Earnings Call Transcript - KN Q4 2023

Operator, Operator

Good afternoon. My name is Audra, and I will be your conference operator today. At this time, I would like to welcome everyone to the Knowles Fourth Quarter and Full Year 2023 Earnings Call. Today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. At this time, I would like to turn the conference over to Sarah Cook. Please go ahead.

Sarah Cook, Vice President of Investor Relations

Thank you, Audra, and welcome to our Q4 and full year 2023 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 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 on Form 10-K for the fiscal year ended December 31, 2022, periodic reports filed from time to time with the SEC, and risks and uncertainties identified in today's earnings release. All forward-looking statements are made as of the date of this call, and Knowles disclaims any duty to update such statements, except as required by law. In addition, pursuant to Reg G, any non-GAAP financial measures referenced during today's conference call can be found in our press release posted on our website at knowles.com, and in our current report on Form 8-K filed today with the SEC, including a reconciliation to the most directly comparable GAAP measures. All financial references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. We've made selected financial information available in webcast slides, which can be found in the Investor Relations section of our webcast. With that, please 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. Before I get into the Q4 results and my remarks on the status of our markets and what we are seeing for Q1, I would like to start off with some highlights from the previous year. We again made significant progress in transforming our business to higher-value products, which we believe will drive increased shareholder value in the years to come. In our Medtech & Specialty Audio business, after a large inventory correction in the first half, we delivered 17% sequential revenue growth in the second half of 2023, with strong operating margins. Our operational performance, coupled with the success of our new products, gives us great momentum as we enter 2024. In our Precision Device segment, we successfully completed the acquisition of Cornell Dubilier, which significantly expands our total available market for capacitors in key markets and drives opportunities for future growth. Since closing in Q4, we now believe the synergies will be higher than our initial expectations. Lastly, the Company closed out 2023 with another strong year of free cash flow of $106 million or 15% of revenues. This has allowed us to continue to fund organic growth and look at additional acquisition opportunities in our target markets, all while continuing to buy back shares and keeping our debt at very manageable levels. We are very excited about the direction we are heading and believe we will continue to drive shareholder value in 2024 and beyond. Now on to our Q4 results. We delivered revenue of $215 million and EPS of $0.28, within our guidance range, with cash from operations of $60 million, which was above the high end of our guided range. Turning to segment results. Medtech & Specialty Audio revenue was up 9% versus the same period a year ago. The Hearing Health market continues to perform well, and we are expecting strong year-over-year growth in the first half of 2024. The dynamics of our aging populations in Western economies, expansion of the middle class globally, and increasing penetration of people with mild-to-moderate hearing loss all point to positive market dynamics in the mid- to long term. Precision Device revenue was up 10% year-over-year, including the acquisition of Cornell. While inventory in the channel remains high, specifically in industrial and distribution, and with a number of OEM customers, underlying demand appears to be stable, and design activity across our core markets remained high. With this backdrop, we expect increased earnings for PD in 2024 as we focus on cost controls and capacity utilization and optimization. Earnings growth will be driven by organic gross margin improvement and the Cornell acquisition and its associated synergies. Channel inventory normalization expected in the second half of 2024 will complement our expected earnings growth. Turning to the Consumer MEMS Microphone business. We continue to move forward with the exploration of strategic alternatives. In the quarter, revenue was up 8% from the same period a year ago. We have now seen three quarters of sequential growth, driven by growing demand in non-mobile products, expanded mobile share, and the ongoing recovery in the PC market. We expect to see strong year-over-year revenue and earnings growth in the first quarter of 2024. To summarize, MSA continues to perform well, and the momentum shown in Q4 gives us confidence in 2024 revenue and earnings growth. In PD, we are expecting channel inventory to correct and demand recovery to begin in the back half of 2024. Synergies identified in association with the Cornell acquisition are projected to be higher than initially expected, beginning to materialize in the second half of 2024. For CMM, we expect to achieve modest full year revenue growth in 2024. While 2023 was a challenging year, we performed well in the second half. Heading into 2024, I am optimistic we have growth across all three of our business units in revenue and total company earnings, along with continued robust cash flow. We continue to transform our company to higher value products and markets, and I'm confident the strategic actions we've taken will drive long-term shareholder value. Before I turn it over to John, remember, we will be providing revenue, EPS and cash from operations guidance. As I said in Q3, we believe these metrics are the best measures for our business and are aligned to the Company's focus. Now let me turn the call over to John to detail our quarterly and annual results and guidance. John?

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported fourth quarter revenues of $215 million, in line with guidance and up 9% from the year ago period, driven by the acquisition of Cornell, which we completed on November 1. EPS was $0.28 in the quarter, within our guidance range, and $0.05 below prior year levels. In the Medtech & Specialty Audio segment, revenue was $67 million, up 9% versus the fourth quarter of 2022 and increased demand in the Hearing Health market. Gross margins were 54.2%, up 260 basis points versus the prior year, driven by factory productivity improvements, favorable product mix and foreign currency impacts. The Precision Device segment delivered revenues of $70 million, up 10% from the prior year, driven by the acquisition of Cornell, partially offset by lower shipments in the distribution and industrial end markets as we continued to see excess channel inventory. Gross margins were 35.4%, down 13 percentage points versus the prior year due to lower factory capacity utilization and the acquisition of Cornell. Consumer MEMS Microphone revenues of $78 million were up 8% versus the prior year, driven by higher shipments into the mobile and compute markets. Although full year revenues were down 12% in 2023, driven by an extremely weak first quarter, we delivered sequential revenue growth over the remainder of the year through a combination of market growth and share gains. Gross margins were 24.7%, 70 basis points above the same period a year ago on higher factory capacity utilization. On a total company basis, R&D expense in the quarter was $16 million, up slightly compared to the prior year. SG&A expenses were $31 million, $4 million higher than prior year levels, driven by the acquisition of Cornell and an increase in professional and legal fees associated with the exploration of strategic alternatives for CMM. Now I'll turn to our balance sheet and cash flow. We generated $60 million in cash from operating activities in the quarter and capital spending was $5 million. We also repurchased approximately 1.2 million shares at a total cost of $20 million and ended the year with cash and cash equivalents of $87 million. On a full year basis, free cash flow was $106 million or 15% of revenues, and we repurchased approximately 2.9 million shares at a cost of $48 million. We exited 2023 with $271 million of debt, which includes $160 million of borrowings under our revolving credit facility and a seller note which was issued in connection with the Cornell acquisition. Lastly, our net leverage ratio was 1.3x 2023 EBITDA. Now moving to our guidance. For the first quarter of 2024, revenues are expected to be between $190 million and $200 million, up 35% versus the year ago period, driven by both organic growth and the acquisition of Cornell. R&D expenses are expected to be between $17 million and $18 million, and selling and administrative expenses are expected to be within the range of $30 million to $32 million, up from prior year due to the Cornell acquisition. We're projecting adjusted EBIT margin for the quarter to be within a range of 12% to 14%. We're forecasting interest expense in Q1 to be between $5 million and $7 million, which includes approximately $2 million of noncash imputed interest. For full year 2024, we expect interest expense of $22 million. And we expect an effective tax rate of 14% to 16% for both the quarter and full year 2024. We're projecting EPS to be within a range of $0.16 to $0.20 per share, up $0.14 from the year-ago period. This assumes weighted average shares outstanding during the quarter of 94 million on a fully diluted basis. Lastly, we're projecting cash from operations to be within a range of $0 to $10 million, and capital spending is expected to be $5 million.

Operator, Operator

I'll now turn the call back over to the operator for the questions and answers portion of our call.

Christopher Rolland, Analyst

So I guess you talked about some excess channel inventory in some of your end markets. I was wondering if you could perhaps flesh that out for us, and maybe discuss how this might affect kind of future revenues or areas as we look through 2024?

Jeffrey Niew, President and CEO

Yes. Thanks, Chris, for the question. So what I would say is the primary area that we see a lot of inventories, what we call it in the industrial/distribution channels. And we've listened to some of the big distributors calls, and they're seeing a fair amount of channel inventory. And it is impacting our business, no doubt, specifically in the PD segment, both in the Cornell portion as well as the traditional PD portion. Now we're hearing a lot that there may be, again, people are projecting a recovery in the back half of the year. But I think what we're focused on in the first half is, number one, we do have strong organic growth in the first quarter, and it's being driven primarily by our MSA business as well as our CMM business. And of course, the additional revenue we get from Cornell through the acquisition, that's the inorganic portion. And to that end, again, I think we're really focused in on cost here in the short term, making sure we're optimizing our factory utilization, getting value creation in our factories, as well as cost control in our factories. And so those are things that we're going to be focused on until we see the recovery. But in the meantime, in a number of our businesses, we are seeing very little channel inventory problem at this point, but primarily industrial and distribution.

Christopher Rolland, Analyst

Excellent. And sorry for this all-encompassing question, but would love to know for March, you guys gave top line and bottom line, but would kind of love to know the moving parts on the kind of sequential changes by segment. And then also to get to your EPS guidance. And any clues on the balance between gross margin and OpEx, how those trend? And then lastly, John, I had a little bit of a question mark getting to your cash from operations. I assume there's some working capital adjustments, but would love to know what those were.

Jeffrey Niew, President and CEO

Okay. I'll address the revenue portion by segment. In the microphone business, we anticipate strong year-over-year growth in the CMM sector. While it has decreased sequentially, the decline is less significant than usual. We are still experiencing good demand in the first quarter, so it isn't as seasonally low as we typically see in a normal year. In our MSA business, there is a seasonal decline. Q4 is generally our strongest quarter in the Hearing Health market, with a major hearing aid show launching products early in that quarter. A lot of preparation occurs in Q4, which makes Q1 usually lower. However, our Hearing Health business has grown significantly year-over-year. As for the Precision Device segment, it shows a notable sequential increase, largely driven by the Cornell acquisition. Now, I will hand it over to John to discuss the EPS and cash flow numbers in more detail.

John Anderson, Senior Vice President and CFO

Yes, sure. So Chris, in my prepared remarks, I provided for Q1 revenue guidance, I provided OpEx, both R&D and SG&A as well as EBIT margins. The only thing I really didn't specifically talk about is gross margins, but you can kind of think of the gross margins being very similar to Q4 levels in Q1. And then, we expect sequential increases over the remainder of 2024. I think that was the first piece. I also provided the interest expense and taxes. So I think you have all the mechanics to get to that EPS guidance we have. I think your other question was on free cash flow.

Christopher Rolland, Analyst

Yes, cash from operations specifically. And I apologize, I joined the call a little late.

John Anderson, Senior Vice President and CFO

Yes. So cash from operations very strong in both Q4 and for the full year, and I would say, a lot of this is sustainable. We did have a benefit in 2023 for a reduction of inventory, about $14 million. When you look at the balance sheet, it's a little camouflaged, because you have the inventory related to the Cornell acquisition. But if you strip that out, the inventory, I'll call the legacy business, down about $15 million, which created some tailwind. I'd also say from a free cash flow standpoint, CapEx were lower than normal. They were extremely low for full year '23. I think we've pushed out some projects and really focused on investments with highest ROI. So I would say that could tick up a little bit going into 2024, more to like a 3% to 5% of revenue range.

Christopher Rolland, Analyst

Okay. I was specifically talking about the guide for cash from operations at 1 to 10. I was wondering if there were some working capital adjustments in there to get there?

John Anderson, Senior Vice President and CFO

For the first quarter, it is typically our lowest quarter for free cash flow and cash from operations. If you look back at the first quarters of 2022 or 2023, you'll notice this pattern. We have significant bonus payouts in this quarter, which contribute to a large outflow. However, aside from that, there isn’t a major shift in other aspects of net working capital. We do expect some increases in inventory as we acquire raw materials and prepare for production ramp-ups later in the year. This could create a slight challenge in the quarter, but overall, the first quarter is historically slower in terms of cash flow.

Jeffrey Niew, President and CEO

Even though Q1 is historically low, we're still expecting for the full year to have a very robust year again in terms of free cash flow.

John Anderson, Senior Vice President and CFO

Similar, maybe a touch lower than 2023. But again, pretty strong cash flow for the full year. So I caution just looking at one quarter.

Lee Jagoda, Analyst

It's actually Lee Jagoda for Bob today. Just starting with the CMM business and the strategic alternatives process. Can you give us any kind of timeframe for a decision one way or the other, whether it be first half, second half? Is it a 2025 event? And then I've got some follow-ups.

Jeffrey Niew, President and CEO

Obviously, we're trying to move this process along as quickly as we can, but there's no definitive timeline at all to complete this. So that's what I’d say for now. And the process is progressing.

Lee Jagoda, Analyst

And then, I guess, in your prepared remarks, it sounds like the business is faring relatively well at the moment. What do you see as sort of the key drivers or variables to 2024 results? And how that might impact the process that's going on?

Jeffrey Niew, President and CEO

You're correct that 2023, particularly the second half, has improved after a challenging first half, especially in Q1. The latter part of the year is looking promising, and Q1 is also showing positive signs. The key factors include several new product launches on our end, customer initiatives, some market share gains, and market recovery. Therefore, we anticipate modest year-over-year revenue growth. I don't foresee any excessive growth this year, but I believe our expectations are in line with what we anticipated three months ago.

Lee Jagoda, Analyst

And then just one last one for me. So had you not had such strong free cash flow in Q4? It sounds like you would have hit your goal of sort of returning 50% of free cash flow to shareholders through repurchase...

John Anderson, Senior Vice President and CFO

Yes, good observation. We came in at just under 50% because December's free cash flow was stronger than we anticipated. However, I believe it is around 45%, compared to the 50% return.

Lee Jagoda, Analyst

And as we look out to 2024, even if we don't have a sale to pay back some of the loan, is that how we should think about cash deployment?

John Anderson, Senior Vice President and CFO

I don't believe there's a significant change in our capital allocation. Considering the current interest rates and the debt we have under our revolver, we are assessing whether it's more beneficial to pay down debt or repurchase shares. It will likely be a combination of both. We're taking this into account because when we established the goal of returning 50% of free cash flow, interest rates were much lower. So, we are evaluating our options.

Tristan Gerra, Analyst

Could you break down the revenue contribution from Cornell in Q4 and what's embedded in the Q1 guidance? And then also, if you could expand on the accretion higher than expected that you expect from Cornell? What's driving that now that you have some visibility on the business post the close of the purchase?

Jeffrey Niew, President and CEO

You're asking about the revenue from Cornell in the fourth quarter. Yes, it matched our expectations for that period, generating around $20 million in revenue over two months, with earnings per share remaining neutral. For the first quarter, the monthly run rate is likely slightly above that, potentially exceeding the $10 million a month mark. When we announced the completion of the deal on November 1, we provided some metrics, and our revenue figures align with those expectations. EBITDA is also closely aligned, perhaps slightly higher. The most important point is related to synergies. We committed to approximately $4 million in cost savings within 36 months of the closing, and we are on track, possibly ahead of that target. Additionally, there is potential for improved product management or pricing strategies, which could lead to price increases in this business. However, given the distribution inventory timeframes, we may not see significant results from this until the second half of 2024. Beyond the initial $4 million in cost savings, we anticipate a considerable improvement in margins for this business due to pricing, especially heading into 2025.

John Anderson, Senior Vice President and CFO

Tristan, just to add a little bit on the accretion. We expect it to be neutral again in Q1. We expect it to be accretive to earnings kind of beginning in the back half of 2024. And I think one thing to point out is in the calculation of accretion, we do include both the cash interest, and then I mentioned this in the script, there's what we call imputed interest. We had a $123 million interest-free loan in connection with that acquisition. So, we calculate using a market rate of about 7.25% on impute interest. So that's included in that.

Jeffrey Niew, President and CEO

Overall, we feel positive about our position three to four months into this acquisition, which we see as a strong fit for us and have the potential to enhance both margins and EBITDA starting in the latter half of the year.

Tristan Gerra, Analyst

Great. And then for my follow-up, within the Precision Device business, if you could give us some details on how the various segments are moving. I'm guessing telecom, industrial, obviously going to be the weakest, given the inventory deleveraging that's going on, but any commentary as well on automotive, defense? And also how is the pricing looking like for the capacitor, which is most of that business? And also if you can remind us whether you have pricing agreements, LTA type of agreements, or is it all spot?

Jeffrey Niew, President and CEO

Yes. Regarding pricing, we discussed this during the Cornell acquisition. We have conducted extensive pricing analysis in the traditional PD business over the years. We anticipate modest price increases in 2024 compared to 2023. The primary observation in the markets is that the industrial and distribution sectors remain quite weak at this time. This is evident in both our overall business and the Cornell operations. This factor was incorporated into our announcements made on November 1 concerning the business closure. The industrial and telecom sectors are crucial here. There are a few large OEMs, without naming them, that have their own inventory challenges, but we expect those to clear up fairly quickly. Our focus is on the recovery of the industrial and distribution sectors. Meanwhile, we are diligently working in our factories to optimize capacity utilization, enhance value creation, and manage operational expenses. This will remain our priority for the interim period, likely through the first half of the year.

Operator, Operator

And there are no further questions at this time. I would like to turn the conference over to Sarah Cook for closing remarks.

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 on our next earnings call. Thank you, and goodbye.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.