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Item 7. Management’s Discussion and Analysis

2021-02-25 compared with 2020-02-20 · 75 added, 108 removed, 165 unchanged (53% of the section changed)

Management's Discussion and Analysis of Financial Condition and Results of Operations

This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019.

Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2019.

CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move.

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Move products ensure required movements are effectively and accurately executed.

We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories.

We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia.

We are committed to achieving our vision by continuing to invest in the development of products and technologies, and talent within these categories.

We manufacture sensors, actuators, and connectivity components in North America, Europe, and Asia.

CTS provides engineered products to OEMs and tier one suppliers in the aerospace and defense, industrial, information technology, medical, telecommunications, and transportation markets.

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We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets.

Impact of COVID-19

The COVID-19 pandemic has resulted in a significant disruption to the global economy that has and is likely to have continued adverse impact on our business.

We have experienced reductions in customer demand in several of our end markets.

We expect that social distancing measures, higher employee absenteeism, and reductions in production due to mandated labor capacity restrictions at some of our plants in Asia, Europe, and North America, as well as the reduced operational capacity of our customers and suppliers, could continue to impact our business into 2021.

As a result of these economic headwinds, we implemented cost savings measures throughout 2020, some of which were temporary in nature.

We continue to evaluate market conditions and the impact on our operations to determine the extent and duration of any future cost measures.

The pandemic could lead to additional extended disruptions of economic activity and the impact on our consolidated results of operations, financial position and cash flows could be material.

We remain cautious about the financial impact into 2021.

Results of Operations:

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(Amounts in thousands, except percentages and per share amounts):

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The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2020 , and December 31, 2019 :

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Operating earnings

Other (expense) income, net

Earnings before income tax

Total other income (expense), net

Earnings before taxes

Income tax expense

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Diluted net earnings per share

Sales were $468,999 for the year ended December 31, 2019 , a decrease of $1,484 , or 0.3% from 2018 .

Sales to transportation markets decreased $1,119 or 0.4%.

Sales to other markets decreased $364 or 0.2%.

The QTI acquisition, which was completed in July 2019, added $9,252 in sales for the year (see Note 19).

Changes in foreign exchange rates decreased sales by $5,135 year-over-year due to the U.S.

Dollar appreciating compared to the Chinese Renminbi and Euro.

Net sales were $424,066 for the year ended December 31, 2020, a decrease of $44,933, or 9.6% from 2019.

Net sales for 2020 were adversely impacted by lower volumes as a result of the COVID-19 pandemic and government activities to control its spread.

Specifically, mandated or selective plant closures due to the pandemic and related government activities drove weak demand in some end markets.

In addition, the activities had a significant impact on our supply chain.

We remain cautious about possible future disruptions on our supply chain, operations, and future demand.

Net sales to transportation markets decreased $57,559 or 19.3%.

Net sales to other markets increased $12,626 or 7.4%.

The QTI acquisition, which was completed in July 2019, added sales of $24,508 in 2020 compared to $9,252 in 2019.

Changes in foreign exchange rates increased net sales by $1,706 year-over-year primarily due to the U.S.

Dollar depreciating compared to the Chinese Renminbi and Euro.

Gross margin as a percent of sales was 32.8% in 2020 versus 33.6% in 2019.

The decrease in gross margin was driven primarily by lower volume, foundry inefficiency in our ceramics manufacturing operations, labor and commodity cost increases, a one-time purchase accounting step-up in the value of finished goods inventory acquired with our QTI acquisition, and an unfavorable impact from currency movements.

These were partially offset by cost improvement projects as well as savings from our manufacturing transition project.

The decrease in gross margin was driven primarily by lower sales volumes, which was partially offset by various cost reduction measures.

Selling, general and administrative ("SG&A") expenses were $67,787, or 16.0% of sales for the year ended December 31, 2020, versus $70,408 or 15.0% of sales in the comparable period of 2019.

The 2019 SG&A costs include amortization of intangibles and other operating costs associated with the QTI acquisition as well as higher environmental expenses, which were offset by

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lower short-term incentive compensation, the impact of cost reduction actions taken in the fourth quarter, and other cost controls during the year.

The 2020 SG&A costs include savings from cost reduction measures we implemented during the year, partially offset by a full year of amortization of intangibles and other operating costs associated with the QTI acquisition.

Research and development expenses were $24,317 or 5.7% of sales in 2020 compared to $25,967 or 5.5% of sales in 2019.

Restructuring charges were $ 7,448 for year ended December 31, 2019 .

The charges were mainly for building and equipment relocation, severance, and asset impairment charges related to the restructuring of certain operations, as well as a lease termination fee related to a property lease we acquired in the QTI acquisition.

Restructuring charges were $1,830 for year ended December 31, 2020 and were primarily as a result of certain initiatives initiated in the third quarter of 2020.

The restructuring actions are focused on optimizing our manufacturing footprint and improving operational efficiency by better utilizing our systems capabilities.

Restructuring charges were $7,448 in 2019.

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Interest income

Other (expense) income

Total other (expense) income, net

Interest expense increased mainly as a result of an increase in debt related to the QTI acquisition.

Other expense in 2019 was principally driven by foreign currency translation losses, mainly due to the appreciation of the U.S.

Dollar compared to the Chinese Renminbi and Euro, as well as an increase in pension expense.

Other income (expense)

Total other income (expense), net

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Interest expense increased mainly due to a higher average debt balance during 2020 related to the QTI acquisition and additional borrowings at the end of the first quarter to ensure adequate liquidity for the next several quarters in light of COVID-19 concerns .

Interest income declined as a result of lower interest rates on foreign cash balances.

The Other income, net for the twelve months ended December 31, 2020 was principally driven by foreign currency translation gains, mainly due to the depreciation of the U.S.

Dollar compared to the Chinese Renminbi and Euro, which were partially offset by pension expense.

Years Ended December 31,

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The effective income tax rate in 2020 was 23.7% compared to 28.1% in the prior year.

This decrease is primarily attributed to the change in the mix of earnings by jurisdiction, decreases in uncertain tax position and offset by the company's decision to no longer reinvest the earnings of its Taiwan subsidiary.

The tax rate in 2020 was higher than the U.S.

statutory federal tax rate primarily due to foreign earnings that are taxed at higher rates and unfavorable impacts to reserves.

The tax rate in 2019 was higher than the U.S.

statutory federal tax rate primarily due to foreign earnings that are taxed at higher rates, the impact of taxes on unremitted earnings and unfavorable increases to reserves.

The tax rate in 2018 was favorably impacted by a one-time rate change benefit related to the Tax Cuts and Jobs Act of 2017 resulting from the election of tax accounting method changes to accelerate deductions on the 2017 tax return, partially offset by a one-time withholding tax on repatriation of earnings from one of our foreign subsidiaries that was completed during the year to enable the use of tax credits due to expire in 2018.

Net earnings were $34,686 or $1.06 per diluted share for the year ended December 31, 2020 compared to earnings of $36,146 or $1.09 per diluted share in the comparable period of 2019.

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Results of Operations:

Years Ended December 31, 2018 , versus Year Ended December 31, 2017

(Amounts in thousands, except percentages and per share amounts):

The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2018, and December 31, 2017:

Years Ended December 31,

Percent of Net Sales

Cost of goods sold

Selling, general and administrative expenses

Research and development expenses

Restructuring charges

Loss on sale of assets

Total operating expenses

Operating earnings

Other income (expense), net

Earnings before income tax

Income tax expense

Diluted earnings per share:

Diluted net earnings per share

Sales were $470,483 for the year ended December 31, 2018, an increase of $47,490, or 11.2% from 2017.

Sales to transportation markets increased $24,873 or 9.0%.

Sales to other end markets increased $22,617 or 15.3%.

The Noliac acquisition added $9,463 in sales in 2018 and $7,084 in sales in 2017.

Changes in foreign exchange rates increased sales by $3,238 year-over-year due to the U.S.

Dollar depreciating compared to the Chinese Renminbi and Euro.

Gross margin as a percent of sales was 35.1% in 2018 versus 33.2% in 2017.

The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796, or 1.1% of sales.

The increase in gross margin was primarily driven by savings related to product line transfers and a favorable impact of foreign exchange rate movements which were partially offset by material cost increases.

Selling, general and administrative expenses were $73,569, or 15.6% of sales for the year ended December 31, 2018, versus $71,943 or 17.0% of sales in the comparable period of 2017.

The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 1.6% of sales.

The increase includes higher stock-based compensation and ERP implementation costs as well as incremental costs resulting from the Noliac acquisition in 2017, including amortization of intangibles.

Research and development expenses were $25,304 or 5.4% of sales in 2018 compared to $25,146 or 5.9% of sales in 2017.

The pension settlement charge recorded in the fourth quarter of 2017 impacted research and development expenses unfavorably by $2,062, or 0.5% of sales.

Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes.

Restructuring charges were $5,062 for year ended December 31, 2018.

The charges were mainly for building and equipment relocation, severance, and travel costs related to the restructuring of certain operations as part of the 2016 Restructuring Plan.

Restructuring charges were $4,139 in 2017.

The loss on sale of assets in 2017 was driven by a loss on the sale of vacant land at our Hopkinton, Massachusetts facility in September 2017.

Operating earnings were $61,038, or 13.0% of sales in 2018, compared to $38,495, or 9.1% of sales in 2017 as a result of the items discussed above.

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Other income and expense items are summarized in the following table:

Years Ended December 31,

Interest expense

Interest income

Other (expense) income

Total other (expense) income, net

Interest expense decreased in the year ended December 31, 2018, versus the same period in 2017 primarily due to lower debt balances, a reduction in interest related to interest rate swaps, and a one-time charge related to a liability that was settled in 2017.

Interest income increased due to higher interest rates.

Other expense in the year ended December 31, 2018, was driven by foreign currency translation losses mainly due to the appreciation of the U.S.

Dollar compared to the Chinese Renminbi and the Euro.

Other income in the year ended December 31, 2017 was driven mainly by foreign currency translation gains due to the depreciation of the U.S.

Dollar compared to the Chinese Renminbi and the Euro.

Years Ended December 31,

Effective tax rate

The effective income tax rate in 2018 was 19.9% compared to 64.1% in the prior year.

The tax rate in 2018 was favorably impacted by a discrete one-time rate change benefit related to the Tax Act resulting from the election of tax accounting method changes, partially offset by a one-time withholding tax on repatriation of earnings from one of our foreign subsidiaries that was completed during the year to enable the use of tax credits due to expire in 2018.

The tax rate in 2017 was unfavorably impacted by the application of the Tax Act, driven by the remeasurement of the net deferred tax assets from 35% to 21% and the one-time mandatory transition tax on the historical earnings of foreign affiliates, which resulted in a net non-cash charge of $18,001.

Net earnings were $46,532 or $1.39 per diluted share for the year ended December 31, 2018, compared to earnings of $14,448 or $0.43 per diluted share in the comparable period of 2017.

Liquidity and Capital Resources

Cash and cash equivalents were $91,773 at December 31, 2020, and $100,241 at December 31, 2019, of which $90,051 and $98,309 respectively, were held outside the United States.

The decrease in cash and cash equivalents of $692 was primarily driven by cash generated from operating activities of $64,405 and net proceeds from an increase in borrowings of long-term debt of $49,700, which were offset by the payment for the QTI acquisition of $73,906, capital expenditures of $21,733, treasury stock purchases of $11,746, dividends paid of $5,238, and taxes paid on behalf of equity award participants of $2,657.

The decrease in cash and cash equivalents of $8,468 was primarily driven by net payments of long-term debt of $45,100, capital expenditures of $14,858, payments for the SSI acquisition of $8,309, treasury stock purchases of $8,080, and dividends paid of $5,179, which were partially offset by cash generated from operating activities of $76,783.

Total debt as of December 31, 2020, and December 31, 2019, was $54,600 and $99,700, respectively.

Total debt as a percentage of total capitalization, defined as long-term debt as a percentage of total debt and shareholders’ equity, was 11.4% at December 31, 2020, compared to 19.7% at December 31, 2019.

Working capital increased by $5,164 from December 31, 2018 , to December 31, 2019 , driven mainly by the decrease in accrued payroll and benefits due to lower short-term incentive compensation and the decrease in accounts payable, which were partially offset by an increase in operating lease obligations.

Working capital decreased by $12,231 from December 31, 2019, to December 31, 2020, driven mainly by the decrease in cash and cash equivalents related to the items noted above.

Cash Flows from Operating Activities

Net cash provided by operating activities was $76,783 during the year ended December 31, 2020.

Components of net cash provided by operating activities included net earnings of $36,146 , depreciation and amortization expense of $24,619 , stock-based compensation of $5,015, other net non-cash items totaling $5,160, and a net cash outflow from changes in assets and liabilities of $6,535.

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Components of net cash provided by operating activities included net earnings of $34,686, depreciation and amortization expense of $26,670, stock-based compensation of $3,417, other net non-cash items totaling $930, and a net cash inflow from changes in assets and liabilities of $10,064.

Cash Flows from Investing Activities

Net cash used in investing activities for the year ended December 31, 2019 , was $95,502 , driven by the payment for the QTI acquisition of $73,906 and capital expenditures of $21,733 .

Net cash used in investing activities for the year ended December 31, 2020 was $23,167, driven by capital expenditures of $14,858 and the payment for the Sensor Scientific, Inc.

(“SSI”) acquisition of $8,309.

See Note 3 "Business Acquisitions" in the Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.

Cash Flows from Financing Activities

Net cash provided by financing activities for the year ended December 31, 2019 , was $30,059 .

The net cash inflow was the result of net proceeds from an increase in borrowings of long-term debt of $49,700, which was partially offset by treasury stock purchases of $11,746, dividend payments of $5,238 , and taxes paid on behalf of equity award participants of $2,657.

Net cash used in financing activities for the year ended December 31, 2020, was $61,333.

The net cash outflow was the result of net payments of long-term debt of $45,100, treasury stock purchases of $8,080, dividend payments of $5,179, taxes paid on behalf of equity award participants of $1,917, and a contingent consideration payment of $1,057.

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Capital Resources

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Standby letters of credit

Amount available

Amount available, subject to covenant restrictions

Weighted-average interest rate

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We also pay a quarterly commitment fee on the unused portion of the Revolving Credit Facility.

The commitment fee ranges from 0.20% to 0.30% based on the our total leverage ratio.

The commitment fee ranges from 0.20% to 0.30% based on our total leverage ratio.

We have entered into interest rate swap agreements to fix interest rates on $50,000 of long-term debt through February 2024.

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The following accounting policies comprise those that we believe are the most critical in understanding and evaluating our reported financial results.

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Revenue Recognition

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Provisions for estimated warranty expenses primarily related to our automotive products are made at the time products are sold.

These estimates are established using a quoted industry rate.

These estimates are established either using a quoted industry rate or based on customer specific circumstances.

We adjust our warranty reserve for any known or anticipated warranty claims as new information becomes available.

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We believe our reserve level is appropriate considering all facts and circumstances surrounding any outstanding quality claims and our historical experience selling our products to our customers.

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Accounts Receivable

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• Limited credit insurance on the majority of our international receivables.

We reserve for estimated credit losses based upon historical experience and specific customer collection issues.

We reserve for estimated credit losses based on historical experience, specific customer collection issues, current conditions and reasonable and supportable forecasts that affect the collectability of the remaining cash flows over the contractual terms of our receivables and other financial assets.

Over the last three years, accounts receivable reserves have ranged from 0.1% to 1.1% of total accounts receivable.

We believe our reserve level is appropriate considering the quality of the portfolio.

While credit losses have historically been within expectations of the reserves established, we cannot guarantee that our credit loss experience will continue to be consistent with historical experience.

We value our inventories at the lower of the actual cost to purchase or manufacture using the first-in, first-out ("FIFO") method, or net realizable value.

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Changes in the actuarial assumptions could have a material effect on our results of operations.

In February 2020, the CTS Board of Directors authorized management to explore termination of our U.S.

Pension Plan (“Plan”) at management's discretion, subject to certain conditions.

On June 1, 2020, we amended the Plan whereby we set an effective termination date of July 31, 2020.

In February 2021, we received the determination letter from the Internal Revenue Service that allows us to proceed with the termination process.

The completion of the Plan termination process, including offering lump sum settlements and the final purchases of annuities, is expected to occur in 2021.

Since the amount of the settlement depends on a number of factors determined as of the liquidation date, including lump sum payout estimates, the annuity pricing interest rate environment and asset experience, we are currently unable to determine the ultimate cost of the settlement.

However, w e expect non-cash settlement charges of approximately $10,000 to $20,000 to be recognized in the second or third quarter of 2021 with the remaining amount of the gross accumulated other comprehensive loss balance to be recognized by the end of 2021.

We do not expect any cash contributions from the Company to the Plan as a result of this termination because plan assets significantly exceed estimated liabilities.

Impairment of Goodwill

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Examples of such events or circumstances include, but are not limited to, the following:

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• Significant decline in market capitalization relative to net book value,

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• More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of,

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• Testing for recoverability of a significant asset group within a reporting unit, and

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If a quantitative assessment is required, we estimate the fair value of each reporting unit using a combination of discounted cash flow analysis and market-based valuation methodologies.

Determining fair value using a quantitative approach requires significant judgment, including judgments about projected revenues, operating expenses, working capital investment, capital expenditures, and cash flows over a multi-year period.

Determining fair value using a quantitative approach requires significant judgment, including judgments about projected revenues, cash flows over a multi-year period, discount rates and estimated valuation multiples.

The discount rate applied to our forecasts of future cash flows is based on our estimated weighted average cost of capital.

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Changes in these estimates and assumptions could materially affect the determination of fair value and impact the goodwill impairment assessment.

Our latest assessment was performed using a qualitative approach as of October 1, 2019 , and we determined that it was likely that the fair values of our reporting units were more than their carrying amounts, and therefore no impairment charges were recorded.

We typically perform a quantitative assessment at least every three years, or as conditions require.

Our previous quantitative test was in 2017, therefore, we performed the current year assessment using a quantitative approach .

Based upon our latest assessment, we determined that our goodwill was not impaired as of October 1, 2020.

We will monitor future results and will perform a test if indicators trigger an impairment review.

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If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value.

No indicators of impairment were identified during the year ended December 31, 2019 .

We recorded a charge of $1,016 during the first quarter due to the impairment of a specific asset group.

In addition, we recorded a charge of $2,200 during the third quarter of 2020 due to the impairment of a specific asset group as a result of the restructuring actions being taken.

No other indicators of impairment were identified during the year ended December 31, 2020.

Environmental and Legal Contingencies

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Changes in laws, regulatory orders, cost estimates, participation of other parties, timing of payments, input of attorneys and consultants, or other circumstances may have a material impact on the recorded liability.

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Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid.

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The assumptions about future taxable income require the use of significant judgment and are consistent with the plans and estimates we are using to manage our underlying businesses.

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The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our global operations.

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Our practice is to recognize interest and penalties related to income tax matters as part of income tax expense.

Generally, outside of Canada and the United Kingdom, it has been our historical practice to permanently reinvest the earnings of our non-U.S.

subsidiaries in those operations.

As previously noted, the Tax Act made significant changes to the taxation of undistributed foreign earnings, requiring that all previously untaxed earnings and profits of our controlled foreign corporation be subjected to a one-time mandatory deemed repatriation tax.

The transition tax substantially eliminated the basis difference that existed prior to the Tax Act.

However, there are limited other taxes that could continue to apply such as foreign withholding and certain state taxes.

We completed the evaluation of our indefinite reinvestment assertion as a result of the Tax Act during the fourth quarter of 2018 and decided not to reinvest the current year earnings of our primary operations, except for in the Czech Republic, Denmark, India, Mexico and Taiwan.

We intend to continue to indefinitely reinvest the earnings in these non-U.S.

subsidiaries.

Following the enactment of the 2017 Tax Cut and Jobs Act and the associated one-time transition tax, in general, repatriation of foreign earnings to the U.S.

can be completed with no incremental U.S.

However, there are limited other taxes that continue to apply such as foreign withholding and certain state taxes.

The company records a deferred liability for the estimated foreign earnings and state tax cost associated with the undistributed foreign earnings that are not permanently reinvested.

Contractual Obligations

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Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements.

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis