CTS Corp (CTS) 2003 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the CTS Corporation third-quarter earnings conference call. (OPERATOR INSTRUCTIONS). I would now like to turn the conference over to your host Vice President of Investor Relations, Mr. George Newhart.

Thank you, Mary, and good morning. I am George Newhart, Vice President Investor Relations, and I will host the CTS Corporation third-quarter earnings conference call. Thank you for joining us today.

Participating from the Company today are Don Schwanz, President and CEO; Vinod Khilnani, Senior Vice President and Chief Financial Officer, and Don Schroeder, Executive Vice President and Chief Technology 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 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. More information can be found into 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 reconciliations are available on our Website in the Investor Relations section.

I will now turn the discussion over to our CEO Don Schwanz.

Thank you, George. I am sure by now you have seen our third-quarter results which were released last night. In general, we were placed with the quarter. On the positive side, our growth initiatives continued on a very positive track, with significant awards coming in several areas. Operating profitability also continued to improve, reflecting our ongoing cost reduction efforts and an improving product mix and communication components. And from a balance sheet prospective, we completed a new bank agreement that lowers our cost and provides stability to our balance sheet going forward.

The disappointing factor in the quarter was the continuing sluggish sales environment. Overall sales in Q3 were 108.5 million, down 2.4 million or about 2 percent from the third-quarter last year, and down about 7 percent from Q2. While we expected the third quarter to be down sequentially due to the seasonal factors, we also had anticipated somewhat stronger primary demand in the major markets that we serve.

From a profit perspective, quarterly results showed continuing improvement. Two major accounting actions impacted the quarter, one related to a tax adjustment that affected Escalade (ph) and the other involved the impairment of certain assets, and it affected earnings negatively. Excluding the impact of those items, net income was 1.6 million, which equates to 5 cents earnings per share. This was our fifth consecutive quarter of positive net earnings since the economic downturn of 2001.

Vinod will provide more prospective on the financial results later in the call.

Before he does that, however, I want to you update on the status of some of our new products and growth initiatives. We continue to be delighted with the progress we are making in growing our automotive business. Our growth strategy includes the aggressive development and introduction of new products, expansion of our customer base, and geographic expansion into Asia. Progress is being made in all three of these strategies.

During the quarter, we received two additional awards for our new integrated accelerator pedal, also called an Accelerator Pedal Module. This product integrates our pedal sensor with the pedal itself, allowing the OEMs to simplify their supply chain, save on assembly time and reduce their total cost. At the same time, it moves us up the value chain. An Integrated Accelerator Pedal ASP is roughly 2 to 3 times a sensor ASP. Year-to-date we have won positions for our Integrated Accelerator Pedal on 19 platforms, which represents about $16 million per year in revenue when all platforms are in full production.

Another area where we have had significant success is with our Fuel Level Sensor. In the last year, we have won positions on three new platforms, secured our first significant customer in Europe for this product, and have been awarded a contract to do the Fuel Level Sensor assembly, along with the production of the sensor. Again, this takes us up the value chain with our customers.

We are also successfully broadening our customer base for automotive products. Today about 60 percent of our products end up in cars manufactured by GM, Ford or Daimler/Chrysler. However, a much higher percentage of our new product wins are coming on platforms of other OEMs. For example, we are having great success penetrating new customers with Integrated Accelerator Pedals. About 80 percent of the pedal business captured so far comes from OEMs other than Daimler/Chrysler, GM and Ford. As these new platform wins go into production, our customer base will broaden significantly.

We are also making progress in Asia with automotive product sales into the region running about 30 percent higher year-to-date compared to last year. We expect sales in this region to continue to grow very rapidly in the years ahead, ramping from about 9 million this year to the $20 million range by 2005.

To better serve customers in the region, we opened a new sales office in Shanghai earlier this year and set up our first Throttle Position Sensor production line in Taiwan last year. Our first automotive product manufacturing operation in China will come online in the first quarter of next year, and we expect to continue to expand our service and production capability in the region as our business grows. In summary, I believe we remain on track to double our automotive product business by 2007.

The markets for our communication and computing components still present a very mixed picture as weakened product demand and industry overcapacity continued to undermine profitability. As a result, we have maintained a cautious posture regarding the investment of discretionary resources in this area. Even so, within this general product market area, we are seeing a slowly improving business climate, and we are achieving positive results in some key areas.

Our communication infrastructure frequency business, for example, continues to do quite well. The communication infrastructure market is actually down about 15 percent from last year as service providers have continued to curtail capital spending. Our sales, however, are up about 15 percent through the first nine months compared to last year as we have been able to take share from a weakened competitive field.

As I have noted before, we have also been moving up the value chain in this serve market by offering higher level modules that incorporate or work with our precision frequency products. So far this year, we have won 32 design positions with our new modules with seven of them coming this quarter. Applications for these modules include new 3G base stations that are in early stages of marketing introduction. If equipment spending on communication infrastructure trends up next year as is predicted by many industry prognosticators, we are well-positioned to benefit.

Our ClearOne line of resistor termination products also continues to do well. We captured another 12 design wins in the third quarter bringing the total to over 100. Sales also continue to grow each quarter as we see more of the new end product designs being released to production. Unit volumes in Q3, for example, were up by nearly a factor of four over last year. We are also seeing positive results in our EMS business. Year-to-date sales are up about 8 percent over 2002 with that growth driven by the wireless communications market.

One of our EMS business objectives has been to broaden our customer and market base. This type of organic new business development takes time, but we are having success. Over half of our new product introduction activity is with new customers. While volumes with these customers are still quite low, we do expect them to grow into significant accounts. Our EMS business is also positioned to benefit from the upturn in IT and communications infrastructure spending should that occur next year as many expect.

So, in summary, our growth initiatives are paying off. Revenues from recently introduced products including Belt Tension Sensors, pedal modules, small engine throttle sensors, frequency modules, ClearOne terminators and (inaudible) modules will reach about 18 million this year, up by a factor of 5 from last year and are expected to grow to nearly 50 million next year. And behind these products are other new products in our development pipeline.

Now Vinod will provide a more detailed discussion of our financial results.

Thanks, Don, and good morning everyone. We were pleased to announce another positive earning and free cash flow quarter yesterday. I would like to begin my discussion of results by going over the favorable tax adjustment and asset impairment items which affected our third-quarter results.

During the third quarter of 2003, CTS recorded a 4.6 million before tax, a 10 cents per share impairment charge, to reduce the carrying value of certain assets to their estimated sales value. Reduction in the sale value of assets was related primarily to previously announced end-of-life products, idle equipment and held-for-sale assets.

Also, during the third quarter, we recorded a tax benefit of 7.9 million or 22 cents per share in connection with the reduction of reserves for tax liabilities. The adjustment in tax reserves was due to the exploration of federal statute of limitations as related to certain transactions where the Company had previously established reserves for an open tax liability. Together these two items provided a net benefit of 12 cents a share in the quarter.

Looking at the operating results of the third quarter 2003, sales of 108.5 million were 2.4 million or 2.2 percent lower than third quarter last year. Sales in the quarter were aggressively affected by a 5.2 million decrease due to previously announced end-of-life communication components. Excluding that, sales were up by 2.8 million or 2.6 percent. Overall EMS sales for the third quarter of 2003 went up 12 percent year-over-year, primarily due to stronger shipments of communication products in China. While components and sensor sales were 11 percent lower year-over-year, primarily due to the reduced sales of end-of-life products and general price reductions.

On a sequential basis, third-quarter 2003 sales were 8.2 million lower, primarily due to lower automotive sales caused by normal third-quarter OEM plant shutdown activities and to a certain extent by the timing of some EMS shipments. Geographically sales to the Asia-Pacific region were up 16 percent in Q3 of this year versus the same period last year, while Europe and Americas were down 16 percent and 6 percent respectively.

Gross margins reached a two-year high of 21.8 percent in the third quarter of 2003, 3/10 of a percent higher than third quarter last year and 8/10 of a percent higher sequentially from the previous quarter. Compared to last year, gross margins were higher due to increased margin in the components segment, driven by further improvement in the manufacturing efficiencies in our Asian operations and also lower depreciation expense. This was achieved despite a higher mix of EMS business in the third quarter of 2003, which inherently carries lower gross margin. Sequentially margins improved by a 1/10 of a percent due to higher margins in both EMS and components segment of our business, driven again by lower manufacturing expenses and better product mix and sale of higher margin components.

With further reductions in depreciation expense and volume-driven increases in the manufacturing capacity utilization, we should see gross margins continue their gradual improvement averaging around 22 percent year-over-year in 2004. SG&A and R&D expenses of 19.7 million in the third quarter were essentially flat compared to the 20 million level in the second quarter of this year, a 2.3 million or as a percent of sales 1.7 points lower than third quarter of last year, primarily due to lower headcount-related expenses. Going forward, we expect to see our SG&A and R&D expenses continue to come down as a percent of sales.

Third-quarter 2003 adjusted operating earnings, which excludes restructuring and asset impairment charge discussed earlier, were 3.9 million or 3.6 percent of sales versus 1.9 million or 1.8 percent of sales in the year ago quarter. Interest expense of 2.1 million in the third quarter included a onetime expense of $438,000 to write-off (inaudible) related to our old bank facility, which was expiring in December 2003 and which we replaced with a new three-year facility with much better terms and pricing in July of this year. Interest expense excluding these onetime fees was 1.7 million in the third quarter versus 2.2 million in Q3 of last year and 1.9 million in the second quarter of this year. Net earnings for the third quarter, therefore, were 6.1 million or 17 cents per share, including 7.9 million or 22 cents of variable tax adjustments and 3.4 million after-tax or 10 cents of unfavorable impairment charges.

I believe results in the quarter demonstrate that CTS is delivering on its commitment to return its earnings to acceptable levels, even in an environment of slack demand and really flat sales.

On the balance sheet front, receivable days were 52, same as last year and the last quarter. Net earnings at 37.4 million or 3.5 million lower than Q3 last year, but increased by 2.4 million sequentially in preparation for increased seasonal demand in the fourth quarter. Working capital, excluding cash and current portion of debt, was 51.8 million or 11.9 percent of annualized sales versus 14.1 percent in the third quarter of last year and 9.6 percent in the previous quarter.

Capital expenditures inched down further to 1.7 million in the third quarter, 4.5 million lower sequentially and 1.6 million below same quarter last year. We expect full year 2003 capital expenditures in the range of $12 to $13 million, with fourth quarter CapEx projected between $5 and $7 million. Free cash flow, which is defined as operating cash flow net of all investing activity, was a positive 7 million in the third quarter. Year-to-date September free cash flow in 2003 was a positive 13.2 million, which is a positive 8 million in the corresponding period in 2002, a 65 percent improvement. Total debt came down to 81 million in the third quarter, 4.3 million lower sequentially from the second quarter and 22.5 million lower from the third quarter of 2002. Debt to capital ratio stood at 22.1 percent at the end of the third quarter, lower sequentially from 24.1 percent in the second quarter.

As a final comment, we completed a private placement of 1 million shares with an institutional investor during the third quarter. This helps CTS put in place a new three-year revolving credit agreement with a much improved pricing and fleet structure, which will generate savings of approximately $1 million per year. With our debt to capital ratio at .2 percent, we foresee no private placement of such nature in the foreseeable future. Overall, we are pleased to report a quarter with strong positive cash flow and the fourth consecutive positive earnings per share quarter after breakeven in the third quarter of last year.

And now I will turn the meeting back to John.

I noted earlier that the third quarter was softer than expected. This was particularly evident in July and August, though demand strengthened again in September. So as we enter the fourth quarter we still see a lot of month-to-month variability in market demand without any clear indication of a change in overall direction. Even so, considering normal seasonal trends along with the growing impact of our new product sales, we expect fourth-quarter revenues to be up 10 to 15 percent over Q3. Correspondingly, earnings per share in the period are expected to be in the range of 7 to 9 cents per share.

Now I will open the call to questions.

(OPERATOR INSTRUCTIONS). Lee Zeltser, Needham & Co.

A few questions. I was wondering first off if you can give us a sense in the component business, how much of the mix was automotive sensors and how much of it was other components? If you could talk about sequential trends in those two component areas?

Automotive was about 25 percent in the quarter. The other components were about 32 percent of total sales, and the remainder was the EMS.

Mostly other components is wireless handsets?

No. It is handset components. It is components that go into communications infrastructure, IT infrastructure. There is a variety of end markets for it.

Wireless handsets as I recall was about 20 percent overall?

No. Handsets are only about 11 percent.

It is down to 11 percent? If you can talk about sales trends sequentially in the automotive and the other components?

Automotive in the third quarter because of the shutdowns have the sales typically falloff a little bit. So if you look from second quarter to third quarter, we actually dropped about a point as a percent of total sales, but that is a seasonal factor that is at play there.

If you look into from a communications market standpoint, the trend was up a little bit driven more by the growth in our EMS infrastructure-related business than probably anything else. The others are pretty constant. I guess quarter to quarter I am not seeing anything really big in terms of a swing from a trend standpoint.

In the EMS business, you talk about diversifying your customer base. Who are the key customers in that business outside of HP?

Motorola would be one. You get into a variety of customers after that. There is quite a few of them in public networks. There are some industrial customers, and it is in those other spaces that we are seeing a lot of new customers come into play.

Motorola, how big where they roughly this quarter in the EMS business?

We don't have a number handy.

Over the past year. What I need is just an approximate.

I think Motorola as you know traditionally has run about -- last year they were about 12 percent of sales for 2002, and that is, of course, handsets and infrastructure. At this point, we don't separate them into the EMS versus the components. In total, they are probably still in that range, I think, of 12 percent.

It is fair to say they are growing on the EMS side of the business, primarily from our China operation.

I think you had said if I heard you correctly gross margins around the 22 percent mark for '04? Is that right?

Yes. We expect them to continue to improve as they have been improving this year as we continue to expand capacity utilization and as we continue to see depreciation expense come down.

Okay. Just lastly, in terms of seasonality trends, you mentioned normally the fourth quarter was up. How about the March quarter? Is that generally down from a seasonal prospective?

Typically from the fourth quarter, it is down. Again, it varies from market to market, but one of the things that we see, in the handset arena particularly, there is an uptick in the fourth quarter because of holiday-related sales, and then there is usually some inventory going on in the fourth quarter that affects demand in their first quarter. There is also often some fourth-quarter demand that is generated as companies spend their remaining capital budget. So it is not unusual, for example, in infrastructure to see a little bit of uptick in the fourth quarter. It is hard to sort out some of that in terms of seasonal trends versus just underlying improvement.

Okay.

Now, for example, we are seeing just a lot of really spot expedites in the infrastructure market. It is not unusual in the fourth quarter to see that. It is higher this year that it was last year in the fourth quarter.

Okay.

It will usually falloff again in the first quarter because budgets are not in place. So you see the first month or two tends to be a little bit slower.

(OPERATOR INSTRUCTIONS). Lee Zeltser.

Just a follow-up. If you could talk about pricing trends in the business, both on the EMS side and the component side?

I guess in general -- and I will let Donald Schroeder comment more specifically in a moment. As we stated before, the pricing trends in the component side were the areas where we saw a more stressful environment in the last couple of years. Everything else was pretty normal. Nothing has really changed.

On the component side, we have seen a pretty steadily improving environment in terms of price pressure. On an annual basis, it -- it varies from component to component -- so what I am saying is more generally true. You can always find an exception here. If you compared what we are seeing on a year-over-year basis right now with what we saw back in, say, the 2000 timeframe, it is getting reasonably close. Wouldn't you say, Don?

The difference is, though, you have to remember back in those timeframes, we were seeing annual growth rates that are higher than we are seeing today. So you are seeing that degree of price pressure with still a lower year-over-year growth rate to support it. So I think when you put the two together, it creates a little bit more pressure on the business than was probably a characteristic of it in 2000.

I think it is fair to say this is the first quarter after a long time we have seen the pricing behave more in a normal fashion like it used to before the big drop-off in the volumes in the communications arena.

Is that through the same EMS business as well?

EMS has been pretty normal, and it has not changed a lot.

I think you mentioned you gained some share in EMS or are looking to gain share. Who would you possibly be looking to take share away from?

I did not say it that way. In the EMS business, there is an underlying trend towards outsourcing, and our approach to the business in many cases is to work with new customers who are outsourcing products in many cases for the first time. In some cases, they are new products that the customer has been outsourcing, but it is a brand-new product. From the time we start working with them, it takes some time for the product to go into production.

When we see competition in these situations, it is not usually a situation where somebody else has been doing the outsourcing work on that product, and we take it away from them. That would be by far the exception to the way we capture business.

So it's more function of just captive share to an outsourcing?

And new products that are going into production, and we win the business in terms of the box build or whatever form, (inaudible), etc..

There are no further questions. Please continue.

I would like to remind our listeners that a replay of this conference call will be available from 4:45 Eastern Daylight time today through the midnight Eastern Standard time October 30th. The telephone number for the replay is 1-800-475-6701, or 320-365-3844 if calling from outside the United States. The access code is 701468.

Thank you for joining us today.

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