Earnings Call Transcript - KN Q2 2022

Operator, Operator

Good afternoon and welcome to the Knowles Corporation Second Quarter 2022 Financial Results Conference Call. My name is Donahue, and I will be your moderator for today's call. All lines will be muted during the presentation portion of the call, with an opportunity for questions and answers at the end. With that said, here with opening remarks is Sloane Bolun, Investor Relations.

Sloane Bolun, Investor Relations

Thank you. Welcome to our Q2 earnings call. I'm Sloane Bolun and presenting with me on the call today are Jeffrey Niew, our President and CEO; and John Anderson, our Senior Vice President and CFO. Please be advised that today's conference call is being recorded. By now, you should have received a copy of our earnings release and webcast slides. If you have not received both documents, they are available on the IR section of our website at knowles.com. 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. Such forward-looking statements include comments about demand for company products, anticipated trends in the company's sales, expenses and profits, and future financial outlook 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, 2021, and periodic reports filed from time to time thereafter 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, we have provided both GAAP and non-GAAP financial measures this quarter. As references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. Please see our earnings release and webcast slides available on our website at knowles.com and in our current report on Form 8-K filed today with the SEC for a reconciliation to the most directly comparable GAAP measures. With that, let me turn the call over to Jeff, who will provide some details on our results.

Jeffrey Niew, President and CEO

Thanks, Sloane, and thank you to everyone for joining us today. Knowles performed well in the second quarter despite an acceleration of the headwinds we experienced beginning in the first quarter. Our revenues were pressured by weaker than expected global consumer electronics demand, lockdowns in China, and excess channel inventory. Even with that backdrop, Knowles still drove gross margins, adjusted EBIT, and EPS at or above the midpoint of our guided ranges, and free cash flow at the upper end of our expectations. We are proud of these results, both for our execution in the quarter and, more importantly, because they continue to validate our strategy to prioritize higher-margin products and markets. I will detail our segment results in a moment. But let me first share the latest update to our strategy. As you saw in our press release, Knowles is accelerating its focus to further deemphasize our exposure to commodity products. As discussed over the last few years and presented at our Investor Call in November of '21, this strategy was in place before the decline of consumer choice demand we've encountered so far in '22. Our MEMS microphone restructuring is expected to yield annualized savings of $25 million to $30 million across factory overhead and operating expenses with an anticipated one-year payback. This program will begin in Q3 with full implementation by the end of Q4. John will provide details, but let me summarize the key benefits to our shareholders. The program expedites our timeframe to achieve our medium-term financial targets. These targets include adjusted EBIT margins in the range of 22% to 24%, driven by higher gross margins from higher capacity utilization with a better mix and higher ASPs. Free cash flow margins of 15% to 17% from operating leverage and lower CapEx. Lastly, we believe our exposure to the smartphone market will be in the mid-teens in 2023 compared to more than 20% of revenue in 2021. In sum, we are very pleased with how Knowles is strategically positioned. Our proactive strategy to focus on the most attractive end markets with above-average corporate margins and long-term growth trends is tightly aligned with value creation for our shareholders. I'm incredibly pleased with the speed with which our teams have reacted to the current market conditions. This strong execution helps propel the company forward towards achieving our mid-term adjusted EBIT and free cash flow margin targets. With that, let me highlight our Q2 results. Revenue of $188 million was below expectations due to continued weakness in consumer electronics and COVID lockdowns I spoke about earlier. Across our segments, we continue to see strength in Precision Devices. Precision Devices revenue grew 19% over last year, and demand was broad-based across all end markets, especially in defense and medical applications. In audio, Hearing Health also grew 19% year-over-year, and Knowles continues to increase market share, which was further aided by new product introductions. In contrast, the MEMS microphone business was negatively impacted by the headwinds I've already mentioned. We are taking advantage of this weaker demand environment to right-size our factory capacity in this business and drive the company towards the financial goals I've summarized. As inventory in the channels reduce and demand in consumer electronics returns, our MEMS microphone business will be well positioned for improved profit margins and cash flows. Turning to our overall profitability, again, we are very pleased to hit our guidance for gross margins despite a very challenging backdrop for revenue growth. Our adjusted EBIT margin of 20% in Q2 was above the high end of our guidance, and EPS of $0.33 was above the midpoint of our expectation. Lastly, our free cash flow exceeded our expectation, and we remain committed to our goal to return at least 50% of our free cash flow to shareholders. I continue to believe our strategic focus on higher-margin products and markets positions Knowles well to continue to create value for shareholders for the years to come. With that, let me turn the call over to John to review our Q2 financials and our Q3 guidance.

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported second quarter revenues of $188 million, down $12 million from the same period a year ago, driven by weak demand for MEMS microphones, partially offset by increased demand in Hearing Health and our Precision Devices segment. Audio revenues of $129 million were down 14% from the same period a year ago, due to weak global microphone demand for consumer electronics, COVID lockdowns in China, and excess PC and smartphone channel inventory. The decline in MEMS microphone revenue was partially offset by increased shipments in Hearing Health, on market growth, share gains, and new products. The Precision Devices segment delivered revenues of $60 million, up 19% from prior year driven by growth across most end markets, with the highest growth coming from defense, industrial, and medtech markets. Second quarter gross profit margins were 41.5% at the midpoint of our guidance range and down 90 basis points from the same period a year ago. Audio segment gross margins finished 300 basis points below 2021 levels, driven by lower factory capacity utilization in our MEMS microphone business, partially offset by lower factory spending and favorable mix in our Hearing Health business. Precision Devices segment gross margins were 46.7%, up 350 basis points from the prior year, driven by favorable mix, productivity gains, and higher factory capacity utilization. R&D expense in the quarter was $18 million, down more than $3 million from the prior year driven by lower incentive compensation costs. SG&A expenses were $24 million, $4 million lower than the prior year driven by lower incentive compensation costs. For the quarter, adjusted EBIT margin was 20%, up 210 basis points from the prior year, driven by a reduction in operating expenses. EPS was $0.33, which was $0.01 above the midpoint of guidance and $0.02 above the prior year with the increase driven by lower operating expenses, reduced interest cost, and a lower share count, partially offset by the impact of lower shipment volume. Now, I'll turn to our balance sheet and cash flow. Cash and cash equivalents totaled $48 million at the end of the quarter. Cash from operations was $20 million, near the high end of our expectations, primarily due to lower net working capital. Capital spending was $7 million in the quarter, and we repurchased approximately 940,000 shares at a total cost of $18.6 million. Before moving to the third-quarter guidance, as Jeff stated earlier, we're accelerating our strategy to reduce our exposure to lower-margin commodity microphones. We're taking actions beginning in the third quarter to right-size our manufacturing capacity and operating expenses in our MEMS microphone business. This restructuring is expected to yield $25 million to $30 million of annualized savings, with roughly half of the savings coming from lower factory overhead and half related to lower operating expenses. We expect Knowles to exit 2022 with a quarterly operating expense run rate of approximately $45 million, which reflects both the impacts of our restructuring actions and normalized levels of incentive compensation. We expect to incur cash charges associated with the restructuring of approximately $23 million to $28 million related to severance and the settlement of vendor obligations. Lastly, the cost reduction actions we're taking today support our strategy of focusing on higher value solutions, which should enable us to deliver on our mid-term financial targets of 22% to 24% adjusted EBIT margin and 15% to 17% free cash flow margin earlier than we communicated last November. Moving to the guidance for the third quarter. We expect total company revenue to be between $170 million and $185 million, down approximately 24% from the same period a year ago, driven by lower shipments of MEMS microphones in connection with weak consumer electronic demand and excess compute and smartphone channel inventory. Revenue from the audio segment is expected to be down more than 30% from Q3 2021, primarily due to lower demand for MEMS microphones driven by the macroeconomic headwinds we've discussed. Precision Devices revenue is expected to be up more than 10% over prior year levels, driven by continued broad-based strength in defense, medtech, and industrial markets. We estimate gross margins for the third quarter to be approximately 37% to 39%, down 390 basis points from the year-ago period, driven by lower factory capacity utilization in our MEMS microphone business, an unfavorable mix due to lower shipments to the high-margin compute market. These negative impacts are partially offset by productivity gains and improved capacity utilization in Precision Devices. R&D expense is expected to be between $18 million and $20 million, and selling and administrative expense is expected to be between $26 million and $28 million, down from the year-ago period driven by lower incentive compensation costs. We're projecting adjusted EBIT margin for the quarter to be in the range of 11% to 13% and EPS to be within a range of $0.17 to $0.21 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 12% to 16% for the quarter and full year 2022. For the third quarter, we expect cash generated from operations to be between $20 million and $30 million and capital spending to be approximately $10 million. While we don't typically provide guidance beyond the current quarter, I'd like to provide some commentary as it relates to our expectations for the fourth quarter of 2022. We're expecting 15% to 25% sequential growth for the total company, driven by Precision Devices and Hearing Health and a modest increase in microphone shipments as channel inventory is expected to improve. We also expect significant sequential improvement in gross margins, adjusted EBIT margins, and cash flow as we benefit from higher shipment volumes and begin to realize the benefits of our restructuring program. We are estimating Q4 gross profit margins to be between 40% and 42%, and adjusted EBIT margins to be above 20%. For the full year, we expect free cash flow as a percentage of revenue to finish above 10%. While demand and inventory levels in the consumer electronics market are challenging, our strategy coupled with our optimized cost structure positions us well to grow profitably when demand returns. This, along with expected continued growth in our Precision Devices and Hearing Health businesses, will enable us to accelerate achievement of the mid-term adjusted EBIT margin and free cash flow margin targets introduced last November.

Jeffrey Niew, President and CEO

I'll now turn the call back to our operator to open the line for questions.

Operator, Operator

Certainly. The first question comes from Bob Labick of CJS Securities. Please proceed.

Bob Labick, Analyst

Thanks. Good afternoon. I wanted to follow up on what you mentioned earlier, John, regarding the discussion about Q4 guidance. Can you provide some insight into inventory adjustments and corrections? Will these be fully completed in Q3 and Q4? Will next year see a return to more normal levels? Is Q4 reflecting true end market demand? What are the main factors to consider, and when can we expect more clarity on managing the inventory and the channel?

Jeffrey Niew, President and CEO

Yes, Bob, this is Jeff. I want to provide some commentary. Most of the sequential growth that John mentioned, between 15% and 25%, is coming from Hearing Health and PD. We anticipate a very modest sequential improvement in the microphone business. We're beginning to see some signs of inventory being worked down, but it doesn't seem to have occurred in Q3 and might extend into Q4. Looking ahead to 2023, we believe the inventory should be cleared from the system. We need to consider the future growth in that business. Overall, most of the growth we expect in Q4 will come from Hearing Health and PD, which have longer lead times and a lot of the business is already booked.

Bob Labick, Analyst

Okay, great. That's helpful. And then when you get through, and let's just say it's 2023, or done by the end of Q4 just for argument's sake for this question, what's the expected impact on your top line from right-sizing or walking away from some of the more commoditized sales, lower margin sales? How much kind of year-over-year would you be walking away? And where do gross margins normalize upon, as we said, once you get through the correction and you have your new cost structure in place?

Jeffrey Niew, President and CEO

I'm going to let John discuss the gross margin shortly. Let's begin with our mobile business and its share of the total company. In 2021, mobile accounted for just over 20%. Looking back to 2019, mobile was around 27% to 26%. This year, we expect to be well below 20% for mobile, and anticipate it will be in the mid-teens next year. As we look ahead, we believe we won't face an inventory correction in the MEMS microphone business. Our goal is to operate our remaining capacity at 90% to 95%. We also expect our Hearing Health business to grow at a rate above GDP, around 4% to 5%, and we anticipate high single-digit organic growth from our Precision Devices business. Going forward, our primary focus will be on enhancing cash flow and improving EBIT margins, which we believe we can achieve in Q4 and into next year. Now, regarding gross margins.

John Anderson, Senior Vice President and CFO

Just in terms of gross margins, Bob, Q3, our gross margins are down close to 400 basis points year-over-year. That's almost entirely or it is entirely driven by a drop in capacity utilization for our MEMS microphone business. As Jeff mentioned and I mentioned, we're taking some pretty aggressive cost reduction actions, about 50% of which are impacting and reducing factory overhead. At more normalized capacity utilization, our gross margin would be closer to 42%.

Bob Labick, Analyst

Got it. Okay. Super. Thank you very much.

Operator, Operator

Thank you. The next question comes from Suji Desilva of ROTH Capital. Please proceed.

Suji Desilva, Analyst

Hi, Jeff. Hi, John. So maybe continuing on the restructuring theme here, the trough utilization you're seeing now versus kind of post restructuring, what might it be, John? And what was the utilization, just so we have some kind of benchmark with kind of what gross margin might do in the future as you reduce the capacity?

John Anderson, Senior Vice President and CFO

Yes, Suji, I'm not going to go into specific gross margin and capacity utilization in terms of we're currently operating at, but it's significantly below kind of our historical target, which is kind of 90% to 95% run rate. And let's be clear, there are three factors that have gone into this current capacity utilization. Number one is globally demand in consumer electronics is down. I think we all acknowledge that. That's a lot like PCs, smartphone market, but even things like gaming, there's a lot of different products that are down. Second, there is excess inventory in the channel, right? So across many of our end markets, there's a lot of inventory in the channel. And the third thing that's driven it is we did make decisions earlier in the year on pricing, to hold pricing and take thus share. So there are three things that add that up to. Now, as far as the capacity utilization that we want to operate at, we've always said it's 90% to 95% on an annualized basis. And that's going to be the target for what we're going to be shooting for in 2023.

Jeffrey Niew, President and CEO

Yes, in response to your other question, we believe we have the opportunity to operate at nearly 90% to 95% capacity within our MEMS business. This will allow us to increase margins to the high 30s and achieve company-wide margins of 42% or more.

Suji Desilva, Analyst

Okay. And then just digging into the fourth-quarter guidance, which you gave us, the 15% to 20% sequential, I believe, you talked about it mostly coming from Hearing Health and PD. I didn't really think of Hearing Health as kind of a strong sequential business. You talked about long-term GDP-ish growth there. So I'm presuming a lot of 4Q's actually coming from PD. Just maybe correct me if I'm wrong, or maybe the OTC business, any color there would be helpful?

Jeffrey Niew, President and CEO

It's not the case that Hearing Health isn't strong; in fact, it contributes significantly. Typically, the fourth quarter performs very well for the Hearing Health business. There’s a major hearing aid show that occurs at the start of the fourth quarter, which generates substantial demand as audiologists attend the show, place their orders, and start developing new products. So, Hearing Health is definitely making a notable contribution, but Product Development is also playing a role.

Suji Desilva, Analyst

Okay. And maybe you can touch my last question on the resilience of PD through what seems to be kind of a weaker economic environment obviously versus consumer-oriented segments? Thanks.

Jeffrey Niew, President and CEO

Yes. So I think we've been obviously very pleased with the PD business. It continues to, like you said, show resilience. I think they're very well positioned in a few markets that are doing extremely well; defense, aerospace, doing very well for them. The life sciences or medical market continues to be very strong for them. I would also add that, again, we're still growing in our EV business, although from a small base, and it is growing. So I think most of the markets that they have, we're seeing strength. And bookings continue to be strong. So I would think of the PD business, again, like the Hearing Health business. A lot of our orders and knowledge of what's going to happen over the next six months is kind of already baked. And so that's why we feel pretty comfortable about where the growth is going to come from in Q4.

John Anderson, Senior Vice President and CFO

Yes, so you just add a little bit. The defense and medtech business represents almost two-thirds of the total PD business.

Jeffrey Niew, President and CEO

I was just kind of adding up the numbers, Hearing Health business being medtech plus PD plus the defense business in PD, about 45% of our business is now medtech and defense. And I'd say the backlog in bookings continues to be very strong.

Suji Desilva, Analyst

Okay, great. I appreciate all the color. Thanks, Jeff. Thanks, John.

Operator, Operator

Thank you. The next question comes from Christopher Rolland of Susquehanna. Please proceed.

Christopher Rolland, Analyst

Thank you. Hi, guys. Yes, I guess my questions are around the restructuring and I guess ongoing expenses that you're going to be able to cut, are expenses going up Q-on-Q? And then how do these trail out as we move through it? Is there any OpEx or is this mostly on the manufacturing and COGS side? I know you mentioned it probably was, but is there anything in OpEx as well?

John Anderson, Senior Vice President and CFO

Yes. Chris, in terms of the annualized $30 million, about half of it is IDL, so factory overhead in our MEMS microphone factories. And then the other half is OpEx, a combination of R&D and SG&A.

Jeffrey Niew, President and CEO

Yes, obviously way down this year.

Christopher Rolland, Analyst

Okay, excellent. And then around inventories, I want to understand the inventory dynamic a little bit. I want to talk about customer inventories, but also your own inventories. You're at 157 days. So would love to know internally where you want to bring that? And then secondly, can you talk a little bit more about the inventory dynamics that you're seeing? Was this just a classic semiconductor cycle where there was overbuying just at the component level, or are these finished goods, finished PC, finished mobile, finished IoT, et cetera, devices that are waiting to be sold? Maybe if you could just classify customer inventories and how you see it, that'd be great too?

Jeffrey Niew, President and CEO

Yes, I will use the PC market as a clear example since it’s the easiest to track in terms of units sold annually. Based on PC sales in 2021, we shipped more units than what was actually sold in the market. Currently, we estimate there’s about three months of inventory available in the PC market due to a mix of existing raw materials, work in progress, and finished goods. With the drop in demand, third-party data indicates PC shipments are expected to decrease by around 15%. If another quarter of inventory is factored in, it becomes evident that this will need to be reduced, further affecting demand. We remain optimistic about discussing inventory reductions with customers. There have been several discounts in the market to help clear inventory. Future demand is uncertain, but inventory levels will definitely decrease. Typically, our inventory is at its lowest around mid-year as we prepare for the second half, but with current lower demand, it’s higher than we’d prefer. We are actively working on a program to align inventory levels by the end of the year.

John Anderson, Senior Vice President and CFO

Yes, I would just add in addition to what Jeff said, you're right, Chris, at 157 days, inventory is well above what we were expecting. It's really a couple of factors. It's a pretty abrupt drop in demand. It's also we're keeping higher safety stock, just with the COVID-related lockdowns that we've experienced in China, we've made a conscious decision to keep more safety stock, things are improving slightly. And I would say we expect inventory to come down fairly significantly between now and the end of the year. The other issue too is we had a conversion in our fab from 6-inch to 8-inch. So we've cut higher inventory for last time buys and things like that. But we expect that to be coming down both in the second half of this year and in '23. And again, this will drive improved cash flow in the second half, particularly in the fourth quarter of this year.

Christopher Rolland, Analyst

Awesome. Thanks, guys.

Operator, Operator

Thank you. The next question comes from Tristan Gerra of Baird. Please proceed.

Tyler Bomba, Analyst

Yes. Hi. This is Tyler on for Tristan. Thanks for taking the question. I just have one. Could you please provide us an update on the capacity ramp of that balanced armature line?

Jeffrey Niew, President and CEO

Yes. So I don't know if you saw during the quarter, we did a fair amount of marketing about high-definition audio and how balanced armatures can enable that. What I would say is that, obviously, the capacity is not fully utilized today. We're expecting to see more of a ramp-up in the back half of the year. I think one of the challenges that we've seen is with China being in lockdown a lot in the first half. New design wins in China have been a little bit tougher to come by. But I would just sit there and say is, first of all, number one is achieving all its cost targets, doing very well on that side. Number two is, we've learned a lot from this on our balanced armature automation line and are applying a lot of the learnings back to our manual line in order to improve gross margin, bring costs down, very important. Third, beyond the balanced armatures for I would say the commercial market, we're starting to see some traction with similar Hearing Health customers and also some demand for the over-the-counter market from a few customers that we have in that space. Overall, I would sit there and say, our expectation is that hopefully, we'll be filling that line in 2023.

Tyler Bomba, Analyst

Great. Thanks for all the insight.

Operator, Operator

Thank you. The next question comes from Anthony Stoss of Craig-Hallum. Please proceed.

Anthony Stoss, Analyst

Hi, guys. John, maybe for you, I wanted to focus in on the September revenue guide. I'm curious if you'd care to comment on if you think you're losing share with your biggest North American smartphone customer, or you're maybe walking away due to ASPs? And then I had a couple of follow-ups.

Jeffrey Niew, President and CEO

Yes, this is Jeff. We're not going to comment on any specific customer. I think we'll just keep going back to the comment here that we're committed to not pursue lower margin business. I think that's something that we've kind of said for the last year, year and a half, Tony, and we'll leave it at that with. Again with the commentary that we expect in '23 our smartphone business will be 15% roughly of the total company revenue.

Anthony Stoss, Analyst

Got it. Thanks for that. John, you provided us with your expectations for OpEx in Q4. What do you anticipate for the end of 2023, specifically regarding gross margins and quarterly OpEx?

John Anderson, Senior Vice President and CFO

Tony, I'm not going to provide guidance for 2023. However, as I mentioned earlier, once we have implemented the cost reduction measures we discussed, which we anticipate will be completed by the end of Q4, we believe that if we operate at a reasonably high capacity, around 90% in the MEMS microphone segment, our gross margins should be 42% or higher in 2023.

Jeffrey Niew, President and CEO

Yes, let me just make one other comment, Tony. I think we kind of sat here on this call here is with the actions that we're taking, the shift in mix, better capacity utilization, lower CapEx spending, right, you can go right now look at all the things we've kind of talked about. When we came out in November of '21 with our call, we kind of said, we can get to the 22% to 24% in EBIT margins and free cash flow of 15% to 17% in the three to four-year timeframe. Well, we're going to be one year into that November. And I would say that based on the actions we're taking, I think we can get to those numbers potentially a year earlier, right? So we're two years away, right? So I would say that's just the commentary we would put. And there's different ways to get there, through OpEx, through better capacity utilization, through better mix, right? There's a bunch of different ways to get there. But we're highly focused on hitting those adjusted EBIT margin targets and the free cash flow of margins.

Anthony Stoss, Analyst

Got it, Jeff. And then last question on the millimeter wave division, any update would be helpful and kind of your thoughts on, if that's going to grow in 2023 over 2022?

Jeffrey Niew, President and CEO

Yes. So we continue to do extremely well in the RF business. It's growing year-over-year, and that's primarily defense. Again, I would say we do have a few customers that we are starting production with in the millimeter wave states. I just would caution, I'm very, very cautious about how well this is going to be accepted. We get big forecasts from people, but a lot of these customers that we have are small and we're just not seeing the rollout of millimeter wave in the commercial marketplace in any big way in the end market, although some of our customers that we have are telling us these could be larger numbers. So I'm very cautious about saying this is going to be a big number for telecom. But again, the defense business continued to do very well. The RF business continued to be very good for us.

Anthony Stoss, Analyst

Okay. If I can sneak in one more just on the restructuring charges, et cetera, I know you guys bought a fair amount of stock back. Is that something that you think you'll ease up on and pay down debt continually?

Jeffrey Niew, President and CEO

No, Tony. I don’t believe there’s a change in our plans. Last November, we committed to returning 50% of our free cash flow to shareholders through share repurchases, and we are on track for that in 2022. I don’t see any reason to alter our approach. We’re confident in our cash flow generation moving forward, especially in the last quarter of 2022 and into 2023. So, there’s really no change in our course. It's also important to note that even with our commitment to returning cash to shareholders, we still have ample capacity for acquisitions, and we will continue to explore those opportunities alongside stock repurchases.

Anthony Stoss, Analyst

Perfect. Thanks a lot, guys. Thank you.

Jeffrey Niew, President and CEO

Yes. Again, this is Jeffrey Niew. Thank you for your time. I think we look forward to the next few quarters in terms of taking action on this restructuring and setting us up for a much stronger Q4 and 2023. Thank you very much.

Operator, Operator

That concludes the conference call. Thank you for your participation. You may now disconnect your lines.