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 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Annual Report on 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, 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, medical, 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. COVID-19 Impact and Supply Chain Uncertainties The COVID-19 pandemic and subsequent supply chain uncertainties have had a significant negative impact on the global economy in 2020 and 2021. This has disrupted the financial markets, negatively impacted the global supply chain and increased the cost of materials and operations, particularly within the global automotive industry. Key semiconductor chip and other critical part shortages continue to force OEMs to shut down production, often on short notice. With customers changing orders on short notice, we run the risk of carrying excess inventory in these situations. These developments are outside of our control, remain highly uncertain, and cannot be predicted. In addition, the supply chain shortages continue to put pressure on our manufacturing costs and equally our gross margins. We continue to actively monitor the ongoing impacts of the COVID-19 pandemic and supply chain issues and will seek to mitigate and minimize their impact on our business, when possible. We anticipate these challenges to continue to impact our results in 2022 and we remain cautious about the financial impact of these potential disruptions on our business. Results of Operations: Year Ended December 31, 2021 versus Year Ended December 31, 2020 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of (Loss) Earnings for the years ended December 31, 2021, and December 31, 2020: Years Ended December 31, Percent of Net Sales 2021 2020 Percent Change 2021 2020 Net sales $ 512,925 $ 424,066 21.0 % 100 % 100 % Cost of goods sold 328,306 285,003 15.2 64.0 67.2 Gross margin 184,619 139,063 32.8 36.0 32.8 Selling, general and administrative expenses 82,597 67,787 21.8 16.1 16.0 Research and development expenses 23,856 24,317 (1.9 ) 4.7 5.7 Restructuring charges 1,687 1,830 (7.8 ) 0.3 0.4 Total operating expenses 108,140 93,934 15.1 21.1 22.2 Operating earnings 76,479 45,129 69.5 14.9 10.6 Total other (expense) income, net (137,359 ) 350 (39,345.4 ) (26.8 ) 0.1 (Loss) earnings before taxes (60,880 ) 45,479 (233.9 ) (11.9 ) 10.7 Income tax (benefit) expense (19,014 ) 10,793 (276.2 ) (3.7 ) 2.5 Net (loss) earnings $ (41,866 ) $ 34,686 (220.7 )% (8.2 )% 8.2 % Diluted (loss) earnings per share: Diluted net (loss) earnings per share $ (1.30 ) $ 1.06 CTS CORPORATION 19 Net sales were $512,925 for the year ended December 31, 2021, an increase of $88,859, or 21.0% from 2020. Net sales growth was driven by the overall improvement in the economy including our focus on end-customer diversification. Net sales to transportation markets increased $42,634 or 17.7%. Net sales to other markets increased $46,224, or 25.3%. The Sensor Scientific, Inc. acquisition, which was completed in December 2020, added sales of $7,112 in 2021. Changes in foreign exchange rates increased net sales by $6,938 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 36.0% in 2021 versus 32.8% in 2020. The increase in gross margin was driven primarily by sales volume and mix . We continue to experience significant inflation in material and freight costs as well as interruptions in the supply chain particularly due to the global semiconductor chip and resin shortages impacting the operations of our business. The impact of the supply chain shortages and OEM shutdowns are expected to continue to have an adverse effect on our operations that we are continuing to mitigate. Selling, general and administrative ("SG&A") expenses were $82,597, or 16.1% of sales for the year ended December 31, 2021, versus $67,787 or 16.0% of sales in 2020. Total SG&A expenses tracked higher with higher costs associated with increased net sales including primarily the restoration of cost saving measures, including incentive compensation in 2021. Research and development (“R&D”) expenses were $23,856, or 4.7% of sales in 2021 compared to $24,317, or 5.7% of sales in 2020. The decrease in overall R&D expenses was primarily due to changes in timing and mix of certain projects. Restructuring charges were $1,687, or 0.3% of net sales in 2021, compared to $1,830, or 0.4% of net sales in 2020. We continue to implement certain restructuring actions to improve our cost structure to remain competitive. Other income and expense items are summarized in the following table: Years Ended December 31, 2021 2020 Interest expense $ (2,111 ) $ (3,272 ) Interest income 840 1,047 Other (expense) income (136,088 ) 2,575 Total other (expense) income, net $ (137,359 ) $ 350 Other expense, net in 2021 was primarily driven by increased pension expense including $126,269 in settlement charges from our U.S. pension plan termination process in the second and third quarters of 2021 as well as foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Czech Koruna and Mexican Peso. Years Ended December 31, 2021 2020 Effective tax rate 31.2% 23.7% The effective income tax rate in 2021 was 31.2% compared to 23.7% in the prior year. This increase is primarily attributable to the impact of the U.S. pension plan settlement charges taken in 2021. Liquidity and Capital Resources Cash and cash equivalents were $141,465 at December 31, 2021 and $91,773 at December 31, 2020, of which $124,635 and $90,051 respectively, were held outside the United States. The increase in cash and cash equivalents of $49,692 was primarily driven by cash generated from operating activities of $86,141 partially offset by $(20,712) and $(15,896) in financing and investing activities, respectively. Total debt as of December 31, 2021 and December 31, 2020, was $50,000 and $54,600, respectively. Total debt as a percentage of total capitalization, defined as long-term debt as a percentage of total debt and shareholders’ equity, was 9.7% at December 31, 2021, compared to 11.4% at December 31, 2020. Cash Flows from Operating Activities Net cash provided by operating activities was $86,141 during the year ended December 31, 2021. Components of net cash provided by operating activities included net loss of $(41,866), depreciation and amortization expense of $26,930, non-cash pension and other post-retirement plan expenses of $132,650, and other net non-cash items totaling $(24,912), and a net cash outflow from changes in assets and liabilities of $(6,661). CTS CORPORATION 20 Table of Contents 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, 2021 was $15,896, driven primarily by capital expenditures. 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, 2021, was $20,712. The net cash outflow was the result of net payments of long-term debt of $4,600, treasury stock purchases of $8,786, dividend payments of $5,173, taxes paid on behalf of equity award participants of $1,503, and a contingent consideration payment of $650. 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. Capital Resources Long-term debt was comprised of the following: As of December 31, 2021 2020 Total credit facility availability $ 400,000 $ 300,000 Balance outstanding 50,000 54,600 Standby letters of credit 1,740 1,740 Amount available, subject to covenant restrictions $ 348,260 $ 243,660 Weighted-average interest rate 1.16 % 1.92 % On December 15, 2021, we entered into a second amended and restated five-year credit agreement with a group of banks (the “Revolving Credit Facility”) to (i) increase the total credit facility availability to $400,000 which may be increased by $200,000 at the request of the Company, subject to the administrative agent's approval, (ii) extend the maturity of the Revolving Credit Facility from February 12, 2024 to December 15, 2026, (iii) replace LIBOR with SOFR as the primary reference rate used to calculate interest on the loans under the Revolving Credit Facility, (iv) increase available sublimits for letters of credit, and swingline loans as well as providing for additional alternative currency borrowing capabilities, and (v) modify the financial and non-financial covenants to provide the Company additional flexibility. This new unsecured credit facility replaced the prior $300,000 unsecured credit facility, which would have expired February 12, 2024. Borrowings in U.S. dollars under the Revolving Credit Facility bear interest, at a per annum rate equal to the applicable Term SOFR rate (but not less than 0.0%), plus the Term SOFR adjustment, and plus an applicable margin, which ranges from 1.00% to 1.75%, based on our net leverage ratio. Similarly, borrowings of alternative currencies under the Revolving Credit Facility bear interest equal to a defined risk-free reference rate, plus the applicable risk-free rate adjustment and plus an applicable margin, which ranges from 1.00% to 1.75%, based on our net leverage ratio. The Revolving Credit Facility includes a swing line sublimit of $ 20,000 and a letter of credit sublimit of $ 20,000 . We also pay a quarterly commitment fee on the unused portion of the Revolving Credit Facility. The commitment fee ranges from 0.175 % to 0.25 % based on our net leverage ratio. Our liquidity, access to capital, and borrowing costs could be adversely impacted by declines in our credit rating, our financial performance, and global credit market conditions, as well as a broad range of other factors, including those related to the COVID-19 pandemic discussed in this Form 10-K. See “Item 1A. Risk Factors” for additional discussion of these and other risks that our business faces. As of December 31, 2021, our material cash requirements for our known contractual and other obligations were as follows: CTS CORPORATION 21 • Long-term debt, including interest – Outstanding principal on our Revolving Credit Facility was $50,000 at December 31, 2021, with no amounts payable within 12 months. Additionally, we had future interest payments based on our hedged borrowings under our Revolving Credit Facility of $3,720 through maturity in December 2026, with approximately $1,162 payable within 12 months. Interest payments under the Revolving Credit Facility are determined based upon the average outstanding balance of our borrowings and the prevailing interest rate during that time and are inclusive of our hedge impact. See Note 13, “Debt,” in our Annual Report on 10K for further details of our debt. • Operating lease payments – We enter into various noncancelable lease agreements for land, buildings and equipment under non-cancellable operating leases used in our operations . Operating lease obligations were $31,894, with $4,826 payable within 12 months. See Note 12, “Leases,” in our Annual Report on 10K for further detail of our obligations and the timing of expected future payments. • Retirement obligations – Expected future payments relating to our defined benefit postretirement plans were $6,609, with $825 payable in 12 months. See Note 7, “Retirement Plan,” in our Annual Report on 10K for further detail of our obligations and the timing of expected future payments. 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 and for the foreseeable future thereafter. However, we may choose to pursue additional equity and debt financing to provide additional liquidity or to fund acquisitions. 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. Critical Accounting Estimates and Policies The Securities and Exchange Commission ("SEC") has defined a company’s critical accounting policies as the ones that are most important to the portrayal of a company’s financial condition and results of operations, and which require a company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. Critical Accounting Estimates Goodwill, Intangibles and Other Long-Lived Assets Purchase Accounting We use the acquisition method of accounting to allocate costs of acquired businesses to the assets acquired and liabilities assumed based on their estimated fair values at the dates of acquisition. The excess costs of acquired businesses over the fair values of the assets acquired and liabilities assumed are recognized as goodwill. The valuations of the acquired assets and liabilities will impact the determination of future operating results. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, revenue growth rates, discount rates, customer attrition rates, asset lives, contributory asset charges, and market multiples, among other items. We determine the fair values of intangible assets acquired generally in consultation with third-party valuation advisors. Intangible assets other than goodwill are recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed or exchanged, regardless of the Company’s intent to do so. Goodwill represents the excess purchase price over the fair value of the tangible net assets and intangible assets acquired in a business combination and is reviewed annually for impairment or more frequently if impairment indicators arise. Finite-lived intangible assets are reviewed for impairment if facts and circumstances warrant. Impairment Assessment – Goodwill Goodwill of a reporting unit is tested for impairment on the first day of its fiscal fourth quarter, 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, CTS CORPORATION 22 Table of Contents • 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 indicators of impairment have occurred, we perform an impairment test. We have the option to perform a qualitative assessment (commonly referred to as a "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. For 2021, w e elected to perform the quantitative assessment. Based upon our latest assessment, we determined that our goodwill was not impaired as of October 1, 2021. We will monitor future results and will perform a test if indicators trigger an impairment review. Impairment Assessment – Other Intangible Assets and Other 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. 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 provision. 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. CTS CORPORATION 23 Critical Accounting Policies Revenue Recognition We recognize revenue in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 606 Revenue from Contracts with Customers net of estimated reserves. Our revenue reserves contain uncertainties because they require management to make assumptions and to apply judgment to estimate the value of future credits to customers for price adjustments. We base these estimates on the most likely value method considering all reasonably available information, including our historical experience and current expectations, and are reflected in the transaction price when sales are recorded. Product Warranties Provisions for estimated warranty expenses are made at the time products are sold. The expense and corresponding accrual primarily relate to our products sold to our transportation markets. These estimates are established using a quoted industry rate and are 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 2.7% of net 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. 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 consumption trends as well as forecasts of product demand including related production requirements. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. Our reserves contain uncertainties because the calculation requires management to make assumptions and to apply judgment regarding historical experience, market conditions, and product life cycles. Changes in actual demand or market conditions could adversely impact our reserve calculations. Over the last three years, our reserves for excess and obsolete inventories have ranged from 10.2% to 16.0% 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. In February 2020, the CTS Board of Directors authorized management to explore termination of the U.S.-based pension plan ("Plan"), subject to certain conditions. On June 1, 2020, we entered into the Fifth Amendment to the Plan whereby we set an effective termination date for the Plan of July 31, 2020. In February 2021, we received a determination letter from the Internal Revenue Service that allowed us to proceed with the termination process for the Plan. As a result, we offered a lump sum payment to eligible participants with vested qualified Plan benefits in lieu of receiving monthly annuity payments in the second quarter of 2021 and purchased a group annuity contract that transferred our remaining obligations for the remaining participants in the third quarter. For a further discussion of the process and related financial impact please see Note 7 to Item 8 of this Annual Report on Form 10-K. Environmental 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. We record environmental contingent loss accruals on an undiscounted basis. Significant judgment is required to determine the existence and amounts of our environmental liabilities. We regularly consult with attorneys and consultants to determine the relevant facts and circumstances before we record a liability. Changes in the estimates on which the accruals are based, unanticipated government enforcement action, or changes in health, safety, environmental, and chemical control regulations and testing requirements could, and have, resulted in higher or lower costs. CTS CORPORATION 24 Table of Contents Recent Accounting Pronouncements The information set forth under Note 1 to Item 8 of this Annual Report on Form 10-K is incorporated herein by reference.