Earnings Call Transcript - KN Q1 2023

Operator, Operator

Good afternoon. Thank you for joining Knowles' First Quarter 2023 Earnings Call. All lines will be muted during the presentation, and there will be a chance for questions and answers at the end. I will now hand the conference over to Patton Hofer, Vice President of Investor Relations at Knowles. Thank you. You may proceed.

Patton Hofer, Vice President of Investor Relations

Thank you, Charles, and welcome to our Q1 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 and company 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 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 to pursuant 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 operation basis, unless otherwise indicated. Also, we have made selective 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 some details on our results.

Jeffrey Niew, President and CEO

Thanks, Patton. And thanks to all of you for joining us today. Our first quarter results were largely in-line with our expectations. Revenue finished slightly below the midpoint of our guidance, but due to strong operational performance and the benefits of mix, we were able to deliver gross margins, adjusted EBIT margins, EPS, and cash from operations all above the midpoint of the guided ranges. Looking at Q1 in more detail, Knowles generated $144 million of revenue slightly below the midpoint driven by weak consumer electronics demand in the market and excess customer and channel inventory across all three segments. In Precision Devices, revenue was down 4% from the prior year. EV, MedTech, and Defense all grew year-over-year, while our industrial market faced inventory challenges, which are now expected to continue through Q2. In MedTech and Specialty Audio, revenue was down 24 percent versus prior levels due to customer inventory adjustments and softer end market demand in the hearing health market. I would note MSA was better than expected as inventory moved faster than we anticipated driving revenue higher in Q1. In consumer MEMS Microphones, revenue was down 48% from Q1 of 2022, as all end markets were down versus prior year. Before I turn the call over to John, I will spend some time discussing the current customer and market conditions for each segment with some insights into what we are seeing for Q2 and the rest of the year. For our Precision Device segments, we continue to have strong demand and growth in our three key end markets: Defense, MedTech, and EV. In Defense, the demand for communications and electronic warfare systems continued to amplify the need for our RF filtering and high-performance capacitor products. Despite awards and shipments in this market being lumpy at times, we grew year-over-year again in Q1 for the seventh quarter in a row, and we are confident based on current bookings and the expected awards that will generate growth in 2023. For MedTech, our high-performance and high-reliability capacitor products grew again in Q1 and we continue to see demand growth throughout 2023. We believe this market continues to show resilience similar to our MSA segment in the face of economic or macroeconomic challenges. In the EV market, we grew 50% year-over-year in the first quarter; Knowles continues to expand its design wins in this exciting market with a broad range of new customers. We expect continued growth throughout 2023 with the EV market being our fastest-growing market for Knowles. In the industrial market, which currently makes up less than 15% of company revenue, we are seeing continued weakness as distribution and customer inventory levels remain elevated. We expect the inventory challenges in the market to continue in the second quarter, but we see signs that lead us to believe that recovery is coming in the second half. Overall, for PD, we expect strong bookings in Q2 for our three key markets, and depending on inventory consumption and our distributors, we could see a return to growth in the second half for this segment. In MedTech and Specialty Audio, as we stated on the Q4 call, we started seeing signs early in Q1 that the inventory situation was improving, which gave us increasing confidence in strong sequential revenue improvement in Q2. Our guide reflects a more than 27% sequential improvement in MSA driven by major hearing aid retailers around the globe starting to see a return to growth. This demonstrates the resilience of the end market and provides confidence in a return to growth starting in Q3 of this year. Lastly, our consumer MEMS microphone segment, demand across all our end markets was down in Q1 versus prior levels, but as we look ahead, we are starting to see recovery in some end markets. Specifically, non-mobile shipments are expected to be up over 30% sequentially as channel inventory has improved and replacement cycles are expected to start in Q3. These markets are still down from prior levels, but definitely showing signs that the first quarter was the bottom. Finally, while the smartphone market has not degraded further, we are not yet seeing a recovery, and due to excess capacity in the market, we are seeing further pricing pressure. While our strategy in the short term has not changed, we will continue to fill our capacity with smartphone business. For CMM, due to normal seasonality of this business and improving market conditions, we are expecting strong sequential improvement for revenue and earnings starting in Q2. We expect sequential improvement to continue for the remaining quarters in 2023. Overall, for Knowles, the outlook for improvement in revenue, margins, and earnings as the year progresses remains unchanged from our last call. The inventory situation in the hearing aid market has improved as forecasted, and we are increasingly confident of second-half growth. In precision devices, the Defense, MedTech, and EV markets remain robust while inventory challenges further dampen the industrial market in the near term. Lastly, for CMM, we are seeing improving trends in computing and ear and IoT, while smartphone demand shows a slower return to recovery. In summary, we are now expecting a 2% to 3% reduction off of last year’s full-year revenue. Now let me turn the call over to John to give us some quarterly details and our guidance.

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported first quarter revenues of $144 million, down 28% from the year-ago period, driven primarily by lower shipment volumes in consumer MEMS microphones and MedTech and Specialty Audio. The precision device segment delivered revenues of $54 million, down 4% from the prior year, driven by excess channel inventory in the industrial market, partially offset by increased shipments in EV, Defense, and MedTech end markets. In the MedTech and Specialty Audio segment, revenue was $46 million, down 24% versus the prior year, as our customers reduced inventory levels and we faced difficult year-over-year comparables, as the first half of 2022 demand benefited from strong COVID recovery. Consumer MEMS mic revenue of $45 million was down 48% versus the prior year, driven by weak global demand for consumer electronics and channel inventory adjustments across all end markets. First quarter gross margins were 37.7%, 270 basis points above the high end of our guidance range and down 390 basis points from the same period a year-ago. Precision Devices segment gross margins were 46.9%, up 130 basis points from the prior year, due to factory productivity gains and lower raw material costs. MedTech and Specialty Audio segment gross margins were 43.5%, down 680 basis points versus the prior year, driven primarily by lower factory capacity utilization, partially offset by foreign currency benefits. Consumer MEMS microphone gross margins for the first quarter were 21.7%, down more than 11 percentage points versus the prior year, driven by significantly lower factory capacity utilization, pricing pressure in the mobile market and unfavorable mix, partially offset by benefits of the restructuring actions announced in August of 2022. R&D expense in the quarter was $17 million, down $3 million from the prior year with the reduction driven entirely by the benefits of the restructuring actions taken in the Consumer MEMS microphone segment. SG&A expenses were $27 million, $2 million higher than prior year levels, driven primarily by higher incentive compensation costs, partially offset by restructuring actions in the Consumer MEMS microphone segment. For the quarter, the adjusted EBIT margin was 5.6%, near the high end of the guidance range. EPS was $0.05 in the quarter, above the midpoint of our guidance range. Now, I will turn to our balance sheet and cash flow. Cash and cash equivalents totaled $52 million at the end of the quarter. We generated cash from operations of $22 million, above the midpoint of our guidance range driven by lower net working capital. Capital spending was $4 million in the quarter and we repurchased approximately 430,000 shares at a total cost of $7.5 million. We ended the quarter with cash net of outstanding borrowings of $7 million. Moving to guidance for the second quarter, we expect total company revenue to be between $165 million and $180 million, up 20% sequentially and down 8% versus the same period a year-ago. We estimate gross margins for the second quarter to be approximately 39% to 41%, down 150 basis points from the year-ago period, but improving 230 basis points sequentially. R&D expenses are expected to be between $15 million and $17 million, down $2 million from prior year levels, driven primarily by prior year restructuring actions in the Consumer MEMS mic segment. We are projecting selling and administrative expenses to be between $26 million and $28 million, up $3 million from the year-ago period, driven primarily by higher incentive compensation costs, partially offset by restructuring actions in the Consumer MEMS microphone segment. We are projecting adjusted EBIT margin for the quarter to be in the range of 14% to 16% and expect EPS to be within the range of $0.20 to $0.24 per share. This assumes weighted average shares outstanding during the quarter of 95.1 million on a fully diluted basis. We are forecasting an effective tax rate of 17% to 19% for both the quarter and full-year 2023, which reflects a change in jurisdictional income and the potential impact of the unmet conditions for our tax holiday in Malaysia. For the quarter, we expect cash from operations to range from $5 million to negative $5 million. Capital spending is expected to be approximately $5 million.

Operator, Operator

Absolutely. The first question is from Bob Labick with CJS Securities. You may proceed.

Robert Labick, Analyst

Thanks. Good afternoon. Thanks for taking our questions. So I wanted to start, obviously, you guys are operating I think very well in a difficult and volatile market. And so I wanted to kind of take a step back and just get like a big picture view. And you have given medium-term targets previously of I think it is 43% gross margin and the 22% to 24% adjusted EBIT margin. And a lot of the growth to getting there was mix shift to higher margin business, plus utilization and then the recovery in CMM. So maybe give us a sense of what the hurdles are? Where we are in that timeline and where you stand, I guess, on CMM? You have done the restructuring. Is there more to come or is it now just utilization to catch up and kind of level set us back to the medium-term targets and where we stand, given all of the volatility in the market?

Jeffrey Niew, President and CEO

Bob, that is a good question. So let me just take a step back like you said and kind of give you on the bigger kind of picture here. But I kind of what we sit there and say is, I think we are making great progress on mix. I think I will take you back to some of our three key markets that we talk a lot about, is MedTech, which includes MSA in the decks that we put together for investors. And then Defense and EV. If you go back, as I kind of said, in 2018 that was about 32% of our total company revenue. Last year it was 47%. I would say it would probably be over 55% of our business now is in between MedTech, EV, and Defense. So we are making good progress there. Those businesses continue to perform extremely well for us. And I highlight, first, even in the short-term, our MSA business, which is the Hearing Health business, it is recovering faster than we had expected a quarter ago. And it continues to demonstrate the resilience of the MedTech markets in the face of some of the macro conditions that we have. So we are very pleased about that. Second, I would sit there and say, on PD, just a little bit more. We are expecting extremely strong bookings, which possibly could be record bookings in Q2, based on our forecast this year, driven by again Defense, MedTech, and EV. And so I think as we see how we are investing what whether it be our R&D dollars, our CapEx, this is kind of playing exactly the place we want to go. Now, if you go to the CMM business, as I kind of said in the prepared remarks, we are starting to see recovery in the non-mobile portions of the market. I would say that my recent discussions, like on Taiwan, which is primary laptop, is that this is coming up a little faster than we probably expected a quarter ago. But I will sit there and say that the mobile portion of this business, we are not really seeing a lot of improvement here. And we are still hopeful with seasonality that we are going to see a strong uplift in the back half on capacity utilization. So, if you take this overall, I don’t think we are backing off our mid-term targets that we have talked about at all. In fact, I would sit there and say that if the rest of the year kind of plays out the way we are expecting, which I will just say this it is about 2% to 3% down is what I kind of said in the prepared remarks. We will be exiting the year probably at like the gross margins that we are expecting around 43%. And so, I think obviously, we got to do that for a full year, but you can see the power that we are getting to with mix capacity utilization to get to that 43% plus. I would just caution, I think the Q3 and Q2 are still going to be a little volatile here. We are expecting sequential growth in Q3 again. Right now, I have projected at about 8% to 10% sequential growth off of the Q2 finish is where I see. But overall, I don’t think we have changing any of what we are talking about for the midterm.

Robert Labick, Analyst

Okay. Super. Thank you for all that color. And then just kind of shifting over to your balance sheet, obviously you have done a fantastic job. You have paid down by your net cash position now it is an enviable balance sheet given the market. Can you discuss the M&A opportunities out there in your pipeline? Is this you have done some restructuring? Is it still an area of focus right now or are you more focused internally? How should we think about, you know, M&A opportunities for you?

Jeffrey Niew, President and CEO

Here is what I say. I would say we are very happy with our balance sheet right now. And we have been very disciplined about what we have been doing with the cash that we have been generating. We have been buying back a fair amount of shares over the last couple of years. And I think we will continue to buy back shares, but we are still interested in M&A, and I would say specifically in the PD space. And I think, over the last couple of years, up until maybe six months ago, some the valuations we were getting were getting a little crazy and we kind of just backed away from that and said we would rather keep that strong balance sheet. I think we are going to benefit from that whether it be this year or next through some of the M&A opportunities that we have. So, I would sit there and say that it is likely we are going to do some M&A over the next 18 months or so and hopefully at prices that are a little more reasonable than they were a year ago.

Robert Labick, Analyst

Okay. Super, I will jump back in queue. Thank you.

Jeffrey Niew, President and CEO

Thanks, Robert.

Operator, Operator

Thank you. The next question is from the line of Christopher Rolland with Susquehanna. You may proceed.

Christopher Rolland, Analyst

Guys thanks for my question. You guys touched kind of on the inventory dynamic. I was wondering if you could go maybe a little bit deeper there. I think you even might have hinted towards inventory replenishment, even I wasn’t sure on that. And maybe you could break this up kind of by end markets if they stick out, if the inventory dynamic sticks out. Thank you.

Jeffrey Niew, President and CEO

Yes. Here is what I would say is, I think we kind of talked on the last call about that inventory for us would not be a headwind this year. We didn’t see necessarily our inventory going down for the full year, but it wouldn’t be a headwind again like it was last year. But I think if you are referring maybe to the inventory in the channel, I would sit there and say is, most of our end markets are in pretty decent shape right now. And so let me start with a few of them. I would sit there and say, after a year of a lot of challenges, the compute market is doing much better in terms of the channel inventory than it was, say six months ago. So we feel pretty good about that. Our hearing health customers in MSA, I visited all these customers in the last quarter. I was with a number of the CEOs of these companies. And I would sit there and say, they are optimistic about the full-year for growth for that market. And I would sit there and say, we are going to obviously benefit from that. It doesn’t appear that the inventory we dealt with in Q1 is going to continue for the rest of the year. In the PD segment, I would sit there and say, MedTech, EV, Defense, a lot of custom products that we are building, I wouldn’t say our customers have a lot of inventory. I wouldn’t say that is the issue. I would say, it is in that industrial/distribution segment where we still see and we are hearing there is inventory in the channel that needs to be burned down. Last quarter I thought we would probably start seeing an uptick in Q2 in that portion of the business. It hasn’t materialized. It now appears to us that it has been pushed out a quarter that we might see the inventory run down in the industrial portion of Precision Devices starting to dissipate in Q3.

Christopher Rolland, Analyst

That is great. And I was talking about distribution. So thank you for that. You also have some kind of interesting options I would say for your business model around EVs, RF, whether for Defense or 5G and balance armature speakers. And I guess I would ask, what are you most optimistic about and when could these be meaningful drivers of your business?

Jeffrey Niew, President and CEO

Yes. So I mean, again, as I kind of stated a little earlier, this is starting to become a pretty significant portion of our business. When I look at Defense, this is - if I go back a few years ago, this was less than - and I know some of this is through acquisition. If I go back to the 2020 timeframe, this was like a $30 million, $40 million business, and through acquisitions and growth, it is going to be over $100 million. Again, we have grown our Defense business on the back mainly of our filtering by a significant amount over the last four years. So we are still very excited about this market, Chris. We see a lot of opportunities both in terms of M&A but also in terms of just organic growth with the product portfolio that we have. So I think we are pretty happy with that. I would say generally speaking, our MedTech business is not growing at like breakneck pace, but I would sit there and say, it is extremely stable and extremely strong gross margins, that goes for both MSA and PD. I would sit there and say, we are now looking at our MedTech business being well over $250 million right, it is a big business. Now again, it doesn’t grow at 10% per year, but it is extremely strong, good gross margin with great cash flow and we are going to continue to look for opportunities to continue to grow that business. And then lastly, EV like you mentioned, it is starting from a small base. But, I mean, it was up 50% in the first quarter and bookings were extremely strong here. We are expanding our customer base. If I go back two years ago, the majority of our business came from a couple of customers. Now we have many customers. And so we are pretty confident about our position in EV. And if I will remind you, this is all on high voltage charging systems, right. And so it is not like we are placing like commoditized low voltage capacitors. These are extremely unique high-voltage capacitors that are being put both in cars and we are actually seeing some design wins in business in the charging stations now as well. So I would say, those three markets are going to be our focus going forward over the next three to four years, because good gross margin generates great cash flow and growth.

Christopher Rolland, Analyst

Great. Thanks so much, Jeff.

Operator, Operator

Thank you Mr. Rolland. The next question is from the line of Tristan Gerra with Baird. You may proceed.

Unidentified Analyst, Analyst

Hi. This is Tyler for Tristan. Thank you for the opportunity to ask questions. To start, can you provide an update on the balanced armature speaker line and how the over-the-counter hearing aid market has been performing?

Jeffrey Niew, President and CEO

Yes. I think there are two good questions. I appreciate those questions. First on the over-the-counter market, I would say I’m incrementally more optimistic than I was a quarter ago. I would say, we have seen more orders coming in, in the over-the-counter market than I would have said a quarter ago for this year. One of the reasons that the MSA business has been doing a little bit better. But I would just say, there are still concerns; it could be channel filling and how that is actually going to sell in the end market. So I’m still holding my breath here. But I would say, I’m incrementally more optimistic about the over-the-counter market. As far as the BA line, I think I mentioned this last quarter. We have not built this line yet. I would say, part of it is the reason is a lot of the designs that we have been working on with customers in China have been slower to come to production. Now with China reopening, we are starting to see more activity. But I think what we are surprised at and happy about is, the ASPs are significantly higher than we would have expected a year and a half ago, to the tune of 30%, 40% higher than we are expecting. So the revenue coming off this line is approaching what we would have expected a year and a half ago at the lower ASPs. I think there are three ways that we are going to fill this line, which is probably a little different than we would have talked about two years ago. One is this high definition audio, which is expanding the range of what you can listen to in the high frequency band, where you can only use the VA really to get that really great high definition at high frequency. Number 2, we are starting to see some of these over-the-counter hearing aid customers use our balanced armature line. And third, even some of our traditional hearing aid manufacturers are starting to use this as well. So we are very confident of filling this line and then hopefully buying another line. I would say, the other thing which has benefited the hearing aid business, which you can see in the MSA margins, is a lot of the learnings that we got off the automated line are being applied to our manual lines, which is helping our gross margin in that business as well.

Unidentified Analyst, Analyst

Great. Yes, it is really helpful. And then just for my follow-up. Can you just provide an outlook on what you are seeing in China and the smartphone market and then if there is anything you - any signs you are seeing for a second-half recovery there?

Jeffrey Niew, President and CEO

I believe there will be some recovery in China and the mobile market in the second half of the year, but I'm uncertain about the size of that recovery. Currently, the overall mobile market is not performing well, and this situation is not unique to China; it's indicative of the general mobile market conditions. It's a challenging environment where many of our customers are struggling to make a profit, and growth is minimal. We continue to view this as a challenge and it reinforces our discussions over the past two years about the need to diversify away from mobile in the long term. Last year, mobile accounted for about 16% of our total revenue, and this year we're anticipating that it will be less than 15%. We are committed to executing our strategy of diversification, and if other markets such as hearing aids, IoT, and computing in the MEMS Microphone segment recover, we hope to reduce the proportion of mobile in our overall business.

Unidentified Analyst, Analyst

Great. Thanks you guys for taking the questions.

Operator, Operator

Thank you. The next question is from the line of Anthony Stoss with Craig-Hallum. You may proceed.

Anthony Stoss, Analyst

Hey Jeff and John. I’m curious if you have made any down shifts to your CapEx plans for the second half of the year, and maybe John you can comment about your expected free cash flow in 2023 over 2022. Then I had a couple of follow-ups.

John Anderson, Senior Vice President and CFO

Yes, sure, Tony. In terms of CapEx, I would say two things. One, there is a shift more of our CapEx will be tilted toward the MSA segment and the PD segment. Overall spend is coming down a bit; we are kind of in the 4% of revenue range is what I would say for 2023. If you think back a few years, we were higher; we were kind of in the 5% to 7% of revenue. And again, it is less capital that we are putting into the CMM segment. In terms of free cash flow, I think it is important. We had decent free cash flow above our guidance in Q1, Q2 is a bit more muted, but I think you really have to look at cash flow for a longer period than a quarter, because it can really be influenced by timing, customer collections, payments at the end of the quarter. But for full-year 2023, we feel really good about free cash flow generation of 15% or more revenues in 2023.

Anthony Stoss, Analyst

Got it. Thank you. And then, Jeff, clearly you have uptick quite a bit in your excitement related to the EV side of the business. I know it has great gross margins. I’m curious if you want to share how big that business is or how big do you think it can become over the next several years for Knowles?

Jeffrey Niew, President and CEO

Yes. I think this year will probably be roughly about 3% of our company revenue this year. Probably around $20 million, somewhere in that range. Up probably 30% to 40% over last year. And I guess what I would say my caution is with this business is we have got a lot of design wins. But the content level with each customer is different. And we have some platforms where we have $20 worth of content per car. Other platforms where it is more like $5. And I guess what is hard for me to gauge at this point is in five years, three years, who are going to be the big winners and losers in the end market in the EV market. And to that extent, I guess I would sit there and say I would be disappointed if in a couple of years this business isn’t $40 million to $50 million. But on the worse side, we witness some of the winners, it could be $60 million, $70 million in two to three years. So I think it is a little early to call how big this is going to be, but I think what we like about this business is the macro of this market is it is going to grow. The question is how fast is it going to grow and what our content for vehicle is going to be.

Anthony Stoss, Analyst

Got it. And the last question for John, I think I heard this correctly. You expect total revenues to be down 2% to 3% year-over-year. Can you maybe help us to understand sometimes Q4, the December quarter is up, sometimes it is down. What do you think Q4 shakes out versus Q3?

John Anderson, Senior Vice President and CFO

Let me just take that, Tony. So again, I kind of mentioned it. I would sit there and say right now we see Q4 being the peak this year and it varies from year-to-year. But I think what we kind of would add just the normal variance from year-to-year, but we would also add the recovery that we are seeing and how it is happening. As I said, the last quarter we gave some, I would say, some soft guidance on the sequential improvement we were going to see in Q2, which we are right on kind of what we said we were going to do.

Jeffrey Niew, President and CEO

Usually, on the high end of what said 15 to 20.

John Anderson, Senior Vice President and CFO

Correct. Correct. And I would just say, right now, we see Q3 being up 8% to 10% sequentially from Q2. And then I think with seasonality and further recovery, which we see Q4 will be the peak.

Anthony Stoss, Analyst

Got it. Alright. Thanks guys. I appreciate it.

Jeffrey Niew, President and CEO

Thanks Tony.

John Anderson, Senior Vice President and CFO

Thanks Tony.

Operator, Operator

Thank you. There are no further questions in the queue. With that, we will conclude today’s Knowles earnings conference call. Thanks for your participation. Please enjoy the rest of your day.