Earnings Call Transcript - KN Q2 2023

Operator, Operator

Good afternoon and thank you for attending today's Knowles Second Quarter 2023 Earnings Conference Call. My name is Kayla Baker, and I will be your conference operator today. 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 will now pass the conference over to your host, Patton Hofer, Vice President of Investor Relations with Knowles. Thank you and you may proceed.

Patton Hofer, Vice President of Investor Relations

Thanks, Kayla, and welcome to our Q2 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 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 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, in 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 measure. 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 on 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. Jeff?

Jeffrey Niew, President and CEO

Thanks, Patton, and thanks to all of you for joining us today. Knowles delivered solid results for the second quarter with revenues of $173 million, adjusted EBIT margins of 16% and EPS of $0.23, all finishing above the midpoint of our guidance range. Gross margins of 42% finished above the high end of the guided range and our teams around the globe continue to improve efficiency, reduce fixed costs and improve mix in light of the macro challenges in certain end markets. In Precision Devices, Q2 revenue was down 20% from the prior year. Given inventory challenges in the industrial distribution and telecom markets have continued as we have experienced further revenue weakness in Q2. Defense was flat versus the prior year and delays in project awards impacted due to bookings and revenue. Finally, the Electric Vehicle market remains exciting for Knowles, growing again in Q2 versus the prior year as we continue to secure additional design wins for onboard and fixed infrastructure charging. In MedTech & Specialty Audio, revenue was down 2% from the prior year, but up more than 30% sequentially as customer inventory levels declined faster than we originally anticipated. We are definitely past the inventory correction we experienced in the first quarter of 2023. I'd also like to take a moment to commend our MSA team as they delivered outstanding margins in the quarter, a true testament to our differentiated products and operational excellence in our factories. In Consumer MEMS microphones, revenue is down 3% from last year, non-mobile was up versus the prior year, driven by new product launches and improved demand in voice over IoT. Computing was also a bright spot in the quarter, finishing better than expected as channel inventory sell-through has improved and upgrade cycles are returning earlier than previously expected. Both smartphone markets continue to be very difficult, especially in China; the shift of mix for gear IoT and compute is positively impacting gross margins in this segment. Now I'll spend a few minutes discussing the current customer and market conditions for each segment before turning the call over to John to provide the third quarter guidance. Starting with the Precision Device segment. In the industrial and telecom markets, which currently make up approximately 10% of total company revenue, we are seeing continued weakness and inventory levels remain elevated. We previously expected the inventory situation to improve in the second half. But based on the current outlook, we now expect these markets to be down in the remainder of the year. For our three key end markets, defense, MedTech and the EV, the long-term outlook is unchanged from our previous expectations. Knowles continues to expand its design wins in these growth markets with a broad range of customers. Demand for components in the MedTech space has been relatively flat in the first half of the year with some excess inventory. Based on current demand, we expect to return to year-over-year growth starting in Q3. For Defense, our previous revenue projections for the year factored in a number of bookings in Q2 for communications, radar and electronic warfare programs, which have been delayed. While we believe our position in our core markets for PD, along with the secular trend within these markets are unchanged, continued weakness in industrial and delayed bookings in defense are reducing our expectations for revenue in the second half of 2023. To mitigate the impact of these delays, we have implemented several measures to reduce costs in Precision Devices to improve profitability. John will provide more detail on these actions for his portion of the call. Moving to MedTech and specialty audio, the Hearing Health market demand has stabilized as hearing inventories around the globe have returned to more normal levels. Our Q3 guidance reflects a more than 20% revenue growth versus the prior year, driven by the improved inventory situation and increases in demand in the traditional hearing aid market, particularly in the US, which is a very positive sign that we are returning to growth in the second half of 2023, which provides confidence for growth in 2024. Lastly, on to our consumer MEMS microphone segment. Due to the normal seasonality of this business and improving market conditions in non-mobile, we are expecting sequential improvement for revenue throughout the remainder of the year. The second half recovery is now expected to be less pronounced than we previously discussed driven primarily by the smartphone market. In non-mobile applications, second half demand in computing and Hearing Health are expected to be up significantly versus the prior year driven by improved channel inventory levels and replacement cycles in computing. In the smartphone market, demand expectations for new products and further weakness in China are driving additional pressure on the recovery in this business, ultimately limiting the upside in the back half of 2023 for CMS. Overall, for Knowles, although the outlook for improvement in revenue in the second half has softened, we are still expecting margin expansion and earnings growth versus the prior year. In MSA's inventory situation, the hearing health market is behind us, as forecasted, and we are increasingly confident of second half revenue growth. In Precision Devices, continued weakness in the industrial market, coupled with delays in defense orders have impacted revenue expectations for the remainder of 2023. We believe, however, the secular trends in defense, MedTech and EV market remain robust. Lastly, for CMM, we are seeing a slow recovery in consumer electronics, primarily due to the smartphone market and softer demand in China. In summary, we are now expecting total company revenues in the second half of the year to be near prior year levels. With the cost efficiencies and actions we've implemented, along with favorable mix, we expect our second half adjusted EBIT margins to be greater than 19%. 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 second quarter revenues of $173 million, down 8% from the year-ago period, driven primarily by lower shipment volumes in Precision Devices and Consumer MEMS Mics. The Precision Device segment delivered revenues of $48 million, down 20% from the prior year, driven by continued weak demand associated with the excess channel inventory in the industrial and distribution markets and timing of shipments into the defense market. In the Medtech and Specialty Audio segment, revenue was $61 million, down 2% versus the prior year as we faced tough year-over-year comparables as the first half of 2022 demand benefited from strong COVID recovery. Consumer MEMS Mics revenue of $65 million was down 3% versus the prior year driven by weak global demand for smartphones, partially offset by growth in non-mobile applications. Second quarter gross margins were 42% and 100 basis points above the high end of our guidance range and up 50 basis points from the same period a year ago. Precision Devices segment gross margins were 39.7% and down 700 basis points from the prior year due to unfavorable capacity utilization. Medtech and Specialty Audio segment gross margins were 53.5%, up 410 basis points versus the prior year driven by productivity gains, lower factory costs and foreign currency benefits. Consumer MEMS Microphones delivered gross margins of 33.6%, up 340 basis points versus the prior year driven by benefits of the restructuring actions announced in August 2022, improved product mix and a gain on the sale of assets, partially offset by pricing pressure in the mobile market. R&D expense in the quarter was $16 million, down $2 million from the prior year with the reduction driven by the benefits of the restructuring actions taken in the Consumer MEMS Microphone segment. SG&A expenses were $30 million, $6 million higher than prior year levels, driven primarily by higher incentive compensation costs and higher professional and legal fees, partially offset by restructuring actions in the Consumer MEMS Microphone segment. For the quarter, adjusted EBIT margin was 16% at the high end of the guidance range. EPS was $0.23 in the quarter, slightly above the midpoint of our guidance range. Now I'll turn to our balance sheet and cash flow. Cash and cash equivalents totaled $54 million at the end of the quarter. We generated cash from operations of $1 million above the midpoint of our guidance range, driven by timing of customer collections. Capital spending was $4 million in the quarter, and we repurchased approximately 300,000 shares at a total cost of $5 million. We ended the quarter with cash net of outstanding bank borrowings of $9 million. Before moving to guidance for the third quarter, I want to comment briefly on some of the specific cost reduction actions we're taking within the Precision Device segment, to mitigate the impacts of our reduced revenue outlook. In Q3, we expect to incur a charge of roughly $2 million, which is expected to result in annualized cost savings of more than $5 million. These actions will be in place by the end of this year, and when implementation is complete, we expect PD operating margins to return near 2022 levels. This will also put total company operating expenses at the low end of our previous range of $43 million to $45 million per quarter. Moving to guidance for the third quarter. We expect total company revenue to be between $170 million and $180 million, down 2% versus the same period a year ago. We estimate gross margins for the third quarter to be approximately 41.5% to 43.5%, up 400 basis points from the year ago period. R&D expense is expected to be between $15 million and $17 million, down slightly from prior year levels, driven by restructuring actions in the Consumer MEMS segment. We're projecting selling and administrative expenses to be between $24 million and $26 million, down $1 million from the year ago period, primarily driven by restructuring actions in the Consumer MEMS and Precision Device segments. We're projecting adjusted EBIT margin for the quarter to be in the range of 18% to 20% and expect EPS to be within a range of $0.26 to $0.30 per share. This assumes weighted average shares outstanding during the quarter of 94.8 million on a fully diluted basis. We're forecasting an effective tax rate of 18% to 19% for the quarter and we expect cash from operations to range from $20 million to $30 million. Capital spending is expected to be $7 million. I'll now turn the call back over to the operator for the question-and-answer portion of the call.

Operator, Operator

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

Christopher Rolland, Analyst

Hey guys. Thanks so much for the question here. Just talking about maybe your largest customer, what we can kind of expect for the back half. I know you've been deemphasizing them over time. It seems like strength came from other areas of the market as well. But how does this affect seasonality? And in particular, for your whole company, you were expecting to have really a strong seasonal December like 20-plus% sequentially, I think, was where the Street was. Does this come into play here at all or is it still just PD related that might dampen that? Thank you.

Jeffrey Niew, President and CEO

Yes. So, I would say, generally speaking, without going to the customer specifics, I think we're pretty close to where we thought the CMM business would be in the back half. It's not a total surprise; it's slightly down, but driven primarily by smartphones in China. So, I think here, I’ve seen compute continue to look relatively strong for us. But our phone is definitely coming in weaker. I would say even more specific, China is coming in weaker. So, our overall expectations for CMM is probably slightly less than we would have said three months ago. I think the primary driver of what we kind of talked about here would probably be more on the PD side versus the prior expectations.

Christopher Rolland, Analyst

Yes. And then on the PD side of things as well, I get the pushouts, defense-related and other. It sounds like maybe there's some inventory as well. Maybe go through where you think there is some inventory build, where you think it is in terms of weeks or however you want to define it? And when you think that inventory is finally going to work through here? And what kind of caught you guys by surprise on the inventory side as well? Thanks.

Jeffrey Niew, President and CEO

Well, I think in the original projections for PD, we were kind of starting to see a recovery in the industrial and distribution portion of the business in the back half. Right now, we're not seeing that recovery at all, quite frankly. So I think that's going to be delayed into 2024 the recovery in industrial and distribution. To make a few more comments, MedTech was stable in the first half. We do expect a return to growth in the back half for MedTech with PD. Further, I'll just make a comment on defense. There have been a number of larger programs that have been delayed, which we haven't changed our position on, but they are delayed. One specific example is Lockheed recently announced that they were going to deliver 150 joint strike fighters this year. That was the original projection. Now they're projecting to deliver only 110 due to various issues on their side. So that's the kind of delays we're encountering in defense. There are a couple of other larger programs like that. Our position in defense really hasn't changed, and the long-term prognosis for defense still looks very good, but some of these orders are delayed. We expected to receive some of these orders in Q2, which didn't materialize, and they're probably going to materialize in the back half, but it prompts the question of whether we can deliver them within the calendar year 2023.

Christopher Rolland, Analyst

Great. Thanks so much, Jeff.

Operator, Operator

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

Unidentified Analyst, Analyst

Hi. It's for Bob tonight. How are you?

Jeffrey Niew, President and CEO

Okay.

Unidentified Analyst, Analyst

So just to clarify your guidance, I think I heard you say in the back half you expect flat revenues and EBITDA margins above 19%. Is that correct?

Jeffrey Niew, President and CEO

That is correct.

Unidentified Analyst, Analyst

Okay. So I guess that would also imply around flat revenue for Q4. And I guess the question is how much of that is conservatism without visibility versus you have visibility to what looks to be flat revenue consolidated?

Jeffrey Niew, President and CEO

I will go through it by business unit. We are comfortable with the projections in the MSA and the medtech specialty audio sectors, as we expect growth year-over-year in the second half. In the consumer microphone business, we anticipate that it will remain flat year-over-year, possibly with a slight increase. The Precision Device business, however, is down. Regarding the Precision Device area, I believe we will receive defense orders, but I cannot predict the exact month they will arrive. There may be some conservatism in our expectations for a timely delivery, and while we hope to fulfill these by the end of 2023, I cannot confirm that since we do not have the orders yet, and we are already in August. On the industrial and distribution side, we are not seeing significant recovery in this market. Is there a chance it could change? Yes, but for now, we think it’s best not to anticipate a return to previous trends in that market until sometime in 2024.

Unidentified Analyst, Analyst

Got it. And then I guess, along the lines of your balance sheet keeps getting stronger. You've talked about allocating 50% of your free cash flow towards share repurchase. Can you give us any update there? And then with regard to acquisitions, has anything changed related to either size or areas of focus versus the last couple of years?

Jeffrey Niew, President and CEO

Well, I think first, let's cover the acquisition portion. I think we look at the acquisitions we've done in the past in 2017; the largest one was about $80 million. With our balance sheet, there is the opportunity to look at some things that are larger than that on a purchase price basis with the discipline around that we don't want to overpay for something. We've discussed this a lot in previous years; the multiples were high. So we're going to be very disciplined about what we do in terms of acquisitions, but they could be larger. Again, I'm optimistic that we're looking at a lot of different opportunities, and we'll see how this all plays out over the next six months to a year. As for the stock buyback, I think we've committed more than 50% of our free cash flow towards share repurchase. Year-to-date, for the full year, we've actually spent more than 50% of the cash flow year-to-date through Q2 on share repurchases. We will continue to buy back shares in line with what we've talked about in the past.

Unidentified Analyst, Analyst

Great. And then just one more for me and I'll hop back in queue. Any update on the OTC hearing aid market? Are you seeing any new entrants, more demand? Anything along those lines?

Jeffrey Niew, President and CEO

Yes, the short answer is we continue to see that it's actually doing better than we originally expected so far. However, we're not seeing a lot of sell-through data. Our traditional hearing aid market is doing better than we expected six months ago. So, I would say two things. One, I think it's a little too early to assess the sustainability of the over-the-counter market based on sell-through data. Also, it's not a super meaningful number in the first half of the year, but it is better than expected. In the meantime, perhaps what we might be observing is that the over-the-counter market is actually generating more interest in hearing aids, leading customers to opt for traditional hearing aids, where they receive full service at a marginally different price.

Unidentified Analyst, Analyst

Great. Appreciate it.

Operator, Operator

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

Anthony Stoss, Analyst

Hey guys. Nice gross margins in a tough environment. Jeff, I wanted to follow up on Q4. So, Q4 is roughly flat with a year ago, Q4 and up 12%. Are you expecting China smartphones, etc., to bounce back in the December quarter, or what do you really need to see to hit kind of an up 12% sequentially for December?

Jeffrey Niew, President and CEO

Yes, I mean we do have some sequential improvement from Q2 to Q3 and Q3 to Q4. But if I refer back to numbers prior to 2022, I would say we're nowhere near the numbers we were shipping per quarter at the end of 2021. Our expectations have come down reasonably since last quarter for China, and it seems doable. We're looking at China to essentially remain flat for the full year compared to 2022, which was also a weak year for China.

John Anderson, Senior Vice President and CFO

And the sequential improvement from Q3 to Q4 is very modest that we have built in here.

Anthony Stoss, Analyst

Got it. If you consider the delays in defense regarding the PD side, how much of that can you attribute to a general slowdown in the business, or is it more in line with what you anticipated if those delays in defense had not occurred?

Jeffrey Niew, President and CEO

I would say, of the shortfall compared to what we had thought a quarter ago, probably about 30% to 35% of it is defense, and the rest is the industrial distribution, where we were previously expecting a stronger rebound. We’re just not seeing that. So, I would say around 60% of the shortfall is due to industrial distribution not recovering and about 35% to 40% of it is delays in defense.

Anthony Stoss, Analyst

Got it. And the last question for me. You called out compute or PC being stronger. It's definitely nice to see. I'm just curious if you looked at that business as a whole? Do you think PCs are going to still be down year-over-year, 2023 versus 2022 for you guys?

Jeffrey Niew, President and CEO

I would say right now, our PC market is going to be flattish year-over-year. But definitely, we expect growth in the back half compared to what it was last year. The first half was really low, especially in Q1 in the notebook tablet market. We had a really weak Q1, and we're anticipating some nice year-over-year growth in Q3 based on orders and demand. Overall, for the full year, it could be roughly flattish for our compute market. In various markets like IoT compute, a lot of them are showing a flattish trend year-over-year. However, we are seeing weakness in the first half and stronger results in the back half. The exception remains the smartphone market, where we just aren't observing a recovery.

Anthony Stoss, Analyst

That's definitely better than your peers, my compliments on how you guys are performing on the compute side for sure. And then I guess, let me throw one to John, on the OpEx, 43% to 45%, is that a good number to use kind of on a go-forward basis, or are there still more levers that you think you might pull and drop it even further?

John Anderson, Senior Vice President and CFO

Yes, Tony, I think I would aim for the low end of that number from a run rate. In this quarter, we had higher than normal OpEx due to some professional fee spending that we pulled forward into Q2 from the back half of the year. However, in my guidance, OpEx goes back down to about $41 million, which is the midpoint of the guidance for Q3. So I would maintain that range of $41 million to $43 million for the remainder of 2023.

Jeffrey Niew, President and CEO

Yes, I mean, just to add, we've taken several actions based on our earlier expectations for growth from PD that are not materializing. Hence, we've implemented cost considerations to ensure we maintain profitability. As demonstrated, even with a shortfall in revenue, we are close to profitability, and our operating margins continue to hold up.

John Anderson, Senior Vice President and CFO

Yes, I would say both gross margins and operating margins are holding up fairly well given the challenges on the top line.

Anthony Stoss, Analyst

Yes, exactly. All right. Thanks, guys. Appreciate it.

Operator, Operator

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