CTS Corp (CTS) 2011 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the CTS Corporation Q2 2011 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions.) And as a reminder, today's conference is being recorded.

I would now like to turn the conference over to our host, Mr. Mitch Walorski, Director of Investor Relations. Please go ahead.

Thank you, Rachel. I'm Mitch Walorski, Director of Investor Relations, and I will host the CTS Corporation's second quarter 2011 earnings conference call. Thank you for joining us today. Participating from the Company today are Vinod Khilnani, Chairman of the Board and CEO, and Donna Belusar, 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 reconciliations are available on our website in the Investor Relations section.

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

Thanks, Mitch, and good morning, everyone. Last evening we released our second quarter financial results for 2011. Sales, earnings, and operating cash flow were all in line with our expectations, despite a somewhat larger impact from the Japan earthquake and tsunami on our sales and earnings.

Some of our key Japanese OEMs were forced to curtail their production by 50% to 60% in the second quarter and are projected to gradually restore it by the end of the third quarter. We expect them to be running at the normal level by September timeframe.

New product launch activities continue at a robust pace, and operating cash flow strengthened to $11.3 million in the second quarter.

Sales in the second quarter of 2011, at $146.9 million, were up 5.8% year over year, primarily driven by an 18.4% increase in the EMS segment. This was partially offset by a decline in the component and sensor segment sales, caused mainly by the reduced sensor sales to key Japanese OEMs like Toyota and Honda due to their earthquake-driven disruption.

Within our component and sensor segment, total automotive sensors and actuator sales, at $39.8 million, were down $4.3 million, or 9.8%, from the same quarter last year. We estimated the impact from Japan's earthquake and tsunami disruption at approximately $6.5 million. Adjusting for that, our sensor sales would have been up approximately 5%. We expect some of this impact to continue in the third quarter. However, new business revenues should allow sensor and actuator sales to grow sequentially in the third quarter.

Second half 2011 global light vehicle production is projected to grow approximately 5% to 6%, both year over year and sequentially, compared to the first half of 2011. North American vehicle inventories finished June at 49 days versus a more normal level of approximately 60 days. We believe Japanese automotive OEMs who were affected by the earthquake and tsunami are probably carrying even lower inventories.

These projections, combined with a couple of new product launches, indicate that we should see a 10% to 13% sequential increase in our sensors and actuator product sales in the second half of 2011 compared to the first half, with especially robust demand in the fourth quarter.

We captured three new sensors and actuators awards in the second quarter, two of which were new and one was replacement of an existing program. There are six new awards for pedal modules and turbocharger sensors, which are not officially awarded yet, but are in the final stages of approval, and we expect to report them in the very near future.

Continuing with the component and sensor segment, sales of electronic components represented 19% of total CTS sales in the second quarter of 2011. Sales of electronic components were up 5.8% sequentially as we saw business improve across all of our product families, namely wireless infrastructure, EMI filters, electromechanical products, piezoceramic, and products sold through the distribution channel. Year over year, electronic component sales were up only slightly, as higher sales across most of our product families were offset by a decline in the wireless infrastructure sales due to product mix and program delays.

On the business development front, launch of our new piezoceramic components for disk drives are on track to ramp up beginning in the fourth quarter. We have begun shipping small quantities of this new component from our Tianjin, China, facility, and we are projected to ramp up shipments in the fourth quarter. New infrastructure design wins are staying at a healthy pace of 62 in the quarter and 120 wins year to date versus 116 year to date last year.

Let me briefly comment on our R&D activities around new technology, a new family of products, which is different from our base engineering and base business new products. You have heard us talk about two new families of products. One is smart actuators for diesel engines, and the second is piezoceramic components for disk drive applications. We have been investing at a clip of $1 million per quarter to develop and launch smart actuators.

In the second quarter, we also spent close to $800,000 to launch our piezoceramic product for disk drives. So in total, we incurred $0.04 per share to the second quarter to develop and launch a new family of products which are in addition to our base business growth initiatives.

Roughly half of this expense will stop in the fourth quarter of 2011, when the piezo product is launched, and the other half, or $0.02 per share per quarter, will continue until fourth quarter of 2012, when the smart actuator product will launch.

Our EMS segment sales in the second quarter of 2011 of $78.9 million were up 18.4% year over year as new customers were added and volumes improved in all of our markets, with industrial and defense and aerospace growing the most. Overall, our segment mix temporarily tilted towards EMS sales in the second quarter, with 53.7% of total CTS sales. This was primarily due to lower sensors and actuator sales to Japanese OEMs.

Based on the new business awards and new product launches, we expect our longer-term trend to reflect stronger component and sensors growth, and we expect it to become close to 60% of our total sales in the next several years.

Looking forward, we expect the global economies to grow modestly in the second half of the year. We also expect revenues from a couple of significant new component and sensor programs in the fourth quarter. In addition, production volumes of our key Japanese OEMs are scheduled to return to normal levels beginning in the September timeframe. We are therefore maintaining our full-year 2011 guidance, with sales increasing 9% to 13% over 2010, and full-year diluted earnings per share to be in the range of $0.70 to $0.75.

Now I will turn the meeting over to Donna Belusar, our Chief Financial Officer, who will provide further details regarding our financial results. Donna?

Thank you very much, Vinod, and good morning to all of you. Our second quarter 2011 sales were $146.9 million, an increase of $8.1 million, or 5.8%, from second quarter 2010 sales. Total second quarter 2011 gross margin as a percentage of sales was 19% compared to 21.9% in the second quarter 2010 due to the temporary shift in sales segment mix, primarily driven by lower automotive and stronger EMS sales.

In addition, the margin reflects higher year-over-year commodity and precious metals costs and new program launch costs in preparation of production build. We can expect gross margins to improve, primarily in the fourth quarter, and be similar to last year, in the range of 21% to 22%, as the new programs in the component and sensor segments that are currently being ramped up in manufacturing are launched, especially the hard disk drive component production and a new global pedal module program.

Selling, general, and administrative expenses were $18.1 million, or 12.3% of sales, for second quarter 2011 compared to $18.3 million, or 13.2% of sales, in the second quarter of last year. Research and development expenses which support the components and sensor segment increased to $4.6 million, or 6.7% of components and sensor segment sales, in the second quarter of 2011 compared to $4.3 million, or 6%, in the second quarter of 2010. As you know, our research and development efforts support the components and sensor segment and reflect our ongoing commitment to technology advancement and the new product growth initiative.

In the second quarter, we incurred some severance-related restructuring charges, approximately $700,000, primarily to facilitate the synergistic integration of our Fordahl acquisition to further streamline the operations and improve our cost structure. In addition, in the quarter we incurred higher-than-normal legal expenses of approximately $350,000, of which a significant portion was related to expenses we are incurring to protect our technology from others who are infringing on our patents.

Total operating earnings were $4.5 million, or 3.1% of sales compared to $7.7 million, or 5.6% of sales, in the second quarter 2010. Total second quarter 2011 interest and other income was $0.5 million income, which includes interest income, interest expense, and currency translation gains. The improvement over second quarter 2010 is primarily due to currency gains, offset by slightly higher interest expense.

The effective tax rate for second quarter 2011 was 17.9% compared to 18.8% in the second quarter of 2010. The decrease in the effective tax rate was primarily due to the change in the mix of earnings by jurisdiction, as well as some discrete items. For full year 2011, the effective tax rate is expected to be in the range of 22% to 24%.

Second quarter 2011 net earnings were $4.1 million, or $0.12 per diluted share. Excluding the restructuring charges and the higher-than-normal legal expenses, adjusted net earnings were $4.8 million, or $0.14 per share, compared to net earnings of $5.9 million, or $0.17 per diluted share, in the second quarter of 2010.

Now I will turn the focus to our balance sheet. Before I proceed with the traditional update, I want to address two items that are part of the overall balance sheet activity. First, during the second quarter, a fire occurred in one of our EMS facilities that has temporarily disrupted manufacturing at this site. We have filed an insurance claim and set up a fire-related other receivable within our current assets. We do not expect to have any material impact on our financials from this fire.

The second item is a small maintenance stock buyback that was triggered in June when we believed the lower stock price became a compelling value. We repurchased 35,500 shares at an average price of $9.19 per share under our existing program authorization. We have 942,000 shares left in our 1 million share buyback authorization as of the end of second quarter.

Now on to cash flow. Our second quarter cash flow from operating activities was $11.3 million and significantly improved over the $1 million in the same period last year, bringing the year-to-date cash from operations to $8.8 million. Capital expenditures were $3.4 million, or 2.3% of total sales, compared to $4.7 million, or 3.4% of sales, in the same period last year. Full-year 2011 capital expenditures are expected to be in the normal range, between 2.5% to 2.8% of sales.

Second quarter free cash flow, which is defined as net cash from operations less capital expenditures, was $8 million, and year-to-date free cash flow is $2.3 million. Based on the strong free cash flow achieved in the second quarter and actions in place to continue to tighten and manage our control over working capital, we anticipate 2011 full-year cash flow to be around $30 million.

Controllable working capital, which includes accounts receivable plus inventory less accounts payable, was 16.9% of annualized sales, improved from 17.3% in the first quarter, but still 1.6 percentage points higher than second quarter last year. Accounts receivable, at $87.8 million, is $8.6 million lower than prior quarter, reflecting the overall lower sequential sales. However, it's up $3.2 million from second quarter 2010.

Inventory at $88.6 million is slightly higher than first quarter and up $19.8 million from second quarter 2010, in support of the higher sales for the second half of the year 2011. We believe we have more room to improve and expect overall controllable working capital as a percentage of sales to be lower by year end 2011.

Cash and cash equivalents were $75.1 million for second quarter 2011, is up $9.8 million from last year's second quarter and is also up slightly from prior quarter. Long-term debt was $74.5 million, a decrease of $5.8 million from prior quarter. Our debt-to-capitalization ratio was 20.7% in second quarter 2011, improved from 22.2% in the first quarter.

This concludes the financial overview of our second quarter 2011 results. Even though the second quarter performance was impacted by temporary sales disruption related to the Japan earthquake, overall, the sales and earnings performance were in line with our internal expectations. We continue to manage our balance sheet and the organizational metrics to deliver growth to our shareholders.

With that, I will now open the call for questions. Thank you. Rachel, you can open the call.

(Operator Instructions.) John Franzreb, Sidoti and Company.

Did I hear you correctly when you said that the piezo product's going to begin to ship in the fourth quarter and not the third quarter? I was under the impression that it was going to be shipping in the third quarter. I don't know if I was wrong about that or if there's been a bit of a pushback.

No, there was no pushback. Technically, we'll actually start shipping in the third quarter, but the volumes will be pretty insignificant, and the real ramp begins in the fourth quarter. Actually, the customers are indicating that the volumes they need from us on the piezoceramics for a hard disk drive have increased. And they continue to increase their quantities needed from us for the next year. And we are, frankly, in the process of putting some additional equipment in place to ramp up production to meet their next year's demand.

What would the revenue contribution be from that in 2012?

John, we have seen numbers anywhere from $10 million to $15 million on the low end to closer to $20 million at the high end. We, frankly, are wondering if it can be that strong. You know that a number close to $20 million may almost double our piezoceramic sales. We continue to watch industry reports. There were some reports that hard disk drive sales next year are supposed to be very robust. You know the two key players in that space are Western Digital and Seagate. And we are, frankly, watching those numbers and trying to confirm that those volumes are as strong as they indicate.

Okay, great. And regarding the automotive sector, this morning it seems like Ford put a more temperate outlook about the second half build rate, both in the US and Europe. Could you just give us your sense of what the demand profile looks like in the automotive sector for the second half of the year compared to what you were thinking about three months ago?

The data we are seeing from the industry research firms still indicate that on a global basis, the volumes in the second half of the year would be 4% or 5% higher than the first half. A couple of comments I will make is, one, we do have global customers. And so we track global production volumes more than just the North American light vehicle, which may be affecting Ford more than us looking at the global number.

The second is, as you know, we have a disproportionately large percent of our sales focused on Japanese OEMs on their global platforms, and that is the reason we're probably affected more in the second quarter. The flip side is that we are expecting those volumes to really ramp up in the fourth quarter, as all their production capacity comes onstream and, frankly, I'm expecting them to further increase those volumes to try to fill up their inventory pipeline. So we should benefit more in the fourth quarter because we are more concentrated on OEMs like Honda and Toyota and Nissan.

In your prepared remarks, I don't recall if it was you or Donna, that somebody mentioned that the legal expenses were related to patent infringements. Is that you're protecting yourself from patent infringements, or somebody's already infringing on some of your patents?

I'm glad you asked that question, because it gives me an opportunity to clarify that. You know, John, that in the last three or four years, CTS has increased its focus on R&D, and we have frequently reported a clear increase in not only the patents which have been granted to us, but the filings. Our patent filings are running at normally twice the rate of our patent grants, which means that the pipeline is full and we're going to get a lot more patents awarded to CTS in the next 12 to 18 months.

As we get more intellectual property, we are increasing our efforts to make sure that people are not infringing on our patents. And in the last couple of years, we have found two fairly large corporations, global companies, who we believe are infringing on some of our patents. And we decided to spend a little bit of money to go after them and try to enforce and try to recover some royalty revenues from them. And so since we concluded that we have a very high probability of winning those, we decided to incur some expenses in the second quarter, and may yet incur some expenses in the third quarter, because we believe that we should be able to get our fair compensation from these companies who are using our patents.

Care to share what product lines they are?

These are all electronic components.

Okay. I'll get back into queue. Thank you.

Hendi Susanto, Gabelli and Company.

Hey, Donna, my first question is I believe that the free cash flow target of $30 million is lower than the earlier target of $30 million to $35 million. Would you discuss that again?

The $30 million would be on the low end of the range. In the prior guidance, we said it was between $30 million to $35 million. We could still get up to $35 million, but I just said, in terms of pinpointing the number, I said we'd get free cash flow around $30 million. But it could be a couple million higher than that. It all depends on timing.

So other than timing, there's no other reason.

Right. Other than timing, there's no other reason for it.

Yes, Hendi, I don't want you to read much more than the fact that last quarter we described it as $30 million to $35 million, and now we are describing it approximately $30 million. The guidance roughly is the same.

Okay. Yes. Vinod, do you have any update on your effort to win the second hard disk drive maker?

We have continued the discussion, and we are continuing to do some preliminary work like prototype work and those kind of things. And right now, we have, frankly, not pushed it a lot more, because we are struggling to put enough capacity in place to take care of the growing demand of the hard disk drive next year. But we have discussions continuing with the second one also.

Okay. And Vinod, where do you see strength in the industrial market and communication market, especially to be on communication market, like many companies have talked about strength in wireless infrastructure. And I wonder whether that's the case for CTS as well.

Hendi, our wireless infrastructure sales are fairly small considering our total sales of the Company. So because they are small, our sales will not necessarily move up or down in relation to the overall market because the market is so large. So it's very possible that if the market strengthens slightly or weakens slightly, our sales may not follow that pattern because our sales will be driven more by the programs and projects we win. And we may get a project in Asia which may give us a little strength in our sales, even if the overall industry is flat to down. Vice versa, if one of our projects gets pushed out in China or India, and we will see some small reduction in our wireless infrastructure component despite the fact that the market is moving in a different direction.

So overall, it's more a project-related, lumpy kind of sales. If I track that based on either the design wins or the percent of share we are getting from some of our more significant customers like Alcatel-Lucent, then I would report that on both of those fronts, we are doing better than prior years.

Okay. And then you also saw like higher sales in the industrial market. Where did those strengths come from?

The industrial market, the comment I made was primarily geared towards EMS.

Okay.

And we are seeing different customers. We have a large customer which makes large CMC machines, or machining centers, or cutting machines. And we are seeing strength there. It's a very global customer. We also have a couple of new customers. One customer makes electric vehicle charging stations in California, and we started shipping to that customer. The third customer which helped us makes control systems for home electronics, and again, a brand-new customer. And this was the first quarter we started shipping to that customer. And so a combination of new customers in industrial and some of our existing customers in the CMC machining kind of a business showing strength.

Do you expect all this to continue into the second half, do you know?

Yes, the current indications are that there should be steady improvement in the second half.

Okay. And then the last question, you have like low-cost facilities in Mexico and Thailand and a new facility in India. How much cost advantage will you have in those facilities?

You're not supposed to ask me tough questions like that, Hendi. Overall, you are correct. We are doubling our Thailand facility, which will come onstream in September or October timeframe. You are also correct that our small India manufacturing facility will come online by the end of this year, so it should benefit next year. And we are growing in Mexico.

Overall, these are the initiatives, combined with moving our segment mix in favor of component sensors, should help us show gross margins to improve year over year next year and beyond. We have not in the past, and we prefer not to, quantify that how much of the margin improvement will come because the mix will move towards the lower-cost facilities, and how much of it will come because we are projected to sell more and more component sensor product like the smart actuators and piezos.

Thank you.

Ken Nagy, Zacks Investment.

Just to follow up, with the expansion of facilities in Mexico and Thailand and India and the new manufacturing in India, I was just wondering what that's going to do to the cost structure and what kind of timeframe.

Okay. Ken, the India factory, we are putting together that facility, frankly, not to drive the cost structure, because we have very little sales going into India, and as India automotive industry and light vehicle industry begins to implement their version of Euro III and Euro IV emission standards, their vehicle will require the kind of sensors which CTS manufactures. Because, as you know, our automotive sensors are primarily driven towards either meeting tougher emission standards or fuel economy.

And the India manufacturing facility is primarily going in there to drive new sales in India. We have some sales going into India which we today ship to customers in Europe, and they take it into India. And they have come to us and said that, "Because of duty structures in India, we would very much like, as we see those sales growing, we would very much like CTS to manufacture that product inside India to avoid the import duties and things like that."

So we're starting with that, and we are in discussions with several large OEMs in India. And they are aware that our factory is going up there. And, frankly, that factory will primarily help the corporation drive more sales into that country, which we don't have today.

Okay. That clarifies things. Thank you.

(Operator Instructions.) John Franzreb, Sidoti and Company.

Could we just touch on the EMS business a bit? It's finally moved into the black, and I'm wondering, based on the schedule runs, if that trend will continue for the balance of the year. Could you just provide a little bit more color commentary on the profit level expectations for EMS for the balance of 2011?

Good. Yes, a very valid question, John. We absolutely expect EMS to perform at a much higher level in the second half than the first half. And my expectation is also that that improvement should be seen in every quarter. So Q3 should sequentially improve, and Q4 should sequentially improve, top and bottom line.

Will that be driven by a particular strength in one industry that EMS is serving relative to another, or are you expecting a rising tide scenario?

We're just expecting a rising tide in the sense that these are the businesses we have already won. And John, we are in the process of launching them. So I'm not counting on any new business to be won to get there. We are expecting to show higher sales because of our new business, not necessarily due to macroeconomic conditions.

And the bottom line has to improve. As you know, that the bottom line is below our historical level, and we have taken steps in the last several months and quarters to revisit our pricing, revisit our overall cost structure to make sure that the margin profile also improves in our EMS business overall.

Okay, thank you very much, Vinod.

(Operator Instructions.)

Okay, I'd like to give comments now. I would like to remind our listeners that a replay of this conference call will be available from 1.30 p.m. Eastern Daylight Time today to 11.59 p.m. on Monday, August 1, 2011. The telephone number for the replay is 800-475-6701, or 320-365-3844 if calling from outside the US. The access code is 209869. Thank you for joining us today.

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.