CTS Corporation - 10-Q quarterly report FY

(Mark One)

Commission File Number: 1-4639

(Exact name of registrant as specified in its charter)

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.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of April 24, 2006: 35,886,365

CTS CORPORATION AND SUBSIDIARIES

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

See notes to condensed consolidated 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, 2005.

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.

Effective January 1, 2006, CTS adopted the provisions of the Financial Accounting Standards Board’s (FASB) Financial Accounting Standard (FAS) No. 123(R), “Share-Based Payment.” FAS No. 123(R) requires that CTS recognize expense related to the fair value of stock-based compensation awards in the Unaudited Condensed Consolidated Statement of Earnings.

Prior to January 1, 2006, CTS accounted for stock-based 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. Accordingly, stock compensation expense was not recognized in the Unaudited Condensed Consolidated Statement of Earnings for stock options granted with an exercise price equal to the market value of the common stock on the grant date. However, prior years’ financial statements did include pro forma disclosures for equity-based awards as if the fair-value approach had been followed. The following table presents the pro forma net earnings and net earnings per share for the quarter ending April 3, 2005, as if CTS had applied the provisions of FAS No. 123(R) during that period:

CTS has elected to follow the modified prospective transition method allowed by FAS No. 123(R), and therefore, will apply the provisions of FAS No. 123(R) to awards modified or granted after January 1, 2006. In addition, for awards which were unvested as of January 1, 2006, CTS will recognize compensation expense in the Unaudited Condensed Consolidated Statement of Earnings over the remaining vesting period. The compensation expense for these awards will be based on the grant-date fair value as calculated for the prior years’ pro forma disclosures. As allowed under the modified prospective transition method, the financial results for prior periods have not been restated. The cumulative effect of the change in accounting principle from APB No. 25 was not material.

As a result of adopting FAS No. 123(R), CTS’ operating earnings and earnings before income taxes for the three months ending April 2, 2006 includes $209,000 of additional compensation expense, equating to $157,000 of after-tax expense included in net earnings. Reported basic and diluted earnings per share are unchanged due to the adoption of FAS No. 123(R).

Prior to the adoption of FAS No. 123(R), CTS presented tax benefits in excess of recognized cumulative compensation costs as operating cash flows in the Unaudited Condensed Consolidated Statement of Cash Flows. FAS No. 123(R) requires these cash flows be classified as financing cash flows. CTS has classified $26,000 and $15,000 of these excess tax benefits as financing cash flows for the periods ending April 2, 2006 and April 3, 2005, respectively.

At April 2, 2006, CTS had five equity-based compensation plans: the 1988 Restricted Stock and Cash Bonus Plan (1988 Plan), the 1996 Stock Option Plan (1996 Plan), the 2001 Stock Option Plan (2001 Plan), the Nonemployee Directors’ Stock Retirement Plan (Directors’ Plan), and the 2004 Omnibus Long-Term Incentive Plan (2004 Plan). As of December 2004, additional grants can only be made under the 2004 Plan. CTS believes that equity-based awards align the interest of employees with those of its shareholders.

The 2004 Plan, and previously the 1996 Plan and 2001 Plan, provides for grants of incentive stock options or nonqualified stock options to officers, key employees, and nonemployee members of CTS’ board of directors. In addition, the 2004 Plan allows for grants of stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units, and other stock awards.

The following table summarizes the compensation expense included in the Unaudited Condensed Consolidated Statement of Earnings for the three months ended April 2, 2006 and April 3, 2005 relating to these plans:

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The following table summarizes the status of these plans as of April 2, 2006:

Stock options are exercisable in cumulative annual installments over a maximum 10-year period, commencing at least one year from the date of grant. Stock options are generally granted with an exercise price equal to the market price of the Company’s stock on the date of grant. The stock options generally vest over four years and have a 10-year contractual life. The awards generally contain provisions to either accelerate vesting or allow vesting to continue on schedule upon retirement if certain service and age requirements are met. The awards also provide for accelerated vesting if there is a change in control event.

The Company estimates the fair value of the stock option on the grant date using the Black-Scholes option-pricing model and assumptions for expected price volatility, option term, risk-free interest rate, and dividend yield. Expected price volatilities are based on historical volatilities of the Company’s stock. The expected option term is derived from historical data on exercise behavior. The dividend yield is based on historical dividend payments. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

A summary of the status of stock options as of April 2, 2006 and April 3, 2005, and changes during the three-month periods then ended, is presented below:

The total intrinsic value of share options exercised during the quarters ended April 2, 2006 and April 3, 2005 was $65,000 and $38,000, respectively.

A summary of the weighted-average remaining contractual term and aggregate intrinsic value of options outstanding and exercisable at April 2, 2006 is presented below:

A summary of the nonvested stock options as of April 2, 2006 and April 3, 2005, and changes during the three-month periods then ended, is presented below:

The total fair value of shares vested during the quarters ended April 2, 2006 and April 3, 2005 was $90,000 and $186,000, respectively.  As of April 2, 2006, there was $869,000 of unrecognized compensation cost related to nonvested stock options.  That cost is expected to be recognized over a weighted-average period of 1.7 years.  CTS recognizes expense on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in substance, multiple awards.

The following table summarizes information about stock options outstanding at April 2, 2006:

Stock settled restricted stock units (RSUs) entitle the holder to receive one share of common stock for each unit when the unit vests. RSUs are issued to officers and key employees as compensation. Generally, the RSUs vest over a five-year period. A summary of the status of RSUs as of April 2, 2006 and April 3, 2005, and changes during the three-month periods then ended is presented below:

As of April 2, 2006, there was $3.2 million of unrecognized compensation cost related to nonvested RSUs. That cost is expected to be recognized over a weighted-average period of 2.0 years. CTS recognizes expense on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in substance, multiple awards.

CTS’ 1988 Plan originally reserved 2,400,000 shares of CTS’ common stock for sale at market price, or award, to key employees. Under the 1988 Plan, 53,482 shares of Restricted Stock were outstanding as of April 2, 2006.  Shares sold or awarded are subject to restrictions against transfer and repurchase rights of CTS.  In general, restrictions lapse at the rate of 20% per year beginning one year from the grant date.  In addition, the 1988 Plan provides for a cash bonus to the participant equal to the fair market value of shares on the dates restrictions lapse, in the case of an award. The total bonus paid to any participant during the restricted period is limited to twice the fair market value of the shares on the date of award or sale. As of April 2, 2006, there was $346,000 of total unrecognized compensation cost related to nonvested Restricted Stock. That cost is expected to be recognized over a weighted-average period of 1.7 years.  CTS recognizes expense on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in substance, multiple awards.

The Directors’ Plan provides for a portion of the total compensation payable to nonemployee directors to be deferred and paid in CTS stock. The Directors Plan was frozen effective December 1, 2004. All future grants will be from the 2004 Plan.

In January 2006, CTS announced its intention to consolidate its Berne, Indiana manufacturing operations into three of its other existing facilities. Automotive product operations at Berne will be transferred to CTS’ automotive facilities in Matamoros, Mexico and Elkhart, Indiana. Electronic components operations in Berne will be moved to CTS’ Singapore facility. Some electronic component related service functions are expected to remain in Berne. The consolidation process is expected to largely be completed in the second half of 2006.

The following table displays the cost associated with the Berne consolidation which are expected to be incurred, as well as a summary of the actual costs incurred through April 2, 2006:

All of the Berne consolidation costs relate to the Components and Sensors business segment. Restructuring charges are reported on a separate line on the Unaudited Condensed Consolidated Statement of Earnings and the restructuring-related costs are included in cost of goods sold.

The following table displays the restructuring reserve activity for the quarter ending April 2, 2006:

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 had four facilities located in Moorpark and Santa Clara, California; Marlborough, Massachusetts; and Bangkok, Thailand.

The following table presents CTS’ unaudited pro forma consolidated results of operations for the quarter ending April 3, 2005 as if the acquisition had been completed at the beginning of the 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 D, “Acquisition”):

Inventories consist of the following:

Long-term debt was comprised of the following:

CTS has a $75 million senior, secured revolving credit agreement that had an outstanding balance of $2.0 million at April 2, 2006. 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 0.38 percent per annum at April 2, 2006. The revolving credit agreement requires, among other things, that CTS comply with minimum fixed charge coverage, maximum leverage ratio, and minimum tangible net worth covenants. 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 capital expenditures and acquisitions. In March 2006, CTS amended its revolving credit agreement to increase the permitted level of unsecured debt under other agreements and to modify restrictions on dividends and other distributions. The revolving credit agreement expires in July 2007.

CTS has $60 million convertible senior subordinated debentures (2.125% 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 2.125% 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 2.125% Debentures, in lieu of delivering common stock, the Company may, at its discretion, deliver cash or a combination of cash and common stock.

The conversion price of the 2.125% Debentures will be adjusted if CTS completes certain transactions, including: distribution of shares as a dividend to substantially all shareholders; subdivision, combination or reclassification of its common stock; distribution of stock purchase warrants to substantially all shareholders; distribution of cash, stock or property to shareholders in excess of $0.03 per share; or purchase of its common stock pursuant to a tender offer or exchange offer under certain circumstances.

Holders may convert the 2.125% 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 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 April 2, 2006, none of the conditions for conversion of the 2.125% million Debentures were satisfied.

CTS may, at its option, redeem all or a portion of the 2.125% 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.

CTS has a registration rights agreement relating to the 2.125% Debentures which became effective in 2004. CTS' obligation to keep the registration statement continuously effective for a period of two years will expire in May 2006. The registration rights agreement provides that in the event of a default in this obligation, CTS is subject to an additional interest penalty of 0.25% per annum of the principal for the first 90 days of default and 0.5% per annum of principal thereafter. If a holder converts during a period of default, in lieu of additional interest CTS must deliver 103% of the number of shares the holder would otherwise have received in settlement. As of April 2, 2006, the maximum additional interest which CTS could incur as a result of the failure to maintain an effective registration statement was approximately $20,000.

The Company has $5.5 million of 6.5% convertible, subordinated debentures (6.5% Debentures) outstanding at April 2, 2006. 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 including a volume weighted average price greater than the conversion price by more than 175% for at least twenty trading days, to force conversion of the debentures into common stock. Interest on the debentures is payable semi-annually.

The conversion price of the 6.5% Debentures will be adjusted if CTS completes certain transactions, including: a common stock split or similar event; a distribution of stock purchase warrants to substantially all shareholders; a distribution of non-cash assets to substantially all shareholders; a cash distribution to substantially all shareholders which together with other cash distributions during the preceding year totals in excess of 3% of the market price of common stock; or a merger or other transaction under which shares of common stock are converted into another class of stock or security or into the securities of another corporation.

While any of the 6.5% Debentures are outstanding, CTS is subject to covenants which among other things, restrict its ability to pay dividends, repurchase stock, make payments on debt which ranks junior to the 6.5% Debentures and engage in certain transactions with subsidiaries and affiliates. CTS' obligation under a registration right agreement to maintain an effective registration statement for the stock underlying the 6.5% Debentures expired in 2004.

In connection with the acquisition of SMTEK, CTS assumed a term loan, which has a balance of $0.9 million at April 2, 2006. 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 months ended April 2, 2006 and April 3, 2005 includes the following components:

In the first quarter of 2006, CTS recognized a pension plan curtailment loss of approximately $0.3 million and another postretirement benefit plan curtailment gain of approximately $0.1 million due to reduced employment levels. Also, effective April 1, 2006, CTS closed one of its U.S. defined benefit plans to new participants.

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) Electronics Manufacturing Services (EMS) and 2) Components and Sensors.

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. Additionally, for some customers, CTS provides full turnkey manufacturing and completion including design, bill-of-material management, logistics, and repair.

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 communications infrastructure and computer markets; terminators, including ClearONE™ terminators, used in computer and other high speed applications, switches, resistor networks, and potentiometers used to serve multiple markets.

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 restructuring and related charges, interest expense, other non-operating income, and income tax expense.

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:

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 quarters ending April 2, 2006 and April 3, 2005.

The following table shows the potentially dilutive securities which have been excluded from the first quarter 2006 and 2005 dilutive earnings per share calculation because they are either anti-dilutive, or the exercise price exceeds the average market price.

CTS incurred approximately $1.3 million and $1.9 million of rent expense in the quarters ending April 2, 2006 and April 3, 2005, respectively. The future minimum lease payments under the Company’s operating leases are $3.6 million for the remainder of 2006, $4.7 million in 2007, $4.0 million in 2008, $3.8 million in 2009, $2.4 million in 2010, and $3.7 million thereafter.

CTS is a global manufacturer of components and sensors used primarily 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, and medical 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.

In the first quarter of 2006, sales of EMS and Components and Sensors business segments represented 55.1% and 44.9% of CTS’ total sales respectively, compared to 58.7% and 41.3% respectively in the first quarter of 2005.

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 unaudited 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 quarter of 2006, there have been no changes in the above critical accounting policies, except that the following policy has been added in consideration of CTS’ adoption of FAS No. 123(R), “Share based Payment,” effective January 1, 2006.

Effective January 1, 2006, CTS adopted the provisions of FAS No. 123(R) which required CTS to recognize the expense related to the fair value of stock-based compensation awards in the Unaudited Condensed Consolidated Statement of Earnings. CTS elected to follow the modified prospective transition method allowed by FAS No. 123(R), and therefore, only applied the provisions of FAS No. 123(R) to awards modified or granted after January 1, 2006. In addition, for awards which were unvested as of January 1, 2006, CTS will recognize compensation expense in the Unaudited Condensed Consolidated Statement of Earnings over the remaining vesting period. Prior to January 1, 2006, CTS accounted for stock-based compensation using the intrinsic value method prescribed in APB No. 25, “Accounting for Stock Issued to Employees.”

FAS No. 123(R) requires companies to estimate the fair value of stock-based awards on the date of grant using an option-pricing model. CTS uses the Black-Scholes option pricing model. A number of assumptions are used by the Black-Scholes option-pricing model to compute the grant date fair value, including expected price volatility, option term, risk-free interest rate, and dividend yield. Expected volatilities are based on historical volatilities of the Company’s stock. The expected option term is derived from historical data on exercise behavior. The dividend yield is based on historical dividend payments. The risk-free rate for periods within the contractual life of the option is based on the U.S. treasury yield curve in effect at the time of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Unaudited Condensed Consolidated Statement of Earnings. CTS’ stock options primarily have a graded-vesting schedule. CTS recognizes expense on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards.  CTS’ stock options generally contain provisions to either accelerate vesting or allow vesting to continue on schedule upon retirement if certain service and age requirements are met. As a result, equity-based compensation expense recorded in future income statements could fluctuate based on the terms of the awards, the assumptions used in the valuation model, or the status of those employees receiving awards.

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

The following table highlights the business segment results for the three-month periods ending April 2, 2006 and April 3, 2005:

Sales in the Components and Sensors business segment were up $3.5 million, or approximately 5.4% from the first quarter of 2005. The increase in sales was attributable primarily to growth in automotive product sales, growth in the sale of electronic components into infrastructure applications, and increased royalty revenue partially offset by a decrease of sales into mobile handset applications as CTS continues to de-emphasize these products.

The Components and Sensors business segment operating earnings were $10.4 million in the first quarter of 2006 versus $3.5 million in the first quarter of 2005. Operating earnings in the first quarter of 2006 included a favorable insurance claim settlement of approximately $1.5 million, or $0.03 per share. Other operating earning improvements resulted from personnel savings related to headcount reductions taken primarily in the first quarter of 2005, margin contribution from the higher sales volume, favorable product mix as the sales shifted from the less profitable handset market into the more profitable infrastructure applications and automotive products, and increased royalty revenue. In the first quarter of 2006, CTS has recorded pension income of $0.8 million in operating income. This amount includes $0.3 million of pension curtailment losses associated with the Berne consolidation, which are included in the restructuring charge discussed above. The remaining $1.1 million of pension income compares to $1.4 million of pension income recorded in the first quarter of 2005. The decrease from prior year results primarily from the amortization of losses resulting from lower pension returns than expected in prior years in the U.S. Plans. The increase in the loss amortization expense item from 2005 to 2006 is a result of a change in mortality assumption (resulting in longer life expectancies), actual plan experience being less favorable than expected, and the amortization of deferred asset losses from prior years.

The EMS business segment experienced a sales decrease of $8.3 million, or 9.1%, in the first quarter of 2006 versus the first quarter of 2005. The decrease in sales was attributable primarily to lower sales into the computer market.

The EMS business segment operating earnings decreased $1.1 million primarily due to lower sales volumes and the incremental costs related to the full quarter of expense in 2006 versus two months of expense in 2005 for the January 31, 2005 SMTEK acquisition.

The following table highlights changes in significant components of the unaudited condensed consolidated statements of earnings for the three-month periods ended April 2, 2006 and April 3, 2005:

First quarter sales of $150.5 million decreased $4.8 million, or 3.1%, from the first quarter of 2005. The decrease was mainly attributable to lower sales in the computer market in the EMS business segment. The Components and Sensors business segment partially offset the sales decrease with higher sales of automotive products, higher sales of electronic components into infrastructure applications, and higher revenue from royalties.

Gross margin increased $3.9 million in the first quarter of 2006 from the first quarter of 2005 due to favorable business segment sales mix and gross margin improvement within each business segment. The Components and Sensors business segment, which inherently generates a higher gross margin, increased to 44.9% of total sales in the first quarter of 2006 compared to 41.3% of total sales in the same period of 2005 due mainly to sales growth in automotive sensor products.

Research and development expenses were $4.1 million, or 2.7% of sales in the first quarter of 2006 versus $4.8 million, or 3.1% of sales in the first quarter of 2005. The percentage decrease was primarily due to personnel savings related to headcount reductions taken primarily in the first quarter of 2005 primarily in the Components and Sensors business segment. 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 were $9.3 million in the first quarter of 2006 compared to $5.7 million in the first quarter of 2005. The increase in operating earnings included $2.1 million of expenses, or $0.04 per share, from restructuring and related charges associated with the consolidation of CTS’ Berne, Indiana manufacturing operations and also included the favorable impact from an insurance claim settlement of approximately $1.5 million, or $0.03 per share. In the first quarter of 2006, CTS has recorded pension income of $0.8 million in operating income. This amount includes $0.3 million of pension curtailment losses associated with the Berne consolidation, which are included in the restructuring charge discussed above. The remaining $1.1 million of pension income compares to $1.4 million of pension income recorded in the first quarter of 2005 The decrease from prior year results primarily from the amortization of losses resulting from lower pension returns than expected in prior years in the U.S. Plans. The increase in the loss amortization expense item from 2005 to 2006 is a result of a change in mortality assumption (resulting in longer life expectancies), actual plan experience being less favorable than expected, and the amortization of deferred asset losses from prior years.

Net earnings of $6.2 million, or 4.1% of sales, increased $2.8 million versus the first quarter of 2005. Net earnings per share of $0.16 were $0.09 higher than first quarter 2005.

Based on the first quarter results and the outlook for the remainder of the year, CTS expects full-year 2006 sales to grow by 6% - 8% over 2005. Full-year adjusted diluted earnings per share are now expected to be in a range of $0.75 to $0.80, excluding full-year Berne restructuring and related charges of approximately $0.08 per share.

Cash and cash equivalents were $12.6 million at April 2, 2006 compared to $12.0 million at December 31, 2005. Total debt on April 2, 2006 was $82.5 million, substantially unchanged from $81.8 million at the end of 2005. Total debt as a percentage of total capitalization was 19.7% at the end of the first quarter of 2006, compared with 19.9% at the end of 2005.

Working capital increased $9.8 million in the first quarter of 2006 versus December of 2005, primarily driven by the following:

Net cash provided by operating activities was $2.6 million for the first quarter of 2006.  Components of net cash provided by operating activities included net earnings of $6.2 million, depreciation and amortization expense of $6.6 million and equity-based compensation of $0.9 million partially offset by unfavorable changes in assets and liabilities of $11.1 million. The unfavorable changes in assets and liabilities were primarily due to increased accounts receivables of $2.9 million, an increase in other current assets of $2.5 million, an increase in prepaid pension asset of $1.2 million, an increase in inventory of $0.9 million and a decrease in accounts payable and accrued liabilities of $3.2 million.

Net cash provided by operating activities was $10.9 million for the first quarter of 2005.  Components of net cash provided by operating activities included net earnings of $3.4 million, depreciation and amortization expense of $6.8 million, equity-based compensation of $0.5 million and a $0.1 million favorable change in assets and liabilities. The favorable changes in assets and liabilities were primarily due to decreased accounts receivables of $2.1 million and an increase of $1.7 million in accounts payable and accrued liabilities. The unfavorable changes in assets and liabilities were primarily due to the $2.2 million increase in other current assets and the $1.9 million increase in prepaid pension asset.

Total free cash flow in the first quarter of 2006 was $0.1 million. Total free cash flow in the first quarter of 2005 was $7.9 million.

Free cash flow is a non-GAAP financial measure which CTS defines as net cash provided by operations less capital expenditures. The most comparable GAAP measure is net cash provided by operations. CTS' management uses free cash flow to evaluate financial performance and in strategic planning, specifically, for investing and financing decisions. CTS' management believes free cash flow is a useful measure because it indicates the ability of a business operation to fund its own required capital investments. CTS' management believes that the non-GAAP measure free cash flow is useful to investors because it reflects the performance of its overall operations more accurately than net cash provided by operations and because it provides investors with the same results that management uses as the basis for making decisions about the business. Free cash flow is not an indicator of residual cash available for discretionary spending, because it does not take into account mandatory debt service or other non-discretionary spending requirements which are not deducted in the calculation of free cash flow. CTS' management takes these limitations into account when using free cash flow to make investing and financing decisions.

The following table summarizes free cash flow for CTS:

Net cash used in investing activities were $2.0 million for the first quarter of 2006, including $2.5 million used for capital expenditures partially offset by $0.5 million in proceeds for sale of assets.

Net cash used in investing activities totaled $38.1 million in the first quarter of 2005. The cash used for the SMTEK acquisition was $35.6 million, and capital expenditures were $3.0 million.

Net cash used in financing activities for the first quarter of 2006 were $0.3 million, consisting primarily of $1.1 million in dividend payments partially offset by $0.8 million in increased short-term notes payable.

Net cash provided by financing activities were $24.9 million in first quarter of 2005, including net proceeds of $38.9 million from borrowings offset by the repayment of debt of $13.0 million assumed in the SMTEK acquisition, and $1.1 million in dividends to shareholders.

Refer to Note G, “Debt,” for further discussion.

CTS believes cash flows from operating activities 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 November 2005, CTS’ Board of Directors authorized a program to repurchase up to one million shares of stock. The authorization expires June 30, 2007. The previously authorized one million share repurchase program dated July 2004 was completed in the fourth quarter of 2005. Reacquired shares will be used to support equity-based compensation programs and for other corporate purposes. During the first quarter of 2006, CTS repurchased 1,500 shares at a total cost of $18,762. At April 2, 2006, CTS was authorized to repurchase approximately 859,100 additional shares.

In November 2001, CTS’ Form S-3 registration statement registering two million shares of CTS common stock to be issued under the CTS’ Direct Stock Purchase Plan was declared effective by the Securities and Exchange Commission.  In November 2005, CTS terminated this direct stock purchase plan under this registration statement.

The following table sets forth the impact that contractual obligations, as of April 2, 2006, are expected to have on the Company's liquidity and cash flow in future periods:

Purchase obligations are defined as agreements that are enforceable and legally binding on CTS and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. CTS purchases direct materials, generally related to customer orders, for production occurring at its manufacturing facilities around the world. These goods are secured using purchase orders, either blanket or discrete. Purchase orders commit CTS to take delivery of the quantities ordered generally over a specified delivery schedule. CTS’ standard purchase order terms and conditions state that, should CTS cancel an order, CTS will reimburse its supplier only for the costs incurred at the time of cancellation. CTS’ purchase order cancellations generally occur due to order cancellation by a customer. If a customer cancels its order, CTS’ standard terms of sale provide for reimbursement of costs, including those related to CTS’ purchase orders. Therefore, these commitments are not included in purchase obligations.

Retirement obligations include defined benefit and other post-retirement benefits. Please refer to “Note H —Retirement Plans” for additional information related to the retirement plans, including the important assumptions.

CTS incurred approximately $1.3 million and $1.9 million of rent expense in the quarters ending April 2, 2006 and April 3, 2005, respectively. The future minimum lease payments under the Company's operating leases are $3.6 million for the remainder of 2006, $4.7 million in 2007, $4.0 million in 2008, $3.8 million in 2009, $2.4 million in 2010, and $3.7 million thereafter.

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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, 2005.

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 April 2, 2006, 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 had 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 April 2, 2006. 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 April 2, 2006 that materially affected, or are reasonably likely to materially affect, CTS’ internal control over financial reporting.

Certain processes in the manufacturer 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 probably 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 probably 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 by insurance, accruals or otherwise, or the ultimate anticipated costs resulting will not materially affect CTS’ consolidated financial position, results of operations or cash flows.

There have been no significant changes in the Company’s risk factors since December 31, 2005.

The following table summarizes the repurchases of CTS common stock made by the Company during the three months ended April 2, 2006:

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.