CTS Corp (CTS) 2007 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the CTS Corporation first-quarter 2007 earnings conference. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for questions, and instructions will be given at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded. I would now like to turn the conference over to Director of Planning and Investor Relations, Mitch Walorski. Please go ahead, sir.

Thank you, Kathy. I'm Mitch Walorski, Director of Planning and Investor Relations, and I will host the CTS Corporation first-quarter 2007 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 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 to the discussion over to our CEO, Don Schwanz.

Thank you, Mitch. Last night we released our first-quarter financial results for 2007. Overall, both sales and earnings were in line with our expectations for the quarter. Sales at $163.3 million were up 8.5% over the first quarter last year, driven by strong growth in automotive sensors and actuators and Electronics Manufacturing Services.

Diluted earnings per share were $0.11, which is down from the $0.13 earnings per diluted share in the first quarter of 2006. Comparisons, however, are distorted by unusual factors, both last year and this. The first quarter last year, for example, included a $0.04 per diluted share restructuring charge that reduced earnings. But it also had a $0.03 benefit related to a favorable insurance settlement; about $0.02 positive benefit from abnormally high royalty payments; and about $0.01 from assets sales. Q1 this year not only did not include these unusual gains, but instead reflected a $0.02 negative impact from expenses for third-party costs related to the recent accounting investigation discussed on our last conference call and in several press releases. So in evaluating earnings for the quarter versus last year, you may want to consider those factors.

On a segment basis, Components and Sensors sales were $69.5 million, up 3% over the first quarter last year. Within the segment, automotive product sales were up 18% driven by growth in pedal modules and actuators. It is worth noting that a light vehicle production in North America was actually down about 7% in the first quarter of '07 versus a year ago. This is a significant drop. About 50% of our automotive product sales go into North American vehicles, so the decline in North America demand probably knocked several points off our growth. Despite that, we still turned in double-digit growth. Asia was a big factor in this, as our sales into that region grew almost 60%, providing about half of the growth.

Electronic components sales were down year-over-year due to slower infrastructure-related sales, weakness in resistor products, and lower sales through distribution. Infrastructure-related demand actually started to decline late in the fourth quarter last year, stayed pretty soft most of Q1, but finally started turning up near the end of the quarter.

EMS sales in the quarter were $93.7 million, up 13% over Q1 last year; but down 13% sequentially from Q4. About half the growth year-over-year came from new customers. Sequentially, the decline was spread across numerous existing customers. HP, our largest customer declined about 17% over the first quarter last year and about 6% sequentially. As I have noted in past conference calls, this decline reflects changing product demand patterns, as several of the older products we manufacture for HP are approaching end of life.

Other highlights for the quarter include receipt of two new pedal module awards and two new belt tension sensor awards from existing automotive customers. Startup production will be late 2008. The total value of the awards is expected to be about $50 million over the life of the four programs.

Our automotive business unit also introduced a new position sensor that is particularly well-suited for high pressure and temperature environments. This sensor is targeted at applications such as turbochargers and is being actively evaluated by customers.

Q1 was also a good one for infrastructure design wins for our electronic components. 38 designs wins were booked in the quarter versus 34 in Q1 last year. Design wins typically take 18 to 24 months to translate into revenue.

Our EMS segment also had a strong quarter in new business development, as five new customers engaged with us for Electronics Manufacturing Services. Two of these were in defense and aerospace, one in medical, one in test and measurement, and the fifth was in industrial. In general, the pipeline of new opportunities remains quite strong.

Lastly, during the first quarter, we began shifting manufacturing operations from our Dongguan, China, factory to the new larger facility in nearby Zhongshan. This transfer should be completed by the end of the second quarter.

Even though the first quarter essentially met our expectations, we are seeing some factors that suggest the year will not be as strong as previously expected. I mentioned earlier that automotive demand was in general below our expectations. We now see this continuing into Q2 and beyond. After a slow Q1, electronic component demand has started to increase, but we're concerned with how fast and robust this improvement will be. We have also seen some of our existing EMS customers shaving their forecasts.

As a result, we're reducing our sales and earnings guidance on the year. Full-year sales are expected to grow 5% to 8% over 2006. This is down from the 7% to 10% we previously projected. Q2 sales currently look to be sequentially up over Q1, but only slightly ahead of last year's second quarter, with most of the growth driven by the EMS business while North American automotive stays soft.

Diluted earnings per share are expected to be in the range of $0.71 to $0.75. This is down from the $0.76 to $0.80 per share previously projected, reflecting the loss in contribution due to lower sales; inefficiencies due to the Czech Republic startup, as this transition stretches out; and higher than previously anticipated investigation-related expenses. The investigation-related expenses are expected to negatively impact the second quarter by another roughly $0.02 per share; but then this episode and the related expenses will be behind us.

Now I will turn the floor over to Vinod Khilnani, our CFO, who will provide further detail regarding our financial results and expectations.

Thanks, Don, and good morning, everyone. As Don noted, first-quarter results were essentially in line with our expectations. Sales at $163.3 million were up 8.5%, driven by strong sales from the EMS segment and automotive products. Gross margins as a percent of sales at 18.6%, although higher than the last two quarters sequentially, were 1.4 percentage points lower than the first-quarter 2006 gross margins of 20%.

Lower gross margins in the first quarter versus last year were driven by three key factors. First, EMS sales represented 57.4% of first-quarter 2007 sales versus 55% in 2006. The higher mix of EMS segment sales in the first quarter of 2007 versus last year affected the margins adversely by half a percentage point, as EMS margins are generally much lower than Components and Sensors segment margins.

Second, royalty income in first-quarter 2007 was $700,000 lower year-over-year, which impacted gross margins by 4/10 of a percent. First quarter of 2006 had substantially large royalty income due to the settlement of certain catch-up payments.

Finally, our Components and Sensors segment product mix adversely affected gross margins by 0.5 percentage points. Higher sales of accelerator pedal modules, which have somewhat lower margins, affected the automotive gross margins negatively. In addition, margins of certain electronic gas recirculation, or EGR, products were lower pending their transfer to our new Czech Republic manufacturing facility from our Scotland operations. The margins have been adversely affected by higher material costs and are expected to be offset by the lower cost structure of our Czech Republic operations. We expect the two EGR production lines to transfer to the Czech Republic in the second half of 2007.

SG&A and R&D expenses at $25.4 million or 15.5% of sales were high compared to 13.9% of sales in the first quarter of 2006. On the one hand, first quarter last year included a favorable settlement of a $1.5 million insurance claim. On the other hand, first-quarter 2007 expenses included a pretax investigation expense of approximately 1.3 million. If these two nonrecurring items are excluded, adjusted SG&A and R&D expenses will be 14.8% of sales in the first quarter of 2007 versus 15% in the same quarter last year.

Interest (inaudible) expenses in the first quarter were $1.2 million better than last year, due to $400,000 in lower interest expense; $400,000 in higher interest income; and approximately the same $400,000 worth of currency translation gains and other income this year.

The effective tax rate in the first quarter was 21% versus 23.8% last year.

From the balance sheet perspective, our controllable working capital as a percent of sales at 14.9% was slightly higher than 14.7% of sales in the first quarter of last year, primarily due to a requested buildup of inventories for an EMS customer. The customer actually prepaid for the inventory; and therefore higher inventories did not adversely affect our cash flow.

Receivable days at 53 compared favorably at 55 days last year.

Operating cash flow in the first quarter of 2007 was $4.1 million compared to $2.6 million last year. Capital expenditure of $2.7 million in the quarter compared with $2.5 million last year. Free cash flow in the first quarter, therefore, was a positive $1.4 million compared to essentially a breakeven first quarter last year.

Debt to capital ratio further improve to 16.4% in the first quarter of 2007, down sequentially from 17.2% at year-end 2006, and from 19.8% in Q1 2006.

Overall, it was a quarter with reasonably good top-line growth and balance sheet performance, but weak operating margins. We expect our full-year operating margins to improve steadily as first quarter is generally our weakest quarter.

Looking ahead, we still expect our full-year gross margins to improve by approximately 100 basis points from the full-year 2006 and the first-quarter 2007 level of 18.6%. Our full-year effective tax rate is expected to be around 21%, same as 2006. Positive free cash flow is expected to be in the range of $24 million to $26 million, with CapEx in the range of $20 million to $24 million for the full-year 2007.

And with that, we will open the call up for your questions.

(OPERATOR INSTRUCTIONS) John Franzreb, Sidoti & Company.

Good morning, guys. First I want to get my hands around the accounting costs. You said $1.3 million. Is that all allocated to the EMS business? Because the press release seems to indicate there's some incremental legal and accounting fees in that business.

John, it is actually split approximately 60/40 between the two segments. 60% in EMS and 40% in Components and Sensors.

Okay, I was under the impression this was just an EMS problem. Why were there costs in the components side of the business?

That is the process we go through. They were charged to the corporate level, and we combine them with other corporate costs, and allocate it to the two businesses based on their sales mix.

Okay, so if I kind of pull that 60/40 out, I get a true sense of what the operating results were for the period?

That is correct.

Great. Secondly, can you talk a little bit about some of the end markets that you are participating in? Particularly what is going on in some of the telecommunications segments that is impacting the demand profile.

It has just been slow through the first quarter. It is pretty broad across the different kinds of applications, base stations, the repeaters, just about everything has slowed down from what it was last year.

As I said, we did see indications of this ticking up right at the end of the first quarter. We expect it to continue to improve through the rest of the year. I think the question in our mind at this point in time is really how fast it is going to do that.

Our projections, John, still reflect that full-year '07 will be higher than full-year '06. But if you just compare the first quarter with first quarter, because of a very soft industrywide environment in the first quarter from compared to last year, in the quarter year-over-year comparisons don't look good.

Okay. One last question. You put the CapEx number 22 to $24 million. Where is most of that spending going to? I'm assuming it's the Czech Republic facility, but is that the case?

It is pretty spread. A lot of new customers, new product launches. The Czech Republic piece should be very normal or minimal. There is nothing unusual driving the capital expenditures due to Czech facility.

There isn't? Okay. So that is a normal maintenance level we should expect going forward?

It is a normal maintenance level; but it also includes new product launches and new customers.

Okay, thank you very much.

Marisha Clinton, Bear Stearns.

It's Marisha Clinton calling in for Kevin Kessel. Going back to the inventory question, it did increase by $11 million sequentially and you did state that a customer prepaid inventory. Was that the bulk of the $11 million or 19% sequential increase?

It was, in bulk. I think the customer-prepaid portion of that inventory was approximately $4.5 million.

Okay. Then the difference?

The difference was just a normal increase in inventory levels.

Okay. Then you guys mention a 21% tax rate for the full year. So does this imply about a 21% effective tax rate for next quarter as well?

That's correct.

Okay.

Well, you know that based on the mix of the business, it can fluctuate quarter-over-quarter. But the current mix of business we have by different tax jurisdictions, the full-year estimate is at 21%.

Okay. Can you guys give a breakdown of your various end markets, a percentage of revenue?

Sure. I think in the first quarter of 2007, communication market is roughly 22%, which is a touch higher than first-quarter '06. Computer market is 20%, which is down from 28% in the first quarter last year. Automotive market is at 29%, which is up from 26% in the first quarter last year. We talk about medical and defense; both of them are roughly 7% of our sales. Up from last year. Last year, medical was 6% and defense was only 2%, so a pretty healthy increase in the defense markets.

Okay. I am just trying to get a sense of seasonality going forward for the rest of the year. Can we expect a back-end loaded end of the year?

From a sales point of view?

Yes, from a sales point of view.

That generally is true.

Okay. Then finally, just a couple of housekeeping questions. Depreciation and amortization for the quarter, what was that number?

Depreciation for the quarter was $5 million.

Okay.

And amortization was roughly $800,000.

$800,000. And stock option expense?

Stock option expense was fairly small. It was approximately $0.25 million.

Okay. Okay, thank you.

[Garish Nair], Thomas Weisel International.

I'm filling in for L. Ganti. Just a few questions. One is on your SG&A as a percentage of sales; they have been higher than what it was in previous year. For example, this year if you back out the $0.8 million of EMS-related -- accounting issues related costs, if you take that out, it is 12.5% of SG&A, which is significantly higher than what it was last year.

Are you looking at total SG&A and R&D for the Corporation together?

No, just the SG&A.

Not the R&D.

Oh, just the SG&A?

It has trended up a little bit, so.

The investigation costs are not $0.8 million but $1.3 million; so you need to adjust for $1.3 million.

Okay, fine. Thanks. Are you through with the automotive product launch issues that you had talked about? You said that they could extend into the second quarter also, so I just wanted some update on that.

You know, I'm assuming you're talking about Canada launch expenses which we had talked about last year.

Yes.

If we look at our Canada launch expenses and the performance overall, their performance did improve dramatically from the fourth quarter of '06. So they are steadily making progress.

However, if you are doing quarter-over-quarter comparisons, then the Canada performance is not back up to the levels we had it in the first quarter of 2006. So it does distort our year-over-year comparisons somewhat.

Okay, thanks.

John Franzreb.

You know, I did the math and took out the cost form the accounting issue and the op margin on the EMS business, and if I did it correctly -- which there is no guarantee -- it looks like the margin was less than 1% in the quarter. Is that right, Vinod?

For EMS?

Yes.

That is correct.

So question one, should we be thinking about the EMS business not achieving some of those targets we had talked about in the past? As you change your product mix, you are kind of hoping to get a 4% or so op margin from this business. Now that you have completed the investigation, does that seem like an unlikely target, and maybe it is just really a traditional EMS business that you have there?

No, I think I would say that our target for the EMS business is the same we have talked about in the past. In addition to the investigation costs, which you know, Don implied that, but there are a lot of new customer launches going on in that business, which may not be very visible from the top-line growth.

Because as you know, the computer portion of the EMS business is going down. We are replacing it with defense and medical and industrial kind of customers. So we do have higher than normal new customer launch activities. So there is that, which is unfavorably affecting the margins. Therefore, we think it is not a long-term thing and we are sticking with our target which you mentioned.

In addition, we have to increase the capacity utilization of our EMS facilities, and that will provide a much bigger contribution to the bottom line than what we have today. So those two factors and improvement of the mix, by reducing the computer piece of EMS and increasing the defense and medical piece and industrial piece of EMS business, we still believe that the long-term targets for the operating earnings are still very, very good.

Well, I mean, you're having that dynamic play out right now. You're having the low telecommunications, the communications side; and you're having a higher defense and industrial and medical side going on. And we are still not seeing much significance on the op margin line. I mean, when do you expect to see that, given that we are seeing that transition right now occurring?

I think as we begin to utilize our capacity better going forward, and as some of these new product launches are normalized, we would expect EMS margins to improve.

We see the margins improving through the year. We can build those models around the customers that we have, and the volumes, and knowing what the margins are.

John, we expect to see the EMS margin steadily improve throughout this year, as Don indicated.

Okay. One last question, picking on EMS a bit here. Any considerations maybe to bundling up the business and exiting? Have you guys bantered about that at all?

No.

No?

No.

Okay. One last question. Looking at the balance sheet, on the annual. You may have touched on this last quarter, I didn't check; but the pension line went down rather significantly. What happened there?

I think, John, there was new accounting regulation, FAS 158, which was implemented starting from this year. Essentially -- and it affects all of the publicly traded companies obviously in the US. But essentially that asks companies to reflect for the balance sheet purposes any unrecognized pension losses which were earlier only reflected in a footnote. But from a balance sheet presentation point of view, go ahead and recognize it in the balance sheet. Which essentially puts the other piece of that in the equity side. So you see your equity adjusted downwards, and by roughly $36 million; and the pension assets go down by $50 million; and the difference goes on the tax side of the equation.

Okay, okay.

It essentially takes away a piece of the assets which was an artificial asset; and now the return on assets truly reflect what the return on asset is of a company.

Okay. Does that change your pension income at all?

No, it has no impact on the P&L side of the game.

What was the pension income contribution this quarter?

Pension income for the quarter was approximately $1.1 million.

Okay, and we should expect the same amount going forward?

That's correct.

Okay, thank you very much, Vinod.

Marisha Clinton.

I just want some clarification on your end market breakdown. You mentioned that medical was 7%, up from 6% last year; and defense was also 7%, up from 2% last year. What was industrial?

Yes, industrial market? I'm sorry, I should have given that to you. I skipped it just to see if you'd catch that. Industrial was approximately 8%, and that compared to 7% last year.

Versus 7%; so other came in at 5%?

That's right.

Okay. Then finally, Motorola, were they less than 10% this quarter?

Yes.

Okay.

One of these days we may have to share with you Motorola numbers, because they are right at the cusp of that number.

Okay, so just below 10% for the quarter. Then HP you said was down 17% year-over-year, and 6% sequentially.

That is correct.

Okay, great. Thank you.

Garish Nair.

In one of your earlier investor presentations we had seen that your automotive sales, you were expecting it to grow 13% year-on-year. Those were your targets, I assume. And your Components and Sensors were assumed to grow at 3% to 6%; and your EMS was expected at 6% to 8%. Do these still hold? What has changed now?

First of all, those were multi-year averages, so we're not saying that will happen every year. We're just saying over that planning horizon we would expect to see those kinds of averages. We still believe that that is a correct outlook. You know, you can tweak it here or there depending on mix and stuff like that. But we don't see this thing radically changing.

Okay, thanks.

(OPERATOR INSTRUCTIONS) We have no further questions. Please go ahead with your closing remarks.

Okay, 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 PM on Thursday, May 31, 2007. The telephone number for the replay is 800-475-6701 or 320-365-3844 if calling from outside the US. The access code is 873723, and thank you for joining us today.

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