Earnings Call Transcript - KN Q3 2023

Operator, Operator

Thank you for standing by. My name is Kayla Baker, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Knowles Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. I would now like to turn the call over to Vice President of Investor Relations, Patton Hofer.

Patton Hofer, Vice President of Investor Relations

Thank you, Kayla, and welcome to our Q3 2023 earnings call. I'm Patton Hofer, Vice President of Investor Relations. And presenting with me on the call today are Jeffrey Niew, our President and CEO; and John Anderson, our Senior Vice President and CFO. Our call today will include remarks about future expectations, plans and prospects for Knowles, which constitute forward-looking statements for purposes of the safe harbor provisions under applicable federal securities laws. Forward-looking statements in this call will include comments about demand for company products, anticipated trends in company sales, expenses and profits, and involve a number of risks and uncertainties that can cause actual results to differ materially from current expectations. The Company urges its investors to review the risks and uncertainties in the Company's SEC filings, including, but not limited to, the annual report on Form 10-K for the fiscal year ended December 31, 2022, periodic reports filed from time to time with the SEC, and the risks and uncertainties identified in today's earnings release. All forward-looking statements are made as of the date of this call and Knowles disclaims any duty to update such statements, except as required by law. In addition, pursuant to Reg G, any non-GAAP financial measures referenced during today's conference call can be found in our press release posted on our website at knowles.com and in our current report on Form 8-K filed today with the SEC, including a reconciliation to the most directly comparable GAAP measures. All financial references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. Also, we've made selected financial information available on webcast slides, which can be found in the Investor Relations section of our website. With that, let me turn the call over to Jeff, who will provide some details on our results.

Jeffrey Niew, President and CEO

Thanks, Patton, and thanks to all of you for joining us today. Knowles delivered solid third quarter results with earnings and cash flow above our expectations. Revenue of $175 million was in line with guidance, while adjusted EBIT margins of 21%, EPS of $0.31 and cash from operations of $40 million finished above the high end of our guidance ranges. In Q3, we took strategic actions to advance our transformation into an industrial technology company by announcing the acquisition of Cornell Dubilier and the exploration of strategic alternatives for our Consumer MEMS Microphone business. These actions reflect our ongoing efforts to increase exposure to high-growth markets and higher value opportunities. The Cornell Dubilier acquisition, which was successfully completed yesterday, bolsters our Precision Devices segment and is a testament to our commitment to growth, innovation and delivering greater value to shareholders. This transaction significantly expands our serviceable available market through Cornell Dubilier's capacitor offerings, which will enable us to deliver a wider portfolio of products and solutions to both existing and new customers. Cornell Dubilier’s end markets are aligned with key growth tailwinds, including increasing defense budgets, medtech and critical care application growth. They are also well positioned in industrial electrification, clean energy and the implementation of next-generation fast-charging architectures. We are thrilled to welcome Cornell Dubilier's talented employees to Knowles and look forward to realizing the tremendous benefits of this transaction for our customers and our shareholders. The acquisition is expected to be accretive to our EPS in 2024. Importantly, we continue to have a strong balance sheet, allowing us to focus on balancing organic investment in R&D and CapEx with accretive M&A. We'll continue to return cash to shareholders through share repurchases. While we won't be getting into the specifics today relative to the exploration of strategic alternatives for the Consumer MEMS Microphone business, I will say the process is progressing. Turning to segment results. Precision Devices' Q3 revenue improved sequentially and was down 22% from the prior year. Demand weakness associated with excess channel inventory continued in Q3, leading to low manufacturing capacity utilization. Demand has improved since Q2, and we are encouraged by the positive ordering trends in Precision Devices as book-to-bill finished above one for the first time in six quarters. We expect orders to continue to rebound in Q4, which gives us confidence in a return to growth in 2024. In Medtech & Specialty Audio, revenue was up 20% versus the prior year as market demand remains resilient. Based on our projected sequential growth and strong execution over the quarter, we believe we are past the inventory correction we experienced in the first half of 2023. We remain confident in our ability to grow Medtech and Specialty Audio in 2024. In the Consumer MEMS Microphone business, revenue was up 2% from last year and earnings were slightly better than expected as consumer electronics markets have stabilized and demand for nonmobile products grew year-over-year. We expect Q4 will be the strongest quarter for the Consumer MEMS Microphone business this year, including the highest quarter for mobile shipments driven by the timing of customer product launches and improved share position. To summarize briefly, Medtech and Specialty Audio continues to perform well and we expect another strong quarter in Q4 with solid momentum heading into 2024. In Precision Devices, ordering trends have improved, but due to timing of the recovery, margins continue to be impacted by low capacity utilization. With the robust secular trends in defense, medtech and electric vehicle markets, complemented by the Cornell Dubilier acquisition, we believe we are well positioned for a return to growth in Precision Devices. For the Consumer MEMS Microphone segment, consumer electronics markets have stabilized and we expect second half revenues to be up year-over-year. Q4 is expected to be the peak quarter for the year, driven by strong shipments to mobile. We expect 2024 to benefit from the improving market trend and for the Consumer MEMS Microphone segment to return to full year revenue growth. While 2023 has been a challenging year, we are performing well in the second half. On the last earnings call, we laid out a target of 19% adjusted EBIT margin for the second half. Excluding Cornell Dubilier, we expect to achieve that target. Although there has been some shift in earnings between Q3 and Q4, our second half EPS is expected to be in line with our previous expectations. As we enter the next phase of our transformation into an industrial technology company, I am confident the strategic actions we've taken will drive long-term shareholder value. Before I turn it over to John, I want to highlight the change in our guidance metrics starting in the fourth quarter. We will be providing revenue, EPS and cash from operations guidance, which is inclusive of the Cornell Dubilier acquisition. We believe these metrics are the best measure for our business and are aligned with the Company's focus. Now let me turn the call over to John to detail our quarterly results and guidance.

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported third quarter revenues of $175 million, in line with guidance and down 2% from the year-ago period, driven by lower shipments in Precision Devices. The Precision Device segment delivered revenues of $50 million, down 22% from the prior year, due to continued weak demand associated with excess channel inventory in industrial and distribution end markets and timing of shipments into the defense market. Bookings in the quarter were $58 million, resulting in a book-to-bill ratio of 1.2 for Q3. In the Medtech and Specialty Audio segment, revenue was $57 million, up 20% versus the prior year as demand has returned to more normalized levels. Consumer MEMS Microphone revenues of $68 million were up 2% versus the prior year, driven by higher shipments into nonmobile applications. Third quarter gross margins were 44.6%, 110 basis points above the high end of our guidance range and up 610 basis points from the same period a year ago. Precision Devices' segment gross margins were 40.4%, down 710 basis points from the prior year due to lower factory capacity utilization. Medtech and Specialty Audio segment gross margins were 54.9%, up 700 basis points versus the prior year, driven by factory productivity improvements, favorable product mix and the favorable impact of foreign exchange rate changes. Consumer MEMS Microphones delivered gross margins of 39.9%, up nearly 16 percentage points versus the prior year, driven by a gain on the sale of assets, lower factory costs, favorable product mix and higher factory capacity utilization, partially offset by price reductions in the smartphone market. R&D expense in the quarter was $17 million, up $1 million from the prior year, driven by higher incentive compensation costs and timing of material spend, partially offset by reduced spending in our Consumer MEMS Microphone segment driven by the benefits of prior year restructuring actions as we continue to shift our focus and spending to our higher-margin businesses. SG&A expenses were $25 million, $1 million lower than prior year levels, driven by lower sales commissions and incentive compensation costs in Precision Devices, partially offset by higher professional and legal fees associated with the exploration of strategic alternatives for Consumer MEMS Microphones. For the quarter, adjusted EBIT margin was 21%, 520 basis points above prior year levels and 100 basis points above the high end of our guidance range. EPS was $0.31 in the quarter, $0.06 above prior year levels and $0.01 above the high end of our guidance range. Now I'll turn to our balance sheet and cash flow. Cash and cash equivalents totaled $75 million at the end of the third quarter. We generated cash from operations of $40 million, above the high end of our guidance range, driven by higher adjusted EBITDA and lower net working capital. Capital spending was $4 million in the quarter. And we repurchased approximately 900,000 shares at a total cost of $15 million. We ended the quarter with cash net of outstanding bank borrowings of $30 million. As Jeff mentioned, future guidance will be provided for revenue, EPS and cash from operations. We believe these financial metrics align best with our long-term strategic focus and are the best measure for our business as we transition to an industrial technology company. We expect to hold a virtual Investor Day to provide updates to our midterm financial targets, capital allocation, addressable markets and long-term strategy shortly after the completion of our evaluation of strategic alternatives relating to the Consumer MEMS Microphone segment. Moving to our guidance for the fourth quarter, which includes the Cornell Dubilier acquisition which closed yesterday. Revenues are expected to be between $210 million and $220 million, up 9% versus the same period a year ago. We're projecting EPS to be within a range of $0.27 to $0.31 per share. This assumes weighted average shares outstanding during the quarter of $93 million on a fully diluted basis. We're projecting cash from operations to range from $40 million to $50 million, and capital spending is expected to be $5 million. We expect to exit 2023 with approximately $80 million of cash and $286 million of debt, which includes $175 million of borrowings under our revolving credit facility and an interest-free seller note which was issued in connection with the Cornell Dubilier acquisition. We expect to have a net leverage ratio of approximately 1.4 as we exit 2023. I'll now turn the call back over to the operator for the questions and answers portion of the call.

Bob Labick, Analyst

I wanted to start, I guess, just with guidance since you just kind of ended there. Can you give us a sense of what's included in that guidance from Cornell Dubilier? I guess it's two months given that it closed yesterday. We just want to confirm that. And maybe give us a sense of what the revenue contribution is there?

Jeffrey Niew, President and CEO

Yes, Bob. Our intention is not to provide guidance by segment moving forward. However, we anticipate revenue of approximately $20 million from Cornell Dubilier for the two-month period we owned it.

Bob Labick, Analyst

Okay. Great. The acquisition has just closed. Can you provide an overview of the integration process and the expected timeline? I understand that when you made the purchase, you noted that their margins are lower than those of Precision Devices, but there is potential to improve them. Can you discuss the opportunity to enhance Cornell Dubilier's margins to align more closely with the historic average of Precision Devices?

Jeffrey Niew, President and CEO

Yes. And just to reconfirm, Bob, kind of what we said was that we expect probably roughly about $140 million of revenue next year, with EBITDA $25 million to $27 million, somewhere in that range for EBITDA next year. And there are some pretty significant cost synergies. That will take some time to get. I think we looked at probably $3 million to $4 million of cost synergies that we think that we'll get. What we didn't detail too much about was revenue synergies. I think there are going to be some revenue synergies with Cornell. We'll probably go into a little bit more detail in that at the Investor Day. But I think we would expect some of these revenue synergies to start showing up in the back half of 2024.

Bob Labick, Analyst

Got it. Okay. Great. And then the last question for me. I'll jump back in the queue. You mentioned at the Analyst Day, just to be clear, when do you expect to conclude the Consumer MEMS Microphone process? Have they concluded it, or how will you decide? What’s the status?

Jeffrey Niew, President and CEO

Yes. That's a question we expected. We included that in John's script. The best way to put this is that we need clarity on the outcome of the strategic alternatives process. I don't have a specific date for when that will be completed. We view it from the standpoint that we need to have some clarity around the outcome of that process. Now, what that clarity means can vary, and I don't want to speculate on what the potential outcomes could be. However, to start providing new midterm targets, we really need to understand the situation regarding strategic alternatives with the Microphone business.

John Anderson, Senior Vice President and CFO

But we are progressing.

Jeffrey Niew, President and CEO

But we are completely progressing. I mean, we are making progress.

Christopher Rolland, Analyst

Perhaps you can talk about Precision Devices, how you see inventory there? Are we almost done with the clear out there? Also, anything else you want to talk about pricing, order trends, et cetera, would love to know.

Jeffrey Niew, President and CEO

Yes, from our perspective, the pricing in the Precision Devices business and the Medtech and Specialty Audio segments has remained very stable. We don't see any pricing issues in these markets. Specifically, in the Medtech and Specialty Audio area, the hearing health market remains resilient and strong. We are optimistic about 2024 and our potential for new products with our customers. The growth in the end market looks promising, and we don't have any inventory concerns currently. Although we've been cautious about over-the-counter products, we haven't noticed a significant increase in demand for them. However, we believe that the marketing of over-the-counter hearing aids is attracting more customers to traditional channels. Overall, we're feeling positive about the Medtech and Specialty Audio business. In the Precision Devices segment, it's a bit more varied. We did achieve a book-to-bill ratio above one for the first time in six quarters, which is a significant milestone. A large portion of the orders we received in Q3 were from defense, which typically involves longer-term commitments, sometimes extending over a year to a year and a half. Looking ahead to 2024, the defense sector looks strong, along with the medical and electric vehicle markets, which also appear promising. However, the industrial and distribution sectors remain weak, with both bookings and shipments lagging. We are aware of the ongoing situation in our distribution channel, and we are starting to see inventory levels decrease. Overall, we are optimistic about the growth prospects for 2024 in the Precision Devices business. Once we return to growth, we expect capacity utilization to improve, and margins to revert to more normalized levels that we experienced previously during growth periods.

Christopher Rolland, Analyst

Yes. The industrial weakness, I would say, is going around. No surprise there. It's a very solid December guide. And without guiding March, perhaps you can just kind of give us the broad puts and takes given your kind of deemphasizing consumer. And so I don't think kind of seasonal trends will hold there. If you could talk about it more broadly and what to kind of expect there would be good?

Jeffrey Niew, President and CEO

Yes, let me begin with the Consumer business. Seasonally, the first quarter tends to be weak since there are no mobile product launches. Therefore, I expect the Consumer MEMS Microphone business to decline in Q1. However, we did experience a very strong Q4 in the Medtech and Specialty Audio sectors, which will see a sequential decrease. The good news is that when we look at the Consumer MEMS Microphone and Medtech & Specialty Audio businesses year-over-year, we should see significant growth, especially considering the weak performance in Q1 of 2023. As for the Precision Devices business, I anticipate it will remain relatively flat year-over-year in Q1, not counting Cornell. Cornell will contribute around $140 million, and while its revenue will likely be more weighted towards the latter part of the quarter, it will still play a role in our projections. Overall, when we exclude Cornell, we expect Precision Devices to be flat year-over-year in Q3, which gives us confidence given the current market conditions. With easier comparisons from Q1 of 2023, we should see notable growth, especially with the addition of Cornell's contributions.

Anthony Stoss, Analyst

Maybe more for John. In terms of total OpEx and gross margins for the December quarter, could you give us kind of your thoughts?

John Anderson, Senior Vice President and CFO

You mentioned something about Q4, Tony?

Anthony Stoss, Analyst

Yes.

John Anderson, Senior Vice President and CFO

Yes. So again, we're kind of moving away from gross margin, really focusing on operating margin with this transformation to industrial tech. What I'll say is Q3 had some onetime benefits that were in both gross margin and operating margins from fixed asset sales. We had roughly $5 million. We also had, I'll call it, an NRE recovery of a couple of million dollars. That is not going to recur in Q4. So you'll see margins going down sequentially.

Anthony Stoss, Analyst

Okay. But just on OpEx, I know it's like too much...

John Anderson, Senior Vice President and CFO

Yes. From an operating expense perspective, we've previously mentioned a run rate of around $43 million to $45 million. We have been slightly below that, and we will see a small increase due to the Cornell Dubilier acquisition. For our core business, we are close to that $43 million to $45 million range, although it may be a bit lower. Additionally, with the inclusion of Cornell Dubilier, their annual operating expenses are approximately $20 million to $25 million.

Anthony Stoss, Analyst

Got it. If things are picking up in bookings for Precision Devices, would you expect total revenue growth in 2024 compared to 2023 when looking at Knowles prior to the Cornell Dubilier acquisition? Jeff?

Jeffrey Niew, President and CEO

Well, I mean, I'm not going to predict the full year at this moment, but I would just start and say is Q1 will definitely be up year-over-year, not counting Cornell. I would say that's kind of the thing I'd step out. It's a little early to start projecting the full year, but I think we're going to start off very well in Q1. Going back to kind of what I answered on one of the other questions, which is then in the Consumer MEMS Microphone business as well as the Medtech and Specialty Audio business, we expect some pretty strong year-over-year growth in Q1. I would say the Precision Devices business is still, I would say, flattish and then add on top of it the Cornell revenue.

Anthony Stoss, Analyst

Got it. And then speaking of Cornell, I'm curious if you could share some light on where they stand inventory-wise. Is it similar to Knowles' position, there's still a little bit to be worked off? Or what kind of commentary can you give us on Cornell's inventory?

Jeffrey Niew, President and CEO

Yes. I think they're seeing a lot of the same thing in their distribution portion of the business. Just remember, this is quite a bit more distribution business. About 50% of our revenue goes through distribution. And they are seeing the same thing. But here's what I would add. Their OEM business, their direct business is actually holding up a little bit better than the Precision Devices business. And the reason I say this is, remember, we had these kind of push-outs on defense relative to things like Lockheed, which we've talked about in previous quarters. They have a fair amount of business in what I would call electrification, clean energy, medtech, and it seems to be holding up pretty well in their OEM business. So that's kind of like kind of a little bit offsetting. So we're not seeing overall quite the decline that we saw in the Precision Devices business. So I think in the distribution/industrial portion of the business, yes, we're seeing similar things.

Anthony Stoss, Analyst

Got it. And then last question for me. John, you made a comment about your Consumer MEMS Microphone business going to be pretty strong in Q4. Was there a different change in Knowles' thinking on how much business you'll take for the December quarter within, say, smartphones or just in consumer in general?

John Anderson, Senior Vice President and CFO

Just repeat...

Jeffrey Niew, President and CEO

Yes. I'm not going to go in detail by customer, but we have seen an increase, we think, in share in the mobile business in Q4. And to the extent I would sit there and say the positive is, obviously, we get a lot better capacity utilization, we get more revenue. But incrementally, in the Consumer MEMS Microphone business, the margins are not as high in the mobile portion of the business.

Operator, Operator

Our next question comes from the line of Tristan Gerra with Baird.

Tristan Gerra, Analyst

Quick questions again on the Precision Devices business. You mentioned that the bucket of weakness was still industrial and industry, is it fair to assume it's about 1/3 of your Precision Devices business? And what do you see in some of the other segments, including automotive, which I think in the past was maybe about 10% of your PD business? Is that slowing? Any additional color on the various end markets within that business?

Jeffrey Niew, President and CEO

Yes, I would just like to mention that the industrial distribution sector represents a little less than one-third of the business, and it has declined significantly year-over-year. While we've touched on the defense sector, its decrease is not as substantial as what we're experiencing in industrial and distribution, mainly due to the timing of orders. Our automotive business, however, is expected to show growth. Starting from a small base, we previously discussed revenue figures ranging from $15 million to $20 million and up to $23 million. This year, we anticipate being firmly in the middle of that range for automotive, with strong year-over-year growth.

Tristan Gerra, Analyst

Okay. Great. And then I know that you're holding commentary on your Consumer MEMS Microphone business, pending the review. Just what is the willingness to reduce the top line as you potentially restructure that or take any other actions relative to what would be a gross margin accretive event? And how do you mitigate which is what some other companies have done reducing production and as such incurring underutilization charges, but at the same time, avoiding inventory build? Just trying to look at, at a high level how things could look like or how is your willingness to change the business model in that regard in terms of how drastic that could be in terms of top line and gross margin impact?

Jeffrey Niew, President and CEO

Yes. Let me address the first point. If you recall, back in the middle of 2022, we implemented some significant changes in this business, reducing costs by approximately $30 million through a combination of operating expenses and cost of goods sold, alongside cutting fixed overhead. Currently, we believe we are at a satisfactory operational level and are running close to our capacity in the latter half of the year. We are optimistic about the potential for growth in the nonmobile segment of the business, which has a much higher margin. This shift in mix is expected to positively impact our margins over the next 12 to 18 months, allowing us to fill our capacity with higher gross margin business instead of mobile business. I do not anticipate any further actions in this segment until we reach a conclusion regarding the strategic alternatives and the future direction of the business.

Operator, Operator

And there are no further questions at this time. This concludes today's conference call. You may now disconnect.