Kieran O'Sullivan - Chairman, President and CEO Ashish Agrawal - VP and CFO.

John Franzreb - Sidoti & Company Hendi Susanto - Gabelli & Company.

Good day, and welcome to the CTS Corporation Second Quarter 2018 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Kieran O’Sullivan. Please go ahead..

Thank you, Stephanie. Good morning, and thank you for joining us today, and welcome to CTS' Second quarter 2018 conference call. The following are some notable items for the quarter. Second quarter sales were $118 million, up from $105.7 million in the same period last year. Gross margins were 35.4% compared to 33.9% in the second quarter of last year.

Adjusted earnings per share were $0.39 compared to $0.28 in the same quarter of 2017. Adjusted EBITDA was 19.6%, up from 18.4% in the second quarter of 2017. Total book business increased to $1.8 billion and we added 4 new customers in the quarter. The transition of our ERP system is progressing, as we switched on our first location in early July.

The transition of manufacturing operations is tracking with the consolidation of our Illinois locations and the end of production in Elkhart in the second half of 2018. Ashish Agrawal is with me for today's call and will take us through the safe harbor statement.

Ashish?.

I would like to remind our listeners that this 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 is contained in the press release issued today 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 under Regulation G, the required explanations and reconciliations are available in the Investor section of the CTS website. I will now turn the discussion back over to our CEO, Kieran O’Sullivan..

Thank you, Ashish. Second quarter sales were $118 million, up 11.7% compared to the same quarter last year. Our organic growth rate was 10.9%. Gross margins were 35.4% compared to 33.9% in the second quarter of 2017.

We are pleased to see 150 point - basis point improvement in our gross margins from the first quarter of 2018, and we continue to focus on driving profitable growth. As previously reported, we implemented extra controls to protect our customers during the transfer of production.

As we advance our vision of being a leading provider of sensing and motion devices and connectivity components, we continue to gain traction with our customers.

Most recently, we renewed a supply agreement with a large industrial customer to supply microactuators for an additional 3-year period, driven by our deep expertise in material composition and quality.

Our accelerator e-pedal, was featured in automotive news, enabling an electric vehicle to be greener by using innovations to boost energy savings, increase performance and reduce harmful emissions, while protecting our environment in line with our brand.

We ended the quarter with a total book-to-business of $1.8 billion, up from $1.76 billion in the first quarter. We had a solid quarter with success in the market driven primarily by 2 wins for accelerator pedals, 1 for North America and 1 in Asia.

We received 10 awards for sensor products from 4 customers and an increased demand from an existing customer for actuators. Electronic components, as already mentioned, we secured a 3-year contract extension with an existing customer for our microactuation application in industrial printing with annual sales in excess of $15 million.

We added 4 new customers in the quarter in our electronic component product lines, 2 new customers in North America, 1 for RF filter product, 1 for EMC product, and we also added a new customer for our Noliac acquisition for water flow metering. The combined annual run rate for these products is approximately $1 million.

We also added a new customer for a military application with initial revenues of 200k in 2018 building to a total award of $2 million in sales. We continue to target further progress in our end market profile in line with our strategy for profitable growth for technologies and products that sense, connect and move.

We're working our M&A pipeline to meet our growth objectives with a continued focus on international expansion. Our renewed energy and focus on innovation is moving forward, as we funded several new projects and added to our advanced development activities. As you will recall, last quarter, we mentioned the impact of steel and aluminum tariffs.

We are carefully following the development on various additional rounds of tariffs. Based on current information, we anticipate a low single-digit percentage of our sales to be subject to tariffs. We're working closely with our customers and will continue to do so as more information becomes available.

We are also monitoring the potential for vehicle tariffs announced in early July and other developments. We are seeing global shortages for multilayer ceramic capacitors and resins, which are creating some headwinds on the material pricing.

As highlighted in our opening comments, the transition of manufacturing operations is progressing in line with our expectations. The largest product line began production recently in Matamoros and will gradually ramp up volumes.

The Lisle facility build-out has advanced adequately to receive the first furnace runs for single crystal boule production in the second half of this year. The implementation of our new SAP system has begun. Our project team worked diligently to go live with our first location.

This is a new way of working for our teams, as we share lessons learned from the experience to make our future activities more robust. This implementation phase will continue to require our teams to balance day-to-day running of the business with learning the new system and process. Most end markets remain robust, despite the ongoing tariff concerns.

Automotive volumes remained steady and are expected to be in the 16.7 million to 17.2 million unit range for North America, 22 million to 23 million for Europe and 28 million to 28.5 million for China. We expect minimal impact due to the reduced output in the Japanese market from the recent floods.

Industry analysts have projected the North American market will end the year below the 70 million unit mark for the first time since 2014. Concerns are focused on record vehicle prices and rising interest rates pointing to a market contraction.

Meanwhile, tax reform has raised take-home pay, consumer confidence is high plus a strong job market allows consumers to commit to vehicle purchases. Electronic component end markets are solid with some allocation issues being managed in our supply chains. Industrial, defense and medical end markets are providing us double-digit growth rates.

We are increasing our guidance for the full year 2018. We expect sales to be in the range of $450 million to $465 million and adjusted earnings are expected to be in the range of $1.40 to $1.55. I'll hand over to Ashish to take you through the results in more detail.

Ashish?.

Thank you, Kieran. Second quarter sales were $118 million, up 11.7% versus the prior year. Foreign currency rates impacted sales favorably by $1.8 million. Organic sales growth was 10.9%. Sales to transportation customers increased by 7.5% and sales of electronic components increased by 19.3%.

Our gross margin for the second quarter was 35.4% compared to 33.9% in the second quarter of 2017. In the quarter, we realized approximately $700,000 in savings related to product line transfers. For the full year, we expect savings in the range of $2.5 million to $3.5 million.

SG&A expenses were $19.6 million or 16.6% of sales in the second quarter of 2018, compared to 15% of sales in the second quarter last year. Included in the SG&A expenses is a charge of $950,000 for environmental remediation at one of our older facilities in Asia. We expect to complete the remediation in early 2019.

We also incurred $0.5 million for tax projects, had a full quarter of costs from the Noliac acquisition including amortization and operating expenses, higher equity-based compensation expense and an unfavorable impact from noncash pension expense.

The total change in pension expense is an unfavorable impact of $600,000 compared to second quarter of 2017. Organic investments remain a key priority. We spent $6.5 million on R&D in the second quarter of 2018, an increase of $400,000 versus last year. Our effective income tax rate in the second quarter of 2018 was 37.7%.

We recorded $1.7 million in tax expense related to repatriation of cash from Taiwan. We completed one of our simplification projects in the second quarter. This will improve our tax rate by 0.5% in 2018 and another 0.5% in 2019. Work is progressing on other projects that will further improve our ongoing tax rate.

Our expectation for our 2018 tax rate is to be in the range of 24% to 27% excluding discrete items. Our second quarter earnings were $0.21 per diluted share. Excluding restructuring, currency and other onetime items, adjusted earnings per diluted share were $0.39 in the second quarter of 2018.

This represents a 39% increase compared to the second quarter of last year. Now I'll discuss the balance sheet and cash flow. Cash and cash equivalents were $102.9 million on June 30, 2018, compared to $113.6 million at the end of 2017. Our long-term debt balance was $57 million at June 30, 2018, down from $76.3 million at December 31, 2017.

Our debt-to-capitalization ratio was 13.5% compared to 18.2% at the end of 2017. During the quarter, we repatriated $22 million from Taiwan. This cash was used to pay down our long-term debt. Our controllable working capital as a percentage of sales increased to 13.9% in the second quarter of 2018 from 12.3% in the first quarter.

This increase included the planned build in safety stock related to our manufacturing transfers. We expect to begin working our inventory levels down towards the end of 2018. Cash flow from operations in the second quarter was $7.6 million, down from $13.5 million in 2017. Capital expenditures were $8 million.

As we have communicated in the past, we expect 2018 CapEx to be in the range of 7% to 9% of sales. As we work through various projects, it is possible that the timing of certain cash outflows might move into 2019. We will give you further updates in our future earnings calls.

As Kieran mentioned a moment ago, we went live with SAP at our first site earlier this month. We expect to go live at our other sites in phases over the course of this year and the first half of 2019. We will keep you informed of our progress. This concludes our prepared comments. We would like to open the line for questions at this time..

[Operator Instructions] Our first question - John, your line is on..

I wanted to start with the topline. Really surprising 19.3% electronic component growth.

Can you just talk a little bit about the drivers there?.

Yes, some of the big drivers, John, are the medical end markets, where we continue to grow with our single crystal. Industrial markets, printing is one of the things we highlighted there that helps us as well. And RF filters is a growing product line for us. And so pretty strong.

And then in the military and defense area, we've been taking shares, as we said last year, and continuing to pick up momentum in those areas as well. And we're pretty pleased, John, also with the transportation, up about 7.5%..

I'll get to that, Kieran.

So would you think this is just easier comp for electronic components? Or is this sustainable kind of a revenue profile for the business now?.

I would say, John, our targeted growth rate is 10% and there's the organic rate, as we said, was 10.9%. The comps get a little tougher in the second half of this year, so we got more work to do. But we - you can see our guidance, so we're getting a little stronger every year, every quarter.

And we've, obviously, got some more work to do to keep that momentum..

And regarding the transportation side of business.

Could you discuss how much of the driver there is growth in different geographies versus growth in new program - new programs that you're adding to the mix?.

I would say, John, it's really more penetration of existing products that we have. We have some new products coming through in the pipeline that we're expecting to get awards on. But really, it's penetration of the existing mix across the different regions. And obviously, some of those are next-generation awards we got a few years ago as well..

Yes, John, and just keep in mind that in the transportation end market, the revenue that's coming online now are awards that we would have won 2 to 3 years ago..

So there's very little cannibalization here.

It's really - it's just new programs that you've won that are finally coming online?.

Correct..

Yes, we've had share gains in the past few years, which is helping us grow better than the market at this point..

Now can you just quickly discuss how much of your business mix in transportation is regular ground vehicles versus, maybe, the Class 8 truck market, there's certainly different growth profiles in those businesses?.

So something close to about 13%, 14% is on the bigger trucks..

John, we don't go on Class 8s. The products that Kieran is talking about would be primarily focused on smaller trucks as well as very heavy-duty pickup trucks as well..

And I guess, I just want to make sure, I kind of want to get 2 quick updates here. I'm going ask a couple of questions, I guess.

One of the transfer deductions, would you say that you're ahead of where you expected to be at this point, or you're just on target?.

John, if you look back over since we made the announcement in 2016, at one point in early '17, we said, we were moving out one product line a little bit by - what we implied was just a few months. And to that revised plan, we're very much on track. We're very pleased how it's going.

We're very pleased that we've got the largest product line already ramping up in a new location with several other products already transferred. And we've got a bit more to do here towards the end of the year, second half.

But very pleased with that and then also with the Illinois consolidation, bringing the boule production into Lisle here, we've got a very controlled phased operation for that in terms of proving out because the climate control and everything else for that operation is pretty critical and making sure we've got the right yields.

So very pleased with how things are tracking this year..

Actually, I'll just follow-up to that topic and I'll get back into queue. Did I hear properly that you had $700,000 in savings from the program in the quarter, how does that compare to the first quarter? Is my question..

John, we did have some savings in the first quarter as well and that's included in our overall estimate that I mentioned for the year, $2.5 million to $3.5 million for the year..

Well, exactly, Ashish, that's actually kind of where I'm walking to, is that - if it's $700,000 and maybe $300,000 in the quarter, you got another $2 million of incremental savings coming to the gross margin line in the second half, is that how I should think about this?.

That would be pretty close to what you should be thinking about, yes..

[Operator Instructions] Our next questioner..

Ashish and Kieran, congrats on positive strong growth in the first half of 2018. Kieran, I think consider the new annual revenue guidance it implies that already growth may be lower than 10%, like first half growth was strong, it's above your long-term organic growth target of 5%. And you mentioned tough comparables with the second half of 2017.

But between, let's say, like 5% and 10% gap in the growth, like what should we be thinking about?.

So if you look at our guidance, Hendi, $450 million to $465 million that would give you a growth rate of somewhere between 6% and 10%. And as I mentioned, the comp rates will get a little tougher in the second half on an organic basis. But we haven't changed our goal of getting to - trying to get to 10%.

Obviously, as I said in the other question, still some more work to do there, but hopefully that helps you with the guidance..

And Hendi, we want to maintain a very close monitoring of the automotive end market. There are obvious concerns about the timing of a slowdown..

So what is your assumption in terms of the timing of slowdown in automotive market?.

When we look at Europe, we're not so concerned about it. We look at North America, it was more than $17 million last year. There is a bit of a range out there. We think it should soften a little bit maybe to the high-16s. And then, of course, with all the tariffs stuff, we're a bit concerned about what's going on in Asia and how that will come out.

So it sounds like it could be flat overall, it would be a good place..

And then Ashish, I think, it's quite encouraging to see gross margin to be above, like, 35%. And with regard to the cost initiatives that you are doing and then the state of the company.

How sustainable is that gross margin with regard to that 35% mark?.

Hendi, the gross margin range that we have quoted in the past, 34% to 37%, not revising that we feel good about our capability to continue working on improving our gross margin as we go forward, with the savings from the production transition as well as operational efficiency that we continue driving towards.

Kieran mentioned some pressure on commodity pricing that we are dealing with and that's included in our guidance range. And we also keep watching currency movement. So those are some of the things that can influence us in the short term.

And Kieran also mentioned that we have implemented additional controls to manage quality better through the production transitions. And as we get more robust at the receiving locations, I would expect us to get some improvement there as well..

Hendi, just the other comment on the gross margin, so you kind of get a perspective on everything that Ashish has said. On the last 2 earnings call, we said, we were disappointed with our gross margins. So we're happy that we're getting back on an improving trend and we've got more work to do..

Yes, so the impact of the tariff, the low single-digit exposure has been taken into account in your guidance?.

Yes, if you - just what we are talking about tariffs to give you a little bit color on that. We talked in the last quarter about the impacts of aluminum. We said somewhere in the $0.5 million range. And as we look at the - not just the cost side of it, but also on the sales side of it, low single-digit is what we're seeing.

We're obviously monitoring that and it's a moving target at the moment. Feel a little bit positive about the comments. We're optimistic about the comments that came out yesterday with Europe. But let's see..

Okay..

And Ashish said, there's some headwinds on the material pricing that we're, obviously, working closely with our suppliers and our customers on as well..

And then if - and then you said that you are monitoring potential tariff on vehicles, if somehow that happens, what is - what will be the opportunity to mitigate that?.

Well, I think the biggest thing that helps us is that we've got presence globally in all the different regions. The question is what happens to the vehicle volumes, that's really our concern.

I was - we were watching the reports from the OEMs yesterday, the likes of GM saying, "Hey, they're going to get impacted on a profit basis." They weren't showing anything on the top line..

Our next questioner..

A quick follow-up. I didn't quite catch the number, the repatriation..

$22 million, John, that's the amount of cash we received back in the U.S..

$22 million. All right. And I haven't really got a chance to go through the cash flow statement. So I apologize. But it looks like cash didn't go up by whole heck of a lot in the quarter.

What's the big uses going on, is it inventory as you do the transition? Because I know you mentioned in your prepared comments something about delayed impact of realizing some of the cash flow benefit.

So can you just kind of walk me through what's going on there?.

Yes, so working capital you will see has gone up a little bit in the quarter as our sales are increasing, we see pressure on receivables obviously. And then we built some additional safety stock as we work through the product transition and that will start coming off towards the 2018 time frame into the first part of 2019.

And then CapEx was also higher than normal right at around $8 million for the quarter..

John, just going back to that repatriation, just so you know, some credits were expiring and by doing that, we're able to maximize the utilization of those credits before they expired. So we're trying to do - maximize the benefit for shareholders..

Thank you, Kieran..

Perfect. I guess, a little bit on that topic.

What kind of tax rate should we be assuming for the second half of the year then?.

John, if you look at our unusual tax item that we booked related to this cash repatriation, once we exclude that, we are very much in that range for the first half, the 24% to 27% that I gave. And that's what I'm expecting for the second half as well..

There are no additional questions at this time..

We'll just give it a minute or 30 seconds, in case there's any final question..

We do have an additional question..

Kieran, one question.

How active is your M&A pipeline now? You mentioned again and again that you are interested in expansion into other areas?.

Yes, Hendi, we continue to work it. Obviously, there's certain things we're looking at. We've got a healthy balance sheet that we need to deploy in the right way and just finding the right assets. So we're active, but nothing to report..

And then any update on turbo smart actuator?.

Sorry, Hendi, could you repeat the question?.

Any update on turbo smart actuator? Like....

With the smart actuator, we're doing pretty well. You can tell we're growing sales there from the percentage of what we talked about earlier like 13% to 14% of the total revenue, so - and working hard to add more customers as well..

There are no additional questions at this time..

Okay. Well, thank you all for joining us on the call today..

Thank you, ladies and gentlemen. This concludes the presentation. You may now disconnect..