CTS CORP 10-K

Item 7. 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. Overview CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. 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, 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. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. 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: Year Ended December 31, 2020 versus Year Ended December 31, 2019 (Amounts in thousands, except percentages and per share amounts): CTS CORPORATION 18 Table of Contents 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 : Years Ended December 31, Percent of Net Sales 2020 2019 Percent Change 2020 2019 Net sales $ 424,066 $ 468,999 (9.6) 100.0 100.0 Cost of goods sold 285,003 311,424 (8.5) 67.2 66.4 Gross margin 139,063 157,575 (11.7) 32.8 33.6 Selling, general and administrative expenses 67,787 70,408 (3.7) 16.0 15.0 Research and development expenses 24,317 25,967 (6.4) 5.7 5.5 Restructuring charges 1,830 7,448 (75.4) 0.4 1.6 Gain on sale of assets — (63) — — — Total operating expenses 93,934 103,760 (9.5) 22.2 22.1 Operating earnings 45,129 53,815 (16.1) 10.6 11.5 Total other income (expense), net 350 (3,549) (109.9) 0.1 (0.8) Earnings before taxes 45,479 50,266 (9.5) 10.7 10.7 Income tax expense 10,793 14,120 (23.6) 2.5 3.0 Net earnings $ 34,686 $ 36,146 (4.0) 8.2 7.7 Diluted earnings per share: Diluted net earnings per share $ 1.06 $ 1.09 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 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 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 $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. Operating earnings were $45,129, or 10.6% of sales in 2020, compared to $53,815, or 11.5% of sales in 2019 as a result of the items discussed above. Other income and expense items are summarized in the following table: Years Ended December 31, 2020 2019 Interest expense $ (3,272) $ (2,648) Interest income 1,047 1,737 Other income (expense) 2,575 (2,638) Total other income (expense), net $ 350 $ (3,549) CTS CORPORATION 19 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, 2020 2019 Effective tax rate 23.7% 28.1% 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. 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. 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 $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 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 $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, 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 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. CTS CORPORATION 20 Table of Contents Capital Resources Long-term debt was comprised of the following: As of December 31, 2020 2019 Total credit facility $ 300,000 $ 300,000 Balance Outstanding $ 54,600 $ 99,700 Standby letters of credit $ 1,740 $ 1,800 Amount available, subject to covenant restrictions $ 243,660 $ 198,500 Weighted-average interest rate 1.92% 3.25% Commitment fee percentage per annum 0.23% 0.23% On February 12, 2019, we entered into an amended and restated five-year Credit Agreement with a group of banks (the "Credit Agreement") to extend the term of the facility. The Credit Agreement provides for a revolving credit facility of $300,000, which may be increased by $150,000 at the request of the Company, subject to the administrative agent's approval. This new unsecured credit facility replaces the prior $300,000 unsecured credit facility, which would have expired August 10, 2020. Borrowings of $50,000 under the prior credit agreement were refinanced into the Credit Agreement. The prior agreement was terminated as of February 12, 2019. The Revolving Credit Facility includes a swing line sublimit of $15,000 and a letter of credit sublimit of $10,000. Borrowings under the Revolving Credit Facility bear interest at the base rate defined in the Credit Agreement. 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 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. The difference to be paid or received under the terms of the swap agreements is recognized as an adjustment to interest expense when settled. We have historically funded our capital and operating needs primarily through cash flows from operating activities, supported by available credit under our Revolving Credit Facility. We believe that cash flows from operating activities and available borrowings under our Revolving Credit Facility will be adequate to fund our working capital needs, capital expenditures, and debt service requirements for at least the next twelve months. However, we may choose to pursue additional equity and debt financing to provide additional liquidity or to fund acquisitions. Critical Accounting Policies and Estimates Management prepared the consolidated financial statements under accounting principles generally accepted in the United States of America. These principles require the use of estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions we used are reasonable, based upon the information available. Our estimates and assumptions affect the reported amounts in our financial statements. The following accounting policies comprise those that we believe are the most critical in understanding and evaluating our reported financial results. Revenue Recognition Product revenue is recognized when the transfer of promised goods to a customer occurs in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods. We follow the five step model to determine when this transfer has occurred: 1) identify the contract(s) with the customer; 2) identify the performance obligations in the contract; 3) determine the transaction price; 4) allocate the transaction price to the performance obligations in the contract; 5) recognize revenue when (or as) the entity satisfies a performance obligation. Product Warranties Provisions for estimated warranty expenses primarily related to our automotive products are made at the time products are sold. 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. We evaluate our warranty obligations at least quarterly and adjust our accruals if it is probable that future costs will be different than our current reserve. Over the last three years, product warranty reserves have ranged from 0.5% to 2.4% of total sales. 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. CTS CORPORATION 21 Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new significant customer accounts, • Ongoing credit evaluations of current customers, • Credit limits and payment terms based on available credit information, • Adjustments to credit limits based upon payment history and the customer's current creditworthiness, • An active collection effort by regional credit functions, reporting directly to the corporate financial officers, and • Limited credit insurance on the majority of our international receivables. 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 or our current forecasts. Inventories 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. We review inventory quantities on hand and record a provision for excess and obsolete inventory based on forecasts of product demand and production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 10.2% to 13.9% of gross inventory. We believe our reserve level is appropriate considering the quantities and quality of the inventories. Retirement Plans Actuarial assumptions are used in determining pension income and expense and our defined benefit obligations. We utilize actuaries from consulting companies in each applicable country to develop our discount rates, matching high-quality bonds currently available and expected to be available during the period to maturity of the pension benefit in order to provide the necessary future cash flows to pay the accumulated benefits when due. After considering the recommendations of our actuaries, we have assumed a discount rate, expected rate of return on plan assets, and a rate of compensation increase in determining our annual pension income and expense and the projected benefit obligation. During the fourth quarter of each year, we review our actuarial assumptions in light of current economic factors to determine if the assumptions need to be adjusted. 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 Goodwill of a reporting unit is tested for impairment annually, or more frequently if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant adverse change in regulatory factors or in the business climate, • Unanticipated competition, • More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, CTS CORPORATION 22 Table of Contents • Testing for recoverability of a significant asset group within a reporting unit, and • Allocation of a portion of goodwill to a business to be disposed. If we believe that one or more of the above indicators of impairment have occurred, we perform an impairment test. We have the option to perform a qualitative assessment (commonly referred to as "step zero" test) to determine whether further quantitative analysis for impairment of goodwill and indefinite-lived intangible assets is necessary. The qualitative assessment includes a review of macroeconomic conditions, industry and market considerations, internal cost factors, and our own overall financial and share price performance, among other factors. If, after assessing the totality of events or circumstances we determine that it is not more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, we do not need to perform a quantitative analysis. 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, 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. In assessing the reasonableness of our determined fair values, we evaluate our results against our market capitalization. Changes in these estimates and assumptions could materially affect the determination of fair value and impact the goodwill impairment assessment. 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. Impairment of Other Intangible and Long-Lived Assets We evaluate the impairment of identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered that may trigger an impairment review consist of, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant underperformance relative to expected historical or projected future operating results, • Significant changes in the manner of use of the acquired assets or the strategy for the overall business, • Significant negative industry or economic trends. If we believe that one or more indicators of impairment have occurred, we perform a recoverability test by comparing the carrying amount of an asset or asset group to the sum of the undiscounted cash flows expected to result from the use and the eventual disposition of the asset or asset group. 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. 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 U.S. GAAP requires a liability to be recorded for contingencies when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Significant judgment is required to determine the existence and amounts of our environmental, legal and other contingent liabilities. We regularly consult with attorneys and consultants to determine the relevant facts and circumstances before we record a liability. 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. Income Taxes 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. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgments and estimates are required in the determination of consolidated income tax expense. Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets in the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. 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. CTS CORPORATION 23 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. Accounting Standards Codification (ASC) No. 740 states that a tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolution of any related appeals or litigation processes, on the basis of its technical merits. We record unrecognized tax benefits as liabilities in accordance with ASC 740 and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available. Our practice is to recognize interest and penalties related to income tax matters as part of income tax expense. 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. Tax. 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 Our contractual obligations as of December 31, 2020, were: Payments due by period Total 2021 2022-2023 2024-2025 2026-beyond Long-term debt, including interest $ 59,265 $ 1,502 $ 2,948 $ 54,815 $ — Operating lease payments 34,891 4,854 8,949 7,682 13,406 Retirement obligations 6,713 816 1,514 1,390 2,993 Total $ 100,869 $ 7,172 $ 13,411 $ 63,887 $ 16,399 We have no off-balance sheet arrangements that have a material current effect or are reasonably likely to have a material future effect on our financial condition or changes in our financial condition. Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements.