CTS CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) (in thousands, except percentages and per share amounts) The following discussion should be read in conjunction with our unaudited Condensed Consolidated Financial Statements and notes included under Item 1, as well as our Consolidated Financial Statements and notes and related Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2020. 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. 25 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. The extent of the impact of the COVID-19 pandemic on our business, financial results and liquidity will depend largely on future developments, including the duration of the spread of the COVID-19 outbreak within the U.S. and globally, the impact on capital and financial markets and the related impact on our suppliers and customers, especially in the transportation end-market. These future developments are outside of our control, are highly uncertain and cannot be predicted. These and other potential impacts of the COVID-19 pandemic, along with the recent increases in consumer demand are resulting in critical raw material and semiconductor chip shortages as well as associated cost increases, that may adversely impact our results for the remainder of 2021, and that impact could be material. We continue to actively monitor the ongoing potential impacts of COVID-19 and the supply chain issues and will seek to mitigate and minimize their impact on our business. We remain cautious about the financial impact of COVID-19 on our business for the remainder of 2021. Results of Operations: First Quarter 2021 versus First Quarter 2020 The following table highlights changes in significant components of the Unaudited Condensed Consolidated Statements of Earnings for the quarters ended March 31, 2021, and March 31, 2020: Three Months Ended Percent of Percent of March 31, March 31, Percent Net Sales – Net Sales – 2021 2020 Change 2021 2020 Net sales $ 128,427 $ 103,075 24.6 % 100.0 % 100.0 % Cost of goods sold 85,836 70,176 22.3 66.8 68.1 Gross margin 42,591 32,899 29.5 33.2 31.9 Selling, general and administrative expenses 18,325 16,759 9.3 14.3 16.3 Research and development expenses 5,687 7,408 (23.2 ) 4.4 7.2 Restructuring charges 81 240 (66.3 ) 0.1 0.2 Total operating expenses 24,093 24,407 (1.3 ) 18.8 23.7 Operating earnings 18,498 8,492 117.8 14.4 8.2 Total other expense, net (3,709 ) (2,502 ) 48.2 (2.9 ) (2.4 ) Earnings before income taxes 14,789 5,990 146.9 11.5 5.8 Income tax expense 2,799 2,182 28.3 2.2 2.1 Net earnings $ 11,990 $ 3,808 214.9 % 9.3 % 3.7 % Earnings per share: Diluted net earnings per share $ 0.37 $ 0.12 Net sales were $128,427 in the first quarter of 2021, an increase of $25,352 or 24.6% from the first quarter of 2020. Net s ales momentum continued in the first quarter of 2021 as a result of overall improvement in the economy; however, we also experienced significant material inflationary pressures and interruptions in the supply chain particularly due to the global semiconductor chip shortage impacting the operations of our business. The impact of the pandemic and supply chain impacts are ongoing and are expected to continue to have an effect on our operations. We are currently unable to quantify these future impacts. Net sales to transportation markets increased $14,320 or 23.3%. Net sales to other markets increased $11,032 or 26.6%. The Sensor Scientific, Inc. (“SSI”) acquisition, which was completed in December 2020, added $1,847 in net sales for the quarter. Changes in foreign exchange rates increased net sales by $2,496 year-over-year due to the U.S. Dollar depreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of net sales was 33.2% in the first quarter of 2021 compared to 31.9% in the first quarter of 2020. The increase in gross margin was driven primarily by sales volume with raw material price increases adversely impacting the results. Selling, general and administrative ("SG&A") expenses were $18,325 or 14.3% of net sales in the first quarter of 2021 versus $16,759 or 16.3% of net sales in the first quarter of 2020. Increased net sales drove the overall decrease in SG&A expenses as a percentage of net sales. 26 Research and development (“R&D” ) expenses were $ 5,687 or 4.4% of net sales in the first quarter of 2021 compared to $ 7,408 or 7.2 % of net sales in the comparable quarter of 2020 . The reduction in overall R&D expenses is primarily due to changes in timing and mix of certain projects. Restructuring charges were $81 or 0.1% of net sales in the first quarter of 2021 compared to $240 or 0.2% of net sales in the first quarter of 2020. Operating earnings were $18,498 or 14.4% of net sales in the first quarter of 2021 compared to operating earnings of $8,492 or 8.2% of net sales in the first quarter of 2020. The change in operating earnings were driven by the items discussed above. Other expense and income items are summarized in the following table: Three Months Ended March 31, March 31, 2021 2020 Interest expense $ (555 ) $ (851 ) Interest income 202 331 Other expense, net (3,356 ) (1,982 ) Total other expense, net $ (3,709 ) $ (2,502 ) Other expense in the first quarter of 2021 was principally driven by increased pension expense as well as unfavorable foreign exchange impact primarily from the U.S. Dollar depreciating compared to the Chinese Renminbi and Euro. Three months ended March 31, March 31, 2021 2020 Effective tax rate 18.9 % 36.4 % Our effective income tax rate was 18.9% and 36.4% in the first quarters of 2021 and 2020, respectively. This decrease is primarily attributed to the change in the mix of earnings by jurisdiction and the establishment of valuation allowance on certain tax credits in the first quarter of 2020. Liquidity and Capital Resources Cash and cash equivalents were $103,392 at March 31, 2021, and $91,773 at December 31, 2020, of which $101,883 and $90,051, respectively, were held outside the United States. The increase in cash and cash equivalents of $11,619 was primarily driven by cash generated from operating activities of $20,110, which was partially offset by net payments on long-term debt of $4,600, capital expenditures of $1,638, dividends paid of $1,291, and taxes paid on behalf of equity award participants of $1,402. Total long-term debt was $50,000 as of March 31, 2021 and $54,600 as of December 31, 2020. Total debt as a percentage of total capitalization, defined as long-term debt as a percentage of total debt and shareholders' equity, was 10.3% at March 31, 2021, compared to 11.4% at December 31, 2020. Working capital increased by $11,627 during the three months ended March 31, 2021, primarily due to the increase in cash and cash equivalents from strong operating cash flows. Cash Flows from Operating Activities Net cash provided by operating activities was $20,110 during the three months ended March 31, 2021. Components of net cash provided by operating activities included net earnings of $11,990, depreciation and amortization expense of $6,800, other net non-cash items of $3,220, and a net cash outflow from changes in assets and liabilities of $1,900. Cash Flows from Investing Activities Net cash used in investing activities for the three months ended March 31, 2021 was $1,638, driven entirely by capital expenditures. Cash Flows from Financing Activities 27 Net cash used in financing activities for the three months ended March 31, 2021 was $7,293. The net cash outflow was the result of a decrease in borrowings of long-term debt of $4,600, dividends paid of $1,291 and taxes paid on behalf of equity award participants in the amount of $1,402. Capital Resources Long‑term debt is comprised of the following: As of March 31, December 31, 2021 2020 Total credit facility $ 300,000 $ 300,000 Balance outstanding 50,000 54,600 Standby letters of credit 1,740 1,740 Amount available, subject to covenant restrictions $ 248,260 $ 243,660 Weighted-average interest rate 1.30 % 1.92 % Commitment fee percentage per annum 0.20 % 0.23 % Our 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. 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, debt service and dividend 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 condensed 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 using a quoted industry rate. 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% 28 to 2 . 7 % 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. Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new 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 credit worthiness, • 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 been approximately 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 historical usage, forecasts of product demand and related production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 10.2% to 14.0% 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 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 a determination letter from the Internal Revenue Service that allows us to proceed with the termination process. In connection with the termination, the Plan has offered a window extending from March 29, 2021 through May 7, 2021 to certain eligible participants to elect to receive a lump sum payment. The distribution date is June 1, 2021. The completion of the Plan termination process, including the final purchases of annuities, is expected to occur in the second half of 2021. As of March 31, 2021, we had gross unrecognized losses related to the Plan of $ 123,238 in accumulated other comprehensive loss that are expected to be recognized in the income statement in 2021. Since the amount of the settlement depends on a number of 29 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, we expect non-cash settlement charges of approximately $10,000 to $20,000 will be recognized in the second quarter of 2021 with the remaining amount of the gross accumulated other comprehensive loss balance to be recognized upon final settlement . We do not expect any cash contributions from the Company to the Plan as a result of this termination because P lan 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, • 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. Our latest assessment was performed using a quantitative approach as of October 1, 2020, 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 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 under performance 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, and • Significant negative industry or economic trends. 30 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 of 2020 due to the impairment of a specific asset group . No indicators of impairment were identified during the quarter ended March 31, 2021. 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. 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. Significant Customers Our net sales to customers representing at least 10% of total net sales is as follows: Three months ended March 31, March 31, 2021 2020 Cummins Inc. 15.7 % 16.5 % Toyota Motor Corporation 13.4 % 11.9 % 31 Forward ‑ Looking Statements This document contains statements that are, or may be deemed to be, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, any financial or other guidance, statements that reflect our current expectations concerning future results and events, and any other statements that are not based solely on historical fact. Forward-looking statements are based on management's expectations, certain assumptions and currently available information. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof and are based on various assumptions as to future events, the occurrence of which necessarily are subject to uncertainties. These forward-looking statements are made subject to certain risks, uncertainties and other factors, which could cause our actual results, performance or achievements to differ materially from those presented in the forward-looking statements. Examples of factors that may affect future operating results and financial condition include, but are not limited to: the ultimate impact of the COVID-19 pandemic on our business, results of operations or financial condition, changes in the economy generally and in respect to the business in which CTS operates; unanticipated issues in integrating acquisitions; the results of actions to reposition our business; rapid technological change; general market conditions in the transportation, telecommunications, and information technology industries, as well as conditions in the industrial, aerospace and defense, and medical markets; reliance on key customers; unanticipated public health crises, natural disasters or other events; environmental compliance and remediation expenses; the ability to protect our intellectual property; pricing pressures and demand for our products; and risks associated with our international operations, including trade and tariff barriers, exchange rates and political and geopolitical risks. Many of these, and other risks and uncertainties, are discussed in further detail in Item 1A. of our Annual Report on Form 10-K. We undertake no obligation to publicly update our forward-looking statements to reflect new information or events or circumstances that arise after the date hereof, including market or industry changes.