CTS Corp (CTS) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the CTS Corporation second quarter 2007 earnings release conference call. (OPERATOR INSTRUCTIONS)

I will now turn the presentation over to your host, Mr. Mitch Walorski, Director of Planning and Investor Relations. Mr. Walorski, you may begin.

Thank you, Christopher. I'm Mitch Walorski, Director of Planning and Investor Relations, and I will host the CTS Corporation second quarter 2007 earnings conference call. Thank you for joining us today.

Participating from the Company today are Vinod Khilnani, President and CEO; Matt Long, Interim Chief Financial Officer and Treasurer; and Tom Kroll, Vice President and Controller.

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 relation section.

I will now turn the discussion over to our CEO, Vinod Khilnani.

Thanks, Mitch. And good morning, everyone. Last night we released the second quarter financial results for 2007. Overall, both sales and earnings were essentially in line with our expectations for the quarter. Sales at $169.6 million were up 2.2% over the second quarter of last year, driven by growth in our automotive sensors and actuators and electronic manufacturing services.

Diluted earnings per share were $0.15 compared to $0.14 in the second quarter of 2006. Both the quarters were negatively impacted by approximately $0.03 per share for unusual items; a manufacture restructuring last year and investigation costs related to our California EMS locations this year.

On a segment basis, component and sensor sales were $70.8 million, down slightly from last year.

Even though light vehicle production in North American was actually down about 3.5% in the second quarter of 2007, versus a year ago, CTS automotive product sales were up 6.1% , driven by growth in pedal modules and actuators. Our automotive sales in Asia grew almost 19% year-over-year in the second quarter, providing almost 40% of the total automotive growth.

Electronic component sales in the quarter, however, were down year-over year, driven by a combination of factors, including timing of orders and customer launch delays, et cetera. We do expect electronic component sales in the second half of 2007 to be 10% to 15% higher than the same period in 2006. EMS sales in the quarter were $98.8 million, up approximately 5% over Q2 last year.

Despite an expected decline in sales to HP of 31% over the second quarter of last year, HP sales were approximately $25 million, or 15%, for a total Company sales in the second quarter of 2007. As the Company has noted in the past conference calls, the decline reflects change in product demand patterns, as several of the products we manufacture for HP are approaching end of life. That, combined with our focus on medical, defense, and aerospace, and industrial markets will continue to shift our product mix within the EMS segment. A 28% growth in the EMS target market more than offset the HP decline. Sales to medical and defense and aerospace customers combined grew 50%.

Other highlights for the quarter include a major production program award for a turbocharger position sensor from a leading global turbocharger manufacturer, a new customer for CTS. Total revenues are expected to be approximately $30 million over the five year life of the program and production will begin in the second half of 2008.

Our automotive business also won seven production program awards from Chery Automotive Company of China for accelerator pedal modules. Total sales from these awards are expected to exceed $10 million over the five year life of the program.

In the electronic components business, 42 infrastructure product design wins were booked, which will have the potential to generate approximately $4 to $5 million of revenue per year. These design wins for RF components were primarily WiFi, WiMAX, and 3G Wireless arenas.

The electronic component business also completed purchasing agreements with two tier one communication OEMs in connection with several of the (inaudible) during the second quarter. One of the OEMs is a major European company and the other one is a major Chinese company. While revenues, to date, from these relationships are not yet material, programs with both companies are expected to grow nicely in 2008.

Five new customers were added in our EMS business, all in our medical, defense, and aerospace, and industrial markets, which we have focused on. Lastly, we did complete the transfer of our Dongguan, China factory to the new larger facility in nearby Zhongshan. It is now up and running. The new facility is a little over 72,000 square feet, compared to the old facility of approximately 40,000 square feet. The major customers we serve from this factory are Nissan and Chery and we will also begin serving Honda from this factory by the end of 2007.

Looking at our financials in a little bit more detail, second quarter 2007 gross margins of 19.4% were 0.3 percentage points higher than last year, primarily due to improvements in EMS gross margin in the second quarter of 2007, and certain restructuring-related costs in the same period last year. Improvements in the EMS segment margins were partially offset by lower components and sensor segment margins due to -- due primarily to product mix.

SG&A and R&D expenses were 14.8% of sales in the second quarter, an improvement from 15.5% in the first quarter. Our normalized second quarter SG&A and R&D expenses, without the California EMS investigation costs, were at 13.5% of sales, half a percentage point lower than the second quarter of last year.

Interest and other expenses in the second quarter were approximately $0.4 million better than last year, primarily due to lower net interest expense driven by lower outstanding debt balances. The effective tax rate in the second quarter was 21%, the same as first quarter of this year, and a little lower than 22.4% in the second quarter of last year.

From the balance sheet perspective, our controllable working capital as a percent of annualized sales at 14.4%, although 1 percentage point higher than second quarter last year, improved 0.5 percentage points sequentially from the previous quarter.

Inventory levels are still higher than our normal levels due to a requested buildup of inventory for an EMS customer. We expect our inventory turn to controllable working capital percent to improve further by the end of 2007.

Operating cash flow in the second quarter was $11.4 million, versus $14.8 million last year. Capital expenditure of $3.6 million in the quarter was slightly higher than $3.4 million in the same quarter last year. Free cash flow, therefore, was $7.8 million in the quarter, versus $11.4 million in the second quarter of last year. Debt-to-capital ratio of 15.9% compared with 18.4% at the end of second quarter 2006.

Let me now share with you a few comments on our outlook for the rest of this year. As I noted earlier, second quarter sales and earnings were essentially in line with our expectation. While I'm somewhat concerned with the economic environment in general, and automotive and EMS industries in particular, we have seen nothing concrete that suggests that second half earnings will be outside our expected range.

Sales, however, will be a little harder to predict in the fourth quarter due to the timing of customer posts in the EMS business. We are, therefore, maintaining our full-year diluted earnings per share guidance of $0.71 to $0.75 per share, enticing the range of our full-year sales growth to 5% to 6%, which still implies that our second half 2007 sales will be up 6 to 8% from the first half of 2007.

Our full-year tax rate is still expected to be around 21%, the same as 2006. And we are also maintaining our positive free cash flow guidance to be around $24 to $26 million, with capital expenditures in the range of $21 to $24 million for the full year of 2007.

And before we open up the call for your questions, let me just add that I'm very excited about the Company's prospects going forward. We have a strong commitment from a very seasoned management team to re-double their efforts to drive profitable growth, to increase customer focus, and production of new products and penetration of new markets. The renewed focus will also be on speed and quality of execution.

And with that, we'll open up the call for your

Thank you very much. (OPERATOR INSTRUCTIONS) Our first question or comment comes from the line of John Franzreb with Sidoti and Company. Your line is open.

Good morning, everybody.

Good morning, John.

Good morning.

First question is regarding the electronic component growth. Vinod, if I heard you correctly, you said you expect it to be 15% in the second half. What's driving that demand?

Infrastructure continues to be fairly strong. We had some delayed customer launches from the first half to second, second half. So, John, that combined with the growth, we expect a strong second quarter compared to first quarter.

Okay. Okay. Second question, costs in the Czech Republic. Can you tell us what kind of -- can you quantify the impact of what it was in the period and when will it no longer be an issue?

I think it will not be an issue by the end of the year. And although second quarter of '07 is clearly better than second quarter of '06 from a launch cost point of view, but in the last conference call, I indicated that there have been some delays in transfer of our production lines from our Scotland facility to Czech Republic, and they were primarily driven by our customers.

If I look at the run rate of the volume in Czech Republic in the second, second quarter, and I look at the run rate of volume in the fourth quarter of this year, we would essentially be doubling the sales which we are booking in Czech Republic in the fourth quarter of this year, compared to the second quarter. And that run rate would allow us enough contribution to essentially offset all the incremental infrastructure we had to put to make Czech Republic factory operational.

Can you remind me what the -- how much cost was in that infrastructure?

Just the incremental cost of the new building, new organization and if you look at all those costs and look at what the -- what the volume should be, so that we not only break even, but we make enough return on those sales, which we would have made if we would have kept it in Scotland. And we believe that volume is probably around $5, $6 million a quarter run rate. And our run rate in the second quarter of '07 was just a touch below $4 million.

Okay. And one last question, Vinod. Having taken over for Don, I just wanted to get maybe your opinion on how you're going to be a different CEO than he was. What do you think, what kind of strengths, maybe, you want to take from what he's put in place, but also, and more importantly, what kind of changes you kind of envision for CTS going forward?

That's a tough question.

Good.

You know, CTS has put in place very good strategies. And Don and I have shared with you in the past that our focus on high margin products, our focus on international growth, our focus on moving the mix within the EMS business towards higher margin, what we call, quote/unquote, more sticky business in defense, aerospace, industrial kind of market, growth in the automotive sensors. All those areas and all those strategies are very good and we would -- we would be moving forward with those strategies with more vigor and more speed.

So fundamentally, there is nothing dramatically different which we are going to be doing to the strategy. I would say that the management team is -- management team has recommitted themselves to re-double their efforts and focus more on execution. We will probably re-double our efforts on acquisitions, profitable growth.

In a way, these things are very similar to what you have heard us talk about in the last several quarters, but we will -- we will put more focus on those kind of areas, better execution, more focus on international opportunities, more focus on international and acquisition areas, as we go forward.

Great. Thanks a lot, Vinod. Good luck.

Thank you. (OPERATOR INSTRUCTIONS) Our next question or comment comes from the line of Kevin Kessel with Bear, Stearns. Your line is open.

Thanks. Hey, guys.

Morning, Kevin.

Vinod, where do you see HP ending, ending up by the end of the year in terms of as a percentage of your sales or in terms of dollar value?

As a percent of sales, if you look, look at year-to-date, we are probably around 17% of sales of the company. I suspect we will be somewhere very similar to third quarter number or maybe a little bit higher. So 15 to 17% of sales for total (inaudible - background noise)

And then as you go into fiscal '08, is that expected to change or (inaudible - background noise) is it going to be relatively stable (inaudible - background noise)

You know, that's harder to predict. A lot depends on, you know, we have -- we have seen double digit growth in our non-communication EMS market, new customers. For example, if I look at second quarter and look at our sales by industry groups, our industrial EMS markets have gone from 7% of the total company to 11% of the total company.

If I look at the defense market, we have gone from 4% of the total company in the second quarter of 2006, to almost double, 8%. So, obviously, the faster growth in those areas and the faster growth in automotive sensors, I suspect will make HP a smaller and smaller percent of the company as we go forward.

Okay. And in terms of your margins, you saw some nice margin improvement this quarter from last, and that partly due to, I guess, EMS now coming from breakeven back to profitability.

Yes.

But how do you expect to actually get EMS from the 2.4% that it is this quarter to more of a kind of an industry average for your sort of a -- for your sort of a mix of business, which would be probably north -- definitely north of 3, maybe 3.5, 4%? How do you plan to do that if you exclude just changing mix? Like what other things can you do?

Kevin, there are -- there are two key drivers behind that. And I think going up to 3, 3.5% would be easier. Our internal targets for EMS continue to be slightly higher than that. Pre-tax operating margins are probably closer to 5% than 3%. And we do realize that going from 3, 3.5% to 5%, the slope would be a little bit steeper.

There are two key drivers at this point which are helping us; one is, clearly you pointed out, was the mix more towards industrial, medical, defense, and aerospace kind of markets would help us. The second lever, as you know, we have plenty of capacity in our EMS business. Our EMS capacity utilization is probably closer to 50, 55% than in other businesses we have, which are probably close to 65, 70%. So as we fill up more capacity in the EMS business, we expect to leverage the overhead expenses and that should help improve the margin percents as we go forward.

Is there anything from an efficiency point of view, like, you know, in terms of lean manufacturing or those sort of programs that you feel --

Absolutely. But those are given. I mean, you have to drive those. We are always looking for opportunities to move production to our low-cost cost structure factories. We are looking to drive, obviously, the material cost down by sourcing it for more effective, cost effective sources. As you know, direct material is a very, very large percent of EMS sales. And we have fairly strong actions going on at almost all of our locations. EMS or non-EMS, we are driving quality and throughput in our factories. That is always underlined very aggressively.

Can you tell us how much of the five customers, the new EMS customers, would contribute on an annual basis once they're fully ramped?

That's a tougher number because we sometimes are given smaller programs as new customers are testing us. And we look at a customer not only how big in business we are winning, but the potential. If they're large companies then sometimes they will test us by giving us a small, small business.

All of these five are in the industrial, medical, and defense, and aerospace areas. They all are starting fairly small and we expect the programs to ramp up. But more importantly, we expect these customers, as they get comfortable, with their execution, to be a bigger customer for us going forward. But they start off fairly small.

Okay. And then just housekeeping, I guess. If you could talk about the inventories that you mentioned earlier. How much of the inventory increase was due to the buildup for a customer, maybe what end market that customer was in? Also, if you could give us the end market breakdown that you were discussing earlier, percentage of sales for industrial and defense and medical. And then, lastly, just your depreciation and amortization, I didn't get.

Okay. Those are three questions. So I'll go over the inventory question. I think the customer is in EMS business. It was a customer which asked us to build inventory and we will be shipping them that inventory -- we started that in Q2, late Q2 we started shipping to them in pretty decent quantities starting from June. We would ship them in third quarter and fourth quarter of this year. We'll clearly be completely done with that excess inventory by the end of the year. And the last estimates I had were approximately $8 to $10 million worth of inventory, which we have for them at this point.

Now, they did pay us a lot of advance monies because we just didn't want to carry a lot of inventory for them. So from a cash flow point of view, they did pay advance payments for a good bit -- good portion of that. So it's roughly $11 million, EMS customer, and we'll be done by the end of the year with that customer.

Your second question, you asked for the mix between the markets. And we have talked about these in the past. And the major markets we talked about is, the first one is communication market. And that is 23% of total company; virtually unchanged from the percent in the same quarter last year. Computer market is down from 27% of the company to approximately 17% of the company. And that's where the biggest drop is, from EMS point of view. Automotive markets have moved up from 26% of the company in the second quarter of last year to 27% of the company in the second quarter of this year. Industrial, which is primarily EMS, has moved up from 7% to 11%. Medical is pretty similar to the same quarter last year, to approximately seven percent of the company. Defense, as I pointed out, again, primarily EMS, but a small piece comes from component and sensors. That has doubled from 4% of the company to 8% of the company. And the other piece stays roughly the same at 7%. So that adds up to 100%.

And on housekeeping, your question was on depreciation?

Yes.

And, Tom, would you share with Kevin what the depreciation number --

Sure the depreciation expense for the quarter was $5 million.

And the amortization?

.8; $800,000.

Okay. And then lastly, do you guys get paid any carrying costs for the inventories? I heard you say you get paid -- they pay earlier for the -- for you to procure it. But what about for carrying it?

No, we did not get paid for the carrying costs. They did pay us in advance, but no carrying costs.

Okay. Thank you very much.

Thank you. Our next question or comment comes from the line of Girish Nair with Thomas Weisel International. Your line is open.

Hi, everybody.

Hi, Girish.

Hi. First question is, could you characterize or could you describe in more detail as to what you are -- what is the nature of your business in the industrial, aerospace, defense? I mean, what is driving the strength there in the end market?

Girish, those businesses, defense and aerospace, are primarily in EMS. And that has been a focus area. If you go back and look at the history of CTS, we essentially had no defense and aerospace business if you go back to 2001, 2002 time frame, except some small numbers from our component and sensor business.

Then we picked up that business. We started that business when we did the SMTEK acquisition in early 2005. And we have decided to grow that business and we have put extra focus on it. And we have gotten some certifications at some of our factories and, therefore, we're seeing the defense and aerospace piece of the business grow very nicely.

Okay. I mean, from an end market perspective, I was trying to understand what is driving the growth there in terms of one part of the growth is your own efforts to focus on these high margin EMS businesses, but at the end market level, do you see that there is an increasing trend to -- for aerospace companies to outsource or either they're signing up to get commercial aviation; is that driving the business?

That's a very good question and comment at the same time, and you're exactly right. The market is growing, combined with weavening market share because we're focusing on it. But the third point, which you said, is also very true, that some of these companies are outsourcing. And that, we are seeing not only in defense and aerospace, but also in medical. We're seeing the trend by these companies to outsource some of the work they used to internally. So those are the three key drivers.

So in terms of outsourcing, would you have any idea how much -- is the opportunity there in these three segments of size?

I don't have, Girish, those numbers at my fingertips. But we can cycle back to you and share with you some of the information we are reading in various studies we see on EMS.

Okay. Thanks. One more question. Is it possible for you to breakout your automotive sales by geography? I'm asking primarily because if you see General Motors and Ford reported very good numbers and that was primarily because automotive sales are very strong outside of US, not in America, Asia also. I was wondering whether you would be leveraged with that phenomenon or not?

We are. We, as I pointed out, we expanded our automotive plant in China from a 40,000 square foot to 72,000 square foot. We are introducing new customers. The major customers from that plant would be people like Chery and Nissan and Honda. Chery has announced a marketing agreement -- I think there was a press release on it -- with Chrysler. You know, we're the primary supplier to Chery on pedal modules. So we clearly are benefiting from growth in Asian market.

The other comment, which may help you, our dependence on the U.S. Big Three Automotive OEMs continues to go down. Several years back, 60% of our automotive sales were to Big Three in North America. That number has come down to 55% in 2006 full year. And my estimate is that in 2007 that number will probably be 50%. Going forward it will continue to go down because pretty much all the awards we have announced in the second quarter were from non-Big Three. And so our penetration is definitely increasing as we -- as we get customers like Toyotas and Hondas and Chery's.

Okay. And so when you're saying this 50%, this is only North America, is it? Because if you see the Big Three are winning -- are gaining market share also in the automotive market.

Well, we look at global sales and North America. The numbers I gave you are global sales. Our North American sales to Big Three's probably around, you know, 40% kind of a range or maybe a little bit less. I'm sorry. North American number would be a lot higher, probably more than 75%. But on a global basis, it's closer to 50 to 55%. But they remain a very big part of our automotive sales. However, the growth is coming more from Asian and -- Asian, primarily, Asian automotive OEMs.

Okay. Thanks, gentlemen.

Thank you, sir. Our next question or comment comes from the line of -- please excuse the mispronunciation -- Rand Gesing with David J. Greene and Company. Your line is open.

You got it right.

Hi, Rand.

Hi. How are you guys doing?

Pretty good.

Good. Can you just characterize sort of North American volume in auto? It sounds like, from your comments, that it might be starting to slow a bit with lower volumes, despite sort of increased content. I just was wondering if you could just characterize that as sort of a trend line?

Well, the second quarter, which is available, the information which is available, the North American light vehicle production was down year-over-year by 3.5% or so. As far as Western Europe is concerned, although the sales were a little higher in the second quarter of '07 slightly compared to '06, but the production was actually lower, by almost a percent. So year-over-year, the production in North America and Western Europe was down. Obviously, we continued to see fairly strong growth of passenger vehicles in China and Asia overall.

When it comes to a full-year forecast, I have seen numbers around -- I'm trying to remember what kind of full-year numbers for light vehicle North American we have seen. I suspect around 16 million, 16.2 million units is, I think the current forecast for full year for North America. I don't know if that helps you or not.

Well, no. I'm just wondering if, you know, if that weakness in units is starting to impact you. I mean, I sort of thought about you automotively as continuing to grow even in North American, despite some weaker volumes.

Well, first half of this year we were definitely affected adversely by the volumes being light. Now, as I pointed out earlier, new products and new customers helped us --

Yes.

-- overcome that and we still reported a little over 6% year-over-year growth in the quarter.

Right.

But if I look at the inventory levels in North America, they -- they are around 64 day at the end of June. Earlier this year, they were -- they were at one point fairly high. We started the year with a supply of -- day supply of automobiles in North America closer to 80. So it has come down, but I don't know if 64 is kind of normal levels for North American, Big Three's probably normal. Japanese automakers carry a lot lower inventory than that.

So it's not clearly a 70, 80 kind of excessive number. It's probably more closer to the normal levels now than before.

Okay. In the components and sensor segment, I think you -- your operating profit was down something like $3 million for the quarter.

Yes.

Can you just sort of characterize what sort of impact -- I don't know whether you had an incremental and investigative cost, I think you talked about at one point two million. I don't know if that is in excess of what you spent in the quarter year ago. But I'm just trying to understand the delta as to what sort of -- you talk about mix, but can you sort of just give me a sense for what's impacting the difference in year-on-year there?

Well, let me just make a general comment that in the last conference call we had talked about investigation costs to be approximately $.02 in the second quarter. That's what we were expecting. The number turned out to be $.03. So we definitely -- it's all behind us, by the way. There's no more investigation costs coming to us.

Okay.

But we did see a penny more than what we expected.

Yes.

So that was on investigation costs. Component and sensor margins, the year-over-year comparison is a little skewed because we had a pretty decent second quarter last year. Our mix was not as favorable in 2007, as it was in 2006. And that was -- that was within both of our large product families, the sensors, automotive sensors on the one hand, and overall electronic components on the other hand.

Volumes, obviously, affected. On a full-year basis, the non-sensor electronic components, we expect a fairly decent second half of 2007, because of --

Right.

-- the timing of the launches and things like that.

Right.

There were other reasons. When I talk about mix, for example -- I'll give you one example. We have (inaudible) product and some of the application of that product is hydro-energy and exploration kind of thing. It's a very high margin product. However, the sales are not evenly spread during the year. You know, you may get a big order and it's pretty chunky.

Okay.

For example, last year in the second quarter, we had million, 1.5 million, maybe 2 million in sales of that product. This quarter, this year second quarter, it was zero. Now, on a full-year basis, I think we will do better in '07 than '06. But just on a quarterly basis, that business did not ship anything --

Yes.

-- because of timing and of the products. So that just a -- that's just one example of how a mix can adversely impact a particular quarter.

Right.

But on a full-year basis, we should be okay.

Okay. So then in the third quarter, I guess the expectation went a little bit better volume in the non-auto piece, some of this investigative cost out, we should have a -- expect to see a better comparison year-on-year in that segment, is that the right takeaway?

Now I prefer to talk about second half than Q3.

Okay. Second half then. In the second half would you say that, that you would certainly see a better comparison?

That's our expectation, yes.

Gotcha. Okay. Last question I had was, in terms of EMS, I don't know -- you know, you talked a little bit about the strategy going forward, trying to sort of fill up the capacity. But I was also wondering about this notion of sort of becoming smaller and more profitable, you know, more targeted in the areas we go after, where we could get paid a decent return based on the customer and end market. So sort of getting smaller to get more -- to get better returns there. And yet, on the call today, you mentioned sort of filling up the capacity we have, which sort of, you mentioned, sort of sounds like a let's get bigger strategy.

So I don't know whether you finalized which -- the direction we may move here, but I was just wondering if you could sort of --

Rand, I won't say the getting smaller strategy. I would say the getting targeted strategy.

Okay.

So we're more targeted. And this quarter's a good example.

Okay.

You know, we had -- our non-communication EMS business, which is primarily defense, aerospace, grew 28% --

Yes.

-- in the second quarter year-over-year. And overall, the EMS business grew approximately 5%.

Right.

That's not a necessarily grow smaller strategy. I would say it's more targeted strategy. So we are going to be growing in more, driven by targeted markets, which will help us not only improve the mix within EMS, but allow us to utilize our capacity more efficiently. And as someone else pointed out, the given in this whole thing is we have to continue to improve our manufacturing operations and drive quality initiatives and throughput and continue to be more efficient and move the product more towards better cost structure locations.

Okay. All right. Great. Thank you.

Thanks, Rand.

Thank you, sir. At this time, I am showing there are no further questions in queue. I would like to turn the presentation back over to our presenters for any concluding remarks.

I would like to remind our listeners that a replay of this conference call will be available from 4:15 p.m. Eastern Daylight Time today to 11:59 p.m. on Tuesday, August 7th. 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 880822. Thank you for joining us today.

Ladies and gentlemen, this does conclude our conference for today. We do thank you again for your participation and for using AT&T Executive Teleconference. You may now disconnect. Good day.