Knowles Corp

NYSE:KN

Earnings Call Transcript 2022-Q1

[Operator]

Good afternoon and welcome to the Knowles Corporation First Quarter 2022 Financial Results Conference Call. Today’s call is being recorded. [Operator Instructions] And with that said, here are the opening remarks with Sloane Bolun, Investor Relations.

[Sloane Bolun, Investor Relations]

Thank you, Savannah. Welcome to our Q1 earnings call. I am 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 do not or 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 company 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, 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 on this quarter. As referenced on this call will be 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 with the SEC for a reconciliation of the most directly comparable GAAP measures.

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

[Jeffrey Niew, President and Chief Executive Officer]

Thanks, Sloane and thanks to everyone for joining us today. We are very pleased with Knowles’ performance to begin 2022. As you saw in today’s release, we reported another quarter with gross margins and EPS above the high end of our guided range. Best of all, we achieved these results despite stronger than expected headwinds from the reemergence of COVID in Mainland China dampening demand and causing additional friction on an already stretched supply chain.

I will touch on our near-term expectations for these headwinds in a moment, but before I do, I want to reiterate our conviction to the mid-term financial targets we detailed at our Investor Day last November. Our year-to-date results, particularly in our Precision Device segment, have only increased our confidence in most significant opportunity to drive shareholder value through continued growth in higher-margin end markets with highly attractive free cash flow dynamics.

With that, let me give a summary of our strong first quarter results. Revenue of $201 million was in line with our guidance driven by a mix of very strong demand in Precision Devices and continued market growth and share expansion in Hearing Health. Precision Device segment revenues totaled $56 million in the first quarter, which was up 47% compared to a year ago, with the vast majority of that growth being organic. Additionally, the Precision Device segment delivered another record quarter for bookings. The demand for this segment was driven broadly across most of our end markets and it’s rewarding to see our strategy so well aligned with long-tailed secular drivers.

Turning to Audio, our Hearing Health business continued to show good growth as the end market for these products remains robust. We continue to have strong execution on new products and managing ongoing supply chain issues, which has allowed us to gain share. While the MEMS microphone business did not grow year-over-year for the quarter, it is performing in line with expectations as we focus on higher-margin products and markets. Looking ahead, this year’s new product pipeline from our customers is more weighted to the back half of the year, which is typical seasonality for this business.

Next, I would like to give a little bit more detail on the macroeconomic headwinds impacting our business before I speak to our continued success on profitability. As you are hearing elsewhere in the industry, supply chain challenges remain very real and were for Knowles in the first quarter as well. While it’s very difficult to predict what will happen next, it is impacting our business at this point. Beyond supply chain challenges, we have increasingly seen the latest COVID outbreaks in China and associated government lockdowns impacting consumer demand for smartphones and other consumer electronics. This is causing demand headwinds in our MEMS microphone business.

While both challenges our fluid situations, we believe the impact on our business will persist in the first half of the year. We’ll provide more detail when discussing the Q2 guidance, but we do not expect to affect our ability to achieve our mid-term financial targets. The issues in China highlight the benefit of our revenue diversification and reinforce our commitment to continue to shift to higher-value products and markets, which are inherently less economically sensitive to consumer demand.

With that, let me turn to our profitability. Knowles grew gross profit to $83 million, up about 7% compared to the year ago period on essentially flat revenue. The major driver of the strength was Precision Device segment, where margins were up 920 basis points year-over-year on favorable mix, pricing power and the IMC acquisition. It is worth noting our 2Q margins will face a more challenging year-over-year compare, given the current lower factory capacity utilization in our MEMS microphone business.

That said, I am very pleased with the progress we continue to make on margins, especially given the macroeconomic headwinds in the MEMS microphone business. Our strategy, strong execution and expense management has allowed us to achieve adjusted EBIT margins of close to 20% for Q1, an increase of 250 basis points over last year. Similarly, we grew EPS to $0.35 per share, which is also above our guided range and represents over 20% growth from the year ago period. Let me reiterate again, we are increasingly confident in our mid-term financial targets and believe the strength and stability of our annual free cash flow is an underappreciated aspect of our business.

Finally, on our last earnings call, we spoke about refining our capital allocation strategy this quarter. To that point, we are pleased to announce our Board of Directors recently approved a new $150 million share repurchase authorization. In addition, we are committing to pursuing bolt-on acquisitions while planning to return 50% of our annual free cash flow to Knowles’ shareholders in the form of share repurchases. We believe capital return will be a more recognized part of Knowles’s value proposition to existing and new shareholders in the future and also hope that this commitment serves as a strong sign of our confidence in our strategy and the bright future for our company.

With that, let me turn it over to John to review our first quarter financials.

[John Anderson]

Thanks, Jeff. We reported first quarter revenues of $201 million, flat with the same period a year ago, driven by higher revenues in Precision Devices, offset by lower shipments in the Audio segment due to weak consumer electronics demand and continued supply chain shortages. Audio revenues of $146 million were down 11% from the same period a year ago, driven by a challenging supply chain and weak microphone demand in the smartphone and compute markets. The decline in MEMS microphone revenues was partially offset by increased shipments in Hearing Health on both share gains and market growth.

The Precision Device segment delivered revenues of $56 million, up 47% from prior year, driven by strong organic growth in defense, industrial and med-tech markets and an acquisition completed in the second quarter of 2021. First quarter gross profit margins were 41.6%, 60 basis points above the high end of our guidance range and up 260 basis points from the same period a year ago. Audio segment gross margins improved 40 basis points over 2021 levels, driven by lower factory spending and favorable product mix, partially offset by lower factory capacity utilization in our MEMS microphone business.

Precision Devices segment gross margins were 45.6%, up 920 basis points from the prior year, driven by favorable product and customer mix, productivity gains, improved factory capacity utilization and an acquisition completed in Q2 2021. R&D expense in the quarter was $20 million, flat with the prior year. SG&A expenses were $25 million, slightly above prior year levels, driven by the acquisition completed in the second quarter of 2021, partially offset by lower legal costs. For the quarter, adjusted EBIT margin was 19.6%, up 250 basis points from the prior year, driven by higher gross profit margins. EPS was $0.35, which was $0.04 above the high end of our guidance and $0.06 above Q1 2021, with the increase driven by higher gross profit margins and a lower effective tax rate.

Now I will turn to our balance sheet and cash flow. Cash and cash equivalents totaled $51 million at the end of the quarter. Cash from operations was $1 million, which was near the low end of our guidance range, primarily due to higher inventory levels and the timing of cash collections. Capital spending was $7 million in the quarter, and we repurchased approximately 300,000 shares at a total cost of $6.8 million.

Before moving to our second quarter guidance, as Jeff stated, the Board of Directors recently authorized a $150 million increase to our share repurchase program. Our strong balance sheet, coupled with our improved financial performance and strategy to focus on higher-value solutions will allow us to continue to pursue bolt-on acquisitions, while planning to return 50% of our annual free cash flow to shareholders in the form of share repurchases.

Moving to our guidance for the second quarter, we expect total company revenue to be between 195 and $205 million, flat with the same period a year ago. Our revenue guidance reflects the negative impact of COVID-related lockdowns in China and continued supply chain constraints. Revenue from the Audio segment is expected to be down 7% from Q2 2021 due to lower demand for MEMS microphones and continued global supply chain challenges, which are partially offset by increased demand in the Hearing Health market.

Precision Device revenue is expected to be up more than 20% over prior year levels, driven by broad-based strength in defense, med-tech and industrial markets and the acquisition completed in Q2 of 2021. We estimate gross margins for the second quarter to be approximately 41% to 42%, down 90 basis points from the year ago period driven by lower factory capacity utilization in our MEMS microphone business and an unfavorable mix due to lower shipments to the higher-margin compute market. These negative impacts are partially offset by productivity gains and improved capacity utilization in both Precision Devices and Hearing Health.

R&D expense is expected to be between 19 and $21 million, down $2 million from prior year levels due to lower incentive compensation costs. We’re projecting selling and administrative expense to be between 27 and $28 million, down slightly from the year ago period, driven by lower incentive compensation costs, partially offset by the acquisition completed last year.

We are projecting adjusted EBIT margin for the quarter to be in the range of 17% to 19% and EPS to be within a range of $0.30 to $0.34 per share. This assumes weighted average shares outstanding during the quarter of $95.7 million on a fully diluted basis. We are forecasting an effective tax rate of 12% to 16% for the quarter and full year 2022. For the second quarter, we expect cash generated from operations to be between $10 million and $20 million and capital spending to be approximately $10 million.

I will now turn the call back to our operator to open the line for questions. Operator?

[Operator]

Thank you. [Operator Instructions] And our first question will come from Tristan Gerra with Baird. Please go ahead.

[Unidentified Analyst]

Yes, hi. This is Tyler on for Tristan. Thanks for taking the questions. Could you talk a little bit about the extent of disruptions you are seeing from the China lockdowns? I know you talked about it, but maybe you quantify it or even talk a little more about it qualitatively either affecting you directly or indirectly?

[Jeffrey Niew, President and Chief Executive Officer]

Yes. And I think – so I think one of the things we talked about first was supply chain. And I think we have talked on previous quarters about the fact that in the first half, you were kind of held back by supply of wafers. That’s still the case. That’s not different than what we had said before. I would say that the things that we are dealing with now with – in China is that we have some issues in terms of shipping materials, which is causing us to take longer to get products to our customers. That’s number one. Number two, some of our customers are starting to say, well, there is a little bit less that we can ship to them right now because they can’t get other materials, right, in order to build. And so I think that’s probably the layer that’s been added on is that some of our customers are not being able to get all the materials that they need in order to build. The third piece, which is not necessarily supply chain related, but we are seeing that there is a definite slowdown in consumer demand in China. And I would say that’s pretty broad-based at this moment that we are starting to hear that – and see in terms of forecast and it’s reflected in our forecast that we are giving for Q2, that demand is going to be down in Q2 compared to what our expectations would have been pre-lockdown. And so, I think we are hopeful at some point, lockdowns will end. But right now and I think that’s the key. I would add this, our hearing health business, very limited impact by what’s going on with COVID and in terms of supply chain or demand in China. Most of our operations for hearing health are outside of China, most of the demand is outside of China. And I would say the same thing for PD. There is a little bit more exposure for PD as we do have one manufacturing facility in China that makes up about 25% of their revenue. And so overall, it’s really affecting our MEMS microphone business the most.

[Unidentified Analyst]

Great. And then for my follow-up, is it fair to say that your defense exposure is of mid to high-single digit of total revenue? And then may be if you could talk about the current geopolitical events if they are going to help your precision devices going forward?

[Jeffrey Niew, President and Chief Executive Officer]

I am sorry, I didn’t hear the second part of that?

[Unidentified Analyst]

The current geopolitical events, are they going to benefit your precision device business going forward?

[Jeffrey Niew, President and Chief Executive Officer]

Well, I don’t know if it will benefit us. I mean I think we have already been benefiting from that. I mean we have U.S. operations. We do a lot of work with the defense and med market. I think we have been benefiting that from that already. But I think that will be a continued benefit. As far as our defense exposure, I would say it’s closer to high-single digits. If I take you back to our investor deck, I believe we stated last year in 2021, it was about 10% of our revenue last year. And our expectations in our defense market, we are going to have pretty good growth, which is a mixture of both organic growth, as well as the acquisition – a full year of the acquisition on IMC.

[Unidentified Analyst]

Great. Thanks for taking the questions.

[Operator]

Our next question will come from Bob Labick with CJS Securities. Please go ahead.

[Bob Labick, CJS Securities]

Thanks. Good afternoon. Congratulations on strong operations.

[Jeffrey Niew, President and Chief Executive Officer]

Thank you, Bob.

[Bob Labick, CJS Securities]

You obviously just spoke about the headwinds from the impact of demand in China. One thing most of the companies we are talking to are also talking about is just the overall macro impact of inflation. What are the biggest inflationary pressures you are facing, if any? And what actions are you able to take to maintain your margins as strong as they have been?

[John Anderson]

Yes, Bob, I can take that. It’s John. We have seen a significant increase in input costs recently, the primary areas being labor cost, ASIC chips and then certain commodities like palladium. And to-date, I mean you can see in our gross margins, they are up year-over-year. We have been pretty successful in passing these cost increases on to our customers in the form of permanent price increases or surcharges. I would say the only exception being in the area of maybe commodity microphones. But elsewhere, whether it’s PD or HHT and some of the higher-value solutions in mics, we have been pretty successful at passing these costs and you see it in our gross margin.

[Jeffrey Niew, President and Chief Executive Officer]

And let me add a little more color. I think we talked about last year with mobile was about 21%, 22% of our sales. This year, we expect mobile to be less than 20% of our sales. And so – and right now, a fair amount of our commoditized mics are in that space. And as we have said on previous calls, we are trying to reduce our exposure to commoditize mics, I wouldn’t say necessarily mobile, but reduce our exposure to commoditized mics, where it’s harder to pass on inflation.

[Bob Labick, CJS Securities]

Yes, that’s great. And then obviously exciting news on the capital allocation and the repurchase authorization and the commitment to repurchase shares with 50% of free cash flow? You have been very successful in M&A in the precision devices market, and you said you will still look for tuck-ins there. Can you just give us a sense of what the pipeline looks like? And if you would expect to potentially have any in the next, I don’t know, 6 months to 18 months, any tuck-ins?

[Jeffrey Niew, President and Chief Executive Officer]

Well, I would say that, as we said in the past, specifically in the kind of PD area, it’s a pretty target-rich environment. But we do want to be very disciplined in what we do here, Bob. And the deals that we have done for PD over the last 5 years, four in total, have all been extremely successful for us. I mean whether from a financial standpoint, you look at it, or from how it’s added to our total, whether in terms of consolidation, in some cases, addition of new products and customers, right. It’s been very successful. I would say that the pipeline looks pretty good right now and I would be hopeful over next year, we can do some more tuck-in acquisitions. That being said, I think when you look at our balance sheet, that’s why we kind of felt really strongly that we can continue to do these things, coupled with return 50% of our free cash flow to shareholders in the form of share repurchases. This is not something that is going to be very difficult for us to do. As I said on the prepared remarks, we really do think it’s an underappreciated portion of what Knowles does, which is generating a fair amount of cash flow.

[Bob Labick, CJS Securities]

Absolutely. Congratulations. Thank you.

[Operator]

And our next question will come from Christopher Rolland with Susquehanna. Please go ahead.

[Duksan Jang, Susquehanna]

Thank you. This is Duksan Jang on behalf of Chris. I just want to ask about your gross margins. They are very strong, obviously. And you talked a lot about how mix was driving the strength. But as shortages are going to alleviate over the second half and as MEMS microphones come back, how do you – how should we think about mix and margins going forward? Thank you.

[Jeffrey Niew, President and Chief Executive Officer]

Yes. I mean I think this is a trend that’s been going on for a couple of years now, which is as you see our hearing health business grow and our PD business grow, mix has been a very important piece in order towards growing our gross margins. That being said, I think you are right, we will have more MEMS microphone business in the back half, which is typically lower than those two other businesses. But on the other side, assuming that the market gets stronger in the back half, we will also have better capacity utilization in the back half. So, I think as I see it, and I will ask John to add some color to this, is that the thing that we are going to – you are going to keep hearing from us is that if you look at back to our Investor Day, the markets that are growing the fastest for us, med, defense, these type of markets, both in hearing health, PD, EV versus, say, mobile is generally a flat to down market in terms of the end market plus we are trying to walk away from commoditized microphones. I think mix will continue to be a big strong driver for us in the future in order to get to that kind of mid-term goal we laid out of 43%.

[John Anderson]

Yes. I mean just kind of along the same lines of what Jeff just mentioned, I mean the theme is related to our gross margin expansion that we have realized over the last several quarters, they are really unchanged as we continue to benefit from mix shift, from a higher proportion of sales coming from PD, HHT and high-value MEMS microphone solutions. I am not giving guidance for the second half of the year, but we do expect full year gross margins to be higher than they were in 2021.

[Duksan Jang, Susquehanna]

Got it. Thank you. And then you also mentioned that there are new products coming in the second half and that also tends to be a seasonally stronger period. Do you have enough supplies coming online to support that growth? Because I think you said wafer shortages are still ongoing and impacting the June guide? Thank you.

[Jeffrey Niew, President and Chief Executive Officer]

Yes. So again, I will piggyback to it, it’s very similar to what we said before. I think – in total, even in the first half, we were getting enough wafers in total, but the mix was wrong. In other words, we had excess capacity or availability of wafers at certain fabs and not enough at another. And I think in the short-term, it’s very hard to change that when I say from one fab to another. In the longer term, as we introduce new products and our customers introduce new products, it gives us an opportunity to bring in a new wafer supplier where we have more demand. So, our hope is, is that we look towards the back half of the year, we will be better aligned in terms of where we have capacity at our wafer suppliers relative to where our demand is.

[Duksan Jang, Susquehanna]

Thank you.

[Operator]

[Operator Instructions] And our next question will come from Suji Desilva with ROTH Capital. Please go ahead.

[Suji Desilva, ROTH Capital]

Hi, Jeff. Hi, John.

[Jeffrey Niew, President and Chief Executive Officer]

Hi Suji.

[Suji Desilva, ROTH Capital]

So, just trying to understand, given the demand softening a bit, can you articulate either in numbers or qualitatively? How much of your microphone segments are China versus non-China if you go smartphone versus ear IoT component? I mean sort of end customer demand. Do you have a sense?

[Jeffrey Niew, President and Chief Executive Officer]

Yes. I would sit there and say, I mean – and this is kind of a broad statement, but in our MEMS microphone business, demand is down across all of our kind of like segments, right, in terms of when you say mobile, ear IoT for China, right. It’s – and then what the overall backdrop is and I think we predicted this, that the laptop/compute market was going to be soft Q1 into Q2, and we are thinking starting to recover in Q3. And that’s a global phenomenon. I think more of the laptop business. And so I think what we have seen in March, a pretty abrupt reductions in forecast from our customers that – well, what do you call it, that is across the board in terms of consumer electronics. Now, again, it’s hard to say what’s going to happen to the quarter, how long lockdowns are going to go. But the bottom line is, I keep coming back to this, we still expect revenue growth this year, we still expect earnings growth this year. As we continue to focus on moving towards higher value, higher margin portions of our business.

[Suji Desilva, ROTH Capital]

Okay. And as you look ahead to the second half, maybe what segments or sub-segments do you have some of the most optimism about in terms of helping drive growth of recovery?

[Jeffrey Niew, President and Chief Executive Officer]

Yes. I mean I think if I look at our PD business continues to look very strong. I mean I mentioned this on my script in my prepared remarks in the press release, we had another quarter of record just blockbuster bookings in PD. And I just – we are very bullish on this because a lot of people would say, are these bookings like things that can be canceled later relative to the fact that there may be people over-ordering. And I would say the answer for the vast majority, the bookings are not, these are custom products that are built either for markets like the defense or the medical market, where we see the demand. And so, I feel very good about the PD business.

[John Anderson]

I would just add, Suji, I mean our biggest challenge in PD is increasing output. We are working to increase output sequentially from Q2 to Q3 to Q4 on this backlog.

[Jeffrey Niew, President and Chief Executive Officer]

Correct. And so – and again, we don’t feel like this is turns business that could disappear if the market weakens. This is like real demand. In our hearing health business, the demand remains robust. I think I always say that the team, they have done an excellent job of executing on new products, coupled with they really minimized the supply chain issues in terms of during this kind of ramp-up from when the hearing health business was affected by COVID back in 2020. And so the demand looks robust. We got to obviously continue to monitor that, but hearing health business looks robust. And I think on the MEMS microphone business, I think it’s a little more wait and see like how these lockdowns develop. I mean I think it’s factored into our numbers for Q2, but we will have to see how this all develops as the rest of the year goes by. But I think from my perspective, Suji, is and I feel like we are still increasing our operating margins, we are increasing our EPS and so this is a really good story that says that when we get back to growth in our MEMS microphone business, you can really see the power that’s going to come in this business in terms of profitability and also cash flow.

[Suji Desilva, ROTH Capital]

Okay, great. Thanks guys.

[Operator]

And with no further questions, that will conclude today’s call. Have a great evening and thank you for your interest in Knowles.