Knowles Corp

NYSE:KN

Earnings Call Transcript 2020-Q1

[Operator]

Good afternoon and welcome to the Knowles Corporation First Quarter 2020 Financial Results Conference Call. [Operator Instructions] With that said, here with opening remarks is Knowles’ Vice President of Investor Relations, Mike Knapp. Please go ahead.

[Mike Knapp, VP, Investor Relations]

Thanks, Christine and welcome to our Q1 2020 earnings call. I am Mike Knapp and presenting with me on the call today are Jeff Niew, our President and Chief Executive Officer; and John Anderson, our Senior Vice President and Chief Financial Officer.

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 including, but not limited to the annual report on Form 10-K for the fiscal year ended December 31, 2019, 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, including 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. Also, we have made selected financial information available on webcast slides which can be found on the IR section of our website.

With that, let me turn the call over to Jeff who will provide some details on our results. Jeff?

[Jeff Niew, President & CEO]

Thanks Mike, and thanks to all of you for joining us today. I hope all of you and your families are healthy and safe. This is no doubt an unprecedented and challenging time and we continue to focus on health and safety of our employees, customers and partners worldwide. I'm very proud of our employees around the globe for stepping up to help solve the challenges we're currently facing and I appreciate their efforts as we continue to execute our strategy.

I believe that our strong balance sheet and diversified customer base in end markets will enable us to weather this difficult period and allow us to continue to invest and support future growth when the markets return to a more normalized level.

In my prepared remarks, I will briefly discuss the Q1 financial results and then talk about what we are seeing in terms of demand across our end markets and products. After that I'll discuss the operational challenges we are encountering as well as the actions we are taking to mitigate near-term impacts on our business.

I will then turn it over to John for more details on the actions we have taken or will be taking to ensure we remain -- we maintain liquidity while still investing in our core business and growth opportunities.

For Q1, we reported revenue of $163 million in line with our updated accounting guidance and down 9% from the year ago period. Audio sales were down partially offset by stronger precision device sales. Gross margins were 35.7% and EPS was $0.03 as COVID-19 caused significant disruptions within our manufacturing operations across Asia which negatively impacted labor productivity and factory utilization.

As I move into the demand an operational portion of my prepared remarks I want to note that the ultimate impact COVID-19 will have on our business in Q2 is very difficult to estimate at this time. I will try to provide as much detail as possible to help investors understand how I see things today knowing that the situation remains very dynamic.

Let me begin with an update on our customer demand across our end markets. In our audio segment, Q1 revenue was down 14% from the year ago periods driven by weaker demand for hearing health products and softer sales into Mobile, Ear and IoT markets. While Q1 audio demand was weaker than our original projections much of the weakness hit later in the quarter and we are anticipating continued softer demand chance throughout Q2.

In hearing health, we began to see a significant slowdown in orders late in the quarter based on end market demand in Europe and the U.S. which represents approximately 85% of the global hearing aid market. This slowdown corresponds to countries that adopted COVID-19 movement restrictions later than Asia with the U.S. lagging Europe by several weeks. Given many audiologists office remained closed coupled with hearing health’s heavy reliance on demand from people over the age of 65 who are at higher risk from COVID-19, we anticipate our hearing health business in Q2 will be down significantly from the year ago period.

Despite this near term weakness we know from prior downturns that hearing health demand is reasonably insulated from economic declines. Since hearing health customers are older and generally less exposed to equity markets, own their homes and having income to purchase hearing aids we expect demand to improve as people feel comfortable that COVID-19 is under control. Based on discussion with our customers who are assuming improving trends related to virus movement restrictions we expect the second quarter to mark the bottom in demand for this market with sequential improvement in the second half of 2020. However, it may take until 2021 to get back to 2019 run rates.

Moving on to the Mobile, Ear and IoT markets. The mobile market represents less than 30% of total company sales in Q1 as smartphone demand trends weakened throughout the quarter. Sales to our largest U.S. and Korean customers were higher than a year ago period while sales for the Chinese volumes were down significantly.

Demand has begun to stabilize in China and we currently expect sales into the Mobile market to remain lower than a year ago period. We are talking to all of our Mobile customers and the industry experts at this point many are expecting smartphone units worldwide in 2020 to be down as much as 15% from 2019.

Revenue from Ear and IoT also declined year-over-year but represented greater than 30% of sales in Q1. As growth rates are reset across consumer electronics we expect true wireless will remain the best performing segment within the year market. We continue to invest in MEMS microphones and balanced armatures solutions to support this market.

In early April, IDC said that it expects demand for smart home product to decline year-over-year in the second quarter and we expect similar trends in our business.

We expect to remain the leader in the MEMS microphone business. As we have previously discussed improved points communication and speech recognition are driving the need for more microphones with increased performance, lower power, higher robustness and smaller size. Our new products and programs across Ear, IoT and Mobile are expected to extend our differentiation and competitive position to drive long-term sales growth with higher gross margins as we continue to increase investment in this business. Overall our microphone revenue in Q2 is expected to be flat with sales in Q1.

Moving to Precision Devices segment. In Q1, sales were up 6% from the year ago period driven by continued demand of our differentiated products across the defense, MedTech and the electric vehicle end markets. We also make good progress fixing the operational issues we experienced in Q4 of 2019. We anticipate sales of Precision Devices to grow more than 5% sequentially in Q2 and expect gross margins to increase as operational improvements continue to take hold despite increases in palladium prices.

Now let me discuss where we stand from an operations perspective. For our manufacturing facilities remain focused on aligning the output -- lighting output with our customers demand as we continue to protect our employees. Most of our non manufacturing employees now work from home and travel throughout the company has been restricted.

In China, where our manufacturing supports MEMS and microphones and high performance capacitor products Q1 was extremely challenging with the extended Chinese New Year followed by slow ramp back to normal production levels as travel restrictions were lifted and our employees were allowed to return to work. Our China operations are now running without production constraints.

In the Philippines, where most of our hearing health solutions are produced, the government has implemented enhanced community quarantine until mid May. Due to the government restrictions and significant demand weakness in the hearing aid market we anticipate very low capacity utilization as we align our output with the demand in the quarter. In Malaysia, where we make microphones for both the consumer and the hearing health market, the government has implemented a movement control order until mid May. As with our Philippines operations because of the government restriction it's a significant demand weakness in hearing aid market. We expect very low utilization in Q2 to align output with demand.

In the U.S. and Dominican Republic where the bulk of our Precision Device solutions are produced we have seen limited impact to date and we continue to monitor the situation daily.

Lastly in response to these market conditions we are taking significant actions to reduce operating expenses, controlled CapEx and manage working capital. We are real valuing all the projects across the company, identifying those projects with the best potential given the adjusted market conditions. Where appropriate we are taking steps to reduce costs this year. The goal is to make sure we maintain a strong balance sheet with ample liquidity while meeting our short-term commitments and supporting the long term potential of the business. As these actions are ongoing we will provide additional details as they're completed but I wanted to specifically address one area.

In intelligent Audio, demand has been below expectation and we are further reducing the allocation of resources to this product line to align with the growth potential and the challenging market conditions. We will continue to support existing products and customer programs. John will provide additional details and how we expect these and other changes will impact operating expense for the balance of the year.

Overall, the primary short-term issue we face today is related to demand rather than supply especially in our hearing health market. Our company remains uniquely positioned across the markets we serve and I believe our strategy to deliver high-value differentiate solutions to a diverse set of growing end markets will enable us to come out of this pandemic well-positioned to take advantage of future growth.

With that I'll turn it over to John to expand on our financial results and provide our details for the second quarter. John?

[John Anderson, SVP & CFO]

Thanks Jeff. We reported first quarter revenues of a $163 million, down 9% from the year ago period as lower shipments in audio were partially offset by increased sales in Precision Devices. Audio revenues of $120 million were down 14% from a year ago period with lower shipments of balanced armatures speakers and MEMS microphones associated with weaker-than-expected demand and hearing health and mobile consumer markets due to the COVID-19 pandemic. The Precision Device segment delivered revenues of $43 million, up 6% from the year ago period driven by continued robust demand in the defense, MedTech and electric vehicle markets.

First quarter gross margins were 35.7% down 320 basis points from the year ago period. In the Audio segment, gross margins were 350 basis points lower due to production related disruptions associated with the COVID-19 pandemic. Specifically Q1, 2020 gross profit margins were negatively impacted by more than 500 basis points due to lower productivity -- due to lower labor productivity and capacity utilization in our China manufacturing facility.

In addition, during the quarter we’ve realized greater than 400 basis points in material savings associated with the ASIC design business acquisition completed late in Q4. This was partially offset by a charge of $2.8 million related to the final settlement of a customer warranty claim. Precision Device gross margins finished slightly ahead of our forecast which was 240 basis points lower than the prior year as increased palladium cost negatively impacted margins by more than 500 basis points partially offset by operational improvements, improved pricing and favorable product mix.

R&D expense in the quarter was $22 million, down 3% from the year ago period with lower spending in Intelligent Audio partially offset by increased spending in our core MEMS microphone and Precision Device businesses.

SG&A expenses were $34 million, up 13% from the year ago period driven by a $4 million increase in legal cost as we aggressively defend our intellectual property. This increase was partially offset by reduced spending in Intelligent Audio. For the quarter, adjusted EBIT margin was 3.4%, down 590 basis points from the year ago period on lower revenue and gross profit margins as well as higher legal cost. EPS for the quarter was $0.03.

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 will turn to our balance sheet and cash flow. We continue to maintain a strong financial position with liquidity of nearly $450 million at the end of the first quarter including a $148 million in cash and borrowing capacity of $300 million. During the quarter we increased our cash balance by drawing $100 million on our revolving credit facility leaving $300 million in availability.

Cash used by operations was $2 million and capital spending was $8 million. The first quarter is typically our seasonal low in terms of cash generation and I'm confident in our ability to generate free cash flow for the full year 2020.

During the quarter we repurchase roughly 1 million shares of our common stock at an average price of $15.06. In the spirit of proactive and prudent liquidity management we are temporarily suspending our share repurchase program. Given the relatively short cycle nature of our business and recent global events visibility in a second quarter is challenging especially as it relates to our hearing health business. In addition, there's a significant amount of uncertainty related at the duration of government workforce restrictions currently affecting our manufacturing operations in both the Philippines and Malaysia.

Based on the current circumstances, we will be providing limited guidance for Q2. Our objective is to reinstate revenue, gross profit and EPS guidance for the third quarter along with our Q2, 2020 earnings announcement.

I would now like to provide some insight into actions we are taking which will help mitigate the financial impacts of the COVID-19 pandemic. In April, we implemented a temporary 10% pay reduction for all salaried employees and a 15% reduction to CEO and board cash compensation. In addition, we are further reducing operating expenses related to the Intelligent Audio business and we expect to have completed these actions as we exit the second quarter. These actions along with other cost reduction measures we are taking across the company are expected to result in cost savings of more than $20 million in 2020. While some of these savings will be reinvested in our core businesses, we now estimate operating expenses to be $50 million in Q2 which is down more than $5 million sequentially and we expect to exit 2020 at a quarterly run rate of $40 million to $44 million.

Finally, we are reducing our capital expenditure plan and expect 2020 capital investments to be in the range of $35 million to $45 million. I'm confident that our strong financial position combined with the cost actions we are taking in response to current market conditions will position the company well to serve our customers needs, generate free cash flow and deliver strong operating leverage over the long term.

I will now turn the call back over to Jeff for closing remarks and then we'll move to the Q&A portion of the call. Jeff?

[Jeff Niew, President & CEO]

Thank you John. Our company remains uniquely positioned across the markets we serve and the diversification of end markets that we've put in place is enabling us to weather the storm while still investing in new growth categories. We expect to maintain or extend our leadership across the end markets we serve. We remain the leader in hearing health solutions and expect recovery to 2019 levels in the next 9 to 12 months. We expect Ear and IoT to drive growth in the future and Mobile market to stabilize as 5G phones are introduced. Precision Device growth is expected to continue and we anticipate 2020 to be another good year for this segment.

With that we'll open up for questions.

[Operator]

Thank you. [Operator Instructions] Your first question comes from the line of Anthony Stoss from Craig-Hallum. Your line is open.

[Anthony Stoss, Craig-Hallum]

Hi guys. A couple of quick ones here, John maybe. Can you give us the percent of revenues that hearing health was in 2019 just we can size up to that of Q2? Also given your Chinese facility is now up in that affected gross margins in Q1, well I know you're not guiding for Q2, do you think your gross margins will be up sequentially in Q2 and then lastly for Jeff the BA opportunity to funnel the automated production process maybe you can just bring us through where you're at right now? What you think will happen for the second half of this year?

[John Anderson, SVP & CFO]

Sure, Tony. In respect to the first question, I think the question was what percentage of total company revenues is hearing health. It's roughly 25% in 2019?

[Anthony Stoss, Craig-Hallum]

And then gross margins up still in Q2, John?

[John Anderson, SVP & CFO]

Yes, in terms of gross margins, I mean -- as I mentioned, in Q1, we had gross margins of hopefully 35%, 35.7%, we were really impacted in our specifically in our Audio segment due to elongated Chinese New Year. We had several workforce restrictions in both our Malaysia, Philippines facilities especially at the end of the quarter. While our China facility is back up and running at close to full capacity, there are still currently restrictions in both Philippines and Malaysia. It's very difficult to quantify, it's a very fluid situation; how long those will last.

In addition, I think it's important we did have, I'll call it, an unusually high warranty claim in the first quarter which was about a 170 basis point impact. So I would say as we look into Q2, we probably see sequentially similar gross margins but remember the utilization as Jeff mentioned in our hearing health business very likely to be lower than it was in Q1 and then the offset is we won't have this charge in warranty that we had in Q1. So I think sequentially similar margins.

[Jeff Niew, President & CEO]

And I would just add one more piece of color to that Tony is that our goal here is not to build inventory through the quarter. So I mean we are keeping especially in the hearing health business the utilization at a very low level until the market starts to return.

[John Anderson, SVP & CFO]

But I will say though it's a gross margins in Q2 and looking out this is probably one of the hardest things for us to have real clear visibility on both the demand in the hearing health market as well as the duration of workforce restrictions at two of our more significant plants is very dynamic.

[Jeff Niew, President & CEO]

Let me give you a little color on the BA, in the automation line, I would say that there has been some impact from COVID-19 especially with the travel restrictions and working at the automation supplier. But I would say it hasn't been overly burdensome the delays and right now I think we've said in the past we said it would be ramping with full production in Q3. I would say it's now more ramping in Q3. So I would say we're probably one to two months behind what I said before. It will have some impact on this year but in the long term obviously this doesn't have much impact at all. As far as the opportunities, I review with the team every other week the funnel of opportunities. I'd say the funnel of opportunities looks very good Tony as we exit 2020 and into 2021. We still feel very comfortable with the reasons we invested in this automation line and where we're headed with it.

[Anthony Stoss, Craig-Hallum]

If I can sneak in just one more. The bulk of the OpEx cost cuts would you say that primarily the Intelligent Audio group?

[Jeff Niew, President & CEO]

Tony, at this point I guess we would say, well we'll go through more detail as we go through this but there's a lot of moving parts. Some of this is temporary which obviously will not be what we're talking about the end of the year like the salary reductions which we hope to eventually give back to people. So there's a lot of moving parts here and what I would just say is as we get through this and we implement everything we're going to do we'll go into more detail about how we got there.

[Anthony Stoss, Craig-Hallum]

Thanks Jeff.

[Operator]

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

[Bob Labick, CJS Securities]

Good afternoon. Thanks for taking the questions. I just wanted to follow up on the BA and automation. I don't know if this is possible at all but I figured I'd ask is it possible to repurpose some of the Hearing Health BA and hold that for more of a consumer product or configure it slightly differently so they can go into the consumer Ear market or could you describe how the two might be different?

[Jeff Niew, President & CEO]

Yes. I think it's a good question Bob and thanks for the question. I guess what I say is remember when we did the balance, new balanced armature automation we also redesigned the receivers from the ground up. They’re totally different designs and that was in order to produce the cost to make them as well as for the purposes of automation. We do have some manual capacity put in place for these new designs. I would say a limited amount and that's mainly just to prove out the designs and maybe have a little bit of startup sampling but they're not really interchangeable.

Remember the hearing health how I describe it always is lower volume high mix. So it's very manual intensive versus the automated has been designed to be low mix but very high volumes.

[Bob Labick, CJS Securities]

Okay. Got it. Great. And then just one other for me. Can you talk about, I think you alluded it to a little bit but the new product areas for your future investment and also as a relation to new products, can you talk about your customer, new product roadmaps if there's been any significant changes in timelines that might impact this year?

[Jeff Niew, President & CEO]

I'll answer that first. I mean, I would sit there and say there's no doubt across the globe that there's been impact on new products. I mean I think that wouldn't take place. How that ultimately affects what's introduced this year I think it's too early to tell Bob. We're working very hard with our customers. I would say our place have been extremely productive working from home. I've been very impressed and I thank all the employees, they have been working from home in order to get things done on new products but some of our customers have been impacted.

Too early to tell how that impacts this year yet and then your new products. Yes, I would say the one thing that that we did mention Intelligent Audio but maybe you didn't kind of catch this in my prepared remarks which is we are increasing the amount of money we're spending on R&D in the MEMS microphone space.

First of all when we had the acquisition last year from AMS we took on some R&D spend that was associated with that. It obviously has been a very successful acquisition. Even in the very short time we've had the design group and the product portfolio but even beyond that we're seeing more opportunities to invest in new products and MEMS microphone into that end we have been increasing the amount of money spent on R&D in MEMS mics. And by the way there has been probably not as big also R&D spending increase in Precision Devices.

[Bob Labick, CJS Securities]

Okay. Super. Thanks very much.

[Operator]

Your next question comes from line of Christopher Rolland from Susquehanna. Your line is open.

[Christopher Rolland, Susquehanna]

Hey guys, thanks for the question. I believe in your remarks you mentioned minus 15% year-over-year and said expectation for Q2 and I guess obviously you guys aren't guiding but as we're thinking about that, should that be a starting point for us for next quarter and would you expect yourselves to be better or worse than that expectation?

[Jeff Niew, President & CEO]

So first of all just to kind of thing what I said was it could be as high as 15% and I was actually referring to the full year. I didn't really say anything specifically about Q2. I think our expectation right now I think in the Mobile market is this is that that China will be recovering. We're definitely expecting some recovery in China in the mobile market. Q1 was extremely weak for our China business within mobile.

And then, I think, now I'm kind of like starting to go into the discussions about stuff that's more public information but you saw Samsung's results they were saying handsets are very, very difficult going into Q2 and I think the wild card here which I think, I think you saw what our largest customer made their announcement they didn't really give much guidance about Q2.

So I'm not trying to punt on this but I think our position in the market still remains the same. I don't think we view that there's a big change in position but there is a fair amount of volatility in terms of what's going to happen in Q2 but again I think the number one thing we see is China will be a lot stronger in Q2 than Q1.

[Christopher Rolland, Susquehanna]

I guess just more broadly, I think the street was kind of looking for a large sequential increase. Would you still expect a sequential increase for Q2?

[Jeff Niew, President & CEO]

In terms of specifically mobile or I mean.

[Christopher Rolland, Susquehanna]

You can do it however you want, whole business --

[Jeff Niew, President & CEO]

I mean, let me start with, we have a very significant reduction in hearing health. I mean, it's very significant. This is not like down 5% or something like that sequentially. It's very significant. I think I talked about it in the prepared remarks that most of the audiologists in Europe and North America have been closed plus you add on the fact that COVID-19 has an outsized impact on older people. So we are concerned that when will people really start going back out in terms of especially people who are in the age range would buy a hearing aid. As far as our, specifically our microphone business like what we said is right now we expect it sequentially to be flat.

[Christopher Rolland, Susquehanna]

Okay. Great. And then maybe a few more details on this warranty claim is just a one-time issue and I don't know if it's related or not but Infineon I think I've mentioned this before claims they're going to grow 50% in MEMS business. Do we have any more clarity into what that mean? I think they previously talked about that business being 200 million growing 50%, so that's 100 million what could be into your market. I'm just wondering if we have any other details there or any thoughts on what they were talking about?

[Jeff Niew, President & CEO]

I will let John handle warranty claim for a moment. John, you want to talk about warranty claim?

[John Anderson, SVP & CFO]

Sure. This was a full settlement of a warranty claim with a customer in our MEMS microphone business. It was roughly $2.8 million in the quarter roughly 170 basis point negative impact to gross margins and I expect that to be behind us. We've always have some level of warranty claims but the reason I called out Q1 is much higher than normal in Q1.

[Jeff Niew, President & CEO]

And then secondly regarding Infineon, I mean, I don't want to overly speculate here as to what they're talking about. We do know and I think the market knows that Infineon has begun to sell finished mics, the full microphones versus bare die and there's a pretty significant difference in revenue associated with selling a finished microphone versus bare die. So I think there definitely is what we are hearing and seeing in the market that they're starting to do that.

[Christopher Rolland, Susquehanna]

Great. Thanks for the clarity guys.

[Operator]

Your next question comes from line of Bill Peterson from JPMorgan. Your line is open.

[Unidentified Analyst]

Hi, this is Alex Kim dialing on behalf of Peterson. Quick questions in terms of the palladium cost. You talked about being an impact for gross margin for 2Q. What is your outlook on palladium cost going forward? Is this going to continue to have an impact on gross margins? Do you have any thoughts about the market right now?

[Jeff Niew, President & CEO]

So I will let John go into the specific details but I think how we look at palladium is what's the market price today. There are opportunities for us to pre-buy some palladium which depending on when we do it could have a positive impact, but overall I would say that for the full year palladium will have a negative impact on gross margin for the full year, but John can you speak.

[John Anderson, SVP & CFO]

Year-over-year, but the prices as Jeff mentioned we did enter into some pre-buys and the prices that we realized in Q1 will be similar to the prices that we'll have over the rest of the year. So again we don't expect further increases but we did have a year-over-year headwind in palladium cost.

[Unidentified Analyst]

Okay. Got it. And then in terms of mobile market. Is the high end portion of the handset market still being affected more relative to the mid range and low end phones, so like the China mobile markets? Can you talk about that as well?

[Jeff Niew, President & CEO]

Yes. I think that's a little hard to say right now because again, I think there was such a dramatic reduction in demand in China in Q1, we're starting to see that come back. I think it's a little too premature to say how the high-end versus the mid-range versus the low-end is going because there's just so much noise in all these numbers now. I wouldn't say anything's changed that we said early say all of a sudden high-end handsets are much stronger but I honestly can't said they're much weaker either. So I mean there's a lot of volatility in these numbers by like location obviously with China first in Q1, most in Q1 has been moved in Q2. Now we're seeing more volatility that where the demands going to come from Europe and North America. So I think we're going to see how that plays out but I think it's a good question and we're definitely monitoring that to see where that goes.

[Unidentified Analyst]

Okay. Got it. That's it for me. Thank you.

[Operator]

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

[Tristan Gerra, Baird]

Hi good afternoon. Given your guidance for your microphone business to be flat sequentially in Q2 is that really the impact of supply disruption given that mobile phone units are expected to actually increase sequentially in Q2 worldwide and you've mentioned also China recovering or is there a market share impact? And then also have you seen some of your largest smartphone customers changing their forecasts either for Q2 or the second half?

[Jeff Niew, President & CEO]

Tristan, I would sit there and say right now we see flat sequentially overall for the microphone business but I mean to be truthful it's moving around a lot. I mean that's I would say is when I look at the markets that we hear our Ear and IoT business, we expect it to be, yes and then I would say the mobile more like flattish but one thing that we are concerned about we had a reasonably strong which we didn't talk about that and our book market in Q1 and we're starting to see that start to slow down somewhat. I think people have talked about this in terms of that with all the work notebooks we're really moving very quickly in Q1, we are concerned there's going to be some decline in Q2.

[Tristan Gerra, Baird]

Okay. Any quantification of the mix tablet, notebooks versus smartphone in Q1 for your mic business?

[Jeff Niew, President & CEO]

Yes. I mean again, it's a little too early to say here but I mean in Q1 tablets and notebooks we're about 15% of our total business. I could see that possibly declining some when you look at our notebook tablet and we call it the other category there's other stuff been here, I could see that declining to being let's move these numbers probably like 11%-12 % of total.

[Tristan Gerra, Baird]

Okay. Great. And then last question. So you mentioned how you're going to keep your own inventories at the current level not trying to rebuild. What do you see in the supply chain, notably in smartphone, are people trying to rebuild? Or what are the label relative to what you see historically?

[Jeff Niew, President & CEO]

Well, I think what we are trying to do is, I say when I say this is really applicable to the hearing health market with such a significant decline, we just didn't want to end up with a ton of inventory in our facility because right now there's a fair amount of data out there from third parties that's talking about what's going on with our hearing health customers. If you're aware Tristan, there are three hearing health customers in Europe who are three of our largest hearing health customers that are publicly traded and they're struggling, the people have already spoken and not given any guidance is too far as to what they see in Q2 and so I think that's really the area.

We are watching the inventory pretty closely on the microphone side but I would say we're probably a little bit more optimistic and we have to be looking a little bit forward there because of normal seasonality in the back half of the year. Q2 would typically be a quarter where we would build some inventory for the Q3 and Q4 ramp but as you know it's going to hard to say is it really going to happen in Q3 or Q4 with some of these seasonal ramps. So it's really by hearing how making sure we align the output to demand.

[Tristan Gerra, Baird]

Great. Thank you.

[Operator]

[Operator Instructions] Your next question comes from the line of Charlie Anderson from Dougherty & Co. Your line is open.

[Charlie Anderson, Dougherty & Company]

Yes. Thank you for taking my question. It sounded like you believe Q2 could potentially be a trough. I wonder what gives you the confidence that we’d sort of trough out in Q2 is it simply some of the shelter-in-place being lifted or is the industry getting creative and how we diagnose and supply? And then as it relates to gross margin impact from hearing health, I wonder if you could maybe speak to the interplay between revenue and gross margin there , fixed cost, any way you can quantify just to help us think about how that will be impacted going forward? And I have got a follow-up.

[Jeff Niew, President & CEO]

Sure. Let me take the first one first. I would say, what's very different about us in the hearing health market Charlie is that unlike the mobile market we're a reasonably small supplier in a much larger market. We're one of the largest suppliers to the hearing health market and so we have, I would say pretty good access to high-level people within the hearing aid market.

Secondly, we watch very diligently third parties that are looking at these markets. As I mentioned we have three customers in Europe that are publicly traded and there is a fair amount of data on it. I think you're right the first thing is the shelter-in-place orders have to come off and we're starting to see that, I think I've read this morning. Italy is starting to reopen. You're starting to see states in the U.S. start to open obviously with restrictions but I think the big wild card here so that's better right away because audiologists will start to reopen their offices but I think the bigger wild card where we're kind of like saying okay how much better is going to take and how long does it take is when do older people feel more comfortable leaving their house and going out to get a hearing aid.

Obviously, there are some things that people are doing to try to mitigate that in terms of fitting at home and longer term there's over-the-counter hearing aids but shorter term I think the primary method for getting hearing aids is still going to an audiologist office and getting fitted.

And so I think what we kind of hear on the marketplace and that's kind of what we're modeling is that Q2 is the trough as audiologists office open and then if people become more what-do-you-call-it confident in not getting sick, there are more people go out getting hearing aid.

I would one last thing to this is we've had a fair amount of, obviously experience with hearing.aid market it's one of our core markets for 40 plus years is that, we don't think this is an economic issue. A lot of the markets like we are talking about in the consumer space is like one of you are going to get their jobs back and are they going to be willing to spend. What our history tells us is that it's not economic in nature.

People who are older typically are not highly invested in equity markets. They typically own their home. They're typically on some type of fixed income. So they know how much money is coming in whether it be from Social Security or pension and so it's usually as we saw at ‘08 or ‘09 there was a very minor impact on that recession on the hearing aid market.

So it really comes down to audiologists reopening and number two people feeling comfortable and that means either some type of treatment, vaccine or reduction in number of cases and then I think that the market will return to normal.

We don't typically give gross profit margins by product line but I can talk a little bit to our fixed cost and capacity utilization from a segment standpoint. So our Audio segment capacity utilization is lower than planned in Q1. We typically are in the kind of low 80% in Q1 due to Chinese New Year that always occurs. Well, because of the elongated Chinese New Year and the other workforce disruptions we experienced, we were probably closer to 70% capacity utilization in Audio in Q1. I expect as we mentioned earlier the microphone business will continue similar capacity utilization but we are expecting a pretty significant downturn in capacity utilization for our hearing health business and that as we said earlier that comprises about 25% of the total.

[John Anderson, SVP & CFO]

And again Charlie, luckily the way we view this, this is temporary. I don't think we view the hearing health market, this is a permanently impaired market. We view this as that once people -- whether it's treatments or the curve starts to change or vaccine, this will not be an economic issue. People will return to the market at 2019 levels.

[Charlie Anderson, Dougherty & Company]

Okay. Great. And then for my follow up on the OpEx reductions. You do have this abnormally high OpEx right now because of the legal expense that vary from quarter to quarter. I'm curious those numbers you gave us does it include continued these elevated legal expenses or not? Thanks.

[Jeff Niew, President & CEO]

No. What we expect a fair amount with this quarter we had between $4 million and $5 million of legal expenses, we expect a similar amount in Q2 and then a pretty significant drop off. Again with COVID-19 the discovery process that we're going through it's really difficult to nail a timing but we have, we do expect this to be behind us by the end of Q3 and so when I talk about that Q4 run rate of $42 million to $44 million we aren't envisioning any legal cost by the end of the year because we do expect this should get behind us.

[Charlie Anderson, Dougherty & Company]

Okay. Great. Thanks so much.

[Operator]

There are no further questions at this time. Mr. Mike Knapp I’ll turn the call back over to you.

[Mike Knapp, VP, Investor Relations]

Great. Thanks very much for joining us today. As always we appreciate your interest in Knowles and look forward to speaking with you on our next earnings call. Thanks and good bye.

[Operator]

Ladies and gentlemen this concludes today's conference call. Thank you for participating. You may now disconnect.