Earnings Call Transcript - KN Q3 2021

Operator, Operator

Good afternoon, and welcome to the Q3 2021 Knowles Corporation Earnings Conference Call. My name is Emma, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. With that said, here with opening remarks is Knowles' Vice President of Investor Relations, Mike Knapp. Please go ahead.

Mike Knapp, Vice President of Investor Relations

Thanks, Emma, and welcome to our Q3 2021 earnings call. I am Mike Knapp and presenting with me on the call today are Jeffrey Niew, our President and CEO, and John Anderson, our Senior Vice President and CFO. Our call today will include remarks about future expectations, plans, and prospects for Knowles, which constitute forward-looking statements for purposes of the Safe Harbor provisions under applicable federal securities laws. Forward-looking statements in this call will include comments about demand for company products, anticipated trends in the 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, 2020, 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 call can be found in our press release posted at our website at knowles.com and in our current report on Form 8-K filed today with the SEC, including reconciliation to the most directly comparable GAAP measures. All references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. Also, we have made selected financial information available on webcast slides, which can be found in the IR 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, Mike, and thanks to all of you for joining us today. For Q3, we reported revenue of $233 million, which is above the midpoint of our guidance and up 13% from the year-ago period, driven by strong demand across our audio and precision device segments. Gross margins improved to 41.8%, near the high end of our guidance range, and our earnings per share was $0.45, above the high end of our expectations. In the audio segment, revenue was up 8% from the year-ago period as hearing health sales increased on strong demand. MEMS microphone sales grew, driven primarily by IoT. Precision devices delivered record revenues again in Q3, up 35% from the year-ago period, driven by improved demand across a broad range of end markets we serve, and an acquisition we completed in Q2. We also delivered cash from operations of $56 million. Overall, another strong quarter that demonstrates the benefit of our investment in differentiated products to increase revenue across a diverse set of growing end markets, driving gross margins higher and delivering strong earnings and cash flow. Let me now spend some time detailing the trends we are seeing by the end markets in each of our business segments. In the audio segment, we saw broad-based improvement year-over-year in MEMS microphone sales, despite experiencing supply constraints. Hearing Health sales also increased from the year-ago period on strong end market demand. As we look forward, we believe recently proposed rules from the FDA on over-the-counter hearing aids, if adopted, will make it easier for people with mild hearing loss to have access to technology that improves their quality of life. We expect this new channel to bolster our growth in hearing health over the years to come. We are increasing our capacity to service our traditional hearing aid market and the opportunities for the over-the-counter and true wireless markets. Moving on to precision devices, sales reached record levels again in Q3 with significantly improved gross margins, as demand from medtech, industrial, defense and electric vehicle markets drove strong year-over-year improvement. We continue to develop advanced solutions for mission-critical applications that rely on our high-performance capacitors and RF filters, which is yielding solid results. In high-performance capacitors, the medtech market drove a significant portion of the year-over-year growth, as demand improved for our high-reliability products used in implantable devices and MRI machines. We're also beginning to see a broadening of our customer base in Asia and Europe, as high voltage EV platforms began to go to production. In our filters, our products continue to see strong demand from defense customers in North America and Europe for communications radar system solutions. We are also beginning to see a number of new design opportunities in 5G millimeter wave telecom, and we secured several prototype orders for small cells in repeater equipment. For the third consecutive quarter, we saw record bookings in precision devices across a wide array of products, giving us confidence that we can grow precision device revenue by greater than 15% this year, with the bulk of the growth being driven by organic initiatives. In a moment, John will discuss the Q3 results and the Q4 guide in more detail. But our revenue growth is currently being held back by several short-term issues that have recently been in the headlines, which include extended lead times and capacity constraints on semiconductors, and more recently, power disruptions in China, as well as some lingering COVID uncertainty. For the past several years, our strategy has been to focus our R&D investment, capacity expansions, and acquisitions in products for growing markets that value our differentiated solutions. This is paying dividends today, as gross margins continue to expand, driving increased operating income and cash flows. As these headwinds start to dissipate, we expect the impact of our strategy to be even more pronounced on our financial results. Our team has delivered three strong quarters so far this year. I believe our leadership positions across the markets we serve and our strategy to deliver high-value solutions to a diverse set of growing end markets position us well for the rest of 2021 and beyond. With that, I'll turn it over to John, to expand on our financial results and provide the guidance for the fourth quarter.

John Anderson, Senior Vice President and CFO

Thanks, Jeff. We reported third quarter revenues of $233 million, up 13% from the year-ago period, driven by increased shipments in both the audio and precision device segments. Audio revenues of $178 million were up 8% due to higher demand for MEMS microphones across mobile and non-mobile end markets, and stronger hearing aid sales. Precision devices delivered record revenues of $55 million, up 35% year-over-year as a result of organic growth of 21%, and an acquisition completed in the second quarter of 2021. Third-quarter gross profit margins were 41.8%, near the high end of our guidance range and up more than 500 basis points versus the same period a year ago. Audio segment gross margins improved more than 450 basis points, driven by productivity gains, higher factory capacity utilization, and favorable product and customer mix. In the precision devices segment, gross margins were more than 600 basis points higher than prior year levels due to productivity gains, improved factory utilization, favorable inventory reserve adjustments, and an acquisition, partially offset by higher precious metals costs. R&D expense in the quarter was $20 million, up slightly from the year-ago period, but lower than expected due to the timing of new hires. SG&A expenses were $27 million, in line with our guidance range, and up $1 million from the prior year, driven primarily by higher incentive compensation costs and an acquisition, partially offset by lower legal expenses. For the quarter, adjusted EBIT margin was 22.6%, above the high end of our guidance range, and up more than 8 percentage points from the same period a year ago, driven by higher gross profit margins, improved operating leverage and favorable FX impacts. EPS was $0.45, above the high end of our guidance range and up $0.21 from the prior year. Further information including a detailed reconciliation of GAAP to non-GAAP results is provided in the financial tables of today's press release and can also be found on our website at knowles.com. Now I'll turn to our balance sheet and cash flow. Cash and cash equivalents totaled $140 million at the end of Q3. Cash generated by operations in the quarter was $56 million, above the high end of our guidance due to higher EBITDA and lower than expected net working capital. Capital spending was $12 million in the quarter. Given our existing cash position and our expectations that we will continue to generate significant free cash flow in the future, we will settle the principal amount of the convertible notes maturing next month in cash. Moving to the fourth quarter, we expect total company revenue to be between $230 million and $235 million, down 4% at the midpoint versus the same period a year ago. Revenue from the audio segment is expected to be down approximately 14% from Q4 2020, driven by timing of customer product launches and supply chain constraints, resulting in reduced MEMS microphone shipments, partially offset by higher Hearing Health revenues. Precision device revenue is expected to be up more than 40% versus the prior year, driven by strong organic growth in the defense, medtech and industrial end markets, and the acquisition completed in the second quarter of this year. We estimate total company gross margins for the fourth quarter of 40% to 42%, up 300 basis points from the year-ago period, driven by higher capacity utilization, favorable product mix and the acquisition completed in Q2. Our gross margin expansion through the first three quarters of 2021 demonstrates the execution of our strategy to deliver high-value differentiated solutions to our end markets. We expect total company gross profit margins will reach approximately 41% for full year 2021, a record high and approximately 200 basis points above the 2019 levels. R&D expense in Q4 is expected to be between $19 million and $21 million, flat with prior year levels. We’re projecting selling and administrative expenses to be between $27 million and $29 million, up $1 million from the year-ago period, driven by higher incentive compensation costs and the impacts of the acquisition completed earlier this year. Adjusted EBIT margin for the quarter is expected to be approximately 21%. EPS is expected to be within a range of $0.43 to $0.45 per share. This assumes weighted average outstanding shares during the quarter of $95.6 million on a fully diluted basis. Despite the near-term supply chain challenges which are impacting revenues, our actions to improve gross margins coupled with our discipline in operating expense spending are resulting in an expected increase in full-year EPS of nearly 40% above 2019 levels. We're forecasting an effective tax rate of 8% to 12% for the quarter. This range includes a discrete tax benefit related to the filing of our 2020 federal tax return. Going forward due to the potential expiration of a tax holiday at the end of 2021, our future expected effective tax rate may increase to 14% to 18%. We're expecting cash generated by operations in Q4 to be between $45 million and $55 million, and capital spending to be approximately $20 million. Please refer to our press release and to our Form 8-K filed today with the SEC for a GAAP to non-GAAP reconciliation. I'll now turn the call back over to Jeff for closing remarks, and then we'll move to the Q&A portion of the call.

Jeffrey Niew, President and CEO

Thanks, John. We're increasingly confident about our new and longer-term prospects as our strategy to deliver high-value differentiated solutions to a diverse set of growing end market is allowing us to expand gross margins while driving operating income and producing strong cash flow. We will continue to drive shareholder value through investment in high gross margin products, accretive acquisitions, and stock buybacks. Before we move to the Q&A, I would like to announce we are planning on hosting an Investor Call in late November to provide an update on our growth opportunities, and our capital allocation strategy, as well as provide new mid-term financial targets. More details will follow in the near future and we're excited about the opportunity to share our plans for revenue growth and gross margin expansion, and what it means for operating margins and cash flow. With that, I'll turn it over to open for Q&A.

Operator, Operator

Your first question comes from the line of Bob Labick with CJS Securities. Your line is now open.

Bob Labick, Analyst

Good afternoon. Congratulations on a nice quarter. I want to dig in on a few things you mentioned earlier. As it relates to the supply chain, can you give us kind of a sense of how much of it is international labor chips shortage, and roughly how big of a revenue hit it is? And then, going from there, how long do you think this will impact you and your customers looking ahead?

Jeffrey Niew, President and CEO

Yeah, so first, I’ll just make a comment. I think we are being cautious in our guidance that we're providing. I think, right now we're kind of in the midst of this, and without going into a ton of detail, I would probably estimate in 2021 this is probably $15 million plus in the back half of the year. So, some of it is in Q3, with the majority in Q4. But I think that's probably about a number, $15 million plus. It's hard to say; again, we're obviously working with our suppliers. I think it's mainly semiconductor issues. I wouldn't call it major labor shortages or issues like that at this point. We have had some downtime on power in China, which had some impact for us in early Q4, late Q3. Some of that seems to have passed right now, but we'll see how that continues through the rest of the quarter. But again, we're being cautious. I would view this as something that will linger into Q1 for sure, maybe possibly into Q2. That's when we start to see these things begin to clear up. Again, I'm not going to call this exactly, Bob, but that's kind of what we see right now.

Bob Labick, Analyst

Got it. Okay, great. No, that's great and helpful color. And then you mentioned the hearing health and over-the-counter market. Can you maybe give us a sense of where the FDA is, how long this could take to be an opportunity for you, and how big the market opportunity might be for you?

Jeffrey Niew, President and CEO

Yeah, I'm not going to speculate on what the government is going to do. I'm just going to talk about how we see this market, though, Bob, and how we see it is incremental. If you look at that pyramid of hearing loss, profound hearing loss, significant hearing loss, mild hearing loss, the most underserved portion is mild hearing loss. And that's also the largest portion of people who have hearing loss. This is where we think this is going to be targeted. We have some customers who introduced over-the-counter products already into the marketplace and are being sold today. I think there are a couple points I would make: Number one, at least preliminarily, people were buying the very early days over-the-counter hearing aids at a much younger average age than in the traditional hearing aid channel by about 10 to 15 years. This is positive for us as it brings more people into the idea of significantly improving their quality of life earlier in their lives, allowing for multiple cycles of technology and purchases of hearing aids over time. So it increases the total addressable market (TAM). The overall hearing aid market is roughly 15 million units a year, so I would estimate in the next two to three years, this could mean a couple million, 2 to 3 million hearing aids a year. We are very encouraged by the idea that people introducing products to the market are not focused on costs but rather on performance. This is particularly important for us. We want people to focus on performance, as we don't want to turn people off with their first experience with a hearing aid by someone buying a cheap product but rather value our high-value products, whether it be in microphones, or in our speakers and receivers.

Bob Labick, Analyst

Okay, great. Thanks. And then one last one and I'll get back in queue. But, obviously showing a lot of success in the precision device market and both organically and through acquisitions you've made in the past too. Can you just give us a sense of the M&A environment out there? And if there's opportunities for you with your pristine balance sheet now to continue to make some acquisitions in precision devices?

Jeffrey Niew, President and CEO

Yeah, I would say the funnel is pretty active. We're very active in the M&A area. But on the reverse side, I would also say the valuations are quite high. From my perspective, it's important to be extremely disciplined about what we pursue given the current valuations. The acquisition we completed earlier this year has been very successful, and the three or four others since 2017 have all been successful as well. We want to maintain that track record. I'm hopeful we can complete more acquisitions over the next 18 months, but we will remain disciplined about valuation.

Operator, Operator

Your next question comes from the line of Suji Desilva with ROTH Capital. Your line is now open.

Suji Desilva, Analyst

Hi, Jeff. Hi, John. Congrats on the cash generation and margin execution here. So, first thing maybe on the gross margins since we’re there. What are some of the key factors that are driving this strength? I know you have an event coming up to talk about it, but how sustainable is some of the improvement that you've seen?

John Anderson, Senior Vice President and CFO

Yeah, good question Suji. In terms of the audio segment, year-over-year our gross profit margin improvement is driven primarily by a higher proportion of MEMS microphones shipped for non-mobile applications, also growth in the hearing health business. Those are key drivers. We're also running our factories at pretty high levels, over 90% in terms of capacity utilization. Those are probably the main factors. We've also been successful at passing on higher chip costs to our customers. With precision devices, the mix is helping as well, with a higher proportion of sales going into higher margin medical and defense applications. We’ve made a lot of progress on productivity gains within the factories, optimizing lot sizes, reducing scrap and excess inventory. It's a combination of tactical execution and favorable mix.

Jeffrey Niew, President and CEO

Let me provide some broader comments, given you the details of what's happening right now. We have talked about this over the last couple of quarters about where we're investing our R&D resources and CapEx. We are focusing on non-commoditized products. As we increase the number of these products in the marketplace and invest more money in these areas, you're seeing that reflected in terms of the mix.

John Anderson, Senior Vice President and CFO

Just to finish up, Suji, with respect to the future, I noted in my script that I'm confident that we'll be at or maybe even slightly above 41% for full year 2021. In this Investor Call we have later in the quarter, we'll talk about opportunities for further gross margin expansion.

Suji Desilva, Analyst

Okay, look forward to that. And then a couple of questions on the supply constraints. In terms of the lead customers and the microphones, I’m wondering if some of the ordering patterns might cause some orders that would usually happen in Q4 to push out to Q1. Any color there would be helpful?

Jeffrey Niew, President and CEO

Yeah, I'm not going to comment specifically on one customer. However, here's what I can say: we all know that the timing of the launch is slightly off from last year. It was delayed because of COVID-related issues, while this year it is more aligned with traditional patterns. Generally speaking, the $15 million that I mentioned earlier reflects what we think we could have shipped more, but I won't quantify what our customers are facing. There are clearly some constraints affecting specific applications and products across the customer base. The $15 million that I referred to is what we believe we could have shipped more if we had the resources to build more microphones.

Suji Desilva, Analyst

Okay, that's helpful clarification. And then lastly, on PD, the bookings visibility appears very strong there. I’m curious if any part of that is related to supply constraints and customers trying to cover their supply needs, or how much of that growth in bookings is really tied to actual demand.

Jeffrey Niew, President and CEO

I would say the vast majority of the growth is not due to supply constraints. We have an industrial distribution piece of business within PD; there could be some more ordering there than we typically see, but for the majority, when it comes to defense or aerospace, the custom products they are ordering do not see a lot of supply constraints right now. The Life Sciences segment isn't really custom-driven, nor is automotive; these aspects seem to be solid. In summary, the growth seems to be strong without significant impact from supply constraints.

Suji Desilva, Analyst

Okay. Thanks for the color, Jeff.

Operator, Operator

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

Tristan Gerra, Analyst

Hi, good afternoon. You talked about passing higher costs to customers, and could that provide a different pricing outlook for next year? In other words, could pricing be up next year as a result? Should we view this as a top-line contributor?

Jeffrey Niew, President and CEO

I think it’s a bit early to make that call yet. We need to get through the holiday season here in the U.S., and then the Chinese New Year, and see where things stand. In spite of everything we're facing, China is still weak for us at the moment. We will see how this develops over the next few months. The pricing environment, especially with MEMS mics, in my opinion, has been reasonably favorable. Overall, the more we focus on non-commoditized portions of our market, the more positive the pricing should become and contribute to gross margin.

Tristan Gerra, Analyst

Okay, great. And then any updates on the balance of the automated speaker? Where do you stand in finalizing that automated factory in the Philippines?

Jeffrey Niew, President and CEO

I'm glad you asked that question, Tristan. The team is there, and I just saw a video with the first products coming off the line. Obviously, it's not fully qualified yet, but we expect to begin shipping to customers this quarter. That’s the plan right now; in Q4, we will start shipping off the automated line. It's been touch and go for a while, and I appreciate the teams in the Philippines for enduring a seven-day quarantine before they could start working in the factory. We anticipate we will ramp up to full utilization of the capacity in the second half of 2022.

Operator, Operator

Your next question comes from the line of Christopher Rolland with Susquehanna International. Your line is now open.

Unidentified Analyst, Analyst

Hi, good afternoon. This is actually a representative for Chris. I want to follow up on the gross margin question. Could you clarify how much more upside the utilization can bring, especially since you've already stated 90% plus utilization? Also, regarding the hearing health segment, could you touch on other drivers that could get you to the 42% gross margin target?

John Anderson, Senior Vice President and CFO

As I mentioned, we will provide more clarity on future gross margin expansion. Some key drivers include better mix with higher growth from hearing health, precision device, and non-mobile MEMS mics. But we'll expand on those drivers during our upcoming Investor Call.

Jeffrey Niew, President and CEO

Let me add a couple of broader comments. We’ve been focusing our investments on new products and non-commoditized segments. As we increase the presence of these products in the market, we’ll also see reflected growth in gross margin.

Unidentified Analyst, Analyst

That sounds good. Over the past few quarters, it appears you've been building internal inventory, but this quarter it was down by 24 days. Would you say you’re in a comfortable range right now? Should we interpret this as strong demand overall, or is it more supply constraints?

Jeffrey Niew, President and CEO

I believe it's a combination of both. We certainly have supply constraints on certain product categories; if we could build more, we would. So there is some seasonality in the decline and a normal pattern where we build inventory in Q1 and Q2, followed by stronger sales in Q3 or Q4. But due to the current supply constraints, we’re not optimizing our inventory building as we usually can.

John Anderson, Senior Vice President and CFO

An additional point to note is that in transitioning to MEMS microphone business at eight-inch, we're carrying a little extra inventory. I’d expect that inventory level to decrease by mid-2022.

Jeffrey Niew, President and CEO

I want to clarify that because of supply constraints, we aren't currently operating our microphone business at full capacity.

Unidentified Analyst, Analyst

Sounds good. Thank you very much.

Operator, Operator

At this time, there are no further questions. Mr. Knapp, I turn the call back over to you.

Mike Knapp, Vice President of Investor Relations

Great. Thanks, Emma. And thanks, everyone, for joining us today. As always, we appreciate your interest in Knowles. We're also going to be participating in the ROTH Conference on November 18, and a Wells Fargo Conference on December 2. We hope to speak with you then or on our next earnings call. We will also have more information out on our investor update later in November. So, thanks and goodbye.

Operator, Operator

This concludes today's conference call. You may now disconnect.