Knowles (KN) Jeffrey S. Niew on Q2 2016 Results - Earnings Call Transcript

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Knowles Corp. (NYSE:KN) Q2 2016 Earnings Call July 26, 2016 4:30 PM ET

Executives

Michael J. Knapp - Vice President-Investor Relations

Jeffrey S. Niew - President & Chief Executive Officer

John S. Anderson - Chief Financial Officer & Senior Vice President

Analysts

Harsh V. Kumar - Stephens, Inc.

Bob J. Labick - CJS Securities, Inc.

Operator

Ladies and gentlemen, thank you for standing by. Good afternoon and welcome to the Knowles Corporation Second Quarter 2016 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.

With that said, here with the opening remarks is Knowles' Vice President of Investor Relations, Mike Knapp. Please go ahead.

Michael J. Knapp - Vice President-Investor Relations

Thanks, Shane, and welcome to our second quarter 2016 earnings call. I'm 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, 2015, 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 on our website at knowles.com, including a 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've made selected financial information available in webcast slides, which can be found on the Investor Relations section of our website.

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

Jeffrey S. Niew - President & Chief Executive Officer

Thanks, Mike. And thanks to all of you for joining us today. For Q2, we reported revenue of $190 million, gross margins of 39.5%, and EPS of $0.13. Revenue was in line with our guidance and we delivered gross margins and EPS that were above the midpoint of our projected range.

Revenue in mobile consumer segment came in as expected. Sequentially, we saw higher microphone shipments to Chinese handset OEMs, offset by lower sales to North American and Korean customers. Sales from intelligent audio solutions were also in line with our expectation. Overall, revenue from MCE comprised 43% of total sales in the second quarter.

As we look to Q3, we expect our MEMS microphone business to increase by more than 50% sequentially, driven primarily by new product launches and continued share gains with Chinese OEMs. At our largest customer, based on market data we review, we anticipate a more moderate ramp in microphone sales to support their new handset launch compared to Q3 of 2015.

Microphone sales over the course of this product cycle are expected to be roughly flat compared with the last cycle. We believe that we will maintain the number one share position at this customer. We continue to see stable trends at our Korean customer on solid success of its latest flagship handset model and remain cautiously optimistic on second half sales to this customer as we maintain strong share across its platforms.

In China, we saw a robust demand from OEMs during Q2, with revenue from these customers up 50% quarter-to-quarter. This strength was broad-based across a variety of platforms and customers. The growth was driven by new handset introductions, multi-mic adoption, higher value mics, as well as our share gains. We expect these trends and growth in China to continue in Q3 and Q4.

In addition to MEMS microphones, we are excited to see initial adoption of intelligent audio solutions from Chinese customers that enable new applications and better performance by combining our high-performance acoustics with software and digital signal processing.

On June 9, at its Tech World Conference in San Francisco, Lenovo announced the launch of its Phab family of devices, the first platforms to adopt the Knowles VoiceIQ Smart Microphone. With this design win, our smart microphones are integrated into an audio solution that includes multiple high-performance MEMS mics, best-in-class audio software and voice processing to create one of the most advanced audio systems in the mobile consumer industry.

Smart microphone opportunities increase our dollar content, move our gross margins higher and place us in a sole-source position on these sockets. I remain optimistic that we will see continued design win success with our smart microphones in the second half of 2016 that should drive meaningful revenue contribution in 2017.

In specialty components segment, Q2 sales were up 6% quarter-over-quarter, in line with expectation, with hearing health, timing and capacitor sales, all increasing sequentially. Specialty components represented about 57% of total company revenue.

We remain the world leader in hearing health solutions, which is a stable market that delivers above corporate average gross and operating margins while also driving strong cash flow generation. Favorable long-term trends, like the rapidly aging population in developed countries, longer life expectancies and an increasingly affluent middle-class in emerging markets, all point to growth for our solutions in the future.

Precision devices sales also improved sequentially in Q2. We are seeing stronger booking trends, particularly in the telecom sector, and expect sales to continue to improve in the second half of the year.

We were also pleased to formally launch our Versant advanced voice technology last week. This is a best-in-class audio solution for hearables in premium earphones, which allows the user's voice to come through clearly in noisy environments, such as wind or crowds. This breakthrough technology offers significant advantages over existing approaches to capture clear voice and enable smaller, more ergonomic product designs.

With this launch, we also announced our first design win on the Bragi Dash, which is already shipping to customers. Again, this solution includes multiple mics, two balanced armature speakers and software, resulting in more than $5 of content per device. Knowles is uniquely positioned in the hearables market, and our expertise in MEMS mics, hearing-aid speakers and software allows us to offer customers a complete audio solution for their devices. We expect more design activity for this solution, and we'll update you on these design wins as they are secured.

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

John S. Anderson - Chief Financial Officer & Senior Vice President

Thanks, Jeff. As Jeff mentioned earlier, we reported second quarter revenues of $190.3 million, in line with our projected range. Mobile consumer electronic revenues of $82 million were in line with expectations, as software demand from the notebook market was partially offset by stronger-than-expected shipments to Chinese handset customers. Revenues from intelligent audio were in line with our expectations for the quarter.

Specialty component revenues of $108 million were up 6% sequentially and also in line with our guidance. Second quarter gross margins were 39.5%, above the midpoint of our guidance due to favorable factory capacity utilization in our MEMS microphone business. Operating expense in the second quarter were $60 million, in line with our projections. Adjusted EBIT margin was 8.1% in the quarter and non-GAAP diluted EPS was $0.13, with both metrics above the midpoint of our guidance range.

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 $47 million at June 30. For the quarter, cash used in operations was $10 million, which was $5 million better than the midpoint of our guidance range due to lower cash used in our discontinued operations. Cash flow from continuing operations was in line with expectations. And capital spending in the quarter was $10 million.

Moving to our third quarter guidance. We expect revenue for the third quarter to be between $225 million and $240 million. MCE revenue is expected to be up more than 50% sequentially at the midpoint, driven by higher volumes at our North American and Chinese OEMs. Specialty component revenue is projected to be flat on a sequential basis, with stable demand expected in both hearing health and precision device end markets.

We project non-GAAP gross margin to be approximately 38% to 40%, down 50 basis points sequentially at the midpoint due to higher anticipated scrap cost and a more moderate ramp in production levels to support a new product launch at our North American customer.

R&D spending in the quarter is expected to be between $24 million and $26 million, up slightly from Q2 levels. Selling and administrative expense is expected to be approximately $32 million to $34 million, down $2 million from Q2 levels.

We're projecting adjusted EBIT margin for the quarter to be in the range of 13% to 15%, and expected non-GAAP diluted EPS for the quarter to be within a range of $0.27 to $0.33 per share. This assumes weighted average shares outstanding during the quarter of 91 million on a fully diluted basis. We're forecasting an effective tax rate of 5% to 10% for the quarter. Please refer to our press release for a GAAP to non-GAAP reconciliation.

For the third quarter, we expect cash flow from continuing operations to be approximately $10 million to $20 million, which includes $6 million in retention payments associated with the Audience acquisition. CapEx in the third quarter is expected to be approximately $15 million.

As previously announced, we were pleased to complete the sale of the MCE speaker and receiver product line on July 7. Cash received net of purchase price adjustment was approximately $41 million. The majority of these proceeds will be used to pay down our existing debt in the third quarter. We expect to exit 2016 with our lowest net debt level since the spin-off from Dover in February 2014, which demonstrates the cash-generating capabilities of our core business.

Lastly, I wanted to update the expectations for full-year 2016 that we provided earlier this year. While second half revenues in MCE have softened slightly versus our earlier expectations, we continue to project modest full-year revenue growth from continuing operations. In addition, we expect full-year gross margins of 39% and to exit the year with an SG&A annual run rate below our $140 million target.

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. Jeff?

Jeffrey S. Niew - President & Chief Executive Officer

Thank you, John. I expect to see an acceleration of revenue and earnings in the second half of the year. This will be driven by new product launches, share gains in China, increased shipments of our intelligent audio solutions, and normal seasonal patterns. This is expected to result in full-year revenue growth. As we look to 2017, the continued need for clear communication and the transition to voice as a primary user interface will propel demand for high-performance audio across multiple end markets.

With Knowles' capability in acoustics, software and digital signal processing, we are solving critical customer problems and pioneering unique audio solutions that will drive higher margins and growth. I expect these capabilities will continue to have a significant impact on our future product roadmap, and I'm excited to see these early design wins starting to generate revenue in 2016.

Operator, we can now take questions.

Question-and-Answer Session

Operator

Thank you. Our first question comes from the line of Harsh Kumar of Stephens. Your line is now open.

Harsh V. Kumar - Stephens, Inc.

Yeah. Hey, guys. Thanks for the opportunity to ask a question. Hey, Jeff and John, maybe a question for both of you guys. I'd love the input here. Gross margins of 39.5% and you're guiding to 39%. Your MCE business is taking off in the back half. I suspect it'll be pretty strong in 4Q as well. I'm just curious – you talked about scrap, just curious what else is going on and what we should be thinking about here?

Jeffrey S. Niew - President & Chief Executive Officer

Yeah. I'll let John comment...

John S. Anderson - Chief Financial Officer & Senior Vice President

Yeah. I'll take the gross margin question, Harsh. You're right. Historically, our gross margins are typically higher in the second half and in Q3, as a result of higher capacity utilization. This year, a little different. In order to level load our microphone production, we actually started building inventory for our largest customer kind of midway or late in Q2. As a result, our Q2 gross margins, as I just mentioned, were a little higher and above the midpoint. But what this also results in, this level loading kind of decreases the capacity utilization in Q3.

In addition, related to our largest customer's new product introduction, we are incurring higher-than-expected scrap cost. We expect this to get resolved and go back to a normalized scrap level or reduced scrap level in Q4 as we exit 2016. And again, I reiterate, full-year gross margins were on track with the full-year margins of 39%.

Harsh V. Kumar - Stephens, Inc.

Got it. Thanks, guys. And then, as my follow-up, you mentioned something about your largest customer where the ramp was flattish with last year. First of all, is that correct and is that dollars or units? And then, can you maybe talk about your position there? I think you mentioned your position is pretty solid. Maybe put that in reference for us, how we should think about that?

John S. Anderson - Chief Financial Officer & Senior Vice President

Yeah. Yeah, that's a good question, Harsh. First thing I would just say is we expect to maintain our number one share position at that customer. Let's just start with that. So I think what we have to do is take a step back and just say builds are not always aligned directly with demand. As we saw last year, in the back half of the year, builds got ahead of the actual demand with our largest customer. And we saw that big drop-off, I mean most of the vendors did, in the first half of 2016.

So, if you start with the market reports that are out that everybody reads, our expectation is that, roughly speaking, that there should be roughly flat from year-over-year. You would expect that the builds would be slower in the early stages than they were last year, but we wouldn't have that big inventory correction in the first half of 2016. And that's kind of what we're seeing in terms of the demand that how the shape of it's changed from the previous cycle. But we do expect our sales to this customer to be roughly flat over the product cycle.

Harsh V. Kumar - Stephens, Inc.

Got it. So, dollars. And then, historically, you've been selling to this customer, Jeff, for a while. Are you back at kind of your historical highs in terms of your share at this particular customer or are you close?

Jeffrey S. Niew - President & Chief Executive Officer

Yeah. I mean I guess, Harsh, what I'd say is we typically have not been talking about share directly about any individual customer. And I would say, going forward, it's really hard for us to project until we see the build and we know everything that goes on. I would say for our overall marketplace, we're not seeing any major shifts in share, with the exception of China.

I mean, Q2 was a very, very strong quarter for us in China. We do expect growth to continue in Q3 and Q4. But there's a lot of tailwinds for us with China that are very, very positive. So I think what we'd say is, overall, we're pleased with our share position overall and where we're headed for the full year.

Harsh V. Kumar - Stephens, Inc.

Got it. I'll get back in line, guys. Thank you.

Michael J. Knapp - Vice President-Investor Relations

Thanks, Harsh.

Operator

Thank you. And our next question comes from the line of Bob Labick of CJS Securities. Your line is now open.

Bob J. Labick - CJS Securities, Inc.

Thank you. Good afternoon.

Michael J. Knapp - Vice President-Investor Relations

Hey, Bob.

Jeffrey S. Niew - President & Chief Executive Officer

Hey, Bob.

Bob J. Labick - CJS Securities, Inc.

Hi. Just wanted to go back with the gross margin. You mentioned a bit of level loading of the capacity. Does this mean that if you expect the high 30%s, 38% to 40% gross margin kind of back-half, would we expect stronger gross margins in the first half of next year? Do you expect this level loading to be the new norm to continue going forward? Or how are you thinking about capacity in gross margins on a go-forward basis?

Jeffrey S. Niew - President & Chief Executive Officer

Well, let me just start from a perspective of sales. I think it's a little too early to start projecting sales in Q1. But, I mean, assuming that we don't see this inventory correction we saw in the first half of 2016, I would say there's some opportunity for margin improvement if we don't see that inventory correction, because that did impact our gross margins specifically in Q1.

I don't know if you have any good color on that, John?

John S. Anderson - Chief Financial Officer & Senior Vice President

No, I think you hit it. I would say that I think the catalyst to improve margins beyond the 39% that we've talked about for full-year 2016 is really penetration with our intelligent audio, which typically comes in at a higher margin given the software content.

Bob J. Labick - CJS Securities, Inc.

Great. Yeah. Just touching on that, can you talk a little bit about – obviously intelligent audio is new product, so you're just introducing this stuff now. Can you talk a little bit about your percent of sales that are new products now and what you would expect that over the next year or so? And is that also therefore the driver for potentially higher gross margins?

Jeffrey S. Niew - President & Chief Executive Officer

Well, we do track internally our new products as a percentage of sales. It typically has been larger in the back half of the year and the trend has generally been positive in terms of new product sales. I don't know, John, if you want to comment on new product sales at all in terms of for the full year at all or do you have any data...

John S. Anderson - Chief Financial Officer & Senior Vice President

Yeah. I mean, it's in the range of one-third of our sales coming from new products in 2016, two-thirds coming from mature products, which those are products that have typically been in the marketplace more than 18 months. I would expect that as we go into 2017, the same thing. As we make penetration with intelligent audio, that percent of sales derived from new products will increase.

Bob J. Labick - CJS Securities, Inc.

Okay. Great. And then, just last one. You touched on the Versant launch and I believe, obviously, part of that has been influenced by the Audience acquisition. Can you talk a little bit about that, how Audience has helped you in regards to the Versant launch and any other new products that could be coming out that have been influenced from the Audience acquisition?

Jeffrey S. Niew - President & Chief Executive Officer

Yeah. Well, let me comment first on the Versant. I would just say is, without the Audience acquisition, we would not be where we are today in terms of Versant. And I think what we have to realize here is that it's driven a lot of opportunity for us with software and mics and speakers on the hearing aid side to increase the content for headsets.

And I gave though just, Bob, one example. I have the Bragi Dash, I have one myself. And I've been driving down the road, which I've never been able to do in my convertible with the top down, going 50 miles an hour, and I can talk clearly to someone on the other side. I mean it really quite frankly is quite amazing what the team, which is a combination again of the acoustics team, both microphones, speakers, and also the software team for the former Audience out in Mountain View of what they put together, really kind of incredible. Our goal now is now we've got this first design win, we've proven the technology out. It's just to start expanding this I would say to other customers.

Bob J. Labick - CJS Securities, Inc.

Super. Thanks so much.

Jeffrey S. Niew - President & Chief Executive Officer

Okay.

Operator

Thank you. And I'm showing no further questions in the queue at this moment.

Michael J. Knapp - Vice President-Investor Relations

Okay. Well, thanks, Shane, and thank you everyone 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, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.

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