Earnings Call Transcript - KN Q2 2024

Operator, Operator

Thank you for joining us. My name is Kaylin, and I will be your conference operator today. I would like to welcome everyone to the Q2 2024 Knowles Corporation Earnings Conference Call. All lines have been muted to minimize background noise. After the speakers' remarks, we will have a question-and-answer session. I now turn the call over to Sarah Cook. You may begin.

Sarah Cook, Vice President of Investor Relations

Thank you and welcome to our second quarter 2024 earnings call. I'm Sarah Cook, Vice President of Investor Relations, and presenting with me 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's sales, expenses and profits, and involve a number of risks and uncertainties that could cause actual results to differ materially from current expectations. The company urges investors to review the risks and uncertainties in the company's SEC filings, including but not limited to the Annual Report form 10-K for the fiscal year ended December 31, 2023. 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. This will include a reconciliation to the most directly comparable GAAP measure. All financial references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. We've made selected financial information available in 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 details on our results. Jeff?

Jeffrey Niew, President and CEO

Thanks, Sarah, and thank you all for joining us today. Let me start by saying, I'm pleased with the performance of our business in the second quarter. We continued to execute on our plan of focusing on high growth end markets, where we have differentiated solutions and in Q2, the business performed as we expected. We delivered $205 million in revenue, which is at the midpoint of our guided range and represents an 18% growth on a year-over-year basis. EPS of $0.24 and cash from operations of $25 million were both in line with our expectations and at the midpoint of our guided range. From a segment perspective, Medtech & Specialty Audio revenue grew 4% sequentially at the end market for our Hearing Health products remains strong. The market dynamic of the aging population, expansion of the middle class globally, and improved hearing aid penetration all remain favorable. We reported adjusted EBITDA margins of over 45%, driven by continued operational execution and our sustained success of new product adoption. We expect the strength to remain throughout the year within 2024 and for 2024 to be a year of growth for the Medtech & Specialty audio segment. Despite the continued headwinds from normalization of inventory levels in our industrial and distribution end markets, precision devices delivered solid results in the second quarter. Driven by the acquisition of Cornell, revenue was up 55% on a year-over-year basis. Adjusted EBITDA margins increased nearly 260 basis points sequentially on flat revenue driven by strong operational execution and improvements in gross margin within Cornell. We have begun to see signs of inventory reduction in our distribution channel and industrial end markets, and we are ready to capitalize on growth as demand improves. I would also add our design activity remains robust and we are well positioned to grow as the market recovers. On our Consumer MEMS Microphone business, we continue to progress towards a conclusion on the strategic alternatives process, taking into consideration all stakeholders from customers to suppliers and shareholders to employees. From an operational standpoint, CMM financial results in the quarter were solid. Revenue was up 9% from the prior quarter and adjusted EBITDA margins grew by 330 basis points. Before I conclude, I would like to touch on our capital allocation activities. In the second quarter, based on our continued robust cash generation, we've repurchased $25 million of shares while also reducing our debt by $34 million. We expect sustained cash generation for the remainder of 2024. The first half of 2024 produced solid financial results. I continue to be pleased with the performance of the business and I'm excited about the opportunities we have ahead of us. My confidence in our ability to deliver shareholder value remains strong as our teams continue to demonstrate operational excellence, execution in innovative products, and expanding our market share across our core businesses. Now, let me turn the call over to John to go into the details of our quarterly results and provide the Q3 guidance.

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported second quarter revenues of $205 million at the midpoint of guidance and up 18% from the year-ago period, driven by organic growth of 2% and the acquisition of Cornell in the fourth quarter of 2023. EPS was $0.24 in the quarter at the midpoint of our guidance range and up $0.01 or 4% from the second quarter of 2023. In the Medtech & Specialty audio segment, revenue was $60 million, down 2% versus the prior year. Our Hearing Health business was up 5%, offset by lower demand in the Specialty Audio market. Gross margins were 54.6%, up more than 100 basis points versus the year-ago period, driven by favorable product mix and benefits from foreign currency. The Precision Devices segment delivered revenues of $74 million, up 55% from the year-ago period, driven by the acquisition of Cornell, partially offset by lower shipments of high-performance capacitors into distribution and OEMs in the industrial end market as customer and channel inventories remain elevated. Gross margins were 37.2%, down 250 basis points from the second quarter of 2023 due to the acquisition of Cornell. While the gross margins at Cornell remain lower than that of the legacy Precision Devices business, we saw a sequential margin improvement at Cornell of 340 basis points. And we expect margins to continue to improve throughout 2024. Excluding Cornell, year-over-year gross margins within the PD segment were flat. Consumer MEMS microphone revenues of $71 million were up 9% versus the year-ago period due to share gains and increased consumer demand primarily in Ear and IoT end markets. Gross margins were 28.1%, a 550-basis point decrease from the prior year due to the absence of a $4 million benefit related to the sale of fixed assets, which was recorded in the second quarter of 2023. On a total company basis, R&D expenses in the quarter were $17 million, up 6% from Q2 2023 due to the acquisition of Cornell. SG&A expenses were $32 million, $2 million higher than prior-year levels driven by the acquisition of Cornell, partially offset by restructuring actions taken in the second half of 2023 in the Precision Devices segment. Interest expense was up $4 million versus the prior year due to higher bank borrowings associated with the acquisition of Cornell in the fourth quarter of 2023. Now, I'll turn to our balance sheet and cash flow. In the second quarter, we generated $25 million in cash from operating activities at the midpoint of our guidance. For the first six months of 2024, we generated $42 million in operating cash flow, representing a $20 million increase over the first six months of 2023. Capital spending was $3 million in Q2 and we ended the quarter with cash and cash equivalents of $84 million. During the second quarter, we repurchased 1.4 million shares at a total cost of $25 million and we reduced outstanding borrowings under our revolving credit facility by $34 million. We exited the second quarter with $261 million of total debt that includes $146 million of borrowings under our revolving credit facility and an interest-free seller note issued in connection with the Cornell acquisition. Lastly, our net debt leverage ratio based on trailing 12 months adjusted EBITDA was 1.1 times. Moving to our guidance, for the third quarter of 2024 revenues are expected to be between $210 million and $220 million, up 23% versus the year-ago period, driven by organic growth of 3% and the acquisition of Cornell. R&D expenses are expected to be between $16 million and $18 million, and selling and administrative expenses are expected to be within a range of $29 million to $31 million, up $5 million from the prior year due to increases associated with the Cornell acquisition. We're projecting adjusted EBIT margin for the quarter to be within a range of 16% to 18%. We're forecasting interest expense in Q3 to be approximately $4 million, which includes $2 million of non-cash imputed interest. We expect an effective tax rate of 9% to 13% for the quarter, which is lower than normal due to the utilization of foreign tax credits. And we're projecting EPS to be within the range of $0.29 to $0.33 per share. This assumes weighted average shares outstanding during the quarter of $92.2 million on a fully-diluted basis. We're projecting cash from operations to be within a range of $35 million to $45 million and capital spending is expected to be $5 million. I'll now turn the call back over to the operator for the questions and answers portion of our call.

Operator, Operator

Our first question comes from Christopher Rolland with Susquehanna. Your line is open.

Christopher Rolland, Analyst

Hey, guys. Thanks for the question. I know you guided for sequential on year-over-year growth in Medtech & Specialty audio and Precision Devices. I assume that's also going to include consumer, and if you could just rank or give us some idea of what that sequential strength might be for those different segments, that would be great.

Jeffrey Niew, President and CEO

Yes. So, Chris, thanks for the question. So first, I think for being very deliberate about this, the sequential growth is coming from the non-CMM portion of the business. So, I think we're starting to see particularly in the Precision Devices business. We think we're starting to see sequential improvement on our way to hopefully in the near future return to year-over-year growth on a pro forma basis when you include Cornell. And we're seeing that being relatively broad-based. So, I think we're pretty pleased. We are seeing some sequential growth in the Medtech & Specialty audio. I think it's going to be quite honestly a little bit more pronounced sequential growth in Q4 versus Q3. But we do expect to have sequential growth in Precision Devices again from Q3 to Q4. As far as the CMM business, we are not seeing a lot of sequential growth in Q3; I'd say it's flattish, but it is coming off, I'd say, a pretty strong Q2 on a year-over-year basis. We had a pretty strong Q2, I think the CMM business was up about 8% or 9% year-over-year in Q2. So, it's coming off a pretty strong Q2.

Christopher Rolland, Analyst

Great. And then I guess, maybe following up there, because September for CMM typically is pretty strong for you guys. Are you seeing something different in context, or is it just purely timing? And then lastly, any update on potentially selling that business?

Jeffrey Niew, President and CEO

Okay. So, let me take the second question first. I would say not a huge update from the last quarter, but I would say we're entering closer towards a conclusion. And so, I think that's about what we can say at this point; we're inching closer towards a conclusion. I would say overall, for the full year, the CMM business is actually going to be up pretty significantly year-over-year. And so, I think it appears, I would say, we're not going to comment by quarter, but I think it's up about 8% or so that's what we're seeing for the full year.

Christopher Rolland, Analyst

Okay, great. Well, great results in the parts of the matter. Thanks, guys.

Operator, Operator

And your next question comes from the line of Anthony Stoss with Craig-Hallum. Your line is open.

Anthony Stoss, Analyst

Afternoon, guys. I have a couple of questions. On the CD acquisition, I think, the past quarter, you were kind of ballparking it to equate to about $135 million to $140 million for the full-year 2024. Is that changed or is that still kind of the right number to think about?

John Anderson, Senior Vice President and CFO

I'd say, it's a little lower than that, although here's what I would say; I think when we announced the deal. We talked about $26 million in EBITDA for this year. We're still sticking; we're going to hit that $26 million of EBITDA even on the lower number. And the way we're doing that quite frankly is the synergies are larger than we had expected. I think we've talked about that probably in the past. I think a couple of quarters ago, we were talking of maybe a couple million dollars of kind of price opportunity. Last quarter, we talked maybe $3 million to $4 million; I would say it's probably closer to $5 million now, in terms of price in that business. So, we're feeling pretty good about where we are. And I think what I'd say talking about the CD acquisition is the margins are coming up a little faster than we would have expected, even on lower revenue, which is I think a really good sign, because as the market starts to recover, we can see that the margins are going to expand and we're going to get to the target margins that we've kind of talked about early on faster than we probably would have said.

Jeffrey Niew, President and CEO

Anthony, just to give a little color to that, when we acquired CD, Q4 of last year, margins were right around 30%. Same thing in Q1 of this year and we're seeing pretty significant sequential improvement. We expect to be in the high-30s as we exit 2024.

John Anderson, Senior Vice President and CFO

Yes. And that's a combination, obviously of some of this capacity utilization, but it's also getting the synergies.

Anthony Stoss, Analyst

Got it, perfect. Second question, just wanted to confirm something, so the September guide, are you assuming anything from your prior biggest handset customer in terms of content in a handset?

Jeffrey Niew, President and CEO

So again, what I'm trying to say is actually, we're not going to make comments on specific customers. I think overall, I would just make the comment again. The growth sequentially is coming from the non-CMM portion of the business. And I think we keep continuing to focus on overall, reducing our exposure to mobile, which is our one of our lowest gross margin markets. But overall, if you look at for the full year, the CMM business will be up 8% based on what we're seeing for this year for the full year.

Anthony Stoss, Analyst

Got it. Okay. And then lastly, Jeff, I think in the past quarters, you were sitting with about five months' worth of inventory in PD and you wanted to bring it down to two months. Are we still in that kind of same five months or is it starting to come in?

Jeffrey Niew, President and CEO

So, you're referring to inventory in the channel. Correct? That's what you're referring to?

Anthony Stoss, Analyst

Yes.

Jeffrey Niew, President and CEO

Yes. We are seeing an improvement in both classic PD and Cornell for Q3, and we expect that to continue into Q4. Inventory in the channel is decreasing, although it is coming down a bit slower than anticipated. The pace of improvement isn't as steep as we hoped, but it is evident. We experienced some solid sequential growth in Cornell, and classic PD has also shown growth from Q2 to Q3. While inventory is decreasing overall, there are still areas with excess inventory. However, we're starting to see positive signs in the PD markets. I want to note the distinction between passives and semiconductors. The semiconductor channel still has a lot of inventory, which we're not heavily involved with, but the passive inventory is decreasing at a faster rate compared to semiconductors.

Anthony Stoss, Analyst

Very good. Thanks, Jeff for all the color.

Operator, Operator

And your next question comes from the line of Tristan Gerra with Baird. Your line is open.

Tyler Bomba, Analyst

Hi. This is Tyler on for Tristan. Thanks for taking my questions. I know you talked about some of the pricing opportunities you have on the Cornell side, but can you speak to pricing across the rest of your businesses?

Jeffrey Niew, President and CEO

Yes. Sure, I can talk about it. I would say first in the Medtech & Specialty audio, pricing is stable. I wouldn't say we've gotten big price increases or reductions; it's very, very stable. Again, a lot of things we have with these customers are longer-term contracts, very stable. I think we're a very valuable supplier. In the Precision Devices segment, outside of Cornell, we're seeing some modest price increases. I think again, I think I've talked about this before, Tyler, where when we first started doing pricing in the classic PD section, we had some larger increases. Now, it's kind of smaller, but continual. And then, I think lastly is CMM business. I'd say, outside of mobile, pricing's been pretty stable in our CMM business. Mobile is still challenged. I would say mobile is still challenged. And so, that's probably our biggest challenge is the mobile area. And again, as we try to over time reduce our exposure to mobile, we would probably see less and less price decreases in that business.

Tyler Bomba, Analyst

Great. And then just looking at the Hearing Health business, have you seen anything notable to call out on the OTC market? Any sense that there's upside relative to your expectations for that business?

Jeffrey Niew, President and CEO

Yes. We've been on the call, like many times talking about OTC, and I've always kind of tried to hold back expectations in terms of how big this could be. It still is not really developing into a significant piece of business for us. And what I could say pretty confidently, there's no socket I can point to that we've really lost that have any significant volume. And so, it's just not developing the way people would have hoped, but more it's kind of in-line with what we'd hoped. Now, what I would say, I still think the OTC market is helping with the traditional hearing aid market, where people are hearing more about hearing aids. And maybe they go look into over-the-counter hearing aids and then they opt into the traditional hearing aid channel. And these are complicated devices. And I think there's probably a little bit of, I would say, an underappreciation for the value of the audiologist in the way this works in terms of a person getting a hearing aid. And I think people are starting to realize that. And again, having been in the market for many years, we didn't factor in too much in for OTC and it's probably meeting expectations, but at a very low level. But the traditional hearing aid channel continues to do very well.

Tyler Bomba, Analyst

Great. Thanks, again for taking the questions.

Operator, Operator

Our next question comes from the line of Bob Labick with CJS Securities. Your line is open.

Bob Labick, Analyst

Thanks. Good afternoon.

Jeffrey Niew, President and CEO

Hey, Bob.

John Anderson, Senior Vice President and CFO

Hey, Bob.

Bob Labick, Analyst

Hi. I would say, you talked obviously about, in Precision Devices in particular. You have the destock going on in the inventory in the channel and stuff. But can you maybe talk a little bit about the overall end-market demand, where the biggest drivers are, where you see that and how long it takes to kind of get back up to that growth rate?

Jeffrey Niew, President and CEO

Yes. Let's break it down into a few different markets: defense, medtech, industrial, and others. Cornell and traditional PD are involved in all these areas. Starting with defense, we're definitely seeing growth, though not as much as we had anticipated. However, for the full year, we do expect growth in defense. In medtech, we've encountered some inventory challenges, not with hearing aids, but in other Precision Devices markets. Nevertheless, we anticipate strong year-over-year growth in medtech in the latter half of the year as the inventory issues ease. The industrial and other markets remain a bit unclear. This market is still experiencing some decline, although we are noticing modest improvements. The recovery in this area may not be as significant as we initially expected, particularly in industrial. We're observing some sequential improvement there. Alternatively, if we look at OEM versus distribution, we expect robust sequential growth in the second half of the year from our OEM customers, largely driven by medtech, while our distribution is projected to see modest sequential growth in the latter half of the year.

Bob Labick, Analyst

Okay. Got it. Thanks. And then, I haven't really had a chance to fully go through this. So, at the risk of sounding a little silly, could you talk about the goodwill impairment in CMM and what I guess, the process was and what that kind of says to us about that segment?

John Anderson, Senior Vice President and CFO

Sure, Bob. I can take that. So, as you recall in the third quarter of last year, we announced that we were reviewing strategic alternatives for the CMM business. That review included a range of possibilities including a potential sale or restructuring in the business. During the second quarter of 2024, we evaluated the potential outcomes of our review. And we concluded as a management team that it's more likely than not that the fair value of the CMM reporting unit was below its carrying value. And as a result, we recorded a goodwill impairment charge of $249 million.

Bob Labick, Analyst

Okay. Got it. You mentioned that you're moving closer to a resolution. Can you discuss mergers and acquisitions? You've indicated that it's likely to happen in the PD segment, but is M&A still possible while you're pursuing strategic alternatives for CMM? Will these be separate processes where you complete the CMM review first and then focus on potential M&A? How is that process unfolding?

Jeffrey Niew, President and CEO

Let me begin by stating that our cash flow remains very strong. We are quite satisfied with our cash flow for the first half of the year. Typically, cash flow is weaker during the first half due to seasonal factors, but this year we experienced robust cash flow. We anticipate this trend to continue in the second half. Additionally, we are actively considering acquisitions, but we want to ensure that any decisions we make do not raise questions from our shareholders. There are numerous opportunities available, and I reference the Cornell acquisition as a strong example of how well it aligns with our operations and the synergies we've gained. It has proven to be an excellent acquisition for us, and we are on the lookout for the next opportunity like Cornell. I don't believe we will need to wait for the conclusion of the CMM process before pursuing M&A. If we identify the right opportunity, our balance sheet is in good condition, and we will proceed with M&A activities.

John Anderson, Senior Vice President and CFO

And Bob, we've always said, we're going to maintain modest debt levels, not going above, call it 275 on a net leverage ratio.

Jeffrey Niew, President and CEO

yes. And that kind of leads to just a little bit on the capital allocation. We are continuing to buy back shares as well, because of the cash flow.

Bob Labick, Analyst

Okay. Super. Thank you very much.

Operator, Operator

And there are no further questions at this time. I will turn the call back over to Sarah Cook.

Sarah Cook, Vice President of Investor Relations

Thank you for joining us today. As always, we appreciate your interest in Knowles and look forward to speaking with you in the next earnings call. This concludes our call today.

Operator, Operator

And this concludes today's conference call. You may now disconnect.