CTS

Business Context and Reporting Period

Company: CTS Corporation
Filing Type: Form 10-Q (Unaudited)
Period Ended: July 1, 2007 (Second Quarter)
Business Overview: CTS is a global manufacturer of components and sensors (primarily automotive, communications, and computer markets) and provides Electronics Manufacturing Services (EMS). The company operates through two reportable segments: Components and Sensors, and Electronics Manufacturing Services.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Q2 2007 sales increased 2.2% ($3.7M) year-over-year, driven by a 4.9% increase in the EMS segment, partially offset by a 1.3% decline in Components and Sensors.
• Profitability: Operating earnings increased $346K in Q2 2007 compared to Q2 2006. However, for the six-month period, operating earnings decreased $2.3M due to higher SG&A expenses.
• Expense Increases: Selling, General, and Administrative (SG&A) expenses rose significantly ($1.7M in Q2; $6.6M in 6 months) primarily due to $2.1M (Q2) and $3.4M (6 months) in legal and accounting fees related to an ongoing accounting investigation.
• Restructuring: The company incurred no restructuring charges in 2007, compared to $920K in Q2 2006 and $2.88M in the first six months of 2006.
• Segment Performance: The Components and Sensors segment operating earnings declined $2.9M in Q2 2007 due to unfavorable product mix, operational inefficiencies at a new Czech Republic facility, and investigation costs. The EMS segment operating earnings improved $1.7M due to volume and mix improvements.

Guidance, Outlook, and Risks

• Full-Year 2007 Guidance: Management expects full-year sales to grow 5% - 6% over 2006. Diluted earnings per share are projected to be in the range of $0.71 to $0.75.
• Accounting Investigation: The company is under an informal inquiry by the SEC regarding accounting misstatements at its Moorpark and Santa Clara, California facilities. This has resulted in significant legal and accounting fees and a material weakness in internal controls over financial reporting.
• Internal Controls: Management determined that disclosure controls and procedures were not effective as of July 1, 2007, as remediation of the material weakness has not been fully tested. Actions taken include increased review of journal entries, removal of vendor setup access for controllers, and enhanced internal audit resources.
• Liquidity: The company maintains a $100 million revolving credit facility (expandable to $150 million) with no outstanding balance as of July 1, 2007. Total debt decreased to $61.5 million from $66.3 million at year-end 2006.
• Capital Allocation: The Board authorized a new share repurchase program for up to 2 million shares in June 2007. During the first half of 2007, the company repurchased 350,000 shares for $4.3 million.

Investor Verification Checklist

• Investigation Impact: Verify the status of the SEC informal inquiry and the potential for additional restatements or penalties beyond the $2.1M in Q2 fees.
• Internal Control Remediation: Monitor the testing and certification of the new internal controls to ensure the material weakness is fully remediated.
• Segment Margins: Assess the sustainability of the EMS segment's margin improvement versus the ongoing pressure on the Components and Sensors segment due to the Czech facility start-up and product mix.
• Inventory Levels: Review the $13.5M increase in inventory (noted in cash flow) to ensure it aligns with the "planned build-ahead" for customer programs and does not signal future write-downs.
• Debt Covenants: Confirm continued compliance with the leverage and fixed charge coverage ratios required by the revolving credit agreement.