CTS Corp (CTS) 2006 Q3 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by. We do appreciate your patience today while the conference assembles. And good morning. Welcome to the CTS Corporation's Third Quarter 2006 Earnings Release. Now at this point, we do have all of your phone lines muted or in a listen-only mode. However, after the executive team's presentation today, there will be opportunities for your questions. Those instructions will be given at that time.

Just as a note, ladies and gentlemen, if you should require any assistance during the earnings call, you may reach an AT&T operator by pressing * then 0 on your phone keypad. As a reminder, today's call is being recorded for replay purposes and that information will be announced at the conclusion of our call.

Ladies and gentlemen, please join me in welcoming our group today. We have CTS Corporation Chairman, President and Chief Executive Officer, Mr. Donald Schwanz, Senior Vice President and Chief Financial Officer, Mr. Vinod Khilnani. And here with our opening remarks is CTS' Director of Investor Relations, Mr. Mitch Walorski. Please go ahead sir.

Thank you, Brent. I'm Mitch Walorski, Director of Investor Relations. And I will host the CTS Corporation Third Quarter 2006 Earnings Conference call. Thank you for joining us today. Before beginning the business discussion, I would like to remind our listeners that the conference call contains forward-looking statements. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. Additional information regarding these risks and uncertainties was set forth in last evening's press release. And more information can be found in the company's SEC filings.

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

Thank you, Mitch. Last night we released our third quarter financial results. From our perspective, results were mixed. The automotive related sales negatively impacted by big three production cut-backs and profits below our expectations due to some launch issues.

On the positive side, we saw solid growth in spite of some market weaknesses and underlying trends point to continued growth in sales and earnings. Total company sales for the quarter were $165.7 million, up 11% year-over-year and essentially unchanged on a sequential basis.

Again, I want to remind you that 2005 results included sales from our LTCC operation, which we sold in Q4 2005 and component sales for handset applications, which is a market that we have been consciously exiting. Combine these two discontinued areas contributed about $3.3 million to Q3 2005 versus $200,000 in Q3 this year.

Sales in the component and sensors segment grew 8% year-over-year, but declined 10% sequentially. The sequential decline was due largely to automotive shut-downs, which traditionally occur in Q3 but was also aggravated by production cut-backs by the big three. The cut-backs are large ranging from 10% to well over 20% and our planned to extend into Q4. We estimate the impact of the cut-backs on Q3 sales to be $3 to $4 million and are projecting the Q4 impact to be over $2 million.

Despite these cut-backs, on a year-over-year basis, sales of automotive products again demonstrated double-digit growth up about 13% driven by new products such as pedal modules and actuators. Component sales to non-automotive customers were essentially flat year-over-year with the growth in component sales into infrastructure applications largely offsetting the lost LTCC and handset related sales I mentioned earlier.

Though slightly softer than we expected, we still saw solid growth in our electronics manufacturing services business, which grew about 13% year-over-year and about 7% sequentially, driven by broad sales growth to new and existing customers. Sales to HP, our largest customer, were essentially flat sequentially, although down about 10% year-over-year, reflecting slowing demand for certain older, lower-end products.

In summary, sales growth while somewhat short of we had targeted was still well ahead of the prior year reflecting the continued success of our growth initiatives.

Earnings per share in the quarter were $0.15 diluted on a GAAP basis and $0.17 when restructuring and related charges are excluded. Results in the quarter compared to $0.16 per diluted share last year.

As I'm sure you noted, earnings in the quarter were generally flat despite the sales increase. That was disappointing. Vinod will discuss this in more detail in a moment. But I want to provide some background.

During a typical year, we do a lot of new product launches. Generally these go well. Unfortunately, in Q3, we experienced serious problems in the launch of two variations of a new automotive product. Frankly in our desire to be responsive to the customer, we accepted accelerated schedules that we should not have. As a result, we have encountered production yield problems that have forced us to work overtime to meet that demand, led to hire scrap and rework levels and have necessitated a lot of engineering work to redesign the product and process. And the entire situation has been exacerbated as the customer has encountered issues in the application requiring other design changes on an accelerated basis.

We have worked closely with the customer in addressing the issues. And have been able to meet the customer's requirements, which is positive for the future. We've also been able to work through many of the process and design issues, but have yet to clear all of them. So the situation is getting better, but it will have a continuing impact into Q4.

We estimate that the problem has cost us about $0.03 to $0.04 per share in the quarter. Not our finest hour, but we are taking the right actions to put this behind us and learn from it.

We should also note that during the quarter we sold our Albuquerque facility to a commercial real estate developer and lease back a portion of the facility. Over the last several years we have reduced our usage of this facility as we have transferred most production operations to our Shenzhenng, China operation. Today, Albuquerque is primarily used for front-end processing of our ceramic components and as a design center.

The result of the sale was a gain in the quarter which helped offset some of the launch cost problems I mentioned a moment ago. Despite a couple of disappointments, there were several other positive highlights of the quarter that I want to call your attention to.

In the automotive market, we won two additional platforms for our accelerator pedal module. Production for one will begin mid-2007 and the other in 2008. We also recently announced a licensing and technical collaboration agreement with Sonceboz for the integrated application of brushless motor and sensor technology in automotive applications.

We believe there is a growing market for this technology in the form of smart actuators. Sonceboz has extensive experience in motor technology and packaging this technology for automotive applications. We bring our expertise in developing and adapting sensors for automotive applications.

While significant revenue streams from these products are still several years away, we believe that opportunities to capture design positions will come as early as next year.

In the electronic component arena, we have continued to have great success capturing new design wins in infrastructure applications. Year-to-date, we have 131 design wins, which compares to 140 for all of last year. So we are on our way to another record year which bodes well for continued strong sales growth for components into infrastructure.

Incidentally, component sales in the infrastructure applications grew another 20 plus percent on a year-over-year basis in the quarter. Component sales in the infrastructure applications account for about 16% of component and sensor segment sales.

Though the transition has been somewhat slower than originally planned, we now have three lines operational in our Czech plant and our delivery and production product to customers from that location. Additional lines are undergoing qualification.

Looking forward to the rest of the year, we are maintaining our previous full year guidance for sales growth at 6 to 8%. That would apply roughly 12 to 20% year-over-year growth in the fourth quarter, but more probably we are in the lower half of that range, given the cut backs by the big three. From a profit perspective, we are expecting diluted EPS to be between $0.74 and $0.77 per share excluding the $0.08 per share in restructuring and related charges that we had talked about. This range reflects the expected impact of the launch problems mentioned earlier.

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

Thanks, Don. As Don noted, it was a challenging quarter with difficult business conditions in the automotive sector and new products launch problems affecting those results.

Before I review the financial performance in more detail, I would like to briefly update you on a few related items. First, we wrapped up the consolidation of our Berne, Indiana facility on schedule in the third quarter. The quarter included approximately $740,000 in total restructuring and related costs of which $254,000 are included in the costs of goods sold.

Total year-to-date restructuring and related costs for the completed Berne consolidation and a further impairment of the lease on an idle facility were $4.3 million pretax or $0.08 per share. $3.4 million of which are captured in the restructuring charge and the remaining approximately $950,000 in related costs are included in the costs of goods sold.

We had earlier estimated the total Berne consolidation costs to be approximately $4 to $4.5 million or roughly $0,08 per share.

Second, our Czech facility continued to ramp up its operations in the third quarter and reached an annual sales run rate of $8 million in September. We've incurred start up expenses of approximately $400,000 in the third quarter. Most start-up expenses are now behind us though we will continue to experience some inefficiencies as remaining product lines are brought on line and qualified. Even so, we expect our Czech Republic operations to break even or become slightly profitable in the fourth quarter.

Thirdly, as Don noted, we sold our Albuquerque, New Mexico facility in late September and leased back roughly one-third the square footage needed to continue our ceramic components operations from that location. The net proceeds from the sale were $12.5 million, giving rise to a gain on the sale of the building of approximately $3.7 million of which roughly $0.7 million were booked in the third quarter and the remaining approximately $3 million will be spread over the five-year life of the lease of 2007 to 2011.

Now, turning to the financial results. We finished the third quarter with sales of $165.7 million, up 11% from last year. GAAP diluted earnings were $0.15 per share. However, with restructuring and related costs of $740,000 discussed earlier were excluded, adjusted diluted earnings per share would be $0.17 compared to $0.16 in the third quarter last year.

Gross margins for the quarter were disappointing at 17.4%, 2 percentage points lower than third quarter 2005. There were three key drivers for the lower margins. First, we had difficulties with two of the latest new automotive product launches, which resulted in higher levels of expedited freight, scrap and labor inefficiencies, totaling between $1.5 million to $2 million pretax in the third quarter.

Secondly, a 5% to 7% drop in the value of the U.S. Dollar, year-over-year against currencies like Canadian Dollar, U.K. Pound Sterling, and Singapore Dollars combined with higher commodity pricing affected the margins by another approximately $1 million.

And finally, lower pension income by approximately $400,000 affected the margins adversely. Overall, approximately half of this estimated $3 million adverse impact on the gross margins was expected and included in our earlier earnings estimates.

SG&A and R&D expenses combined at $21.5 million were 13% of sales in the third quarter of 2006 versus 13.5% of sales in the same quarter last year. We continue to find ways to leverage our operating expense base despite higher equity based compensation expense which we began including in our income statement as a result of the new accounting rules which went into effect from the first quarter of this year.

Total other expenses were $0.6 million better than last year driven primarily by lower interest expense due to reduced level of borrowing. Effective tax rate for the quarter was 24.4% unchanged from our second quarter 2006 year-to-date rate. This compares to an effective tax rate of 23% last year in the third quarter.

Adjusted net earnings were $6.5 million or 3.9% of sales, which excludes restructuring and related costs. From the balance sheet management perspective, our controllable working capital as a percent of sales include sequentially and year-over-year to 14.1% in the third quarter versus 14.4% in the second quarter and 14.2% last year in the third quarter.

We continue to work on further improving our working capital towards our target of 13 to 13.5% of sales.

We did sell our $2.5 million of Delphi pre-petition account receivable in the third quarter to clean up our receivables portfolio. And year-to-date we have bought back approximately 71,000 shares at an average price of around $13.40. We have 790,000 shares remaining at the end of Q3 2006 from our 1 million share buy-back authorization.

Free cash flow for the quarter was $5.8 million, from the negative $1.5 million in the third quarter last year. Operating cash flow for the quarter was a strong $11.1 million, more than twice the $5.1 million in the same quarter last year.

Capital expenditure for the quarter at $5.3 million was somewhat lower than $6.6 million in the third quarter last year. Full year capital expenditure is now projected in the range of $16 million to $19 million and we are raising our free cash flow projection to a range of $24 million to $28 million for full year 2006.

We finished the quarter with a debt-to-capital ratio of 16.7%, down sequentially from 18.2% in the second quarter and down from 23.2% in the third quarter last year. Free cash flow generated in the third quarter combined with the proceeds from the sale of our Albuquerque building helped lower the leverage ratio.

All in all, it was a quarter in which we completed our Berne consolidation on schedule and slightly under budget, ramped up our Czech facility and essentially put the bulk if not all of our start-up expenses behind us. The quarter had good sales growth from prior year and improved free cash flow. And we were able to offset a large percent of our unfavorable gross margin impact from launch related expenses, weaker U.S. Dollar and increased commodity prices to higher sales, improved operating expense leverage and gains from the sale of excess properties and equipment.

One final comment relating to the fourth quarter. CTS will adopt FAS Number 158, which is employers accounting for defined benefit and other post-retirement plans, effective December 31, 2006.

This new FAS requires companies to recognize on its balance sheet the funded status of defined benefit plans. CTS is currently assessing the impact of adopting this new standard. However, based on the funded status of its defined benefit plans as of December 31, 2005, adoption of FAS 158 will result in a reduction in our prepaid pension assets and an increase in long-term deferred tax assets, which in turn result in a net decrease in shareholder's equity. Please note that this is only a balance sheet reclassification and it will not impact our statement of earnings or cash flow.

And now I will open the call for your questions.

Indeed and thank you very much Mr. Khilnani and Mr. Schwanz for your time and that overview today. We do appreciate that. And ladies and gentlemen, and as you just heard, at this point we turn towards your questions and comments. We invite you to queue up simply by pressing * then 1 on your phone keypad. [OPERATOR INSTRUCTIONS]

And representing Bear Stearns, our first question we go to the line of Kevin Kessel. Please go ahead sir.

Thank you. Good morning, guys. I just wanted to get a sense in terms of the automotive difficulties in terms of the launch, you said $1.5 to $2 million pretax in the quarter that you expect it to impact to -- in December, but maybe not to the same degree. Do you have a sense in terms of what the impact might be on the December quarter?

Yes, Kevin. We are estimating that the Q4 impact from this may be in the range of $0.5 million to $1 million pretax. Probably closer to $1 million pretax.

Okay. And then you spoke about the currency impact. But that's more of a year-over-year --

That percent is more of a year-over-year, not sequential.

Right. So -- But -- Okay. So, because I'm looking at sequentially the sales levels is essentially identical. And even if you backed out the $2 million, you'd still be well below. So I don't know if the pension income was a sequential change or what else was the result of the sequential decline of gross margin.

Sequential decline, currency was to some extent there was small impact.

Okay. Still there?

And I apologize Mr. Kessel.. Our host line has just disconnected. Ladies and gentlemen, please stay on line. We will recontact Mr. Schwanz and the others. And we'll resume the conference in just a moment.

And ladies and gentlemen, thank you very much for standing by. We have reconnected our host line. We do apologize for that. We will now resume our question and answer session. We did have Mr. Kessel in queue. So please go ahead, sir.

Kevin, any more tough questions, we'll hang up again.

Yes.

Well, I think we lost you right after I responded that the Q4 impact would be close to $1 million.

Right. That's from the automotive?

Okay. And then in terms of just clarifying the guidance here, the $0.74 to $0.77 that you have, what are the EPS -- quarterly EPS estimates that you're using in that calculation for the first three quarters?

First quarter, $0.20, second is $0.19 and third is $0.17.

Okay. So you're using $0.17.

So that would leave $0.18 to $0.21 for the fourth quarter.

And in terms of that $0.17, you said restructuring -- I think you said restructuring charges of $700,000 -- $786 or something would be backed out?

Yes.

So, maybe I'm -- I just want to understand where it's broken out. I see the restructuring of 486. What was the remaining on that?

The related charges are always in the costs of goods sold. They are added to the costs of goods sold.

Okay. So that was the other 300 or so thousand?

That's correct.

Now, that would be including the gain on sale then, wouldn't it?

We are including the gain on the sale in it and the rationale for that is you know that every quarter we have certain amount of normal gains from the sale, just like we had in the third quarter of last year, of roughly $300,000. We recognize that we had unusually large overall gain from the sale of the assets because of the Albuquerque building and that was roughly $700,000. So that is probably an unusual gain in nature. But, we figured that there were unusual one-time launch related issues also. So we have tried to not take that out of our adjusted earnings.

Can you say what stock option expense was and how it's broken out in the quarter?

It was approximately $200,000.

Was it all in costs of goods sold or where --?

No. I think it was split between costs of goods sold and SG&A.

So essentially equal in each one?

It's primarily in SG&A.

Okay. And then in terms of your -- when you look out to '07, you've announced some accelerated pedal wins. None of them are that significant I think in '07 in terms of impact. What do you see driving the growth of CTS going into '07?

First of all with respect to the automotive arena, as you know the lead times on designs -- on design wins to production are fairly long. So we've got very good visibility forward for the next couple of years. At this point in time, in the year typically and the next year's sales from the automotive market are about 95% booked. And the variation that we would expect to see is primarily due to production variations from the estimates that we might use. Some might be higher. Some might be lower. And like this year, we got impacted with the big three cutting back and stuff like that. So we've got very good visibility. A lot of that production came from design wins that we won a couple years ago. Pedal launches for example or actuators or whatever. And the products are just going into new vehicles next year. So it's past design wins that drives that part of it. It's actually unusual to have a pedal win like I just talked about that would produce revenue in '07. Typically the lead times are much longer than that.

On the -- in electronic components, we've talked about the continuing growth and sales into infrastructure. And for the past several years, the decline in sales of components in the handsets is then bigger than the growth it came from sales into other areas. And basically the sales in the handsets is over. We had a miniscule amount in Q4 this year. And don't expect any in the future. And so we're not going to see that year-over-year kind of impact, negative impact. And so we'll start to see the impact of the infrastructure show through into the top line.

Again, that goes back to design wins. I talked about the design wins in the quarter. I mentioned, I think it was 142 last year, 40 -- something like that. Those design wins typically take about 18 months to even 2 years to start producing revenue. So the design wins from last year, they're starting to produce some revenue this year and even more next year.

On the EMS side, it's about new customers and growing your business with existing customers. You know that in that market the underlying market growth due to increasing outsourcing is about 10%. So we look at that and that's a driver for the growth in that business.

Can you quantify that automotive increase that you expect from the 95% booked rate?

I --

In terms of millions of dollars that you think --?

I really can't at this point in time. I could. I'm not going to at this point in time. We don't usually try and put guidance out for the next year, specifically until the first quarter. We have said as you know when we've talked about automotive growth on a 3 to 5 year basis, we've consistently said we expect it to be in the double-digit range. And we talked about over the next three years, '05 to '08, growth in the 14 to 18% range.

Okay. Thank you.

And did you have any follow-up questions, Mr. Kessel?

No. Thank you very much.

You're very welcome sir. Thank you. And next in queue, let's go to the line of Scott Merlis, representing Thomas Weisel Partners. Please go ahead, sir.

Morning, everybody. How are you? Just to get a closer look at the launch costs. What -- How well have -- do you have visibility that this could be meaningfully less by the first quarter? How identifiable is the problem and the solution and what kind of visibility that it could be meaningfully less by the first quarter?

We pretty well understand what the problems are. As you know when you're in -- you're producing products for automotive applications, there's quite a process you go through. In order to prove out any changes, you need a process or product design before you implement them. So it's more driven by the timeline to get the corrections in place than it is by understanding the problem.

Was this a substantially new design? Can you get into that? How it was a substantially new design?

It is.

Oh, okay. So now I understand it better now right away. So, it's the whole process then. Do you still have to create incremental changes into the design to get the yields up?

Yes.

Gotcha. And that would have to be validated by the customer.

Yes.

Gotcha. Okay. But there is some opportunity to reduce it by the first quarter?

Oh, absolutely.

Okay.

It's already started coming down.

And the specific type of product again is --?

I'd rather not go into that, Scott.

Okay. And getting back to future growth in automotive, a follow-up to previous questions. When you -- you are gaining, winning a lot of business from Toyota, an industry leader, are they awarding it two years in advance or are they three years like a lot of others? Are they much different in the timing of their awards?

It's more a couple years. It varies a little bit. It depends on how big a variation is, the nature of their model change, what they're doing.

And since Toyota -- so is it more two years or three years would you say?

Well, I think it's probably in between.

Okay.

It varies.

Some can be two years.

And the -- When you look at this particular relationship and the way Toyota has worked, they have given you a supply award I believe --

Two of them.

-- if I'm not mistaken.

Two of them.

Can you -- two awards.

Yes.

And can you -- How hard is it to expand that relationship to other products that you're doing? Do you have engineers in there doing development work on totally new products? How do you leverage the awards? How do you leverage your success with the pedal launch with Toyota in particular because they're so important?

Yes. They're a relatively new customer to us as you know. We just started working with them a couple years ago. We've really broke into Toyota with our pedal modules and we won a substantial amount of business from them as you're aware. And initially as we started working with them, they basically said go pay attention to your pedal business and demonstrate the kind of supplier you are. And so we have done that.

And really as -- as we progressed, the doors have started to open for us to go in and talk to Toyota engineers about other kinds of opportunities. And so we're in there doing that. And we're hopeful it will lead to other opportunities going forward.

But another thing I think to understand about Toyota is they really try and develop long term relationships with their suppliers. So, we're not going to go in there and just bump a supplier out of place right now for a product that they already have in production. So we're going to have to be working with them on new things and -- where we can bring in something new and different from a technology standpoint or whatever. And that's the way I see the business growing.

So to win totally new product, do you have to -- do you have engineers on the ground there doing development work or do you -- would it be smart to increase your engineers?

Well, most of the engineering work that we do today, we do either in the U.S. or over in the U.K. We have apps engineering people over in Asia. And we are in the process of trying to expand our technical capability over there. But right now, it's still fair to say that most of it's in North America or Europe.

And the last question, getting back to the numbers, is the cash flow -- and I might have missed something, the cash flow forecast went from 24 to 28 for this year?

I think we slightly increased the range of our full year free cash flow because we slightly lowered our capital expenditure range. So the old range for free cash flow was $23 to $26 million and we have increased it to $24 to $28 million range.

And the reason was Cap Ex.

Primarily.

Thank you. That covers it. I appreciate it.

And thank you very much, Mr. Merlis. [OPERATOR INSTRUCTIONS]

And representing Sidoti & Co. we do have John Franzreb up in queue. Please go ahead.

Good morning, guys. My first question is about the automotive business. You said $0.03 to $0.04 was the production problems. And I know a lot of your business is booked in the year ahead. But at what point do lower production levels result in an underabsorption issue for you and how does it impact gross margins?

The lower production levels impact pretty much right away. So when Don indicated that the big three have lowered the volumes and lowered their produce their full, which affected us in Q3 and will affect us in Q4, the absorption is impacted right away in Q3 and Q4.

So could you peg how much of the gross margin it is on the current run rate in production?

I haven't quantified it. But our estimates were that -- between the two quarters, I think we indicated that the sales impact because of the curtailment of production volumes by the big three was $5 to $6 million in sales. If I have to give you a very rough estimate the absorption impact from that may be of the magnitude of a million dollars.

Great. That's helpful. And secondly, the asset sale, you said $700,000 was the one facility. What was the balance of that $1.33 million?

Well, the whole thing is one facility, Albuquerque facility. But we -- If you sell a facility and you are leasing back 10% or more of the same facility then the rules say that you should essentially take the gain and spread it for the life of the lease.

Right.

So the $700,000 in the quarter reflected the gain on a portion of that transaction, which we allocated to the land.

Okay.

And the rest of the gain which was roughly $3 million we have to spread over the next 5 years. So you will see roughly a $5, $600,000 of gain flowing into each of the next 5 years.

Okay. What I'm referencing is that $1.332 million on the P&L.

Oh. Yes.

Right. $700,000 of it is the gain. What's the rest?

Okay. The rest was just a whole bunch of small transactions, selling of the equipment, excess equipment and things like that in -- in North America and in Asia.

Okay. And the $430,000 in the P&L, what was in that number then? The other income?

Oh, that was primarily lower interest expense and then there was a small gain from the currency translation and exchange from a balance sheet point.

Okay. And when you spread the balance of that $3.7 million, should we assume that's equally at $150,000 a quarter or does that flow through a different way than --?

No. No. That would be a pretty good estimate.

Okay. Don, I wonder if you could just give us an update on the business in the EMS market and what's the sales mix looking like? You already kind of alluded to the fact that the fence was picking up a medical as a driver. Can you give us some more color on what's going on there?

As you know we have been trying to increase our penetration of the medical market and the aerospace market in industrial segments. And that's been going quite well. We've got -- let's see, in the quarter we had another 5 new customers. And if I recall, one of them was medical, one was defense and aerospace. I think one was industrial and the others were computing or networking kind of customers, to the best of my recollection.

So, we're slowly growing those pieces. On the computing side is the side that has not been growing as much. Has been pretty flat. The communications piece, we've picked up additional customers there. So that's been growing along with the other pieces. And that's our second biggest area from a market standpoint.

Okay. And any additional comments maybe on the -- what the infrastructure market looks like and overall health there?

You know, that's always been a market that from a market standpoint has been very lumpy. Not only do you see the Cap Ex expenditures by the service providers bounce around a lot, but it depends a lot on who wins any particular commitment like this Sprint commitment recently to the WiMax kind of thing. So you got to be with the person who wins. And then you get a big kicker for a quarter or two. And then it's on to the next one. So it's very lumpy. It's very hard to predict in general.

And our growth and infrastructure sales have way outpaced the market growth driven really by a couple factors. One, we've been able to take share and some of our traditional products, our oscillator products for example. We've also been introducing modules, our F Types of modules that have been really driving us into some new space, both in terms of product space and have enabled us to go into other customers and other applications that opened other doors for us. So, it's those two things that have driven that growth above the kind of Cap Ex growth that you see out there that's in the space that we're chasing.

John, let me add a comment to the EMS question you asked earlier just to quantify Don's comment. You know we have said that medical and defense are clearly focused areas for us in EMS.

Right.

In the third quarter of 2006, those two areas, medical and defense, were 20% of our EMS sales, which compares to only 13 in the same quarter last year. And sequentially, last quarter Q2 success was 17. So that just clearly indicates what Don was talking about, additional customers generating additional sales in medical and defense area of EMS.

That's fantastic. Just for my benefit, do those have better margins than your traditional EMS customers or is it just pretty much the same margins no matter what?

Clearly better margins and that's one of the reasons why we like that area.

Very good. One last question and I'll let someone else queue up. The Cap Ex budget for '07, have you set that or give us a range maybe for next year? I know you just pulled down the current one.

No. I think we normally give guidance for the following year sales growth and cap ex a little bit later.

Okay. Thank you.

And thank you very much, sir. We do have a follow up question. Let's go back to Kevin Kessel now with Bear Stearns. Please go ahead.

Hi there guys. Can you say how much of the percentage of sales HP and Motorola were in the quarter?

HP was roughly 22% of CTS' sales. And that is really similar to second quarter of '06. That number by the way was closer to 28% last year of CTS' sales. Motorola remains to below 10%. So we're not required to break that out. It's a fairly high single digit, but still below 10%.

Was it similar to last quarter as well?

Yes. Maybe a touch lower than last quarter. Clearly higher than Q3 2005.

And then Don, just touching on your comments earlier about the computing segment being slower and some products -- some older products starting to impact that market. At CTS, have you won or do you expect to win follow on business from this customer as they introduce new products? Or do you think this will be kind of a trend over time where it will ramp down and end of life?

There are I think four basic families of storage products that we manufacture, four or five. Anyway, they -- if you were to kind of position them in from a performance range at this rate, they bear their lower end products and higher end products, if you will. If I can put it that way. No. This is attached storage. So it's standalone storage. And the way HP works is they refresh these products. So that's going on I guess you could say constantly. So, we take the -- we work with them and they'll bring out a portion of the product that's got a new power supply in it or a new storage drive or the electronics will change in some other area. So they're constantly updating their product. And even beyond that, they're changing the software to continue to improve their performance to the product.

So in that sense, we are constantly working with them on new variations of the product. All that being said, there's a trend out there toward -- at the lower end for people who don't need to have these large attached storage systems. Now, I'm not an IT guy. So I won't necessarily get this right. But their storage needs are less and there may be other differences. They use like late storage systems in conjunction with servers. And that's done by a different part of HP. We don't do that work. And one of the things that we're seeing is with some of the older lower-end products, that is being -- that market is slowly eroding and switching over to the blade storage kinds of systems.

So we're seeing a little bit of that. Even though the higher end stuff unit wise continues to grow.

So the high end is growing. The low end like you said is being replaced by blades. And there is at this point it doesn't seem as if there's a plan to be able to get in on the blade side of the business and stuff by somebody else already?

No. That's not really out kind of stuff. Just -- We do not focus on just the high kind of -- high volume stuff that's got pretty predictable demand and level flow and stuff like that. We really work with customers that have more complex needs where the volumes may jump around or there's higher mix from month to month. So it's a different kind of business that we focus on.

Okay. And then just in terms of housekeeping, can you give us what depreciation and amortization were in the quarter?

Sure.

And also what you expect the tax rate to be going forward?

Sure. Depreciation expense for the quarter was roughly $5 million. And that compared to $5.4 million in the same quarter last year.

Okay. And what about the tax rate?

Tax rate for the quarter was 24.4, same as previous quarter.

And going forward do you expect it to stay at that level?

It shouldn't be dramatically different. Although it will bounce around to some extent depending on the mix of -- profitability mix between different countries, which have different tax rates.

And then just lastly, just in terms of overall margins, I think your goal was to get your SG&A down if I'm not mistaken to 12.5% of sales? I assume that seems like a realistic goal here even in the near term based on where you're running now.

Well, we continue to state that that is our goal.

Okay. And then what about for -- obviously the gross margins here have been impacted by some of these one time issues, which should be behind you by the time you get into your March quarter of '07. Where would your target be in terms of gross margin levels? Would it still be around the 20% level? Or do you think at this point it's probably lower because EMS is growing at a faster clip?

Well, we never talked about our gross margin target primarily because they move around due to our segment mix and things like that. Now we have talked about our operating margin targets. That we have said we will continue to see them increase because we expect our bottom line growth to be more than our top line growth. So we'll continue to get leverage and we will continue to improve operating margin. But we have never broken out a target for gross margins per se.

I guess another way to ask is once these operational issues are behind you, would you expect to be at similar levels to where you were running in kind of the March June timeframe?

Well, it's safe to say that when these launch issues are resolved, the margins would clearly improve from where we are in Q3.

And what about the Berne savings? You guys were expecting $1.5 to $2 million in the second half of this year. Is that still benefiting the gross margin and helping to offset it somewhat?

Well, we did say that the Berne restructuring will be completed in third quarter. And we begin to see those savings in the fourth quarter.

Okay. I'm sorry. Go ahead.

And I beg your pardon, Mr. Kessel. Our host line has disconnected once again. Ladies and gentlemen, please stand by. We'll be reconnecting in just a moment.

And ladies and gentlemen, thank you very much for standing by. We have reconnected our host site, Mr. Schwanz and I believe we had Mr. Kessel in queue. Please go ahead.

Kevin, we apologize. I don't know why every time you ask a question, somebody doesn't want us to answer your question.

No. I think you guys have. What I was saying right before you disconnected was the cost savings expected on a full year basis I believe was somewhere around $4.5 to $5 million. And I --

I think we had talked about a one-year payback and so $4 million was a restructuring cost. And you're right. We're expecting a full year benefit of $4 million next year.

Okay. Great. Thank you very much.

Okay. And then we have a question now from Greg McGowan with Value Line. Please go ahead, sir.

Thank you. For EMS, looking at sales sequentially this year, did you have some delays in Q1 that whereby that caused Q3 to become a catch-up quarter if you will? Or are we in a situation where $100 million in sales here is rather sustainable?

All we can say is that there wasn't anything unusual whereby the sales got pushed out from previous quarters to this quarter.

Okay.

Pretty normal quarter.

Yes. Okay. And the sales growth, that came from medical, aero, industrial, were those from customers that you acquired -- that you had when you acquired Syntec or do you get a boost there from new customers since that acquisition?

It's a combination of new customers and the customers we got from Syntec.

Is there any additional color that you can provide there?

No. Other point we will make which we made earlier that there were fairly large increases in medical and defense and industrial customers. But bulk of the increase came from medical, defense and communications.

Okay. Very well. Thank you very much.

And thank you very much, Mr. McGowan. And with that, Mr. Schwanz, and our host panel, I'll turn the call back to you. There are no further questions.

I would like to remind our listeners that a replay of this conference call will be available from 4:15 p.m. today through 11:59 p.m. on Wednesday, November 1, 2006. 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 843762. And thank you for joining us today.

And ladies and gentlemen, that does conclude our earnings call for this third quarter. Thank you very much for your participation, as well as for using AT&T Executive Teleconference Service. You may now disconnect.