CTS Corporation - 10-Q quarterly report FY

 

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: 574-293-7511

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes þ No o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of July 26 2005: 36,469,972.

 i 

  Item 1. Financial Statements

The accompanying condensed consolidated interim financial statements have been prepared by CTS Corporation (CTS or the Company), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. The unaudited condensed consolidated interim financial statements should be read in conjunction with the financial statements, notes thereto, and other information included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

The accompanying unaudited condensed consolidated interim financial statements reflect, in the opinion of management, all adjustments (consisting of normal recurring items) necessary for a fair statement, in all material respects, of the financial position and results of operations for the periods presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ materially from those estimates. The results of operations for the interim periods are not necessarily indicative of the results for the entire year.

CTS accounts for stock-based employee compensation using the intrinsic value method prescribed in Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” and its related interpretations. Had employee compensation cost for CTS’ fixed, stock-based compensation plans been determined based on the fair value method, as defined by FAS No. 123, “Accounting for Stock-Based Compensation,” CTS’ net earnings and net earnings per share would have been adjusted to the pro forma amounts indicated below:

Effective January 31, 2005, CTS acquired 100% of SMTEK International Inc., (SMTEK). The results of SMTEK’s operations have been included in the consolidated financial statements since that date. SMTEK is an EMS provider serving original equipment manufacturers in the medical, industrial, instrumentation, telecommunications, security, financial services, automation, aerospace, and defense industries. SMTEK has four facilities located in Moorpark and Santa Clara, California; Marlborough, Massachusetts; and Bangkok, Thailand. As a result of the acquisition, CTS expects to expand into new EMS markets, reduce customer concentrations, and increase its global footprint.

The net assets acquired were $48.1 million. The purchase price was comprised of $34.7 million of cash consideration, CTS common stock valued at $10.9 million, and $2.5 million of estimated transaction cost. In addition, CTS assumed $13.0 million of SMTEK debt which was immediately repaid. CTS issued approximately 812,000 shares of common stock in connection with the acquisition. Under generally accepted accounting principles, the value assigned to the common stock was determined based on the average market price of CTS’ common shares over the two-day period before and after the terms of the acquisition were agreed to and announced.

The following table summarizes the estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition.

During the second quarter of 2005, the Company revised its estimate of the fair value of net deferred tax assets acquired after completing its analysis of SMTEK’s historical net operating losses and the related carryforward limitations by taxing jurisdictions. As a result of that analysis, the Company recorded a net deferred tax asset of $6.2 million. In addition, the Company recorded reserves of $0.7 million for the consolidation of the Marlborough, Massachusetts facility, acquired in the SMTEK acquisition, into CTS’ Londonderry, New Hampshire facility. CTS is in the process of obtaining a third-party valuation of certain intangibles and analyzing other aspects of the acquired operations. Accordingly, the allocation of the purchase price is subject to refinement.

Of the $11.2 million of amortizable intangible assets, $10.7 million was assigned to customer relationships (13 year useful life), $0.4 million to customer order backlog (90 days useful life), and $0.1 million to employment agreements (2 year useful life). The $23.8 million of goodwill was assigned to the EMS business segment. None of these amounts are deductible for tax purposes.

The following table presents CTS’ unaudited proforma consolidated results of operations for the three months ended June 27, 2004 and the six months ended July 3, 2005 and June 27, 2004 as if the acquisition had been completed at the beginning of each period. The pro forma information is presented for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisition actually been made at such date, nor is it necessarily indicative of future operating results.

In 2005, the Company purchased all of the capital stock of SMTEK for $61.1 million. In conjunction with the acquisition, CTS issued common stock and assumed liabilities as follows (refer also to Note C, “Acquisition”):

Inventory consist of the following:

CTS has the following intangible assets:

Of the net intangible balance at July 3, 2005, $34.0 million relates to the Components and Sensors business segment and $34.3 million relates to the EMS business segment.

CTS recorded amortization expense of $1.9 million and $1.2 million for the six months ended July 3, 2005 and June 27, 2004, respectively. CTS estimates annual amortization expense of $3.4 million in 2005.

CTS had line of credit arrangements of $22.3 million and $13.3 million at July 3, 2005 and December 31, 2004, respectively. These arrangements are generally subject to annual renewal and renegotiation, and may be withdrawn at the banks’ option. The majority of the line of credit arrangements existing at July 3, 2005 are unsecured. However, one line of credit for $0.5 million is secured by building and equipment in Thailand.

Long-term debt was comprised of the following at July 3, 2005 and December 31, 2004:

CTS has a $75 million senior, secured revolving credit agreement that had an outstanding balance of $4.8 million at July 3, 2005. Any outstanding balances under the revolving credit agreement are senior to CTS’ convertible debentures. The revolving credit agreement is collateralized by substantially all U.S. assets and a pledge of 65% of the capital stock of certain non-U.S. subsidiaries. Interest rates on the revolving credit agreement fluctuate based upon LIBOR. CTS pays a commitment fee on the undrawn portion of the revolving credit agreement. The commitment fee varies based on performance under certain financial covenants and was 0.4 percent per annum at July 3, 2005. The revolving credit agreement requires, among other things, that CTS comply with a minimum fixed charge coverage, a maximum leverage ratio, and a minimum tangible net worth. Failure of CTS to comply with these covenants could reduce the borrowing availability under the revolving credit agreement. Additionally, the revolving credit agreement limits the amounts allowed for dividends, capital expenditures, and acquisitions. The revolving credit agreement expires in July 2007.

CTS has issued $60 million convertible senior subordinated debentures ($60 million Debentures). These unsecured debentures bear interest at an annual rate of 2.125%, payable semiannually on May 1 and November 1 of each year through the maturity date of May 1, 2024. The $60 million Debentures are convertible, under certain circumstances, into CTS common stock at a conversion price of $15.00 per share (which is equivalent to an initial conversion rate of approximately 66.6667 shares per $1,000 principal amount of the notes). Upon conversion of the $60 million Debentures, in lieu of delivering common stock, the Company may, at its discretion, deliver cash or a combination of cash and common stock.

Holders may convert the $60 million Debentures at any time during a conversion period if the closing price of CTS common stock is more than 120% of the conversion price ($18.00 per common share) for at least 20 of the 30 consecutive trading days immediately preceding the first trading day of the conversion period. The conversion periods begin on February 15, May 15, August 15, and November 15 of each year. Holders may also convert the notes if certain corporate transactions occur. As of July 3, 2005, none of the conditions for conversion of the $60 million Debentures were satisfied.

CTS may, at its option, redeem all or a portion of the $60 million Debentures for cash at any time on or after May 1, 2009, at a redemption price equal to the principal amount of the notes plus any accrued and unpaid interest at the redemption date. Holders may require CTS to purchase for cash all or part of their notes on May 1, 2009, 2014, and 2019, or upon the occurrence of certain events, at 100% of the principal amount of the notes plus accrued and unpaid interest up to, but not including, the date of purchase.

The Company has $20 million of 6.5% convertible, subordinated debentures (6.5% Debentures) outstanding at July 3, 2005. These debentures are unsecured and convert into CTS common stock at a conversion price of $20.05 per share. At any time after April 2005, the purchasers may accelerate the maturity of the debentures. CTS also has the right at any time after April 2005 and under certain circumstances, to force conversion of the debentures into common stock. Interest on the debentures is payable semi-annually. In accordance with the provisions of the 6.5% Debentures, one debenture holder exercised its put option and accelerated the maturity of its debenture, totaling $5 million, in the second quarter of 2005.

In connection with the acquisition of SMTEK, CTS assumed a term loan, which has a balance of $0.9 million at July 3, 2005. The term loan is secured by machinery and equipment of the Thailand manufacturing facility and requires monthly payments through May 2011.

Net pension (income) / postretirement expense for the three and six month periods ended July 3, 2005 and June 27, 2004 includes the following components:

In 2005, CTS recognized a pension plan curtailment loss of approximately $0.5 million due to reduced employment levels.

FAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires companies to provide certain information about their operating segments. 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 ceramic (LTCC) electronic substrates used in various communications 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 performed under a contract manufacturing agreement with an OEM or other contract manufacturer. EMS also includes design and manufacture of interconnect systems and complex backplanes as may be required by the customer.

The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in the Company’s annual report on Form 10-K. Management evaluates performance based upon segment operating earnings before interest and income taxes.

Summarized financial information concerning CTS’ reportable segments is shown in the following table:

Reconciling information between reportable segments’ operating earnings and CTS’ consolidated pre-tax income is shown in the following table:

During the first six months of 2004, CTS sold approximately $16.5 million of assets held for sale, including its Longtan, Taiwan building. The proceeds on sales of these assets held for sale approximated the carrying value. CTS also sold excess land located near its Canadian facility for approximately $2.7 million during the first six months of 2004 and recorded a related gain of $2.7 million.

Certain processes in the manufacture of CTS’ current and past products create hazardous waste by-products as currently defined by federal and state laws and regulations. CTS has been notified by the U.S. Environmental Protection Agency, state environmental agencies and, in some cases, generator groups, that it is or may be a Potentially Responsible Party (PRP) regarding hazardous waste remediation at several non-CTS sites. In addition to these non-CTS sites, CTS has an ongoing practice of providing reserves for probable remediation activities at certain of its manufacturing locations and for claims and proceedings against CTS with respect to other environmental matters. In the opinion of management, based upon presently available information relating to all such matters, either adequate provision for probable costs has been made, or the ultimate costs resulting will not materially affect the consolidated financial position, results of operations, or cash flows of CTS.

Certain claims are pending against CTS with respect to matters arising out of the ordinary conduct of its business. For all claims, in the opinion of management, based upon presently available information, either adequate provision for anticipated costs has been made or the ultimate anticipated costs resulting will not materially affect CTS’ consolidated financial position, results of operations or cash flows.

FAS No. 128, “Earnings per Share,” requires companies to provide a reconciliation of the numerator and denominator of the basic and diluted earnings per share (EPS) computations. The calculations below provide net earnings, average common shares outstanding, and the resultant earnings per share for both basic and diluted EPS for the three and six month periods ending July 3, 2005 and June 27, 2004.

The following table shows the potentially dilutive securities which have been excluded from the diluted earnings per share calculation for the three and six month periods ending July 3, 2005 and June 27, 2004 because they are either anti-dilutive, or the exercise price exceeds the average market price.

In October 2004, the American Jobs Creation Act of 2004 (Jobs Act) was signed into law. The Jobs Acts provides certain domestic companies a temporary incentive to repatriate, during 2005, previously undistributed earnings abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. To qualify, the repatriated earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by the company’s chief executive officer and subsequently approved by the company’s board of directors. In the second quarter of 2005, CTS’s Board of Directors approved a domestic reinvestment plan (the Plan), authorizing the Company to receive cash dividends of up to $75 million during the current taxable year. The Company did receive dividends of $50 million from certain foreign subsidiaries during the quarter and, accordingly, the Company recorded a related tax expense increase of $4.5 million. The Company continues to review the possibility of repatriating additional foreign dividends under the Plan. CTS expects to determine the amounts and sources of foreign earnings to be repatriated, if any, no later than the fourth quarter of 2005. While the Company is not yet in a position to determine the impact of the additional qualifying repatriation on its 2005 income tax expense, the related potential income tax effect on possible repatriation amounts up to $25 million is approximately $1.6 million, of which, foreign withholding taxes are estimated as $0.4 million.

At July 3, 2005, no provision had been made for U.S. federal and state income taxes on approximately $138 million of foreign earnings, which are expected to be reinvested outside of the United States indefinitely. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to U.S. income taxes (subject to a possible adjustment for foreign tax credits), state income taxes, and withholding taxes payable to the various foreign countries. As noted above, the Company is reviewing the possibility of repatriating up to $25 million during the remainder of 2005, the tax effect of which is described above. In the event all undistributed earnings were remitted, approximately $5.0 million of foreign withholding taxes would be imposed. The amount of unremitted earnings for which no taxes have been provided decreased substantially in the current quarter due to the change in tax law and actions taken described above, which caused the Company to change previous plans to permanently reinvest a portion of those unremitted earnings.

During the second quarter of 2005, the Company recorded a tax benefit of $1.7 million resulting from the reversal of reserves that were no longer required following the successful resolution of tax issues in certain jurisdictions.

During the second quarter of 2004, CTS changed the estimate of its 2004 effective tax rate from 25% to 23%. The lower effective tax rate reflects the increased profits being reported in lower-taxed jurisdictions and the notification that manufacturing incentives in one foreign jurisdiction qualified CTS for a lower statutory rate, expiring in 2011, subject to certain conditions.

In July 2004, CTS’ Board of Directors authorized a program to repurchase up to one million shares of its common stock in the open market during the next two years. Reacquired shares will be used to support equity-based compensation programs and for other corporate purposes. During the second quarter of 2005, CTS repurchased 322,100 shares at a total cost of $3.7 million. CTS is authorized to repurchase an additional 494,900 shares under the July 2004 program.

In late December 2004, the FASB issued FAS No. 123R, “Share-Based Payment.” FAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period). FAS No. 123R eliminates the alternative to use APB Opinion No. 25’s intrinsic value method of accounting that was provided in Statement 123 as originally issued. FAS No. 123R will be effective for CTS in January 1, 2006. CTS currently follows the provisions of APB Opinion No. 25 to account for stock options. Accordingly, the provisions of FAS No. 123R will reduce earnings upon adoption. CTS is currently reviewing the provisions of FAS No. 123R to determine its impact on CTS’ financial statements.

In November 2004, the FASB finalized FAS No. 151, “Inventory Costs, an amendment to ARB No. 43, Chapter 4.” FAS No. 151 amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. FAS No. 151 is effective for CTS on January 1, 2006. CTS is currently reviewing the provisions of the new standard, but does not expect the standard will have a material impact on its financial statements.

CTS is a global manufacturer of components and sensors used in the automotive, communications and computer markets. The Company also provides electronic manufacturing solutions, including design and supply chain management functions, primarily serving the communications, computer, industrial, security, medical and aerospace markets under contract arrangements with the original equipment manufacturers (OEMs). Sales and marketing are accomplished through CTS sales engineers, independent manufacturer’s representatives and distributors. Sales are reported through two business segments, Electronics Manufacturing Services (EMS) and Components and Sensors.

On January 31, 2005, CTS acquired all of the outstanding stock of SMTEK International Inc., (SMTEK), an EMS provider serving OEM’s in the medical, industrial, instrumentation, telecommunications, security, financial services, automation, aerospace, and defense industries. CTS expects this acquisition to accelerate its expansion into new markets, reduce customer concentrations, and increase its global footprint. Under the purchase method of accounting, the assets acquired and liabilities assumed from SMTEK were recorded as of the date of acquisition, at their respective fair values. CTS is in the process of obtaining third-party valuations of certain intangible assets. Accordingly, the allocation of the purchase price is subject to refinement. The results of SMTEK’s operations have been included in the consolidated financial statements since January 31, 2005. Please refer to Note C — “Acquisition” for more information related to this transaction. SMTEK is included in the EMS business segment.

In the second quarter of 2005, sales of EMS and Components and Sensors business segments represented 58.0% and 42.0% of CTS’ total sales respectively, compared to 50.4% and 49.6% respectively in the second quarter of 2004. The EMS sales percentage increased year-over-year due primarily to the acquisition of SMTEK.

As discussed in more detail throughout the Management’s Discussion and Analysis:

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.

Management believes that judgment and estimates related to the following critical accounting policies could materially affect its consolidated financial statements.

In the first six months of 2005, there have been no changes in the above critical accounting policies, except that the following policy has been enhanced to address the SMTEK acquisition.

CTS accounts for acquisitions under the purchase method of accounting pursuant to FAS No. 141, “Business Combinations.” Under the purchase method of accounting, the values assigned to assets acquired and liabilities assumed are based on various factors including fair market values, discounted expected cash flows, and third-party valuations. Goodwill represents the excess of cost of the acquired business over the net amounts assigned to assets acquired and liabilities assumed.

CTS reviews the value assigned to its goodwill on an annual basis in accordance with FAS No. 142 “Goodwill and Other Intangible Assets.” In addition, CTS assesses the carrying value of long-lived and other 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.

Adjusted operating earnings is a non-GAAP financial measure which CTS has calculated excluding the 2004 gain on the sale of excess land in Canada. Management believes adjusted operating excluding this item is useful information to investors in making comparisons between periods.

Adjusted earnings per share is a non-GAAP financial measure which CTS has calculated by excluding the 2005 tax expense related to the cash repatriation and the reversal of tax reserves and the 2004 gain on the sale of excess land in Canada. Management believes adjusted earnings per share excluding these two items is useful information to investors in making comparisons between periods.

Refer to Note J, “Business Segments,” for a description of the Company’s business segments.

The following table highlights the segment results for the three-month periods ending July 3, 2005 and June 27, 2004:

Sales in the Components and Sensors business segment were down $1.7 million, or 2.5% from the second quarter of 2004. The decrease in sales was attributable primarily to lower sales into mobile handset applications, partially offset by growth in the automotive products. Segment operating earnings were $7.5 million, down $1.3 million from second quarter of 2004, which included a $2.7 million gain on the sale of excess land in Canada. Other operating earning improvements resulted from cost improvement initiatives and savings related to personnel reductions incurred in the first quarter of 2005.

The EMS segment experienced a sales increase of $22.4 million in the second quarter of 2005, or 32.3% from the second quarter of 2004. The EMS revenue increase includes sales of $29.3 million from the acquired SMTEK business partially offset by lower communication infrastructure sales in China.

The EMS segment operating earnings increased $1.0 million primarily due to higher volumes as a result of the SMTEK acquisition.

The following table highlights changes in significant components of the condensed consolidated statements of earnings for the three-month periods ended July 3, 2005 and June 27, 2004:

Second quarter sales of $158.3 million, increased $20.7 million or 15.1% from the second quarter of 2004. The increase was attributable to $29.3 million of sales from the acquired SMTEK business and growth in automotive products, partially offset by lower EMS sales into the communication infrastructure market in China and Component and Sensors sales into mobile handset applications.

Gross margin increased $3.4 million in the second quarter of 2005 from the second quarter of 2004, primarily due to increased sales. As a percentage of sales, gross margin decreased to 20.4% in the second quarter of 2005, from 21.0% in the second quarter of 2004. This is primarily due to a higher percent of EMS segment sales, which inherently have a lower gross margin percentage than Components and Sensors segment sales. Improvements in the Components and Sensors segment margins and savings related to personnel reductions incurred in the first quarter of 2005 partially offset the impact of the segment mix change.

Selling, general and administrative expenses were $17.7 million, or 11.2% of sales, in the second quarter of 2005 versus $16.6 million, or 12.1% of sales in the second quarter of 2004. The increase was, to a large extent, due to the incremental expense impact resulting from the acquired SMTEK business.

Research and development expenses were $4.6 million, or 2.9% of sales versus $4.7 million, or 3.4% of sales in the second quarter of 2004. The percentage decrease was primarily due to the acquired SMTEK business as research and development expenditures in the EMS business segment are typically much lower than in the Components and Sensors business segment.

Significant ongoing research and development activities continue in Components and Sensors to support expanded application and new product development.

Operating earnings in the second quarter of 2004 included a $2.7 million, or $0.05 per share, impact from the gain on the sale of excess land in Canada. Adjusted operating earnings improved to $10.3 million, or 6.5% of sales, in the second quarter at 2005 from $7.9 million or 5.8% in the second quarter of 2004 (see reconciliation of adjusted operating earnings). The adjusted operating earnings increase relates to the gross margin improvements, as noted above.

In the second quarter of 2005, income tax expense included a net impact of $2.8 million or $0.07 per share related to the $4.5 million of expense for the repatriation of foreign cash to the United States under the provision of the American Jobs Creation Act of 2004 and a $1.7 million benefit relating to the reversal of income tax reserves due to the successful resolution of tax issues in certain jurisdictions.

Net earnings of $3.9 million, or 2.5% of sales, decreased $3.0 million versus the second quarter of 2004. Net earnings per share of $0.10 were $0.08 lower than second quarter 2004. The adjusted earnings per share for the second quarter of 2005 was $0.17, or a $0.04 per share increase from adjusted earnings per share in 2004 (see reconciliation on page 21).

The following table highlights the business segment results for the six-month periods ending July 3, 2005 and June 27, 2004:

During the first six months of 2005, sales of Components and Sensors and EMS products, as a percentage of total sales, were 41.6% and 58.4% respectively. The first six months of 2004 sales of Components and Sensors and EMS products, as a percentage of total sales, were 50.7% and 49.3% respectively.

The Components and Sensors business segment sales decreased $1.1 million or 0.8% from prior year. The decrease was primarily due to lower sales into mobile handset applications, partially offset by growth in the automotive products. Operating earnings decreased $0.8 million due to a $2.7 million gain on sale of excess land in Canada in the first half of 2004. The negative impact of lower sales volume was more than offset by ongoing cost improvement initiatives, lower depreciation and changes in the allocation of certain factory costs to the EMS segment due to the establishment of a new EMS operation in shared Singapore facilities.

The EMS segment experienced a sales increase of $55.0 million in the first six months of 2005, or 42.9% from the first six months of 2004. The EMS revenue increase includes sales from the acquired SMTEK business of $52.5 million and increased sales of networking equipment, partially offset by the lower sales in the communication infrastructure market in China.

EMS segment operating earnings increased $1.2 million primarily due to higher volumes, partially offset by the establishment of a new EMS operation in shared Singapore facilities, as noted above and increased depreciation and amortization expense.

The following table highlights changes in significant components of the condensed consolidated statements of earnings for the six-month periods ended July 3, 2005 and June 27, 2004:

Net sales of $313.7 million, including $52.5 million from the acquired SMTEK business, increased $53.9 million for the first half of 2005, or 20.8% from the first half of 2004. Other increases in sales were primarily due to higher demand in networking equipment and growth in automotive products partially offset by reduced sales in communication infrastructure.

Gross margin increased $7.0 million, or 13.0%, for the first half of 2005, primarily due to increased sales, including sales from the acquired SMTEK business. As a percentage of sales, gross margin decreased to 19.3% in the first half of 2005 compared to 20.6% in the first half of 2004. This is primarily due to a higher percentage of EMS segment sales, which have a lower gross margin percentage than Components and Sensors segment sales.

Selling, general and administrative expenses increased $4.1 million, primarily due to the incremental expense impact resulting from the addition of the acquired SMTEK business. In addition, the first half of 2005 included $0.7 million intangible assets amortization expenses associated with SMTEK acquisition.

Research and development expenses were $9.4 million, or 3.0% of sales versus $9.6 million, or 3.7% of sales in the first half of 2004. The percentage decrease was primarily due to the acquired SMTEK business as research and development expenditures in the EMS business segment are typically much lower than in the Components and Sensors business segment. Significant ongoing research and development activities continue in Components and Sensors to support expanded application and new product development.

Operating earnings in the first half of 2004 included a $2.7 million, or $0.06 per share, impact from the gain on the sale of excess land in Canada. Adjusted operating earnings improved to $16.0 million, or 5.1% of sales, in the first half of 2005 from $12.8 million or 4.9% in the second quarter of 2004 (see reconciliation of adjusted operating earnings). The adjusted operating earnings increase relates to the gross margin improvements, as noted above.

Income tax expense included a net impact of $2.8 million, or $0.07 per share, related to the $4.5 million of expense for the repatriation of foreign cash to the United States under the provision of the American Jobs Creation Act of 2004 and a $1.7 million benefit relating to the reversal of income tax reserves due to the successful resolution of tax issues in certain jurisdictions.

Net earnings of $7.3 million, or 2.3% of sales, decreased $2.1 million versus the first half of 2004. Net earnings per share of $0.19 were $0.07 lower than the first half of 2004, however excluding the impact of the 2005 income tax expense related to the cash repatriation and the reversal of tax reserves as noted above, adjusted earnings per share for the first half of 2005 was $0.26, a $0.06 per share increase from adjusted earnings per share in 2004 (see reconciliation of adjusted earnings per share).

Based on the first half 2005 results and revised estimates for the balance of the year, the company expects full-year 2005 sales growth to be in the range of 19% to 28% over 2004. Earnings per share, excluding the second quarter tax adjustment impact of $0.7 per share, are now expected to be in the range of $0.62 to $0.68.

Significant events impacting liquidity for the first six months of 2005 were as follows:

Cash and cash equivalents decreased to $14.2 million at July 3, 2005 from $61.0 million at December 31, 2004. Total debt on July 3, 2005 was $88.9 million, down from $97.5 million at the end of 2004. Total debt as a percentage of total capitalization was 21.6% at the end of the second quarter of 2005, compared with 23.9% at the end of 2004.

Working capital decreased by $31.9 million in the first half of 2005 primarily due to the SMTEK acquisition. The cash and cash equivalents decrease of $46.8 million related primarily to the repayment of debt offset by improvements in cash flows provided by operations. Other significant impacts to working capital included an accounts payable increase of $13.9 million partially offset by the accounts receivable increase of $5.5 million and the inventory increase of $15.9 million which were primarily due to the second quarter of 2005 sales increase of 15.1% which, as stated above, is primarily due to the acquisition of SMTEK.

The following table summarizes free cash flow for the Company:

Free cash flow is a non-GAAP financial measure which CTS defines as the sum of net cash provided by operations and cash used for capital expenditures. The most directly comparable GAAP financial measure is net cash provided by operations. Management believes that free cash flow provides useful information to investors regarding the Company’s ability to generate cash from business operations that was used and/or is available for internal growth, service of debt principal, dividends, share repurchase and acquisitions and other investments. Management uses free cash flow as one measure to monitor and evaluate the performance of the Company.

During the first six months of 2005, net cash provided by operations was $24.6 million and capital expenditures were $5.9 million. Total free cash flow in the first six months of 2005 was $18.7 million.

During the first six months of 2004, net cash provided by operations was $4.7 million, despite funding the working capital required for business growth and capital expenditures were $6.2 million. Total free cash flow in the first six months of 2004 was an outflow of $1.5 million

Cash flows provided by operations were $24.6 million in the first half of 2005 primarily driven from net earnings of $7.3 million, depreciation and amortization of $13.6 million and deferred income taxes of $3.0 million.

Cash flows provided by operations were $4.7 million in the first half of 2004. Components of cash flows from operations include earnings of $9.4 million and depreciation and amortization of $14.0 million partially offset by unfavorable changes in current assets and current liabilities of $11.4 million, primarily due to increased accounts receivable and inventory to support higher sales and the new EMS operation in Singapore. In addition, the prepaid pension asset increased $4.9 million, and there was a gain of $3.1 million on sale of assets.

Cash flows used in investing activities were $40.7 million in the first half of 2005, including $35.6 million used in the SMTEK acquisition. Capital expenditures were $5.9 million.

Cash flows provided by investing activities totaled $12.8 million through the first half of 2004, including $16.4 million of net proceeds from the sale of the Longtan, Taiwan facility and $2.1 million from the sale of excess land in Canada, partially offset by $6.2 million of capital expenditures.

Cash flows used in financing activities for the first half of 2005 were $28.6 million, consisting primarily of $13.0 million from the repayment of debt related to the SMTEK purchase and a net $9.7 million reduction to the Credit Facility, a $3.4 million purchase of treasury stock and $2.2 million in dividend payments

Cash flows provided by financing activities for the first half of 2004 were $4.7 million, consisting primarily of $57.8 million proceeds from the $60.0 million Debentures due 2024, $42.0 million repayment of the 7.5% industrial revenue bonds, $8.9 million repayment of the Credit Facility, and $2.2 million in dividend payments.

CTS has a credit agreement containing a $75 million senior, secured revolving credit agreement. The outstanding balance under the credit agreement at July 3, 2005, was $4.8 million. Any outstanding balances under the revolving credit agreement would be senior to CTS’ convertible debentures. The revolving credit agreement is collateralized by substantially all U.S. assets and a pledge of 65% of the capital stock of certain non-U.S. subsidiaries. Interest rates on the revolving credit agreement fluctuate based on LIBOR. CTS pays a commitment fee on the undrawn portion of the credit agreement. The commitment fee varies based on performance under certain financial covenants and is currently 0.4 percent per annum. The revolving credit agreement requires, among other things, that CTS comply with a minimum fixed charge coverage ratio, a maximum leverage ratio and a minimum tangible net worth covenants. As of July 3, 2005, CTS was in compliance with these covenants. Failure of CTS to comply with these covenants could reduce the borrowing availability under the credit agreement. Additionally, the credit agreement limits the amounts allowed for dividends, capital expenditures and acquisitions. The credit agreement expires in July 2007.

CTS believes cash flows from operations and available borrowings under its Credit Facility will be adequate to fund its working capital and capital expenditure requirements. CTS may choose to pursue additional equity and/or debt financing to fund acquisitions and/or to reduce its overall interest expense or improve its capital structure.

In July, 2004, CTS’ Board of Directors authorized the repurchase of up to one million shares of its outstanding shares of common stock. Under this program, CTS purchased 322,100 in the first half of 2005, resulting in authority to repurchase an additional 494,900 shares before June 30, 2006.

On November 13, 2001, CTS’ Form S-3 registration statement registering two million shares of CTS common stock to be issued under CTS’ Direct Stock Purchase Plan was declared effective by the Securities and Exchange Commission. As of July 3, 2005, CTS could issue up to approximately 48,000 additional shares of common stock under this registration statement.

On December 14, 1999, CTS’ shelf registration statement on Form S-3 was declared effective by the Securities and Exchange Commission. CTS could initially offer up to $500.0 million in any combination of debt securities, common stock, preferred stock or warrants under the registration statement. During the first half of 2005, CTS did not issue any securities under this registration statement. As of July 3, 2005, CTS could offer up to $435.1 million of additional debt and/or equity securities under this registration statement.

In late December 2004, the FASB issued FAS No. 123R, “Share-Based Payment.” FAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award — the requisite service period (usually the vesting period). FAS No. 123R eliminates the alternative to use APB Opinion No. 25’s intrinsic value method of accounting that was provided in Statement 123 as originally issued. FAS No. 123R will be effective for CTS in 2006. CTS currently follows the provisions of APB Opinion No. 25 to account for stock options. Accordingly, the provisions of FAS No. 123R will reduce earnings upon adoption. CTS is currently reviewing the provisions of FAS No. 123R to determine its impact on CTS’ financial statements.

In November 2004, the FASB finalized FAS No. 151, “Inventory Costs, an amendment to ARB No. 43, Chapter 4.” FAS No. 151 amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. FAS No. 151 is effective for CTS on January 1, 2006. CTS is currently reviewing the provisions of the new standard, but does not expect the standard will have a material impact on its financial statements.

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Forward-Looking Statements

Statements about the Company’s earnings outlook and its plans, estimates and beliefs concerning the future are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s expectations, certain assumptions and currently available information. Actual results may differ materially from those reflected in the forward-looking statements due to a variety of geopolitical, economic, health, industry and other factors which could affect the Company’s operating results, liquidity and financial condition. We undertake no obligations to publicly update or revise any forward-looking statement. Examples of factors which may affect future results include, but are not limited to: rapid technological change, general market conditions in the automotive, communications and computer industries; reliance on key customers; 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. Investors are encouraged to examine the Company’s 2004 Form 10-K, which more fully describes the risks and uncertainties associated with the Company’s business.

There have been no other material changes in CTS’ market risk since December 31, 2004.

CTS maintains a set of disclosure controls and procedures designed to ensure information required to be disclosed by CTS in reports that it files or submits under the Securities Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Management recognizes that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. As of July 3, 2005, the end of the quarter covered by this report, an evaluation was carried out under the supervision and with the participation of CTS’ management, including the chief executive officer and chief financial officer, of the effectiveness of CTS’ disclosure controls and procedures. Based upon that evaluation, the chief executive officer and chief financial officer have concluded that CTS’ disclosure controls and procedures are effective at the reasonable assurance level referred to above, provided that the evaluation of CTS’ disclosure controls and procedures did not include an evaluation of the effectiveness of the internal control over financial reporting for the SMTEK business, as described further below.

The SMTEK business has facilities located in Moorpark and Santa Clara, California; Marlborough, Massachusetts; and Bangkok, Thailand. Each of these facilities reports financial results that are included in this report for the quarter ended July 3, 2005. CTS’ management has not made an assessment of the SMTEK business’ internal control over financial reporting since the date of the acquisition. Other than changes resulting from CTS’ acquisition of SMTEK, there were no changes in CTS’ internal control over financial reporting during the quarter ended July 3, 2005 that materially affected, or are reasonably likely to materially affect, CTS’ internal control over financial reporting.

Refer to Note L, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements in Part I of this Form 10-Q.

The following table summarizes the repurchases of CTS common stock made by the Company during the three months ended July 3, 2005:

The Annual Meeting of Shareholders of CTS Corporation was held on May 4, 2005. At the meeting, the following matter was submitted to a vote of the stockholders of CTS:

The election of nine directors to serve for one year beginning at the 2005 annual shareholders’ meeting and expiring at the 2006 annual shareholders’ meeting. A summary of votes by directors is shown below:

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.