CTS Corporation
Form 10-K 2004

EXHIBIT (13)

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (2002-2004)

Overview

CTS is a global manufacturer and supplier of components and sensors to the automotive, communications, and computer markets. The Company also manufactures and designs specialized electronic products for industrial, communications, and computing infrastructure OEMs. Sales and marketing is accomplished through CTS sales engineers, independent manufacturers’ representatives, and distributors. Total sales in 2004 of $531.3 million were reported through two business segments, Electronics Manufacturing Services (EMS) and Components and Sensors, which represented 50.9% and 49.1% of CTS’ total sales in 2004, respectively.

In 2004, the Company experienced a strong year-over-year sales increase and improved net earnings significantly from 2003. During this period, the Company continued to focus on three key priorities: (1) improving profitability concurrently with growing sales; (2) strengthening the balance sheet; and (3) developing new sources of revenue to drive future growth. During 2004, CTS continued to see growth in certain of its existing served markets, as well as new business awards from existing and new customers. Additionally, CTS continued to report progress in growth initiatives, especially new automotive platform positions and precision frequency products for the communications infrastructure market.

As discussed in more detail throughout the MD&A:

Acquisition

On November 16, 2004, CTS entered into a merger agreement with SMTEK International, Inc. The agreement was approved by SMTEK shareholders on January 31, 2005. SMTEK is a publicly traded company in the electronics manufacturing services (EMS) industry with sales of $102.4 million and operating earnings of $4.0 million in the reported 12–month period ended September 30, 2004. With operations on both the east and west coasts of the United States, and in southeast Asia, SMTEK serves over 25 major customers in the medical, industrial and security, aerospace and defense, and communications markets. The estimated aggregate purchase price is approximately $60 million, consisting of $35 million cash consideration, $13 million of SMTEK debt assumed by CTS, approximately 812,000 shares of CTS common stock valued at $10 million, and $2 million of estimated transaction costs.

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Benefits of the acquisition include:

Outlook

Including the impact of SMTEK, CTS expects 2005 full year sales to grow by 30-35%, and diluted earnings per share to be in the range of $0.65 - $0.72. The earnings per share guidance includes a negative impact of approximately $0.05 per share from adopting the new accounting rule on contingently convertible debentures. The Company expects the SMTEK acquisition to be accretive by $0.04-$0.06 per share in 2005.

Critical Accounting Policies

CTS management’s discussion and analysis is based on its consolidated financial statements that have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses and the related disclosure of contingent assets and liabilities. CTS evaluates its estimates on an ongoing basis, based on historical experience and other assumptions believed to be relevant under the circumstances. Actual results may differ, perhaps materially, from the estimates under different assumptions or conditions.

CTS’ served markets are characterized by rapid technological change and frequent new product introductions and enhancements. These characteristics, along with global economic conditions, are risks that require management judgment when determining appropriate accounting decisions. Management believes that judgment and estimates related to the following critical accounting policies could materially affect its consolidated financial statements:

Estimating inventory valuation, the allowance for doubtful accounts and other accrued liabilities

CTS management makes estimates of the carrying value of its inventory based upon historical usage, new product introductions and projected customer purchase levels. The ever-changing technology environment of the served markets affects these estimates. Similarly, management makes estimates of the collectability of its accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Finally, CTS is involved in litigation in the normal course of business and is regulated under a number of environmental and safety laws. Accruals for known exposures are established based on management’s best estimate after considering the advice of legal counsel.

Valuation of long-lived and intangible assets and depreciation/amortization periods

CTS assesses the carrying value of long-lived and intangible assets and the remaining useful lives whenever events or changes in circumstances indicate the carrying value may not be recoverable or the estimated useful life may no longer be appropriate. Factors considered important which could trigger this review include significant decreases in operating results, significant changes in its use of the assets, competitive factors and the strategy of its business, and significant negative industry or economic trends. The Company cannot predict the occurrence of future impairment-triggering events nor the impact such events might have on the reported asset values. Such events may include strategic decisions made in response to the economic conditions relative to product lines, operations and the impact of the economic environment on our customer base.

When the Company determines that the carrying value of long-lived and intangible assets may not be recoverable based on an assessment of future undiscounted cash flows from the use of those assets, an impairment charge to record the assets at fair value may be recorded. Impairment is measured based on fair values utilizing estimated discounted cash flows, published third-party sources, third-party offers and information furnished by third-party brokers/dealers.

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Income Taxes

Deferred tax assets and liabilities are determined based on the difference between the financial statement and income tax bases of assets and liabilities and carryforwards using currently enacted tax rates. CTS must also estimate its current tax exposure for situations where taxing authorities would assert tax positions different than those taken by the Company. Such reserves are routinely reviewed and adjusted when required to reflect changes in estimates based on factors such as changes in tax laws, results of tax authority reviews and statutory limitations. CTS estimates its income tax valuation allowance by assessing which deferred tax assets are more likely than not to be recovered in the future. The valuation allowance is based on CTS’ estimates of taxable income in each jurisdiction in which it operates and the period over which the deferred tax assets will be recoverable.

CTS believes it will more likely than not realize the benefits of its $54.4 million U.S. net operating loss carryforwards, which expire in 2021 through 2024. The Company assessed the future realization of these deferred tax assets utilizing taxable income projections for years 2005 through 2013. The projections were based on taxable income estimates consistent with historical earnings patterns of its traditional automotive and electronic component product lines and a return to levels of profitability in its communications components product lines consistent with management and independent consensus views of the moderate recovery expected in the markets served by CTS. In the event that actual results differ from these estimates in future periods, CTS may need to establish an additional valuation allowance or reduce the valuation allowance, which could materially impact the results of operations and financial position.

The annual effective income tax rate is based on CTS’ current legal organization and forecasted earnings in the various taxing jurisdictions in which the Company operates. Changes in CTS’ legal organization, the amount or the location of global earnings could impact its future effective income tax rate. In 2004, CTS’s effective tax rate decreased from 25% to 23% primarily as a result of increased profits being reported in lower taxed jurisdictions.

Retirement Plans

Actuarial assumptions are used in determining pension income and expense and the pension benefit obligation. CTS, after considering the recommendations of its actuaries, assumes a discount rate, expected rate of return on plan assets and a rate of compensation increase in determining its annual pension income and expense and the projected benefit obligation. Experience gains/losses arising from any variance between the expected rate of return of plan assets and the actual results are amortized over periods ranging from 5 to 16 years. During the fourth quarter of each year, CTS reviews its 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 affect on CTS’ results of operations in future years.

For 2004, CTS had a weighted-average discount rate of 6.17% for pension income and expense. CTS reduced the discount rate assumption for 2005 to reflect the interest rate decline on high-quality corporate bonds. The Company reduced the discount rate on its domestic plans from 6.25% at January 1, 2004 to 6.0% at January 1, 2005. The range of discount rates utilized by its foreign plans was also increased from 3.5% - 5.4% in 2004 to 3.5% - 5.6% in 2005.

The Company also revised its long-term expected return on plan asset assumption as a result of its evaluation of long-term returns. The expected return on domestic plan assets at January 1, 2005 was lowered to 8.50% from 8.75% and the range of expected returns on foreign plan assets stayed the same, at 3.50% - 7.00%.

CTS expects these changes in actuarial assumptions, combined with the pension asset balance at the end of 2004, will reduce 2005 consolidated pension income by approximately $3 - $4 million.

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Results of Operations

Business Segment Discussion

CTS has two reportable business segments: 1) Components and Sensors and 2) Electronics Manufacturing Services (EMS).

Components and sensors are products which perform specific electronic functions for a given product family and are intended for use in customer assemblies. Components and sensors consist principally of:  automotive sensors and actuators used in commercial or consumer vehicles; electronic components used in cellular handsets, communications infrastructure, and computer markets; low temperature cofired ceramics (LTCC) used in various communications, military, aerospace, and automotive applications; terminators, including ClearONE™ terminators, used in computer and other high speed applications, switches, resistor networks; and potentiometers used to serve multiple markets.

EMS includes the higher level assembly of electronic and mechanical components into a finished subassembly or assembly, such as printed circuit board assembly, performed under a contract manufacturing agreement with an OEM or other contract manufacturer. EMS also includes the design of interconnect systems and complex backplanes as may be required by the customer.

For additional information on business segments, refer to "Note M - Business Segments."

The following table summarizes net sales and operating earnings by business segment:

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The 2004 Components and Sensors business segment sales increased $8.1 million, or 3.2%, from 2003. The increase was primarily due to increased demand for the automotive sensor products, communication infrastructure products and favorable foreign exchange, due to the weakening of the U.S. dollar against the British Pound and the Euro. Despite a small sales increase, segment operating earnings more than tripled from the prior year, primarily due to favorable impact from the contribution of incremental sales and product mix of approximately $3.8 million. Lower depreciation expenses of $7.9 million, due to a lower level of capital expenditures in recent years versus high levels of capital expenditures in the preceding years, and an intersegment cost allocation to EMS Singapore operation of $1.7 million also helped to improve segment operating earnings in 2004. The segment operating earnings also included $3.9 million of gain on asset sales, including $2.7 million gain from sale of excess land in Canada, and a favorable impact of foreign exchange rate movements. Research and development expenses decreased $2.7 million in 2004 compared to 2003, as a result of streamlining research and development activities. These favorable factors were partially offset by product launch costs of $2.8 million and higher operating expenses of $4.9 million related to incentive compensation and professional services.

Components and Sensors 2003 business segment sales decreased $18.0 million, or 6.7%, from the prior year. The decrease was primarily due to a reduction of end-of-life product sales of $16.2 million and continuing softness in the communications market. End-of-life product sales represent the final shipments of products that have been replaced by newer technologies or no longer meet the Company’s profit objectives and the decision is made by the company to cease manufacturing. Sales into the automotive market increased slightly in 2003, benefited by the introduction of new product and sales into Asia. Despite the overall sales decrease, segment operating earnings improved $13.3 million primarily from $10.1 million of lower depreciation and amortization expense and reduced operating expenses of $11.9 million mainly in wages and related benefits. These improvements were partially reduced by the impact of lower volume of approximately $4.6 million and $4.1 million of favorable items occurring in 2002, primarily related to a $3.1 million customer reimbursement.

EMS 2004 business segment sales increased $60.2 million, or 28.7%, from the prior year. The revenue increase was primarily due to $24.9 million increase in data storage systems, $20.8 million increase in communications infrastructure systems and $9.3 million increase in networking equipment from both existing customers and new customers. The operating earnings of $7.8 million decreased $3.2 million from the prior year. The decrease in earnings was primarily driven by price reductions in connection with the product transfer to Singapore and an unfavorable impact of foreign exchange rate movements. These price reductions were partially offset by cost reductions. CTS anticipates additional cost reductions after a full year of EMS Singapore operations. Also, EMS incurred an intersegment cost allocation of $1.7 million from the Components and Sensors segment. Additionally, in 2004, some start-up costs were incurred to support the new operation in Singapore. These unfavorable factors were partially offset by the favorable impact of $6.9 million from higher sales and product mix.

CTS earnings are subject to fluctuations of foreign currency exchange rates. For 2004, the impact of foreign exchange rates was positive on Components and Sensors segment operating earnings, while negative on EMS segment operating earnings, primarily due to the weakening of the U.S. Dollar against the Euro and British Pound. To a large extent, the unfavorable impact was offset by the favorable impact.

EMS business segment sales increased $23.2 million, or 12.4%, in 2003 from the prior year. Sales into the communications market increased, due primarily to stronger shipments of infrastructure products into China and Europe. Additionally, shipments of computer products increased in 2003, following a decline in the prior year. Segment operating earnings of $11.0 million increased $0.2 million from the prior year primarily from favorable volume impacts, partially offset by product mix, of $1.2 million, and $1.0 million of higher general and administrative and selling and marketing expenses.

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Net sales increased $68.3 million in 2004, or 14.8%, from prior year, primarily due to the EMS increase of $60.2 million related to increased demand for communications infrastructure systems, networking equipment, and data storage systems. In addition, Components and Sensors sales increased $8.1 million, primarily related to increased demand for automotive products, and communications infrastructure components.

The 2003 net sales increased $5.2 million, or 1%, from 2002. This increase was primarily due to higher EMS product sales of $23.2 million, partially offset by an $18.0 million decrease in Components and Sensors product sales. The improved sales volume in the EMS business segment was driven by growth in shipments of communication products primarily in infrastructure end markets in China. The decreased sales volume in the Components and Sensors business segment principally reflects the decision to end-of-life certain products in the third quarter of 2002.

The Company’s 15 largest customers represented 69% of net sales in 2004. This is a slight decrease from 71% and 73% in 2003 and 2002, respectively. This percentage is decreasing as the Company continues efforts to broaden its business base, particularly in automotive and wireless infrastructure product offerings. Sales to Hewlett-Packard Company represented 33% of net sales in 2004, 2003, and 2002. Sales to Motorola, Inc. were 13% of net sales in 2004 and 2003, and 12% in 2002.

CTS’ products are usually priced with consideration to expected or required profit margins, customer expectations, and market competition. Pricing for most of CTS’ Components and Sensors and EMS products generally decrease over time and also fluctuate in accordance with total industry utilization of manufacturing capacity. In both CTS segments, nominal annual price reductions are in the single-digit range, which is typical of the industry. CTS continues to work on cost reduction to offset the negative price impact on profit margin.

Gross margin increased $13.0 million, or 13.5%, in 2004 from 2003, primarily due to higher sales of $68.3 million and lower depreciation expense, as mentioned in the Business Segment Discussion. However, gross margin as a percentage of sales declined because of the higher percent of EMS segment sales, which inherently have a lower gross margin percentage than Components and Sensors segment sales.

Gross margin in 2003 increased $5.7 million, or 1.0 percentage point, over 2002, to 20.9%, on improved sales of $5.2 million. Items contributing to the gross margin percentage increase included $6.2 million of lower depreciation expense, $6.0 million from favorable product mix and volume–related improvements, partially offset by $3.7 million in lower pension income. The 2002 gross margin also included a favorable adjustment of $3.1 million for a customer reimbursement and $1.3 million of restructuring related charges.

Selling, general and administrative expenses as a percentage of sales decreased 0.4 percentage points to 11.9% in 2004 from prior year, as the Company was able to leverage existing resources with higher sales. The total dollar amount increased $6.6 million, primarily due to the increased expenses for incentive compensation, professional services, and normal cost of living adjustments.

Selling, general and administrative expenses decreased to $56.9 million, or 12.3% of net sales in 2003, versus $63.3 million, or 13.8% of net sales in 2002, reflecting Company initiatives to control costs and scale operations to existing market conditions. Cost reductions were achieved primarily in salaries and wages and lower depreciation and amortization expenses.

Research and development expenses were $19.1 million in 2004 versus $21.5 million in 2003 and $24.1 million in 2002. The reductions in research and development spending reflect savings due to organizational consolidation, changing business mix, and the streamlining of research and development activities. Significant ongoing research and development activities continue in the Components and Sensors business segment, particularly for automotive products in support of growth initiatives. CTS’ research and development investment is primarily focused on expanded applications and new product development, as well as current product and process enhancements. Research and development expenditures in the EMS business segment are typically very low.

Operating earnings in 2004 increased to $31.1 million, or 5.9% of sales, from $13.8 million, or 3.0% of sales, in 2003. Favorable changes contributing to the margin improvement were gross margin increase and gain on asset sales offset by increase of operating expenses, as discussed above. Operating earnings in 2004 included gain on asset sales of $3.9 million. As discussed in the Restructuring and Asset Impairment Charges section below, operating earnings in 2003 included an asset impairment charge of $4.6 million.

Operating earnings in 2003 of $13.8 million improved $28.6 million over 2002. Favorable changes to operating earnings resulted from gross margin improvement and a reduction in operating expenses. In addition, 2003 included a $4.6 million asset impairment charge, while 2002 included $19.6 million of restructuring, asset impairment and restructuring-related one-time charges, and $4.1 million of favorable items which include a $3.1 million customer reimbursement.

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Interest expense in 2004 was $5.5 million, or 28.0% lower than 2003. This was primarily due to payment in whole of CTS industrial revenue bonds, which carried a coupon rate of 7.5%. Cash from operation and proceeds from the convertible senior subordinated debentures issued in May 2004, as discussed in the Liquidity section, which bear an annual interest rate of 2.125%, financed the payment of the industrial revenue bonds. Interest expense decreased $2.6 million in 2003 compared to 2002 primarily due to lower average outstanding debt balance.

In 2004, CTS changed its estimate of its 2004 effective tax rate from 25% to 23%. The lower effective tax rate reflects the transfer of certain business operations to jurisdictions with lower statutory tax rates and the notification that manufacturing incentives in one foreign jurisdiction qualified CTS for a lower statutory rate, expiring in 2012, subject to certain conditions.

During 2003, the Company recorded a tax benefit of $7.9 million resulting from the reversal of reserves that were no longer required following the expiration of statutory deadlines.

Net earnings in 2004 increased $7.4 million, or 58.7%, to $20.0 million in 2004 from $12.6 million in 2003. Net earnings in 2004 included the impact of $3.9 million pre-tax gain on asset sales. Net earnings in 2003 included the impact of a pre-tax $4.6 million asset impairment charge and a $7.9 million tax benefit.

Restructuring and Asset Impairment Charges

During the third quarter of 2003, CTS recorded a $4.6 million pre-tax impairment charge to reduce the carrying value of certain assets, held by the Components and Sensors business segment, to their estimated fair value. Approximately $3.3 million of the impairment charge reflected a write down for electronic equipment following final production of previously announced end-of-life products and a re-assessment of the current market value for equipment held for sale. An additional $1.3 million of the impairment charge related to excess capacity on a production line following an assessment of future capacity needs. All restructuring-related reserve balances had been fully utilized at December 31, 2003.

In the third quarter of 2002, CTS recorded $18.3 million of pre-tax restructuring and impairment charges. The charges included $5.0 million restructuring charges, $12.5 million of asset impairments and $0.8 million of pension curtailment losses. The charges were incurred in order to effect operational improvements and related organizational realignments primarily in the Components and Sensors business segment, involving the relocation of certain manufacturing operations. CTS completed substantially all of these restructuring actions by the end of 2002. Also during 2002, CTS recorded in cost of sales $1.3 million of restructuring-related charges, consisting primarily of equipment relocation costs.

Liquidity and Capital Resources