Earnings Call Transcript - KN Q3 2025

Operator, Operator

Thank you for joining us. My name is Eric, and I will be your conference operator today. I would like to welcome everyone to the Q3 2025 Knowles Corporation Earnings Conference Call. I will now turn the call over to Sarah Cook. Please proceed.

Sarah Cook, Vice President of Investor Relations

Thank you, and welcome to our third quarter 2025 earnings call. I'm Sarah Cook, Vice President of Investor Relations. 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 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 included, but not limited to, the annual report on Form 10-K for the fiscal year ended December 31, 2024, 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 with the exception of cash from operations or 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 thanks to all of you for joining us today. As we continue to execute our strategy of leveraging our unique technologies to design custom engineered solutions and then deliver them at scale for customers and markets that value our solutions, we achieved strong results in the third quarter of 2025. Revenue was $153 million, up 7% year-over-year. EPS of $0.33, up 22% year-over-year, and cash from operations was $29 million, all of which were above the midpoint of our guided range. I believe our results continue to demonstrate that our focus on the markets and products where we have significant competitive advantage is paying dividends and positions us well for future growth. Now turning to the segment results. In Q3, Medtech & Specialty Audio revenue was $65 million, up 2% year-over-year. Our continued operational excellence, sustained success of new product adoption and cutting-edge technology is evidenced with our strong gross margins. I expect that Medtech & Specialty Audio will have revenue growth within the range of 2% to 4% over the year in 2025, and we are optimistic about our future growth opportunities we detailed at our Investor Day. In the Precision Devices segment, Q3 revenue was $88 million, up 12% year-over-year. We saw revenue growth across all our end markets: medtech, defense, industrial, and EV and energy. Our strong intimacy with our customers' applications has led to accelerating design wins. Coupled with robust secular trends in our end markets, I am confident in our ability to continue to grow revenue in the fourth quarter and beyond. While we are seeing growth across all our end markets, I would like to highlight the defense market as it was particularly strong with design wins and bookings outpacing other end markets. Our capacitors and RF microwave solutions serve a wide variety of military applications. We have a compelling product offering of RF filters being used in the next generation of defense systems serving a broad base of applications from radar, detection and jamming to ground communications, ensuring reliable and secure military communications. Our capacitors provide the electrical energy source needed for extremely harsh applications like munitions and detonation devices. Defense spending is increasing and shifting towards spending on electronic warfare where our products are in high demand. In Q3, bookings in the PD segment remained strong, particularly in defense and with our distribution partners. We continue to believe that channel inventories are now at normalized levels as they are now matching orders to end market demand. We continue to collaborate with our customers leading to a robust pipeline of new design wins as our customers continue to choose our innovative and differentiated solutions across all the markets we serve. We are positioned well for organic growth, and I expect the Precision Devices segment will grow at the high end of our stated growth range of 6% to 8% in 2025. I would like to reiterate the strategy we are executing across both of our business units. We are leveraging our unique technologies, creating custom products through our customer application intimacy and then scaling into production with our world-class operational capabilities for end markets with strong secular growth trends. It is proving to be a winning combination, leading to year-to-date revenue growth of 5% and EPS growth of 15% on a year-over-year basis. John will go through our Q4 guidance shortly, but as we stated on previous calls, we are expecting to finish the year strong with revenue and EPS growth accelerating in the second half of 2025. As we look to next year, with new design wins ramping and a very healthy backlog of existing orders, we expect to see organic growth rates at the high end of our stated range of 4% to 6% for the total company. This is an increase from historical levels, supported by strong secular growth trends in our end markets and new initiatives such as the expansion of our specialty film production coming online. Cash generation from operations continued to be robust in the third quarter, allowing Knowles to purchase $20 million in shares and reduce outstanding bank borrowings by $15 million. We have a very strong balance sheet that will continue to support our growth as we pursue synergistic acquisitions and buy back shares while continuing to keep our debt at very manageable levels. In summary, as I said last quarter, I'm excited by the momentum and strength the business demonstrated and the growth opportunities that we have in front of us, both in the near and longer term. Our design wins continue to be strong across our product portfolio. This is driving increased demand for our products, which gives me confidence that we have entered a period of accelerated organic growth from historical levels. We are laser-focused on what we do best, designing custom engineered products and delivering them at scale for customers and markets that value our solution, positioning us well for growth in 2025 and beyond. Now let me turn the call over to John to detail our quarterly results and provide guidance for Q4.

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported third quarter revenues of $153 million, up 7% from the year ago period and at the high end of our guidance range. EPS was $0.33 in the quarter, up $0.06 or 22% from the year ago period and also at the high end of our guidance range. Cash generated by operating activities was $29 million at the high end of our guidance range, driven by lower-than-expected net working capital. In the Medtech & Specialty Audio segment, Q3 revenue was $65 million, up 2% compared with the year ago period, driven by increased demand in the specialty audio market. Q3 gross margins were 53%, flat versus the year ago period. As expected, segment gross margins in the third quarter improved more than 200 basis points sequentially, and we expect gross margins to be above 50% for the full year 2025. The Precision Devices segment delivered third quarter revenues of $88 million, up 12% from the year ago period. Segment gross margins were 41.5%, up 150 basis points from the third quarter of 2024 as higher end market demand and production volumes in our ceramic capacitors and RF microwave product lines resulted in increased factory capacity utilization. These improvements were partially offset by higher production costs and lower-than-expected yields associated with the ramp-up of the specialty film product line. It's worth noting that specialty film output trends within the quarter were positive. And as we exited Q3, we are well positioned for both sequential growth and gross margin improvement in the fourth quarter. On a total company basis, R&D expense in the quarter was $9 million, flat with Q3 2024 levels. SG&A expenses were $26 million, up $2 million from prior year levels, driven primarily by annual merit increases and higher incentive compensation costs. Interest expense was $2 million in the quarter and down $2 million from the year ago period as we continue to reduce our debt levels. Now I'll turn to our cash flow and balance sheet. In the third quarter, we generated $29 million in cash from operating activities. Capital spending was $8 million in the quarter. We continue to expect to generate operating cash flow of 16% to 20% of revenues for full year 2025. During the third quarter, we purchased 940,000 shares at a total cost of $20 million. We exited the quarter with cash of $93 million and $176 million of debt, which includes borrowings under our revolving credit facility and an interest-free seller note issued in connection with the Cornell acquisition. The remaining balance of the seller note matures next month, and we expect to fund this payment with a combination of cash on hand and revolver borrowings. Lastly, our net leverage ratio based on trailing 12 months adjusted EBITDA was 0.6x, and we have liquidity of more than $350 million as measured by cash plus unused capacity under our revolver. Before turning to the fourth quarter guidance, I want to give a brief update on the tariff situation as it relates to Knowles. While the situation remains fluid, we continue to believe our exposure to tariffs is less than 5% of revenue and 3% of cost of goods sold. We've had success in passing these additional costs on to our customers, and our expectation is to continue to do so without loss of business. Moving to our guidance. For the fourth quarter of 2025, revenues are expected to be between $151 million and $161 million, up 9% at the midpoint year-over-year. R&D expenses are expected to be between $8 million and $10 million. Selling and administrative expenses are expected to be within the range of $26 million to $28 million. We're projecting adjusted EBITDA margin for the quarter to be within the range of 22% to 24%. Interest expense in Q4 is estimated at $2 million and includes non-cash imputed interest. We expect an effective tax rate of 7% to 11%. As we move forward, I expect the tax rate to increase in 2026 to the range of 15% to 19%. We're projecting EPS to be within a range of $0.33 to $0.37 per share. This assumes weighted average shares outstanding during the quarter of 87.2 million on a fully diluted basis. We're projecting cash generated by operating activities to be within the range of $30 million to $40 million. Capital spending is expected to be $12 million, and we expect full year capital spending to be approximately 5% of revenues as we've increased investments associated with capacity expansion related to our specialty film line. In conclusion, our year-over-year revenue and earnings growth were strong in the third quarter. And with the backlog and increased order activity, we expect to continue to deliver both sequential and year-over-year revenue and earnings growth in the fourth quarter of 2025.

Operator, Operator

I'll now turn the call back over to the operator for the questions-and-answers portion of our call. Your first question comes from the line of Christopher Rolland with Susquehanna.

Christopher Rolland, Analyst

Congrats. So I guess my first is going to be on specialty film. If you guys could just remind us on current capacity, your plans or even an update on your plans for capacity additions and how from a demand standpoint, you guys see revenue now into next year and whether you have high confidence on high-volume additional customer opportunities for this product in particular?

Jeffrey Niew, President and CEO

Yes, Chris, let me break that down into two parts regarding specialty film. First, concerning the energy order we received in Q1, we expect to start delivering it in the latter half of the second quarter, with a ramp-up that really takes off by the end of that quarter, estimating around $25 million in that business for Q2. In terms of the other part of the specialty film business, we currently have a backlog exceeding $25 million, close to $30 million, which does not include the energy order. We anticipate more orders coming in, so we feel confident that the specialty film line will likely be in the $25 million to $30 million range this year. Adding the $25 million from the energy order, we expect revenue to reach at least $55 million or $60 million next year, and we are expanding our capacity to meet these orders.

Christopher Rolland, Analyst

Excellent. I would like to discuss the design activity mentioned in the press release. I'm curious about what you were referring to and what supports the high end of your target growth range. Additionally, considering Medtech, Precision Devices, or any subsegment, what do you expect to see above that?

Jeffrey Niew, President and CEO

Yes. If I were to assess the situation now, I would estimate the Medtech and Specialty Audio business to grow in the range of 2% to 4% next year. As for the Precision Device sector, which is now larger than Medtech, I anticipate its growth to be at the upper end, possibly exceeding the 6% to 8% range we mentioned at the Investor Day for organic growth. The foundation for this optimism, aside from the energy order we highlighted, is the considerable success we are experiencing. I want to commend the Knowles teams for their excellent execution. They are effectively utilizing our unique technologies and customizing them for specific applications in the medical, industrial, and defense sectors while scaling up operations to world-class standards. We are witnessing significant design wins across the board, which supports our confidence in current growth rates alongside that energy order. Additionally, we are achieving notable success this year in the electric vehicle sector, particularly with specialized design wins where we have distinctive and competitive products.

Operator, Operator

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

Bob Labick, Analyst

Congratulations. Also my congratulations as well on the strong performance.

Jeffrey Niew, President and CEO

Thanks, Bob.

Bob Labick, Analyst

Yes. So I just want to follow up on the kind of the specialty film. There's obviously lots of excitement going on in the capacitors. You talked about the energy order coming on next year and then the other specialty, I guess, I think you said medical and defense. And any way you can elaborate on some of the products that these are going into or the ability for follow-on orders in the non-big energy one and how that could progress over time?

Jeffrey Niew, President and CEO

Yes. I mentioned a few specialty applications that we've discussed before, and they are growing quickly and performing well for us. The specialty film is primarily centered around pulse power applications. These are applications where the capacitor is not used in the traditional sense as a basic component of an electronic circuit. Instead, it's utilized to store a significant amount of energy that must be released quickly to power something. We’ve previously talked about defibrillators, railgun applications, and more recently, radiotherapy, which is a great opportunity for us. Many emerging applications are developing, and aside from the unique energy order, we have a number of distinctive applications coming to market. We are constantly being approached on a weekly and daily basis. Our position relative to technology and our ability to provide solutions is quite unique. Additionally, it is advantageous to have our manufacturing based in the U.S.

Bob Labick, Analyst

Got it. Yes. It sounds like these are new applications solving problems may be better than before in kind of existing markets, but taking share from older technologies. Is that post...

Jeffrey Niew, President and CEO

I wouldn't say taking share. I would say this is like new applications that didn't exist before that are requiring like a significant amount of power to be delivered in a very rapid period of time in order to power the device. I think one of the ones that we alluded to, which is coming is downhole. And that's another application that, quite frankly, we're taking prototype orders for right now, but we could see down the road with all the work that we've been doing that these downhole applications where our capacitors would be in high heat environments, have to be taken downhole in order to be involved in fracking and cleaning of drill bits. There's a whole bunch of different applications here that we've been working on for like a year or two. And we're in the prototype phase right now, but everything indicates like that one is another application that would require pulse power.

Bob Labick, Analyst

Got it. Very exciting. And shifting gears, obviously, the balance sheet is in good shape. You're buying back stock. You've had M&A in the past. Can you just give us an update on the M&A environment? I don't know if it's like with tariffs, it slowed down. Has it like reopened up a little bit? Or what's the opportunity...

Jeffrey Niew, President and CEO

Yes, we are definitely focused on this. I believe that as a company, we have a solid organic plan. We want to ensure that if we pursue an acquisition, it is clear to our analysts and shareholders why we chose to do so. We are still very focused on acquisitions, but we want to be selective, ensuring that any opportunity we consider makes sense and creates significant value. I remain hopeful that we will complete something in the next year or two, but we need to ensure it is the right decision. John, do you have any comments?

John Anderson, Senior Vice President and CFO

I think that the environment has improved from a quarter ago. There's more assets out there. Interest rate expectations are coming down. So again, we've got a good pipeline, but it's difficult to say when we're going to be able to complete. And as Jeff said, we're being disciplined.

Operator, Operator

Your next question comes from the line of Anthony Stoss with Craig-Hallum.

Anthony Stoss, Analyst

John, probably the first question for you. I'm curious if you can share the book-to-bill now and where it was maybe a quarter ago. And then palladium prices are up about 30% in the last 30 days. I know this impacted you guys early in 2022. I'm curious at what price of palladium do you think would have a negative effect on your gross margins?

Jeffrey Niew, President and CEO

So I'm going to let John take the palladium question first, and then I want to just cover the book-to-bill.

John Anderson, Senior Vice President and CFO

Yes, Tony, you're right. The costs of palladium have increased. I will say we're in a good position because we have prebuys secured. We're locked in at prices below today's market value at least through the first half of next year. If the prices continue to rise, I recall that 12 to 18 months ago, they exceeded $2,000 per troy ounce, and now they're around $1,500. We're keeping a close watch on this. If there are chances to prebuy beyond the second half of 2026, we will take those opportunities. However, I don't believe this will negatively affect our gross margins at this time.

Jeffrey Niew, President and CEO

We were able to raise prices previously, and now we've fixed the price, as John mentioned, through the middle of next year. This means we won't experience significant volatility in a short time frame. If prices stay the same in the latter half of next year, we will likely have discussions with our customers about it, but it's not a major concern right now. Regarding our book-to-bill ratio, it was one for the quarter within PD. It's important to note that this was the second-largest order quarter in the last four quarters. Revenue has increased significantly, making it more challenging to achieve the extraordinary book-to-bill ratios we had in the first half, but we are starting to deliver on those. We had a very strong bookings quarter, the second largest in the past year, and our backlog is quite high, which is why we have had so many orders in the last three quarters, not counting the energy order. We feel confident about our bookings. I checked the bookings for this month and it seems we are experiencing another strong month in October. The trends are positive, particularly in defense and with our distribution partners, where we have over 100 partners in the defense market.

Anthony Stoss, Analyst

If I could sneak in one more for John. You said it's good to hear that the thin film you're making improvements in Q4 on the gross margin side. How much or how many more quarters do you think that will last? And what kind of impact is it at now?

John Anderson, Senior Vice President and CFO

Tony, are you referring specifically to the specialty film line?

Anthony Stoss, Analyst

Yes.

John Anderson, Senior Vice President and CFO

Margins were a key area for improvement in Q3. We had a solid quarter overall, but margins were significantly lower than both the company's total and the PD average. We are facing increased costs, including fixed overhead and higher-than-normal scrap expenses. However, we did observe some positive trends in Q3, with August performing better than July and September showing much improvement over August. So we are on the right trajectory moving forward.

Jeffrey Niew, President and CEO

I think you're not going to really see the full benefit of the gross margin we expect to achieve until probably late Q2 when the energy order starts to fully ramp up. Remember, we're in the process of hiring people and getting equipment operational. We're putting overhead in place to fulfill this energy order, but we haven't delivered or produced many units yet. This is affecting our gross margin, and that impact is not likely to diminish fully until mid- to late Q2.

John Anderson, Senior Vice President and CFO

But I do, again, see sequential improvement from Q3 to Q4 in gross margins due to improved output and capacity utilization.

Operator, Operator

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

Tristan Gerra, Analyst

Could you give us a sense of the gross margin leverage on incremental utilization rates and where utilization rates are currently? And also as a follow-up to the prior question, what is the gross margin impact from the ramp in specialty film in Q3? And assuming that impact, as you said, disappears by mid next year, is it kind of a linear decline? Or is it more of a decline that happens mostly when you start ramping in Q2 of next year?

John Anderson, Senior Vice President and CFO

Yes. A lot of questions to unpack there, Tristan. I would say the first thing with respect to the gross margin utilization and capacity, you really have to look at it on a product line-by-product line basis. We have some product lines that are running close to full capacity within the ceramic capacitor business and others that we've got some capacity. So it's really difficult to kind of go and give you a blanket on what our capacity utilization is.

Jeffrey Niew, President and CEO

But generally speaking, like our drop-through on incremental revenue.

John Anderson, Senior Vice President and CFO

I would say that question is easier to answer on average, but it depends on the product line. Overall, you can think of 35% to 40% dropping to the bottom line on every dollar of sales. Our gross margin is around 45%, and our variable contribution margin is higher than that. We don't have a lot of incremental operating expenses. So if I were modeling this, every dollar of sales would be about 35% to 40%. If it's an MSA, it will be a bit higher, and certain areas within PD might be a bit lower. But overall, you can use the 35% to 40% figure.

Jeffrey Niew, President and CEO

Maybe, John, if you agree, but I think what you're going to see is some linear improvement in Q4, Q1 and into Q2. And when you're going to see probably a bigger jump up in Q3 once we're fully running the production. So it's going to kind of be linear and then a jump up.

John Anderson, Senior Vice President and CFO

Yes. The only thing I would say is sometimes Q1 has a little seasonality where in some...

Jeffrey Niew, President and CEO

I'm talking about specialty film specifically. You will see linear sequential improvement Q3, Q4, Q4 to Q1, Q1 to Q2 and then a big jump up as we get into Q3.

John Anderson, Senior Vice President and CFO

In some of our other businesses, such as MSA, Q3 and Q4 are typically strong quarters, followed by a slight decline in Q1.

Jeffrey Niew, President and CEO

I believe the main point is that several of our businesses, particularly in the specialty film product category, have the potential for increased gross margins, which should contribute to improving the company's EBITDA margins over time.

John Anderson, Senior Vice President and CFO

Yes. I would just make one last point on this. If we're going to finish somewhere between 44% and 45% in 2025, there is an opportunity to go higher in 2026, really driven by the ramp-up in the specialty film line in the second half of '26.

Jeffrey Niew, President and CEO

Your exposure to distribution and industrial within PD, is that still around 40%? And you've mentioned that inventory levels are back to normal. Is that the case for industrial and distribution as well? And you've mentioned a very nice ramp in industrial. So should we assume that even in that segment, inventory levels have normalized? And if not, when do you think that happens?

John Anderson, Senior Vice President and CFO

I would say, generally speaking, a big portion of what we categorize in our distribution business is industrial, and that business is up. Now here's what I'd just say is it's a little opaque yet to answer the question on industrial growth year-over-year, because you're taking into account inventory burn down. But I can definitely say that if you look at the growth in distribution, we're going to have some pretty nice growth in our distribution business. And when we see their POS reports, they're seeing nice growth as well. And a big portion of that's industrial. Now again, it's hard to actually say how much industrial is growing. But I can tell you is the inventory is for sure out. We're definitely seeing ordering trends that are saying that orders are lining up with demand as opposed to if we're burning out inventory, we don't really need that much to order that much from you.

Operator, Operator

There are no further questions at this time. Ladies and gentlemen, this concludes today's call. Thank you all for joining, and you may now disconnect.