CTS Corp (CTS) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the CTS Corporation Second Quarter Results Conference Call.

[Operator Instructions].

As a reminder, this conference is being recorded today, Thursday, July 28, 2005. I would now like to turn the call over to Mr. Mitch Walorski, Director of Investor Relations. Please go ahead.

Thank you, Adrian. I'm Mitch Walorski, Director of Investor Relations and I will host the CTS Corporation's Second Quarter Earnings Conference Call. Thank you for joining us today. Participating from the company today are Donald Schwanz, President and CEO; and Vinod Khilnani, 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 the 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 extent that today's discussion refers to any non-GAAP measures relative to Regulation G, the required explanations and reconciliation are available on our website in the Investor Relations section.

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

Thank you, Mitch. Good morning. Last night we released our second quarter financial results. As I'm sure you noted, the results were mixed with earnings, excluding one-time gains and losses up significantly, but sales growth below expectations. This morning, I want to provide you some perspective on those results beginning with sales. Second quarter sales of 158.3 million were up 15.1% over second quarter sales last year and up 1.9% over first quarter sales. However, the growth resulted from the SMTEK acquisition, which closed at the end of January. Excluding SMTEK, sales were actually down about 6% on a year-over-year basis and down about 2% sequentially.

The largest single driver for the weak sales was a much softer market for communications infrastructure products, particularly in Asia. As I noted in last quarter's conference call, demand for base station systems out of China, and to some extent from other Asian countries, fell substantially compared to 2004, impacting sales of electronics manufacturing services. We assemble base stations, as many of you know, as well as the sale of components that go into those base stations. This factor alone took 10 to 12 points off year-over-year growth on a total Company basis and about 19 points off the growth of our EMS segment.

We also experienced lower component sales for communication handset applications. On a year-over-year basis, the decline represented about 2.5 points off of quarterly sales growth. As those who are familiar with CTS know, we have de-emphasized components sales for the handset market because of unfavorable economics. So, declining component sales in this market were not a surprise, though the drop was sharper than anticipated. Today, handset component sales represent only about 2.5% of total company sales.

On the positive side, automotive product sales were up 14% in the quarter on a year-over-year basis, even though auto production in the period was softer. In North America we saw demands slow further late in the quarter as some OEMs scaled back production and announced extended shutdowns to alleviate high inventories. GM, as you know, also implemented a very aggressive promotion in June that had a very positive impact on their sales and inventory situation, prompting DaimlerChrysler and Ford to adopt similar approaches in July. While these promotions are likely to help third quarter car sales in inventories, we do not anticipate a sustained demand increase for the year.

The bright spot in the quarter was earnings. Operating earnings, excluding the 2004 gain on the sale of excess land in Canada, improved by 30% on a year-over-year basis. This is about twice the rate of sales growth. In fact, both business reporting segments, EMS and Components and Sensors showed solid improvement in operating margins after adjusting to eliminate the gain on the Canadian land sale. The improved margins were driven by a combination of mix, volume leverage, and our continuing efforts to drive efficiency improvements.

Despite the softer than anticipated sales environment in the quarter, we continued to see significant new business activity. In our EMS business, the SMTEK acquisition is proving to be everything we hoped it would be. The complementary capabilities that resulted from the combination are bringing us new opportunities for existing as well as new customers. Several existing customers have already expanded their commitments to CTS Electronics Manufacturing Solutions because of the expanded capabilities we now have. We brought on 7 new customers in the quarter.

During the quarter we achieved ISO 13485 certification in our Thailand facility, making us one of the few EMS providers in the region with this medical certification. We are, incidentally, pursuing the same medical certification in our Singapore facility. In the automotive arena, we won 3 small programs for our belt tension sensor during the quarter and received formal launch authority for several previously awarded platforms. We also continue to see a variety of new opportunities for our accelerator pedal module and are currently developing pedals for 2 new OEMs. Award decisions for these opportunities are expected later this year.

Sales into Asia during the quarter were up year-over-year, about 20%, reflecting our success in penetrating new customers in that region. In Electronic Components we are having good success capturing design-in positions with new products. In fact, the second quarter was a record quarter for us in securing design wins in infrastructure applications. A number of these wins are in wireless repeaters, which are enjoying significant growth in the market.

We also captured our first design wins at a major European communications infrastructure OEM and a Chinese communications OEM. I should note that a very high percentage of our design wins are associated with 3G applications. Overall, I continue to be pleased with our growth strategies and believe we are on the right track.

I also want to touch on a few other areas of importance to the business. First, as regards to the SMTEK acquisition, the integration of SMTEK with our own EMS business is nearly complete and has gone very smoothly. Earlier this quarter we announced our intent to close the former SMTEK Marlboro facility and consolidate operations into our Londonderry, New Hampshire facility. This consolidation, which is underway, should be completed in August. Consolidation of the 2 facilities, which are only about 60 miles apart, is expected to begin showing benefits later this year with $0.02 to $0.03 per share savings expected in 2006.

As a side bar, I want to comment on industry mix in customer concentration in our EMS business, which we often get asked about. Both the mix and concentration have changed dramatically since the acquisition of SMTEK. Currently, about 51% of the EMS sales are in the computer market, 21% in communications, 12% in industrial and security, 9% in medical, and 7% in aerospace and defense. HP and Motorola, which are the 2 largest customers, represent about 55% of the EMS sales, down from about 90% last year. Today, 17 customers account for about 90% of our EMS sales based on Q2 results.

Switching subjects again, because of the projected growth of our automotive product sales in Europe and the increasing number of OEMs locating in central Europe, we are actively exploring the opening of an automotive product manufacturing operation in the Czech Republic. If undertaken, we expect that operations would begin next year. A decision on preceding is expected later this year. Finally, I want to address our financial guidance for the year, given results for the first half and our current view of the market. As I noted earlier, the biggest driver for the shortfall in sales so far this year has been delayed spending for communications infrastructure equipment in Asia.

At this time it is still uncertain when this demand will return, though our customer remains optimistic that it will be later this year. In any event, consideration of this and other factors has led us to adjust our total year sales guidance to a range of 630 million to 680 million, which is 19 to 28% over last year. We are also reducing our diluted EPS guidance to a range of $0.62 to $0.68, excluding the $0.07 unusual tax impact recorded in the second quarter.

Now I will turn the meeting over to Vinod Khilnani, our CFO, to discuss financial results in more detail.

Thanks, Don. As Don indicated on balance, we were pleased with our second quarter earnings, especially in light of softer than expected sales. Overall, year-over-year sales in the second quarter were up 15%, and adjusted operated earnings were up 30%. Adjusted operating earnings exclude the 2.7 million gain on the sale of excess Canadian land last year. Even though sales in the second quarter were short of expectations, we were still able to report improved gross and operating margins. We continued our year-over-year adjusted EPS improvement trend, maintained our controllable working capital below our 13% of sales target, and achieved strong free cash flow.

During the second quarter we repatriated 50 million of our overseas cash under the American Jobs Creation Act of 2004. As a result, we accrued a one-time tax expense of 4.5 million for other transactions. We also booked a favorable tax adjustment of 1.7 million in the quarter to reflect reversal of certain tax reserves due to favorable outcome of two pending tax issues in Asia. Excluding this unusual net tax expense of 2.8 million, or $0.07 per share, adjusted earnings per share was $0.17 per share diluted in this quarter versus a consensus estimate of $0.16 per share and $0.13 per share in the second quarter last year, if you take away the impact of the gain on the sale of Canadian land.

Adjusted operating earnings were 10.3 million or 6.5% of sales in the second quarter of 2005 versus $7.9 million or 5.7% of sales in the second quarter of last year, excluding the unusual gain on the sale of excess Canadian land in 2004. Operating margins in the second quarter of 2005 improved in both the business segments. EMS operating margins of 3.1% improved by four-tenths of a percent from Q2 last year driven by higher gross margins of the former SMTEK business.

Components and Sensors adjusted operating margins reached 11.2%, up 2.3 percentage points from last year due to higher gross margins, as a result of improved product mix and manufacturing efficiencies, and lower operating expenses driven by reduced headcount and lower professional fees. Consolidated gross margins as a percent of sales were 20.4% up 2.2%, 2 percentage points sequentially by 0.6 percentage points lower from second quarter of 2004.

Compared to the first quarter of 2005, gross margins were higher due to improved product mix, manufacturing efficiencies, and higher production levels. Compared to last year, consolidated gross margins were 0.6 percentage points lower due to higher mix of EMS business, which in general, has lower gross margins. The EMS segment was 58% of second quarter 2005 sales, was approximately 50% in the same quarter last year. Adjusting for the segment sales mix, gross margins would have been 1.3 percentage points higher than last year.

Total SG&A and R&D expenses combined were 14.1% of sales in the second quarter of 2005, 0.4 percentage points lower sequentially, and 1.4 percentage points lower year-over-year. Tight management of expenses, combined with higher revenue, continue to allow us to lower our operating expense percents steadily despite reduced pension (ph) income.

We expect this improvement to continue as we progress towards our target range of 13% to 13.5% of sales in the next 4 to 6 quarters. As discussed earlier, this quarter included 2 unusual tax items that netted 2.8 million. So excluding those items, our base effective tax rate remained at 23%. Adjusted net earnings and diluted earnings per share were 6.8 million and $0.17 per share respectively, if the unusual net tax expense is excluded.

From the balance sheet management perspective of a controllable working capital, which includes receivables, payables, and inventories were 12.3% of sales better than our target of 13% of sales and one-tenth of a percent lower than last quarter. Controllable working capital is, however, 0.9 percentage points higher than second quarter of last year due to slightly higher inventories and somewhat faster render (ph) payments.

Free cash flow was a positive 10.8 million in the second quarter of 2005, versus 7.9 million in the first quarter and 7.2 million in the second quarter of 2004. $3.7 million of the free cash flow was utilized to buy back approximately 322,000 shares of CTS common stock during the quarter, at an average purchase price of approximately $11.55 per share. A strong free cash flow of 10.8 million in the second quarter included improved working capital of 1.9 million and capital expenditure of $2.9 million. Our debt-to-capital ratio came down to 21.6% in the second quarter of 2005 from 29.8% at the end of first quarter of 2005. Our leverage is now back down to the lower end of our target range of 20% to 30% debt-to-capital ratio.

Looking ahead, we expect to generate 40 million to $50 million of cash from operating activities in 2005 and project our full year capital expenditures in the range of 16 million to $20 million. Capital expenditure as a percent of sales is running somewhat lower than our normal range of 3% to 5% of sales due to available capacity. In summary, the results of this quarter, once again, demonstrated margin improvements, decline in operating expenses as a percent of sales, earnings growing faster than sales increased, excellent working capital management, and as a result, positive free cash flow and a strong balance sheet. Let me make a final comment on the impact from the recent 2% revaluation of China's renminbi before we open up the call for your questions.

You will remember that in our last conference call we estimated that a 5% revaluation of renminbi may create an unfavorable pretax annual impact of approximately $700,000 or so. We also noted that as we increased our renminbi denominated sales in China and balanced our renminbi inflows and outflows, this exposure will continue to come down. We believe the recent 2% revaluation will have a relatively small and favorable impact of roughly 200,000 to $300,000 per year on our operating earnings, which will further reduce as we continue to manage our currency exposures globally by balancing our foreign currency flows.

With that, we will open it up for your questions. Adrian?

Thank you. Ladies and gentlemen, at this time we'll conduct the question and answer session.

[Operator Instructions].

Our first questions comes from the line Sid Parakh, with The Robins Group. Please go ahead.

Good morning, everybody.

Good morning, Sid.

Good morning, Sid.

Can you explain the revenue guidance that you have given? What I've noticed is it's a wider range. Your previous guidance was 690 to 720 million. Right now you are saying 630 to 680 with just 2 quarters to go in the year. It just sounds to me like there's more uncertainty than there was. Can you just elaborate, please?

Well, the answer goes back to this issue around communications demand in Asia for base stations. It's primarily driven by China Unicom and their customary buying cycle, which got delayed this year, I'm not sure why. In the past, when they've placed orders, we've seen that demand ramp very, very quickly and a significant amount of revenue go out in a fairly short period of time.

So the question really is, is it going to come in the year or not. And there are still people who believe that might happen. We only have 6 months left in the year, but it could. It could happen fairly soon and it could have a fairly big affect. So, that's why you see a pretty wide range.

Can you -- what's your internal sense? Do you think it will come in within this, say, the next two quarters or are you thought of preparing yourself to see it come early in 2006? Also, do you think that the business is there or has it just gone away?

First of all, I do believe the business is there. Secondly, I have no clue when this is really going to happen. Predicting how and when they're going to spend money has not worked very well in the past.

But I would add that this is primarily EMS business we are talking about. So, on the one hand we have the capacity and it can come fairly quickly and it is normally in larger chunks when you look at the top lines. The second point is simply because it's EMS business, the bottom line impact of that is obviously a lot less than the sales swing on the Component and Sensors side.

Right.

All that being said, there is a component content to it.

Right. Now, also, can you give us an overview of all the major customer -- or new customers that you've acquired in 2005 so far? Also of any that you may have lost that we are not aware of.

I cannot disclose the names of customers.

Well, if you could just quantify them as in -- or say, for instance, like you've said in the past, that you acquired 10 customers, which would bring 40 million in revenues annually, or something to that effect?

Well, as Don is preparing to answer that, I would answer the second part of the question. I'm not aware of any customer of any significance which we have lost.

Okay.

Do you have any further questions?

Yes.

Then I'll come back and -- I've got to dig out some papers here and I will answer that question.

Okay. That's fine. Meanwhile, I just have another question. You've said even though GM and Ford and the other manufacturers have cleared a lot of debt inventories due to the heavy promotions that they've been offering in the past, you said you don't think that Q3 -- that you'll see an increase in sales in Q3 based off of that. Do you think at some time -- I would just tend to think that it should happen at some point of time. Would that be Q4 or there in 2006?

Basically, what they were doing with the promotions was moving out excess inventory, trying to get that 2005 inventory position down. So, obviously that was all built already.

Right.

So the next question is, to what extent have they borrowed from demand that would have gone otherwise to 2006 new models this year? There's obviously a school of thought that says that they have stolen some part of that demand and actually pulled it up and that in the end it will all smooth out to about the same total demand level for the year.

Okay.

But they did correct their inventory situation ...

...Right.

... by doing it. They got them to take the vehicles that were excess.

So, would that mean that you have say more, visibility or stability in that part of the business, given that they have reduced their inventories?

Yes. It is a pretty stable part of the business anyway. You don't tend to see as much variation there as you do in other parts of the business. But I certainly feel better with the inventory position down, knowing where that is. Let's see if I can answer the other questions. The customers, we are talking EMS customers, now they are medical customers, some military, some industrial customer. So, there is quite a mix. The revenue impact this year will be relatively small. Just because of ramp time. And next year some of these customers, - -particularly when you are dealing some of the medical ones where they have to go through an approval cycle. It will take a while because of things they have to do before that stuff ramps. So, we don't see a lot in them. But several of our others are in the single digit millions, I'll put it that way - -a year.

Would you say single digit each of them, or?

There are several of them in that category.

And finally, if you could just talk a little bit about the margins you have seen this quarter and what sort of an outlook do you think we should model into our estimates?

Well, this was a very good quarter from a gross margin point of view. If you look at the performance of each of our segments separately you will note that they are - have improved substantially. In sense of business and EMS business. If you look at our segment report adjusting for usual items last year components sense our operating margins have gone from 8.8% in the second quarter of 2004 to 11.3%. So, we are getting into the double digit arena which he had said all along, is our target range to go take it up to that range.

If you look at EMS segment we have talked about that there was a target of 5%, we had come down in that arena because of going to Singapore and currency impact and some allocation related we had talked about in the prior quarter and that is also a segment we begin to see our operating margins move up from 2.7% in the second quarter of 2004 to something like 3.1%. So, we made progress in both areas primarily because we helped by product mix, we continue to see improvement in other manufacturing efficiencies. We continue to leverage our fixed overhead, manufacturing overhead as the volumes improve.

And frankly, we did have some unusual launch related expenses in the first quarter and prior to that, which are going away. We also still have unusually higher launch related activities as Don has pointed out earlier in our previous conversations. Then when you launch a product in the early stages the gross margin does suffer because we on going on learning curve. So, we are improving on that area also. So, we feel pretty good about it, our margins. If you look at overall margins I frankly, think the margins will fluctuate anywhere from 19% range to 20, 21% that is pretty hard to predict, because of some many variables including segment mix.

Okay. But what you are trying to say is that the levels at which you are at today, you are comfortable and I understand that a lot of it has to do with operation efficiencies. So, it wouldn't be unfair to sort of model similar, maybe slightly slower margins just based on what the product mix or other factors, right?

Hard for me to predict, but the margins we have the range you are seeing, I would not call it unusual.

Okay. All right, thank you. That's it for me.

Thank you. Our next question comes from the line of George Nissan with Merrill Lynch. Please go ahead.

Thank you very much. I have a couple of questions regarding raw material costs. Over the past year, several of your competitors have recently implemented some new strategic initiatives to reduce their overall costs, raw materials. By establishing a better line of communication to their supplier base. I'm interested if you could apply some color today on the call as when you guys are planning on doing from now on to reduce our overhead raw material costs by opening a better line of collaboration and communication with your suppliers?

George, if you are referring to issues about raw material costs and the kinds of escalation that have been seen by some of the automotive suppliers who are dealing with a lot of steel or plastics or those kind of commodities, we don't have a lot of that that we have to contend with. We use some silver and gold in our processes. We do have some plastics so we have some exposure to that. But it is not a big driver for the business. And that is why we really haven't tried to make a point of that in the calls. We just deal with it.

How are you dealing with it, in terms of obviously you are trying to reduce some supply chain costs. Because if you could find some areas of improvement, I'm sure you would? What are you guys looking to do?

Well, we always do that. We work with the suppliers, we also look at design approaches that will allow us to change to lower cost materials or reduce the amount of material if the material costs start to escalate on us. Or we see that it is in an escalating trend. So, there are different approaches, but we just don't have the exposure to the materials that have been seeing huge kind of price increases to where it really becomes a driver to the business.

Okay. Do you feel like your suppliers are working with you, like in a joint partnership or do you feel like they have been kicking back and saying there are price increases you guys are willing to work with us and absorb those price increases. Or what you guys been hearing from your suppliers?

I think that generally, George, they work very closely with us. And we live -- we deal with industries where we have for a long time found ways, working with the suppliers to design changes to reduce our cost and pass them on to the automotive, for example, automotive industries. So, we have lived in that environment for a long time. We did not see anything unusual in the last quarter or 2 or 6 months or a year which was different from that environment.

One final question. What are you guys looking to do by the end of the year to reduce overall costs? What is your top initiative before the year end?

We have ongoing initiatives in all areas. In materials side, in our labor side, we have our businesses are constantly looking at reeling (ph) out the production facilities. There are numerous activities which are ongoing.

Okay. Thank you very much. Good luck down the road.

Thanks, George.

Thank you. Our next question comes from the line of Scott Merlis, with Thomas Weisel Partners. Go ahead.

Good morning, how are you?

Good morning, Scott.

Good, how are you?

Just a little follow-up on the China Unicom business. You said it was both sensors and EMS.

We supply compliments that go into those base stations, but that is by far the smaller portion of the revenue. We also assemble base stations.

So, it is more on the EMS side?

Absolutely. I would say 90% EMS, probably more than 90.

And two, I understand the term, the normal buying cycle - -I guess the normal buying cycle can be volatile anyway, but in other words, as they build more base stations there are stable customers, so when they decide to deploy another base - - build another base station that will be the time - - 6 months in advance you will get an order? I'm just trying to understand one, what is the normal buying cycle with China Unicom. And two, why there is some degree of confidence that the order will eventually come. We don't know if it is this year but it will resume?

A couple of things, first of all, China Unicom is one of the service providers in China. They have an extensive network of base stations. And they continue like everyone else to expand their network. They are building, upgraded, etc. And, like most of the companies they put together some plans about how they are going to go do that. And so, there is some expectation that develops in collaboration with their suppliers as to what their needs are going to be. What they are going to go buy. They have been acquiring base stations from customer of ours, in the past. And so, their network uses this particular configuration of base stations and it is fairly logical for them as they extend that network to continue to use a similar configuration, similar product.

So there is kind of a tie there. It's not like they couldn't break it, but there is a tie there. In the past, and this is no guarantee of how they will operate in the future, but in the past what they have done is, as I understand it, they have entered into negotiations that have extended for over a long period of time. About what exactly is going to be supplied and at what price and terms, etc., etc. and when those negotiations were concluded deliveries began very soon thereafter. When I'm talking about soon, I'm talking within a month. So, it is not like 6 months lead time. It is very, very quick. And so, the supply chain is just not that long that it can't ramp fairly quickly. So, we are not going to in my mind, see 6 months advance notice on this. We are going to see a month or something.

Could you review for me the subassembly that your EMS operation is making here?

We are making the base station.

The -- pretty much the -- then shipped to whom?

They ship it to our customer who in turn does a more comprehensive test on it. They install some portions of it. We don't put everything in to it. But they install some additional portions to it before shipping it out.

Okay, so you are building most of the base station.

Yes. It is a box built process.

But it is most of the value.

I wouldn't say that. It is a substantial value. Again, I'm saying some things that I'm not absolutely certain of. But I believe all of the radio units, for example, are installed by the customer, not by us. We are a big part of it.

When we think -- then switching from sales to margins. Your margins have shown very strong improvement a lot of progress there. When we think of the trends going out to '06. One thing that can help margins obviously is volume growth. Because you still have capacity available and two you did mention you could get a $0.02 pickup was that -- I think that was closing Marlborough. The question is as you begin to look at '06 what, how hard is it to have a meaningful improvement in margins, because you have improved so much already? Does severance, can you really get less severance or is that continuing or is that a little bit less? Launch cost are you always going to have launch costs? What might make it easier to improve margins next year or harder as we begin to look at the conceptual trends?

That is a tough question. Let me see if I can add some more clarity to that. We have said that from an EMS point of view that we will see the margins continue to improve over the next 6 quarter timeframe and we have set up a target as 5%. Staying with EMS if you ask me, which is an easy part of it and which is a tougher part of it. I will tell you that my view is that we probably have in EMS more than normal levels of changes and launches and entering into the new industries, new products kind of activity. And so, to some extent those things will always be there, but where I stand today, I think we have more this year than I expect in '06. We also know that the business that came with SMTEK had higher margins. We have said that several times.

So, the mix, that mix is obviously going to continue to help us more as we go forward. And you already mentioned that Marlborough consolidation will give us a full impact next year compared to this year. You also pointed out that as we increase our sales we have said our operating expenses will not increase, obviously at the same pace as our top line growth and so we will continue to get leverage. So, all those elements I think are going to help us as we go forward.

On the component and sensor side, the mix within the component and sensor as sensors automotive sensors, become a bigger and bigger component of that segment, is going to have a positive impact on our margin. In addition to that, we have said that our electronic components continue to improve as depreciation become smaller and smaller percent of their cost structure. So, those are some of the elements which I think will continue to help us to improve our margin over and above the leverage we will get from operating expenses.

That is actually very helpful. That brings us -- we've gone from sales and margins, now the cash flow. Could you review for me the 40 to $50 million cash flow guidance that you gave? Was that lowered from previous guidance, or with the earnings side being lowered or is that -?

No, I don't think we have lowered our cash flow guidance. Actually, we have probably slightly improved the cash flow guidance than we have given in the past. If you look at the cash flow we have generated this quarter, and the way I look at it I look at operating cash flow having 2 components. One is the component which comes from pure profitability of the Company which is at a cutting thing. The second component, which is a little bit more variable, is the working capital. So, you may have a quarter in which you may have great operating cash flow, but a large component may come from the swings in the working capital.

And that in my mind at least is slightly lower in quality than the cash flow which comes from the profitability of the Company. Because the working capital can to some extent swing back. If you really look at our cash flow, free cash flow, in the second quarter. Almost all of it is coming from the profitability side of the game. So, if you look at our net earnings and if you convert those GAAP net earnings to cash flow net earnings, that number is actually increasing. Because we are adding back to depreciation and the deferred tax component of that.

So, the quality of cash flow in this quarter is extremely hard, because almost all of it is coming from the P&L of the Company or the income statement of the Company. And the working capital is positive, but that is pretty much offsetting, not fully, but to a large extent the capital expenditures we have to incur. So, overall we are slightly improving the cash flow guidance.

Was the old one 40 -- I don't even remember off hand ...

...Actually, Scott my colleague has pointed out to me that in my guidance before I said that from an operating point of view we will generate 40 to 45 million before. And I am now increasing it to 40 to 50.

Right. That is what I thought. Okay. Thank you very much.

Scott, let me just add something here. Another way to look at this is we work very hard to keep our working capital, what we call controllable working capital which is the receivables, the inventory, the net payables down. And we talk about the range in trying to keep it under 13%. That is an investment you have to make if you re going to grow the business, grow sales. And, so it is important to keep that investment in the added sales growth as low as possible, and also the CapEx. We work very hard to be efficient in that regard. So, the capital demands for growth as low as possible, and also the CapEx, we worked very hard to the efficient in that regard. So, the capital demands for growth end up being low and that certainly helps in terms of the free cash flow that we have.

Yes, and next year's cap spending, any initial thoughts? It was 16 to 20 this year.

We really haven't put together a plan, but there is nothing at this point in time that is going to, in my mind, kind of change the pattern that we've been in dramatically.

I think to add to that comment, Scott, I think we will stay at the lower end of our stated range of 3 to 5%.

Okay. So this strong net free cash flow is -- can be partly used for stock repurchase and I guess that sure strategy.

Could be acquisitions, could be lots of things. So -.

Right, but it's very healthy, looks very healthy.

We clearly have part of that free cash flow in this quarter to buy back stock.

Right. Thanks for the run down.

Thanks Scott.

Thanks.

Thank you. Our next question comes from the line of Kevin Kessel, with Bear Stearns. Please go ahead.

Good afternoon guys.

Hello there.

I just wanted to get a little more clarification on the overall guidance you have for -- what it implies for the second half. You know, from the sounds of it, it's primarily due to the weakness in communications and restructure, I understand that, and I guess China Unicom is one of the issues there. Would that be really the sole reason here or are you guys seeing weakness outside of that particular customer and that program?

Well, the rest of it ends up being relatively small. We've seen some general weakness in communications infrastructure and I could kind of lay it off to the Cingular ATT merger, but I'm not sure that tells the whole story because it's been a postponement of capital spending. Because of that, we have seen some 3G spending move out. If you look at our customer -- and this is from a component standpoint now I'm talking about. If you look at the customers, we are weighted towards North American infrastructure OEMs. Heavily weighted toward them, as opposed to European or Asia, and so when you see a push out or delays in CapEx in the infrastructure arena in North America, it hits us, and so we have felt that.

There's been some just general sliding out of kind of 3G timing, some of the service providers talk about. So, that is one area. It's nowhere near the magnitude of the China Unicom thing, but it is there, it is a factor. We did, as I had mentioned, see the handset demand falloff faster than we had anticipated, but at this point in time it's getting down to -- it's a small enough percent of the Company's sales that at least as a future driver it's kind of really pretty much out of the picture.

All right. Now, China Unicom, I mean what percentage would they account for all your infrastructure customer sales or the shipments that you make to them? I mean is it - I assume they would have more than one customer and are they really the only end customer?

They are the end customer.

Oh, they are? So it's kind of completely dependent on ...

... A service provider.

They are the only service provider that you guys just buying into (ph) from that prospective?

It's not the only one, it's just ...

...Right.

... a very, very big one.

Right.

OK? In China, in China.

In China. And does the low end of your guidance range then, the 630, is that implying that really these orders don't come through, is that the way to interpret the range? The low end as the orders don't come in, the high end is the orders to come in from China Unicom?

Directionally you are correct, but that is not the only -- I wouldn't say that -- I don't want to imply that China Unicom you know is $50 million. It's not.

Right, right, because ...

...Okay? But, there's more things when we put together the range we think about, you know, the things that are higher risk and say, "All right, if some of these didn't happen, that's where the lower end is", and the reverse when we look at the top end. So it's more than just one factor.

Sure. Okay, and in terms of your largest customer, I mean is the demand there okay as well or are you seeing a little bit of weakness there?

Well, first of all, the customer we are talking about for us here is not our largest customer.

Right, second-largest, right.

Yes. And as I said before, I think the demand there from a networks perspective is there. You know, everybody keeps expanding their networks, upping their capabilities, so I think it's there. I think it's more of an issue of timing.

Okay, and then on -- but on your storage -- for your storage customer, is the demand there? Is that looking okay for the second half?

Very stable.

Very stable? So that didn't have anything to do with the reduction ...

No.

Good.

And we are up year over year.

And you are up year over year there?

Yes.

Yes.

Your comments imply obviously seasonality here in September, at least from the auto perspective. I mean but yet your guidance implies then if you were down in September very, very large, even at the low end, a very large double-digit increase in December. So, what exactly is going to be driving that do you think?

For one thing, from an automotive standpoint, we probably will see a little less than we have in the past because there's a number of platform launches that are affecting the quarter, so they offset to some degree the normal demand loss to shutdowns. So, we are not going to see that in equate the same ...

...You are talking about the EGR sensors that you are launching and things like that?

Well, there's several of them. You know, BTSs, pedals, there's a variety of them.

That we'll offset some of them?

Yes.

I mean is there a chance that your September quarter is flat or slightly up from June or do you still expected to be seasonally down? On the top line.

I would expect it to be seasonally down.

Okay.

But not a lot.

Right. and so that implies, you know, the low-end double-digit increase in December, that's going to be driven by just general seasonality as well as additional sensor ramps and any EMS ramps or -?

Yes.

... what would ...

I think in addition to the seasonality we have several new launches which are going to start hitting a pretty close to mature volumes in the fourth quarter.

Okay. And then just looking at SMTEK's contribution in the quarter, of around I think 6 million or roughly incremental, that was a little bit lower than our estimation. I think we were looking for more like 9 to 10. Did you sense some weakness there? I know the integration has gone well, but did you guys see weakness and all in that customer base?

Not at all.

No.

So you are expecting 6 million then?

SMTEK is hitting bottom-line at least.

Right.

At what we expected.

What about on the top line? That's where it looks weak to me.

Top line is not too far from our expectation. They are within the range of our expectation.

Okay.

Some of it is timing.

Okay, the timing of the ramps. And then what about the -- you know, you obviously mentioned acquisitions, potentially. You've obviously bought back stock this quarter, any thought given to a timeline for acquisitions? Is it something that's just opportunistic once you see something you like or do you guys think that within the next year you'll probably end up doing acquisitions?

It's opportunistic in the sense that we look all the time and if we see an opportunity that we think we can -- that will bring shareholder value, we will pursue it. If we don't, we are going to do anything. So it's opportunistic in that sense, certainly, so we are not very driven around timelines. The only thing I would say in that regard is that we are still digesting an acquisition.

Sure.

Not trying to imply it's not going well, because it is going well, but we would be careful how much we load on the management team.

I've got it.

Having said that, opportunistic should not be viewed as we being -- looking at it from a passive point of view. We do have active programs to, on an ongoing basis, look for opportunistic candidates.

Okay. And then just finally, just two housekeeping questions. Last quarter, you spoke about your EMS wins, and I think you said you won 14 new programs that may contribute 10 million this year and 20 million next year to the top line. Is there a similar metric you can give this quarter, in terms of wins and contribution? And then lastly, what was depreciation in the quarter?

I'll take the easy question. Depreciation in this quarter was 5.9 million, and in addition to that, we have amortization expense and amortization expense for the quarter was just a touch less than $1 million.

And then on EMS?

On the EMS side, as I mentioned, the new customers that we have, some of these customers are -- we are in early stages on prototype products, so you won't see a lot of revenue this year, just from a ramps standpoint, so it won't have a lot of effect on the year anymore. And we have -- this is not a side to our estimates, we always have in our forecasts and stuff like that, assumption about a certain amount of new business, so it's consistent with that. If I look into next year, several of these customers get into the single digit million dollar year range. There were 7 new customers in the quarter.

Okay, so seven new customers and it might be as much as, you are saying, 7 million next year, nothing this year in terms of -?

(inaudible) nothing, I -.

...Limited.

If there is revenue this year, it would not alter our view of the year.

I understand, but the 10 million that you announced last quarter, that's still pretty much on track, do you think? The 14 customers that may contribute 10 million.

Yes, I believe so. I didn't go back and look at it, but I don't know I've anything that would alter that scenario.

Okay, great, thank you guys.

Thank you. Our next question comes from the line of John Franzreb, with Sidoti & Co. please go ahead.

Good morning guys.

Hi, John.

Don, in your prepared remarks you mention about an opportunity in Eastern Europe and in Czech Republic for (inaudible) sensors, could you just elaborate a little bit about what's going on over there?

All I was really trying to say is that we see general demand growth in Europe for automotive products, and as we look at our footprint, and where our customers are, and more and more automotive OEMs are putting up factories over in Central Europe, we felt it would be a good idea for us to -- we have to do something to add capability and we felt it would make good sense to go look at putting in operation in Eastern Europe, and so we are assessing that's right now.

How big of a plant are you thinking about and how would it impact capital spending next year?

It's -- first of all, we would lease the plant, so from a building standpoint, the CapEx requirements would be relatively small. Our thought process would be to move some of the existing product that we manufacture over there so, we'd be moving some equipment. There's always some leasehold improvements that you've got to put in when you do this kind of thing, but it's not a huge factor.

John, moving from Scotland our automotive operations in Scotland to Czech Republic potentially.

Oh, really? Okay.

Yes.

So we have some new things going into Scotland. We take some old things and move them over into central Europe, put some new things here, so it would be kind of a mix.

Okay, so that kind of touches into my second question. You said that cap ex is down because you have excess capacity. What you're capacity utilization running right about now?

Yes, that's always a tricky question. I would say our capacity utilization isn't too much different from what we shared with you 3, 4 months back. I would put it at 70 percent range. Don comes up with a slightly different number than I do always.

You know, from a building standpoint, we got a lot of space. When you get into production equipment and stuff like that, it ends up being so products specific it's really hard to answer, and we are adding capital, new products, as a ramps. We have to do that. That's more true in the automotive side than it is in the electronic components side. We don't have to -- we don't have as much of a production capital issue there.

John, you also know that that number is a pretty rough average. In some product families, we have as much as 50, 60% capacity left, i.e. the capacity utilization is probably below 50 and some others we have probably you know way up in the 85% range.

Right, right. One last question. EMS customer wins, can you just talk a little bit about what the competitive landscape is like right now in environment? It seems like the wins have been a little bit slower as far as, you know, total volume in dollars. Could you just talk about the competition out there right now?

I don't know that I see anything really different from a competitive landscape perspective. You know, approach is to go in with customers and you know try and get new products from them and then grow with them and get quality customers from that standpoint. So, many of the customers, our expectation is that we are going to ramp our business volume with them over time, as we can get more and more products from -- we have some very, very large customers, for example in the medical arena, and they share their business among several EMS providers today.

And they do that quite intentionally, and our goal is through our performance to get more of these launches. But, absent somebody doing something wrong, they don't typically start moving things from one provider to another. I mean that occasionally happens, that we will pick up business where a company has decided to just move it because they aren't happy with a competitor, but that's not the predominant driver for what's going on out there. So, like the customers I talked about, when I mentioned some of -- several of these are in the single digit millions next year. We would expect to see those revenue streams grow in future years.

Okay. Thanks very much guys.

Thank you, our next question comes from the line of Reik Read, with Robert Baird & Co. please go ahead.

Yes, good morning guys.

Hi Reik.

Just quickly on the EMS side, you mentioned the 7 new wins. Are those all new customers or are those also potentially existing customers with new projects?

No, they are all new customers.

Okay, and is there a number in addition to that that would be new projects from existing customers?

That's happening all the time, and it gets really hard to characterize. I did mention that we have some existing customers who have committed to give us additional business as a result of the combined capabilities of the company, and that is truly something new. We also have HP, as you know, as our largest customer, and HP is always introducing new products. So, we have new projects going on with them all the time. You know Motorola is a very large customer of ours, same thing, and you just get lost in the numbers if you try and count all of those kinds of things because it's replacing older products, and some of it is expansion.

Some are truly new.

...Yes, some is expansion. We end up working with a different division for example, that we haven't worked with before, and there's that kind of thing happening.

Okay. And then with respect to the automotive side of things, you talked a little bit about, you know, the stability with the auto builds, but what about as these new programs ramp, how much incremental revenue can be generated now from just new programs, even if build rates stayed flat?

I think bulk up will increase going forward, it's been on exactly these kind of things, new programs, new customers, because as you know the volumes are -- you know, basic volume increases in North America and Europe, pretty mature markets, our probably 1 or 2% range. So, I would say bulk of our double-digit growth we are talking about is coming from new customers and new products with the existing customers.

And as you know, if we get an award for an existing product, I'll call it, and a customer wants to put it on a new platform, so it's not a product that -- it's a product we've been in production with, we don't have to add capacity or something like that, you are still looking at typically from award time to when you start producing it, 18 months, and that's pretty fast.

And a lot of the new products, when we start dealing with things like pedals and stuff like that, where there's a lot of -- even after the selection, there's a lot of design work that got to be done in conjunction with a customer, and then just the long lead process in many cases there we are talking about it over a couple years. So in the short timeframe that we have left this year in 6 months. The business is really driven by in-demand at this point in time. We would not expect to win something that would be driving revenue in the automotive product arena in that short timeframe.

Okay, and then would the facility consolidation that you have going on, aside from any normal, one-time charges that you may incur as a result of that -- is that something where you have transition costs as you move equipment around and you move people around that would last in the short-term?

You're talking about the Marlborough consolidation?

Exactly.

Yes, there are some short-term impacts. We believe that over the course of the year it pretty much washes out.

Okay. So, some headwind in the third quarter and then tailwind in the fourth quarter is the way to look at it?

That's probably a fair way to -- there is some of it that it affected the second quarter, but that was pretty minor. Most of it's going on now.

Okay, great. Thank you very much.

It's not a lot.

I'll say that it's south of a penny.

Okay, great. Thank you guys.

Thank you. Our next question comes from the line of Greg Weaver with Curian Capital. Please go ahead.

The penny -- is that for in total or is that just this quarter?

As Don said, bulk of it will probably take place in the third quarter.

So that's in total?

That's in total.

Less than a penny. Okay, and on the China Unicom, is that a 3G or is that CDMA1X?

It's the CDMA.

Okay. So, you're not going to get hung up by this 3G thing then?

Well, we have a lot of components that have -- we've got a lot of design wins in 3G platform so I don't want to confuse it with the China Unicom thing I was talking about, but at the same time, we would be a large beneficiary of growing 3G orders.

Okay, and could you comment a little bit about SMTEK again? I mean, year-over-year, it's down. My sense was that things were pretty robust over there. If you look at their reported quarter from June of '04.

I think your characterization is probably incorrect.

I think if you look at SMTEK's fourth quarter, which they reported -- their calendar quarter -- they did not report that. So, if you back to the Q2 fourth quarter, which they reported, that was pretty close to the revenues that you're seeing in this second quarter which we have reported. Approximately 29 million or so.

29.9 in June of '04, they reported, right?

Right.

Right, so I mean obviously, the whole transition and merger went smoothly but by the same token, my sense was that it was growing. I mean, if you took the stud (ph) period and grossed it up for a full three months, it was over 30 million, right?

It wasn't 30. I think it was -- I think the timing of the months and the quarters probably looked misleading. If you look at SMTEK -- what kind of sales they did in first quarter of '04, which they reported they did 23 million. In the second quarter, they reported 29.9, as you said. So, compared to the second quarter, they are pretty flat, top line. Bottom line, they are substantially better. Some of it is mixed and some of it is the kind of business they are keeping and not accepting.

Okay, and just on a gross margin front again -- I was very pleased to see your improvement here, but once again, how do we get a 210 basis point gross margin improvement sequentially with an EMS and component mix pretty comparable, sequentially?

If you look at them separately, and I will comment on operating margins and you can -- you know, operating margins are probably a pretty good proxy for gross margin because not too much change takes place between that and operating earnings.

Right. You sited leverage though, as well, which I don't understand given that basically revenue is flat, sequentially, right?

Yes, I think that leverage is probably overall -- in the corporation, leverage is a factor because of addition of SMTEK revenue. The revenues are higher, year over year, so leverage is helping from that point of view.

Yes, I'm talking strictly sequential. Q1, Q2 here.

No, there's not much leverage there so it's really mix and manufacturing efficiencies had a pretty large improvement.

How much of the 210 basis point improvement would you say is mix?

Frankly, we haven't broken it out. We did highlight that in the first quarter there were some unusually large launch-related expenses. We did highlight that they were probably larger than normal severance expenses in the first quarter so sequentially benefited because some of those unusual items disappeared or pretty close. They went down dramatically.

Okay. Lastly, could you comment on how things are going with the Ford occupant sensor deal? The decision was supposed to be right around now, right?

We said expected a decision in the second half of the year. It's still in test. We're still going through what call IR tests. We've been working with Ford and seat (ph) suppliers, modifying configurations. I don't know that I can add much more than that.

So the timing for the decision in your mind is still relatively near-term?

Yes. If you're going to make them the 2008 model year, which I believe I'm correct in that's what we're targeting for right now, that we would have to have a decision by very early next year, I would think.

End of the year, very early next year, I would think.

Okay. Thank you very much.

[Operator Instructions].

Mr. Walorski, there are no further questions at this time. Please go ahead.

Okay. Thank you, Adrian. I would like to remind our listeners, that a replay of this call will be available 4:15pm eastern day light time today, through 12:59am on Friday August 5, 2005. The telephone number for the replay 800-475-6701 or 320-365-3844 if calling outside the US. The access code is 788889. Thank you for joining us today.

Ladies and gentlemen this does conclude today's conference call. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.