to continue through the second quarter. Is that the case and if so, how much you have embedded in that EPS number?

John, in the first quarter and second quarter we expect some business interruption recoveries, which essentially will offset expenses which we are incurring. But that amount will depend on what our incremental expenses are. So for example, if we incur $1 million in incremental expense in the first quarter, we expect maybe with a few months lag that money to come back. So we look at that as essentially reimbursement. In addition to that we are expecting some small amounts, I will estimate that, but that amount can be anywhere from $1 million to $2 million of what we call reimbursement, because of the damage to our property in Thailand. So fairly small amount compared to what happened in 2011. But we may have a little bit of that extra revenues, which I will estimate $1 million to $2 million in the first three, four months of the year.

And in the revenue outlook, I'm assuming you are including Valpey-Fisher in the topline expectations. Is that true and how much you are assuming for Valpey?

We're expecting Valpey to generate approximately $15 million. And that would reflect the revenues for roughly 11 months, because we just completed the transaction at the tail-end of January. So we are incorporating those $15 million, which is roughly 2% of our growth coming from acquisition and the rest, organic.

And could you just talk a little bit about Valpey and what was the thought process behind the acquisition? And how do you expect that business to grow?

Valpey primarily is focused on engineered frequency product. And within our electronic component business, we have roughly $18 million of engineered frequency business. So this essentially doubles or more than doubles our engineered frequency business and that gives us a broader product range and also takes the product range more towards military and aerospace applications. So it broadens our products range to common customers, which allows us to get some sales and marketing synergy. And it also provides us a very small engineered frequency manufacturing base in United States, which allows us to cater to the military and aerospace customers, because our existing business has manufacturing base in Singapore. So we see a good bit of synergy from the engineering organization and sales and marketing organization. And therefore, we're projecting that this acquisition, although small, will be slightly accretive in the very first year of its integration.

Will there by any associated consolidation restructuring cost with Valpey?

We were expecting a little bit, but that was covered in our restructuring cost in 2011. So I believe it's behind us.

You mentioned that your distributors are keeping inventory low in your prepared comments. How much of your sales goes to distributors and could you just talk a little bit about that? When do you expect to see that give way to maybe a normal seasonal selling cycle?

I would say a very small, maybe 10% to 15% of total CTS sales goes through distribution, and these are normally very large distributors like Avnet and All American type people. And the product we sell to distribution is a combination of what we manufacture in-house and we do what we call buy-sell kind of product. We did see that softening in the last four months of 2011. My expectation is that sometime in February-March-April timeframe after the impact of the Chinese New Year on the first quarter, we expect that to bounce back. On the positive side, we also recognize that the inventories are probably a little bit lower than normal in the distribution cycle. And digressing from this, I think our inventories to some of our key automotive OEMs are also materially less than what they would like to see. Thus, our confidence that those will bounce back frankly starting from first quarter.

We'll move on to the line of Hendi Susanto at Gabelli & Company.

My first question is do you have operating cash flow target for 2012?

Hendi, we don't have a target per se, but since we are not expecting CapEx to be materially different from this year, you can pretty much assume that if you add back $15 million, $16 million of our CapEx to our free cash flow, that will give you the operating cash flow target.

And then when I look into your 10% to 13% sales growth for 2012 and calculate all the estimates of the sales increase given in your latest presentations, I have $25 million in pedal modules, $7 million in grill shutters and turbocharger sensor, $15 million from Valpey-Fisher, $12 million in piezoceramic for hard disk drive and additional $4 million in electronic components. If I sum all those, I get 10.7% sales growth. What are other growth opportunities you're seeing aside from those?

Hendi, you're exactly right. I mean we have openly talked about these large new programs which are kicking in, in 2012 and ramping up. And we are counting on all of those to contribute to the sales. In addition to that, we expect some additional sales increase across the board in our base business, keeping in mind somewhat mild growth prospect in the global economies. So those combined for normal base growth gives us confidence that we will have our sales in the 10% to 13% range.

And then looking at your fourth quarter, EMS operating margin was very strong at 4.2%. And in the previous earnings call, you mentioned 2% to 3% short-term operating margin target for EMS. So how should we think of the strong operating margin going forward into 2012?

I think, Hendi, Q4 is very muddy, because on the one hand they had a lot of disruptions and inefficiencies because they were producing many of the Thailand products in California. And so we had direct labor which was duplicated. We were replacing low-cost Thailand labor rates with high California labor rates. But the reason you see a high number is because it's convoluted because included in that is the insurance recoveries. So I would tell you that you should look at EMS as a normalized 2% to 3% operating margin next year and the Q4 operating margin is overstated because of insurance recoveries.

And one bookkeeping question is for Thomas, how much was your pension cost in 2011 and how much do you anticipate in 2012?

Well, the pension income in 2011 is roughly $3.5 million and as, Vinod, mentioned in his remarks, we do expect that to have a negative impact on us in 2012 to the tune of $0.07 to $0.08. So we're not looking for any pension income in 2012.

So Hendi, it's a key point. We had $3.5 million of pension income in 2011 and we are essentially projecting breakeven next year. As you know, many companies are experiencing the same trends because the interest rates are low which has lowered the discount rate. And this lower discount rate combined with lukewarm stock market performance in 2011, is affecting everybody's pension numbers. Fortunately, in our case it's more going from an income to a breakeven and not increasing our cost. But what that suggests is that we are projecting a strong earnings per share growth next year even after absorbing a pension hit of roughly $3.5 million which is $0.7 per share.

Now we'll move on to the line of Alek Gasiel at Barrington Research.

Vinod, I know you have provided some details on the call but maybe you can go over to put on a little more color, just some guidance on sensor, actuator, electronic components and EMS. Just provide a little more qualitative detail if possible.

Sure, I think as you know we are expecting a fairly strong rebound in our sensor side of the business, which is driven by two things. One, it's driven by the fact that we have new customers and new products launching in that product family which is going to give us a very, very strong growth next year. And that growth is going to get magnified to some extent because you know that that is an area where in the second and third quarter of 2011, the sales were low because of the impact on the Honda and Toyota. So 2012 is going to benefit not only a bounce back from that side but also new products. So we're going to have a very strong year on the automotive sensors and actuators side in 2012. Electronic components business, similar story to some extent. We have new products like the piezoceramic hard disk drive business. Actually it is ramping up as we speak. We should see that ramp up visible in the first quarter of 2012. So that new product combined with couple of new customers launching and fairly low inventories in the distribution pipeline again gives us confidence that our electronic components business year-over-year should grow, as I said earlier, I think around 20% range. EMS on the other hand, as you know, our strategy is to be a little bit more selective and not necessarily chase new business and deteriorate our margins. Our focus there is going to be we want new sales, but we want to focus on our pricing and margins at the same time. And therefore, we expect our EMS sales to grow, as we have consistently said in our investor presentations, in the mid-single digits, so I would say anywhere from 4% to 6% growth, because we will be selective in that area. So again, we should see our segment mix improve, because components and sensors should grow strong 15%, 20% range and EMS should grow in 4%, 5% range. And that is one of the key drivers for operating margin improvement in 2012.

Now looking at the new business that you guys are going to be ramping up, is there any way of providing maybe on how that should fall throughout the quarter for the year?

We have a few pieces which are launching in the middle of the year. So the second half of the year would be a little bit stronger than the first half of the year. But having said that, because of some unique situations around the impact of fourth quarter this year and a little bit product lines not being in the channel, we may not see necessarily that the first quarter would be our weakest quarter. Our first quarter traditionally is the weakest quarter and fourth quarter goes up. I would say the first quarter would probably more in line with an average quarter for the company. So we should see improvements starting from the first quarter. But having said that, overall second half should be stronger than the first half.

We'll go next to the line of Brad Evans at Heartland.

I think you've already hit on my question, but I'm just trying to perhaps understand why we wouldn't see maybe a little more operating leverage than what you're forecasting in 2012. I clearly understand the shift in mix to components and sensors from EMS, but I am surprised that we're not seeing maybe just a little bit more operating leverage. Are there things that stand out to you as to why we're not seeing maybe a little more of an inflection point there?

Sure. I think it's a very good point and it probably helps to highlight couple of things. So with the 10% to 13% topline growth, if you look at our EPS growth, it is not showing that leveraging. But that's why we wanted to highlight that a 10% to 13% sales growth should give us an operating income growth of 20% to 22%. So you will see leverage at operating income of 20% to 22%. Now, the pension income is an above operating income line. So we are absorbing a $3.5 million pension income change and still signing up in our guidance of a 20% to 22% operating earnings. If you adjust for the $3.5 million to our operating margin, I suspect that 20% to 22% increase from a true operations point of view would probably look more like a 30% to 35% increase. So we are showing a pretty good leverage. And the other comment which Tom made was we are expecting our effective tax rate to increase from 20%, 21% to 25%. And again, one of the reasons our effective tax rate is increasing is because we are seeing our earnings generation in U.S. improve. And that affects the book EPS. But because you know that we have a tax loss carryforward, from a free cash flow point of view, it is this kind of a change which is giving the Board confidence to increase dividends, because they see not only cash flow improve, but the cash flow is being generated more and more in U.S. which gives them more flexibility to make those kind of decisions. So I just wanted to highlight that the leverage is there. And the second is that we are absorbing high tax rate, but it is non-cash hit.

I'm sorry did you mention capital spending for the year? If you did, I missed it and I apologize.

Yes, Brad, we spent $15.6 million.

I'm sorry your outlook for 2012.

We didn't provide an outlook. But again, our target is generally a little less than 3% of sales.

For your free cash flow guidance to get to the 16 to 21, it looks like you're actually expecting working capital would be of a use of cash in 2012. Is that correct?

It'll be pretty close to where we are, but we are expecting improvements as we try to drive down the inventory levels.

So it looks like your free cash flow guidance maybe indeed conservative then, because it looks like you could be closer to 20 to 25. But that's just how my math is shaking out.

Brad, one thing which will change is that, Tom is right, we will improve our working capital. However, the incremental sales will require us to absorb some. So depending on what the incremental sales are and where the sales fall, the mix of the sales, there are some higher sales in the fourth quarter. There may be a tail-end need for higher inventory receivables and things like that. But you are right, depending on the mix of it, we may have an opportunity.

I'm sorry. Is there a pension contribution that you're including in your free cash flow guidance?

No, Brad. No, pension contribution there.

How much of your cash is in the U.S. right now?

We essentially today have all our cash outside U.S. And that is one reason why we have the use of the revolving credit facility and the debt is in U.S. and all of our cash reserves are outside U.S.

And do you have any share count, actually the fully diluted share count. But do you have any share count reflecting the share buyback in the quarter? I guess what would be on the face of the 10-K.

We don't have that exactly, Brad. We can cycle back to you to provide you that information.

Vinod, I'm curious, can you just to speak to my last question of cash flow and capital free cash flow allocation? I know it's frustrating, the great depression or recession, I should say. And then obviously while CTS is a relatively small company, we seem to have been hit by almost everything that happened geopolitically with the exception of Libya, I guess, last year. I'm just curious how you're thinking about deploying cash flow. I realize, that a lot of the cash was offshore but it sure seems like buying back stock as aggressively as you possibly can is-- would be a smart move?

The Board considers all uses of cash all the way from dividend increase, to buybacks, to acquisitions. And I would think that in the last three months we have demonstrated to our shareholders that we are capable of doing all three. We did the small acquisition Valpey-Fisher for roughly $18 million. As, Tom, pointed out we have ramped up our stock buyback in the fourth quarter because we think that the stock was trading at lower than what we think the true value is out there. And frankly, we increased our dividends and I frankly don't remember when was it last time that we increased our dividend. So that's clearly a message the board was sending to the shareholders that we are willing to consider that. And so to be honest with you, I think we have a pretty good track record. You have here an organic growth which is based on new products which we have developed and won. So we're using our cash for organic growth. We are using our cash for an acquisition growth. We are using our cash to buy back and we are using our cash from a dividend increase point of view. And I think the board will continue to evaluate based on the trends and the needs of the company which they should.

[Operator Instructions] We do have follow-up from the line of Hendi Susanto at Gabelli.

Vinod, one follow-up question. Could you share insights into relative strengths and weaknesses you are seeing in defense, aerospace, communication and industrial markets? I think we are hearing inputs about like the (product) inventory being at the low level, but at the same time, I heard some pocket of strength in certain products?

Hendi, overall the percent of business we have in defense and aerospace is relatively small. And if you look at the percent of our sales in defense and aerospace in components and sensor side, it's even smaller. I've heard from some of our customers and the businesses that they are seeing softness in defense and aerospace. They saw that in the fourth quarter and they are expecting that softness to continue in 2012. I don't see that as a material development for CTS for two reasons. One is, our profit contributions in sales from defense are relatively small. And b, we have a good portion of our sales in homeland security type applications or drone applications and things like that, which we believe are not going to be affected by the defense budget cuts. Actually there was a news in today's Wall Street that the defense department strategy is to reduce the number of active battalions and reduce what they call traditional military expenditures. But they want to dramatically increase their unmanned drone capabilities. And I suspect night vision and homeland security kind of initiatives will not be affected. So I guess, where I'm going with your question is that, yes, we have heard the same thing that there is softness in the military and defense spending. And it did affect some pockets of our electronic components business. However, overall, it's not a material piece of information for CTS going forward, because our small sales are distributed pretty broadly between unmanned drone kind of applications to homeland security, to night vision, and things like that. So I frankly don't see any material impact on CTS from that.

And how about in the communication and industrial markets?

Communication and industrial markets were pretty lukewarm, not very exciting in fourth quarter and may stay soft in the first half of next year. We're not counting much on that, our assumption is that the markets will be soft. Our growth projections are primarily driven by the new product launch like high-density disk drive applications or actuators, or additional new wins on some global platforms on pedal modules.

Thank you. There are no further questions on the phones at this time, gentlemen.

I would like to remind our listeners that a replay of this conference call will be available from 1:30 p.m. Eastern Standard Time today, to 11:59 p.m. on Thursday, February 2, 2012. 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 231985. Thank you for joining us today.

Thank you. And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.