CTS Corp (CTS) 2003 Q4 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by. Welcome to the CTS Corporation fourth quarter and year-end 2003 results conference call. At this time, all participants' lines are in a listen-only mode. Later there will be an opportunity for questions with instructions given at that time. (OPERATOR INSTRUCTIONS) As a reminder, today's conference call is being recorded. I would now like to turn the conference over to our host, Vice President of Investor Relations, Mr. George Newhart. Please go ahead.

Thank you, Rod. I'm George Newhart, and I will host the CTS Corporation fourth quarter earnings conference call. Thank you for joining us today. Participating from the company today are Donald 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 this 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. More information can be found in the company's SEC filings.

To the extend that today's discussion refers to any non-GAAP measures relative to regulation G., the required explanations and reconciliations are available on our website on the Investor Relations section. I will now turn the discussion over to our CEO, Don Schwanz.

Thank you, George and good morning. First I would like to warn everyone in advance that I'm getting over a very bad cold and I may have difficulty getting through this without coughing, so I apologize in advance if that happens. In any event last evening we released our financial results for the fourth quarter and the year. It was for us the best quarter since early 2001. Sales increased by nearly 22 percent over the third quarter and by 13 percent over the fourth quarter last year. Earnings also improved significantly, growing to 11 cents per share from 5 cents per share in Q3, excluding the onetime impacts for the tax credit and restructuring costs in that quarter.

Other financial metrics, including free cash flow, working capital and debt levels also showed improved quarterly results. One of the biggest positives in the quarter was the broad uptick in market demand. Not only did this have a beneficial effect on the quarter, but it also suggests potentially a more robust demand environment in 2004. The greatest beneficiary in this pickup in demand was our EMS segment. Sequentially sales improved 38 percent over the third quarter and were up 25 percent over the fourth quarter last year. On a total year basis our EMS sales were up 12 percent over 2002.

The growth in EMS sales during the quarter came in both the computing and communications markets. Sales of high-end computer storage products were very strong. In infrastructure communications both old and new customers showed strong sales gains in the quarter. EMS sales from our Tangay (ph) and China operation showed continued growth propelled by spending and wireless infrastructure in that region. While certainly positive, it is important to remember that infrastructure spending in China has remained fairly robust even though globally spending has been soft. Still, our EMS sales in China exceeded $40 million for 2003, more than doubling from 2002, and we expect them to be strong again in 2004.

I also want to note that one of our initiatives in the EMS business this past year has been to broaden our business space. In the fourth quarter we added five new customers, including customers in both the automotive and medical markets. One of CTS's competitive strengths as an EMS provider has been our ability to globally serve OEMs with a need for a high mix in low to medium volume manufacturing services for complex products within markets around the world. This allows us to provide new product introduction services locally to a customer's design center and then provide assembly and box build services convenient to the end markets in North America, Europe and Asia. We will be expanding this capability in 2004.

In response to requests by one of our customers, we will be opening an EMS operation in Singapore. In the past we have been shipping this customer's products into Singapore after box build operations in Europe. The change to Singapore box build will save both on logistics and assembly costs. EMS operations are expected to begin in Singapore in the April timeframe and will be conducted out of our current component manufacturing facility there using excess space in the building.

Our components and sensor business also benefited from the improving economy with sales up about 9 percent over the third quarter and up about 4 percent over the fourth quarter last year. On a total year-over-year basis, however, component and sensor sales were down nearly 7 percent, driven by our decision in 2002 to go end of life on certain product lines, primarily related to handset markets. Within the component and sensor segment, sales of our automotive products in Q4 were up about 8 percent over Q3 and 5 percent over Q4 last year. This sequential increase was primarily driven by the resumption of normal automotive production rates after the summer shutdowns in North America and Europe, although the fourth quarter was also adversely affected by the holidays.

More importantly to our long-term expectations for this business, during the quarter we won a number of new platform and model positions which will continue to drive future growth. Key wins included four integrated accelerator pedal programs, with three different agent OEMs. One of these included an automotive OEM in China. Combined these programs should ramp to about $4 million in annual revenue by 2006. A manifold actuator program that will contribute 6 to $8 million per year in annual revenues by 2007 and third, a pedal sensor program for application in heavy trucks in China. While not large in itself, this win like the integrated accelerator pedal win in China is a strong indicator that our China growth strategy is working. In fact, sales of our automotive end products in China were up about 125 percent year-over-year in 2003.

For 2004 we expect our sales growth in automotive products to begin to accelerate as recently introduced new products begin to ramp. Valve tension sensor sales for example, will grow from about $2 million in 2003, to around $10 million in 2004 as the regulatory requirements drive increasing use of this product beginning with 2005 model year cars. Some of the new integrated accelerator programs will also begin to run initial volumes. Assuming some modest growth in automotive production, overall growth of automotive products should be in the mid teens in 2004 with strong growth carrying into subsequent years.

Sales of manufactured components for nonautomotive markets were also up in the quarter. Even though we have reduced our exposure to the handset market, our growth and component sales was driven in part by the strong upturn in handset demand in the quarter. Some of which was the normal seasonal upturn, and some of which was driven by a surge in promotional offerings for phones and service contracts just before cell phone number portability went into effect. However, aside from the impact of growing handset demand we also saw our component sales in the communications infrastructure and computing applications show strong growth.

I have noted in the past that CTS has been successfully growing its sales into the communications infrastructure market even though a service provider spending on capital equipment for infrastructure has continued to soften over the last two years. While I have not yet seen industry data regarding Q4 demand, our sales in this sector should continue to show strong growth in the range of 21 percent sequentially and 18 percent year-over-year. Perhaps as a result of stronger fourth quarter spending by service providers forecasters are sounding more upbeat for next year suggesting that some growth in market demand is more likely. As a side note we saw our component sales through distribution channels jump up in Q4 to the highest level in over two years, since sales through distribution tend to go into a very broad base of application it is another indicator that breadth and improvement in overall market demand.

Looking ahead into 2004 we expect our overall level of component sales to be down slightly as we continue to deemphasize low margin products. On the positive side we are looking for continued strong growth in our higher margin infrastructure component sales, as well as continued growth in components for computing applications. For the company overall, we are planning around 3 to 6 percent sales growth for 2004 though much depends on how the apparent economic upturn plays out over the next year. We are still taking a cautious view on this.

Incidentally for those trying to make apples-to-apples comparisons, the residual year-over-year loss in sales from previously announced end of life products negatively impacts sales growth for the year by about one point. On a quarterly basis, sales are expected to be down 10 to 15 percent in Q1 from Q4, which reflects normal seasonal pattern. Note with a greater portion of our sales coming out of China, the Chinese new year in the first quarter is becoming a bigger factor in first-quarter seasonality.

Now I will turn the call over to Vinod Khilnani, our CFO to discuss financial results in the quarter and provide some additional information on factors which are expected to impact our EPS results in 2004.

Thanks, Don, and good morning everyone. Sales and earnings which were at the top end of revised and improved guidance provided a strong finish to the year. Don has already provided some color on sales revenue, so let me focus my remarks on other factors which affected our financial results.

Gross margins of 20.8 percent was a 10th if a percent higher than the same period last year. Although higher mix of EMS revenue adversely affected the margins by 7/10 of a percent, lower expenses and further improvements in the manufacturing efficiencies in the communication component operation had a positive impact on 1.5 (indiscernible) points on our margins. More than offsetting the impact of negative mix.

Compared to the third quarter, however, gross margins were one percentage point lower primarily due to higher mix of EMS sales which were 49 percent of total sales in Q4, 2003 (indiscernible) only 43.for percent in Q3, thereby affecting the margins adversely. We continued to keep a very close eye on our operating expenses as manufacturing operations ramped up due to higher demand and new product launch activity increased to support recent design wins.

SG&A and R&D expenses in the fourth quarter of $20.1 million essentially flat in absolute terms. That allowed us to lower than materially as a percent of sales to 15.2 percent versus 17.5 percent in Q4, 2002, and 18.2 percent in Q3 of 2003. Operating earnings therefore were a strong 7 point 4 million dollars, an improvement of 4.4 million from Q4 2002 and up 3.5 million sequentially. If we exclude the impairment charge which had affected the Q3 results adversely.

As a percent of sales operating earnings reached 5.6 percent, the highest in three years. Interest expense of 1.7 million in the fourth quarter was 0.8 million lower than same period in the year before due to lower debt balances, better interest rates under our new bank revolving credit agreement. Interest expense was 0.5 million lower sequentially from the third quarter. Other expenses were 0.4 million fourth quarter, primarily due to currency translations caused by weaker dollar against pound sterling.

Our effective income tax rate excluding the Q3 tax credits remains at 25 percent, despite the fact that our tax rate in China has moved up from 7.5 percent to 15 percent. CTS was able to make other improvements to offset this increase and expect its effective tax rate to stay at 25 percent in 2004. Net earnings of 3.9 (ph) million or 11 cents per share diluted again were the highest since the heydays of 2000 excluding the favorable impact of the tax credits discussed earlier. We are pleased to finish 2003 with positive and improving earnings per share of 2 cents in Q1, 6 cents in Q2, 5 cents in the third quarter excluding tax credits and impairment charges and finally, 11 cents in the fourth quarter.

These results again demonstrate that we continued to make progress in improving the underlying cost structure in the business. From the balance sheet perspective too we made significant improvements in 2003. Controllable working capital which includes receivables, payables and inventories finished the year at 9.8 percent of sales, improving from 11.9 percent at the end of 2002 and 12.2 percent in the third quarter of 2003. Receivable days are stable at 52 and inventory turns improved to 10 from 7 at the end of 2002 and 7.8 in the third quarter.

Capital expenditures for the quarter inched up slightly to $2.8 million, versus 1.5 million in Q4 2002, and 1.7 million in Q3 2003. Even so due to timing of certain expenditures 2003 capital expenditures were only $9 million in 2003. Lower than the 12 million to 13 million range indicated by us in our last earnings conference call. We expect our capital expenditures in 2004 to be around $20 million, closer to our normal level of around 4 percent to 4.5 percent of sales. Free cash flow which is defined as operating cash flow net of all investing activities was a positive 6.8 million in the fourth quarter 2003. 2.4 million higher than Q4 2002.

Total debt came down further to 75.9 million at the end of the year, 19.5 million lower than the year ago level and 5.1 million lower sequentially from the third quarter. Debt to capital stood at 20.5 percent, down from 26.5 at the end of 2002 and 22.1 percent at the end of quarter three 2003. We are delighted to close 2003 with a strong finish, full year 2003 sales were up 5 percent adjusting for EOS (ph) products. Gross margin for the year were 20.9 percent, up one (indiscernible) from 2002 full year.

Operating earnings as a percent of sales was 4.0 percent, less than 0.4 percent in 2002 excluding restructuring and related onetime charges and credits in 2002. Diluted EPS excluding the 7.9 million tax credits in 2003 and restructuring and other unusual charges and credits in 2002 and 2003 was 23 cents in '03 versus a loss of 16 cents in 2002. Free cash flow for full year 2003 a positive 20 million was 7.6 million higher than 2002.

Looking ahead into 2004 we see continued improvement in our financial results, driven by sales growth and operational improvements. We expect our depreciation expense to decline further from our Q4 '03 run rate of approximately $8 million a quarter to $7 million a quarter in 2004. Our gross margin in 2004 are expected to improve further over 2003 by half a percent to a full percentage point depending on the segment mix.

Improvements in margins and operating expenses will be somewhat dampened by the high level of product launch activity in the automotive sensor business in 2004. Although debt will generate incremental sales in 2005 of approximately 25 to 30 million, as they ramp up they will require roughly $2 million of launch related expenses in 2004. In addition, there are two non-operating factors which should nearly offset each other in 2004.

First, we are changing our defined benefit pension plan assumptions to be more conservative. After discussions with our actuarial consultant CTS is further lowering its long-term expected return on its U.S. pension assets from 9 percent to 8.75 percent. In addition, we are reducing the current discount rate for pension liabilities from 6.75 percent to 6.25 percent. These changes will lower our consolidated total FAS 87 pension income by approximately $3.5 million or 7 cents per share in 2004. Please note that despite tightening these two key assumptions for 2004 CTS continues to be in an overfunding situation and expects that cash contributions to its pension plan will be immaterial the next four to six years. This was according to an asset and liabilities study which our actuaries completed in the fourth quarter.

The second non-operating factor relates to an expected onetime gain of approximately $3 million from the pending sale of excess land in Canada sometime in early 2004. Inclusive of these factors, earnings per share in 2004 are projected to be in the range of 40 cents per share to 44 cents per share. We are delighted with our 2003 Q4 and full year performance, and expect to further improve our margins and profitability in 2004. And now we will open the call to questions.

(OPERATOR INSTRUCTIONS) Thomas Hopkins with Bear Stearns.

Just curious wanted to go over the revenue target for '04 and the planning. In a typical recovery year for cycle it seems like we ought to see slightly higher revenue growth, understand that you have talked about some of the handset component programs going end of life. But can you give us a little more detail as to why the revenue growth might not be a little bit better in a recovery year?

I think that probably the best way to answer that question is to say that we did not see anything that would indicate an upturn before the fourth quarter. And there are a lot of seasonal factors that play into the fourth quarter, some of them kind of unusual, and it is hard to sort out how much is a true change in the demand pattern and forecast that with any degree of certainty. So as I said, we are still taking a fairly cautious view of this. As we get into the year it could be that we will see the economy more robust than we are expecting. But the reticence on our part is as much as anything from not seeing enough data yet over a long enough period of time to project it with confidence.

Is there any way maybe you can quantify for calendar year '04 the impact of some of the end of life programs? I believe you said maybe it was a 1 percent impact on '03, or maybe you meant on '04, I'm not sure.

It's about on '04, it ends up being -- hang on a minute here, -- it's another $3.5 million worth of revenue year-to-year drop for those products.

Okay.

And '04 there is still about $3 million. We have to give notice as to when we are going to go out of production on those products.

Okay. I think that's it. Thanks a lot.

Reik Read with Robert W. Baird.

I wanted to ask quickly on the last question as I kind of listen to your comments and you seem to be seeing some things that were going very, very well. You saw 13 percent strength in the quarter. It appears that the EMS business in general is on the rise, the segments that you participate in appear to be on the rise. You've got new auto contracts; the phone business is going up. Is there something else? Is it conservatism, is there pricing or something else that is in there that causes you to have what appears to be guidance below what we would have expected?

Pricing is really pretty normal. The unusual price pressure we saw over the past couple years is for the most part gone. You can find it in spots out there, but I would say it is pretty much gone. So there is nothing like that playing into it. When you get into some of these product areas, though, just take infrastructure as an example. We saw infrastructure tick up a little bit in the fourth quarter of '02. And then that wasn't sustained. It ended up softening again in terms of overall demand in the next three quarters. And so it is very hard for me to sort out what we saw in fourth quarter in terms of what that's going to mean generally.

A lot of the infrastructure business we get is the beneficiary of the very strong demand in China that has kind of held the whole market up. And that piece of it, I wouldn't really expect to grow. And you hope that it doesn't fall off, but I really wouldn't expect that piece to grow. So when you start looking at some of these pieces and putting it together into an overall story, yes, we could go and just forecast in pretty broad optimism, but with only a couple months -- I'll say the data being different than it had been for a long time -- we are just reluctant to do that.

Okay, and the note I want to ask on the EMS business the operating margins were roughly the same as a year ago but you had much stronger growth. Should we be expecting the mid fives as a long-term operating margin or are their some other things that are playing into that at this point?

The point I wanted to make was that we said historically the difference between the margin and EMS business out of our component business can be as much as 20 points. So if you take that kind of a difference and the fact that EMS business in the fourth quarter was around 49 percent of the total sales, versus in the prior quarters was more like 43 percent that creates some impact on the margins.

I'm sorry, maybe I wasn't clear. I was just meaning the EMS margins themselves, not the overall company margins. They are roughly flat with what they were a year ago, and I'm just wondering why would the EMS margins be flat if you are up as much as you were or is just the mid fives what you can attain or are some of these new programs that you're ramping up causing a little bit of a headwind and we might see some margin improvement in the EMS space as we go forward?

It is a combination of some headwind because of these launches plus some of the EMS growth which is coming from China may have slightly lower margins than the base, and therefore we are projecting EMS margins to be staying around 5 percent, but not higher than that.

One of the factors that plays into that is it depends on the program, different programs have different levels of material content relative to the labor. And depending on whether we manage the supply chain or the end customer manages the supply chain affects the margin you could earn on that material. So you may see comparable sales level, but different value adds depending upon the kind of business it is.

And let me ask this on margins as we look into '04 -- Vinod can you give us an idea -- if I look at it from an operating margin perspective what is the contribution to the operating margin from every incremental dollar of sales if you exclude the pension impact? I don't know if you have that.

That again is very different. The divergence between the contributions we get to the business from EMS versus component is very different than even within component business, the mix can be very different. So it is very hard to easily project that number without knowing the exact mix of the product.

Could you give us a sense -- just for the company as a whole can you give us a sense of a range of what that contribution margin might be in '04?

Again, I would say it depends. EMS business for example is a contribution margin which can be depending on the mix anywhere between 7 percent to 12 percent of sales. Component business can give a contribution margin which can vary anywhere from 20 percent to 3 percent. So it's really, very, very different. And that makes it very difficult for us to project that number without knowing the exact mix of products within the channel.

Okay, great. Thank you very much.

Lee Zeltser with Needham & Co.

A follow-up on some of the revenue projections you talked about for '04. When you talked about deemphasizing some of the component product segments, can you tell us specifically what end markets we're talking about that you might deemphasize your presence in components and is it any specific customer?

The primary area of course is the area that we announced last year, and that related to the handset market, and it related to frequency products going into the handset market. There are a variety of customers probably just because of the low (ph) legacy more than anything else that affects Motorola because that was business that came with that acquisition. Some of the other -- there are some other older components that are related to our older resistor products, so there's a few others but there is not just kind of a general area. It would be hard to answer.

Just to clarify, Don, you mentioned the word deemphasizing. I understand some of the products would be at end of life, the others you just don't expect to grow as quickly or --

We're just not investing in development related products. We are not putting a lot of sales and marketing into pursuing new markets for the products. There is different levels that I'll say de-emphasis. Some of them just wind down on their own. We will just manage them for cash. But it is not where the company sees itself in the future.

Okay. Basically as a follow-up, as that business kind of trails off and I realize these revenue projections are basically on an organic basis with the companies that are cash position and with the stock up where it is right now, what is your appetite for positions going forward?

Very clearly things have changed dramatically over the course of the last couple years. We are now financially in a position to undertake acquisitions. So let me go back to some things that I said before. What is our philosophy about it. First of all, we would be looking for acquisitions where there is a clear and quick value proposition. We're not looking to take -- bet the company kinds of risks. The acquisitions would be in the space that we are competent in today. In other words, they would be related to the products and markets that we have today. So we would try to extend our footprint or acquire a technology that would be valuable or in some cases there are some things that we do see that would constitute what I might call a drop in. There's the kinds of things that we could put into our factory operations with almost no additions of overhead, and we look for those kinds of things. Those tend to be fairly small. But we've got our eyes open. We are looking around. We will be very careful if we do something. I am not saying we will or we won't do something at this point in time. I don't know.

Fair enough. Thanks very much.

(OPERATOR INSTRUCTIONS) Greg Weaver (ph) with Firm Capital.

Just a clarification here, so on your component business did you say that overall component revenue would be down slightly?

Yes.

So that infers that given your automotive growth that is like $18 million there roughly, right, (indiscernible) midteens growth?

The overall sensors and components segment -- let's be clear what we're talking about -- the overall sensors and components segment will be up. That is our projection. The automotive business, product business portion of that is going to be up in the midteens, as I mentioned. The components that go into predominantly the communications, computing, some industrial, some consumer, some aerospace, there's a variety of places they go. That part of the business is where we are going to see the decline. Some of it driven by the end of life, some of it driven by some areas where we have not indicated we are going into life, but we are just deemphasizing and letting them wind down.

Okay, so right, you quantify that to about $3.5 million in '04 of additional end of life hit right over '03?

Right, that's the ones that we specifically announced in September of 2002. And we made a specific announcement, specific sets of products, took a charge related to that. And I'm trying to be clear since then as to what that ongoing impact has been as that slowly winds down.

And the product that you're phasing out in this group, are any of them losing money?

They are from a margin standpoint. They are negative, they are cash contributors, but they are not profitable overall.

So given your rationalization of your product line here, wouldn't we expect to see some better margin leverage then? I mean ex the normal business leverage?

Right, what you're seeing here is we are trying to change the mix to the higher margin products. We are deemphasizing the lower margin products and moving toward higher margin products, no question about it, that's part of the strategy. So for example I've talked about growth in infrastructure. Infrastructure as an area we have been growing. Our share in that market even though the market has been soft and on average those are higher margin products.

Right, so we saw 100 basis point improvement in your gross margin in '03, right?

Yes, and I think this was clearly an element of that.

How much of the -- versus the end of life stuff versus some of this phase-out, how much of this phase-out stuff was happening in '03? Ex the specific products you just cited a minute ago?

I think '02 versus '03 we have estimated that the end of life magnitude was in the range of $15, $16 million. So that contributed towards improving the mix, offset to some extent by the mix which was between EMS and components. And because in the end of life amount now remaining in '04 is approximately 3, 3.5 million, we will see a little bit more benefit in '04 because of that mix but obviously not as large as we saw in '03.

And on your EMS business is there any substantial contracts there that are rolling off or any negotiations that lends some uncertainty to your forecast?

There are no large businesses or contracts we have lost. Neither there are any large negotiations going on, which may jeopardize as far as we know any large chunks of business in '04.

If you are asking whether we have multi-year agreements, or we went to a company and said all right we will take over and do this on a multi-year basis, our business is not generally done that way. So it doesn't -- we don't have those kinds of contracts that would roll off and affect us.

Great. Thank you.

We have no further questions in queue. Will turn it back to the host line.

I would like to remind our listeners that a replay of this conference call will be available from 4:15 PM Eastern standard time today through midnight Eastern standard time Tuesday, February 3s. 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 717081. Thank you for joining us today.

Ladies and gentlemen, that does conclude your call for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.