Knowles Corporation

Good afternoon. Thank you for attending today's NOLS first quarter 2023 earnings call. All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end. If you'd like to queue for a question on today's call, you can do so by dialing star one. I'd now like to pass the conference over to your host, Patent Hofer, Vice President of Investor Relations with NOLS. Thank you. You may proceed.

Thank you, Joel, and welcome to our Q1 2023 earnings call. I'm Patton Hofer, Vice President of Investor Relations, and presenting with me on the call today are Jeffrey New, 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 NOLS, which constitute forward-looking statements for purposes of the safe harbor provisions under applicable federal securities law. 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, 2022, periodic reports filed from time to time with the SEC, and the risks and uncertainties identified in today's arranged release. All forward-looking statements are made as of the date of this call, and NOLS 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 nols.com and in our current report on Form 8-K filed today with SEC, including a reconciliation to the most directly comparable GAAP measures. All financial measures 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 form, which can be found in the investor relations section of our website. With that, let me turn the call over to Jeff, who will provide some details on our results.

Jeff? Thanks, Patton, and thanks to all of you for joining us today. Our first quarter results were largely in line with our expectations. Revenue finished slightly below the midpoint of our guidance, but due to strong operational performance and the benefits of MIX, we were able to deliver gross margins, adjusted EBIT margins, EPS, and cash from operations all above the midpoint of the guided ranges. Looking at Q1 in more detail, NOLS generated $144 million of revenue slightly below the midpoint driven by weak consumer electronics demand in the market and excess customer and channel inventory across all three segments. In precision devices, revenue was down 4% from the prior year. EV, med tech, and defense all grew year over year while our industrial market faced inventory challenges, which are now expected to continue through Q2. In med tech and specialty audio, revenue was down 24% versus prior levels due to customer inventory adjustments and softer end market demand in the hearing health market. I would note MSA was better than expected as inventory moves faster than we anticipated, driving revenue higher in Q1. In consumer MEMS microphones, revenue was down 48% from Q1 of 2022 as all end markets were down versus prior year. Before I turn the call over to John, I'll spend some time discussing the current customer and market conditions for each segment with some insights into what we are seeing for Q2 and the rest of the year. For our precision device segments, we continue to have strong demand and growth in our three key end markets, defense, medtech, and EV. In defense, the demand for communications and electronic warfare systems continue to amplify the need for our RF filtering and high-performance capacitor products. Despite awards and shipments in this market being lumpy at times, we grew year over year again in Q1 for the seventh quarter in a row, and we are confident based on current bookings and the expected awards that will generate growth in 2023. For Medtech, our high performance and high reliability capacitor price grew again in Q1, and we continue to see demand growth throughout 2023. We believe this market continues to show resilience similar to our MSA segment in the face of macroeconomic challenges. In the EV market, we grew 50% year over year in the first quarter. NOLS continues to expand design wins in exciting market with a broad range of new customers. We expect continued growth throughout 2023 with the EV market being our fastest growing market for NOLS. In the industrial market, which currently makes up less than 15% of company revenue, we are seeing continued weakness as distribution and customer inventory levels remain elevated. We expect the inventory challenges market to continue in the second quarter, but we see signs that lead us to believe a recovery is coming in the second half. Overall for PD, we expect strong bookings in Q2 for our three key markets, and depending on the inventory consumption in our distributors, we can see a return to growth in the second half for this segment. In MedTech, especially audio, as we stated on the Q4 call, We started seeing signs early in Q1 that the inventory situation was improving, which gave us increasing confidence on strong sequential revenue improvement in Q2. Our guide reflects a more than 27% sequential improvement in MSA, driven by major hearing aid retailers around the globe starting to see a return to growth. This demonstrates the resilience of the Zen market and provides confidence in a return to growth starting in Q3 of this year. Lastly, our consumer MEMS microphone segment. Demand across all our end markets were down in Q1 versus prior year levels, but as we look ahead, we are starting to see recovery in some end markets. Specifically, non-mobile shipments are expected to be up over 30% sequentially as channel inventory has improved and replacement cycles are expected to start in Q3. These markets are still down from prior year levels, but definitely showing signs that the first quarter was the bottom. Finally, while the smartphone market has not degraded further, we are not yet seeing a recovery, and due to excess capacity in the market, we are seeing further pricing pressure. While our strategy has not changed, in the short term, we will continue to fill our capacity with smartphone business. For CMM, due to normal seasonality of this business and improving market conditions, we are expecting strong sequential improvement for revenue and earnings starting in Q2. We expect sequential improvement to continue for the remaining quarters in 2023. Overall for Knowlson, the outlook for improvement in revenue, margins, and earnings as the year progresses remains unchanged from our last call. The inventory situation in the hearing aid market has improved as forecasted, and we are increasingly confident of second-half growth. In precision devices, the defense, medtech, and EV markets remain robust while inventory challenges further dampen the industrial market in the near term. Lastly, for CMM, we are seeing improving trends in computing and ear and IoT, while smartphone demand shows a slower return to recovery. In summary, we are now expecting 2% to 3% reduction off of last year's full-year revenue. Now let me turn the call over to John to give us some quarterly details and our guidance.

Thanks, Jeff. We reported first quarter revenues of $144 million, down 28% from the year-ago period, driven primarily by lower shipment volumes in consumer MEMS mics and MedTech and specialty audio. The precision device segment delivered revenues of $54 million, down 4% from the prior year, driven by excess channel inventory in the industrial market, partially offset by increased shipments in EV, defense, and MedTech end markets. In the MedTech and specialty audio segment, revenue was $46 million, down 24% versus the prior year, as our customers reduced inventory levels and we faced difficult year-over-year comparables as the first half of 2022 demand benefited from strong COVID recovery. Consumer MEMS mic revenue of $45 million was down 48% versus the prior year, driven by weak global demand for consumer electronics, and channel inventory adjustments across all end markets. First quarter gross margins were 37.7%, 270 basis points above the high end of our guidance range and down 390 basis points from the same period a year ago. Precision Devices segment gross margins were 46.9%, up 130 basis points from the prior year due to factory productivity gains and lower raw material costs. MedTech and specialty audio segment gross margins were 43.5%, down 680 basis points versus the prior year, driven primarily by lower factory capacity utilization, partially offset by foreign currency benefits. Consumer MEMS microphone gross margins for the first quarter was 21.7%, down more than 11 percentage points versus the prior year, driven by significantly lower factory capacity utilization, pricing pressure in the mobile market an unfavorable mix, partially offset by benefits of the restructuring actions announced in August of 2022. R&D expense in the quarter was $17 million, down $3 million from the prior year, with the reduction driven entirely by the benefits of the restructuring actions taken in the consumer MEMS microphone segments. SG&A expenses were $27 million, $2 million higher than prior year levels, driven primarily by higher incentive compensation costs, partially offset by restructuring actions in the consumer MEMS microphone segment. For the quarter, adjusted EBIT margin was 5.6%, near the high end of the guidance range. EPFs was $0.05 in the quarter, above the midpoint of our guidance range. Now I'll turn to our balance sheet and cash flow. Cash and cash equivalents totaled $52 million at the end of the quarter. We generated cash from operations of $22 million above the midpoint of our guidance range driven by lower net working capital. Capital spending was $4 million in the quarter, and we repurchased approximately 430,000 shares at a total cost of $7.5 million. We ended the quarter with cash net of outstanding borrowings of $7 million. Moving to guidance for the second quarter. We expect total company revenue to be between 165 and 180 million, up 20% sequentially and down 8% versus the same period a year ago. We estimate gross margins for the second quarter to be approximately 39% to 41%, down 150 basis points from the year-ago period, but improving 230 basis points sequentially. R&D expenses expected to be between 15 and 17 million, down $2 million from prior year levels driven primarily by prior year restructuring actions in the consumer MEMS mic segment. We're projecting selling and administrative expense to be between $26 and $28 million, up $3 million from the year-ago period driven primarily by higher incentive compensation costs partially offset by restructuring actions in the consumer MEMS microphone segment. We're projecting adjusted EBIT margin for the quarter to be in the range of 14 to 16% and expect EPS to be within a range of 20 to 24 cents per share. This assumes weighted average shares outstanding during the quarter of 95.1 million on a fully diluted basis. We're forecasting an effective tax rate of 17 to 19% for both the quarter and full year 2023. which reflects a change in jurisdictional income and the potential impact of the unmet conditions for our tax holiday in Malaysia. For the quarter, we expect cash from operations to range from $5 million to negative $5 million. Capital spending is expected to be approximately $5 million. We'll now turn the call back over to the operator for the question and answers portion of our call. Operator?

Absolutely. We will now begin the Q&A session. If you'd like to ask a question, please press star followed by one on your touchstone keypad. If for any reason you would like to remove that question, please press star followed by two. Again, to ask a question, press star one. As a reminder, if you are using a speakerphone, please remember to pick up your handset before asking your question. We will pause here briefly to allow questions to generate in queue.

The first question is from the line of Bob Labic with CJS Securities.

You may proceed.

Thanks. Good afternoon. Thanks for taking our questions.

Hey, Bob. Hey, Bob.

Hi. So I wanted to start, obviously, you guys are operating, I think, very well in a, you know, a difficult and volatile market. And so I wanted to kind of take a step back and just get like a big picture, you know, view. And You've given medium-term targets previously of, I think it's 43% gross margin and the 22% to 24% adjusted EBIT margin. And a lot of the growth to getting there was mixed shift to higher margin business plus utilization and then the recovery in CMM. So maybe give us a sense of what the hurdles are, where we are in that timeline, and where you stand, I guess, on CMM. You've done the restructuring, is there more to come or is it now just utilization to catch up? And, you know, kind of level set us back to the medium-term targets and where we stand given all of the volatility in the market.

Yeah. Bob, that's a good question. So, you know, let me just take a step back, like you said, and kind of give you on the bigger kind of picture here. But, you know, I kind of what we sit there and say is I think we're making great progress on mix. I think I'll take you back to some of our three key markets that we talk a lot about is MedTech, which includes MSA in the decks that we put together for investors, and then defense and EV. If you go back, as I kind of said, in 2018, that was about 32% of our total company revenue. Last year, it was 47%. I would say it would probably be over 55% of our business now is in between MedTech, EV, and defense. So we're making good progress there. Those businesses continue to perform extremely well for us. And I highlight first, even in the short term, our MSA business, which is the hearing health business, it's recovering faster than we had expected a quarter ago. And it continues to demonstrate the resilience of the MedTech markets. in the face of some of the macro conditions that we have. So we're very pleased about that. Second, you know, I would sit there and say on PD just a little bit more, you know, we are expecting to have extremely strong bookings, which possibly could be record bookings in Q2 based on our forecast this year, driven by, again, defense, med tech, and EV. And so, you know, I think as we see how we're investing, you know, whatever it be, our R&D dollars, our CapEx, This is kind of playing exactly the place we want to go. Now, if you go to the CMM business, as I kind of said in the prepared remarks, we are starting to see recovery in the non-mobile portions of the market. I would say that my recent discussions on Taiwan, which is primarily laptop, is that this is coming up a little faster than we probably expected a quarter ago. But I will sit there and say that the mobile portion of this business We are not really seeing a lot of improvement here. And we're still hopeful with seasonality that we're going to see a strong uplift in the back half on capacity utilization. So if you take this overall, I don't think we're backing off our midterm targets that we've talked about at all. In fact, I would sit there and say if the rest of the year kind of plays out the way we're expecting, which I'll just say that about 2% to 3% down is what I kind of said in the prepared remarks, we'll be exiting the year probably at like the gross margins that we're expecting, around 43%. And so I think obviously we've got to do that for a full year, but you can see the power that we're getting to with mixed capacity utilization to get to that 43% plus. I would just caution, I think Q3 and Q2 are still going to be a little volatile here, We are expecting sequential growth in Q3 again. Right now I projected about 8% to 10% sequential growth off of the Q2 finish is where I'd see. But overall, I don't think we're changing any of what we're talking about for the midterm.

Okay, super. Thank you for all that color. And then just kind of, I guess, shifting over to your balance sheet, obviously you've done a fantastic job. You've paid down. You have your net cash position now. It's an enviable balance sheet given the market. Can you discuss the M&A opportunities out there in your pipeline? You've done some restructuring. Is it still an area of focus right now, or are you more focused internally? How should we think about M&A opportunities for you?

Here's what I'd say. I would agree with you. We are very happy with our balance sheet right now. And we've been very disciplined about what we've been doing with the cash that we've been generating. We've been buying back a fair amount of shares over the last couple years. And I think we'll continue to buy back shares. But we are still interested in M&A, and I would say specifically in the PD space. And I think over the last couple years, up until maybe six months ago, some of the valuations were getting kind of a little crazy. And we kind of just backed away from that and said we'd rather keep that strong balance sheet And I think we're going to benefit from that, you know, whether it be this year or next, through some of the M&A opportunities that we have. So I would sit there and say that, you know, it's likely we're going to do some M&A over the next 18 months or so, you know, and hopefully, you know, at prices that are, you know, a little bit more reasonable than say they were a year ago.

Okay, super. I'll jump back in queue. Thank you.

Thanks, Bob.

Thank you. The next question is from the line of Christopher Rowland with Susquehanna. You may proceed.

Hey, guys. Thanks for my question. You guys touched kind of on the inventory dynamic. I was wondering if you could go maybe a little bit deeper there. I think you even might have hinted towards an inventory replenishment even. I wasn't sure on that. And maybe you could break this up kind of by end markets if they stick out, if the inventory dynamic sticks out. Thank you.

Yeah. Here's what I'd say is, you know, I think, you know, we kind of talked on the last call about, you know, that inventory for us would not be a headwind this year. We didn't see necessarily our inventory going down for the full year, but it wouldn't be a headwind again like it was last year. But I think if you're referring maybe to the inventory in the channel, and I would sit there and say is most of our end markets, I would say, are in pretty decent shape right now. And so let me start with a few of them. I would sit there and say, you know, after a year of a lot of challenges, the compute market is doing much better in terms of the channel inventory than it was, you know, say six months ago. So we feel pretty good about that. Our hearing health customers in MSA, you know, I visited all these customers in the last quarter. I was with a number of the CEOs of these companies, and I would sit there and say, they are optimistic about the full year for growth for that market. And, you know, I would sit there and say, we're going to obviously benefit from that. It doesn't appear that, you know, the inventory we dealt with in Q1 is going to continue the rest of the year. In the PD segment, I would sit there and say, MedTech, EV, defense, a lot of custom products that we're building. I wouldn't say our customers have a lot of inventory. I wouldn't say that's the issue. I would say it's in that industrial slash distribution segment where we still see and we're hearing there is inventory in the channel that needs to be burned down. At last quarter, I thought we would probably start to see an uptick in Q2 in that portion of the business. It hasn't materialized. It now appears that it's been pushed out a quarter that we might see the inventory run down in the industrial portion of precision devices starting to dissipate in Q3.

That's great, and I was talking about distribution, so thank you for that. You also have some kind of interesting options, I would say, for your business model around EVs, RF, whether for defense or 5G, and balance armature speakers. And I guess I would ask, you know, what are you most optimistic about? And when could these be meaningful drivers of your business?

Yeah, so, I mean, again, as I kind of stated a little earlier, you know, this is starting to become a pretty significant portion of our business. You know, I look at You know, defense, this is, you know, if I go back a few years ago, this was, you know, less than, and I know some of this is through acquisition. If I go back to the 2020 timeframe, this was like a, you know, $30, $40 million business. And through acquisitions and growth, it's going to be over $100 million. You know, again, we've grown our defense business on the back mainly of our filtering by a significant amount over the last four years. So we're still very excited about this market, Chris. We see a lot of opportunities both in terms of M&A, but also in terms of just organic growth with the product portfolio that we have. So I think we're pretty happy with that. I would say generally speaking, our MedTech business, it's not growing at breakneck pace, but I would sit there and say it is extremely stable and extremely strong gross margins, and that goes for both MSA and PV. I would sit there and say we're now looking at our MedTech business being you know, well over $250 million, right? It's a big business. Now, again, it doesn't grow at 10% per year, but it's extremely strong, a good gross margin with great cash flow. And we're going to continue to look for opportunities to continue to grow that business. And then lastly, you know, EV, like you mentioned, you know, it started from a small base, but, I mean, you know, it was up 50% in the first quarter, and bookings were extremely strong here. We're expanding our customer base. If I go back two years ago, the majority of our business came from a couple customers. Now we've got many customers, and so we're pretty confident about our position in EV, and I'll remind you, this is all on high-voltage charging systems, right? And so it's not like we're replacing commoditized low-voltage capacitors. These are extremely unique high-voltage capacitors that are being put both in cars, and we're actually seeing some design wins in business in the charging stations now as well. So I'd say those three markets are going to be our focus going forward over the next three to four years because good gross margin, generate great cash flow, and growth.

Great. Thanks so much, Jeff.

Thank you, Mr. Roland. The next question is from the line of Tristan Guerra with Baird. You may proceed.

Hi, this is Tyler for Tristan. Thanks for taking my questions. First, building off of the previous question, hey, could you provide an update on the balanced armature speaker line and then also how has the over-the-counter hearing aid market been trending?

Yeah, those are two good questions. I appreciate those questions. First, on the over-the-counter market, I would say I'm incrementally more optimistic than I was a quarter ago. I would say we've seen more orders coming in in the over-the-counter market than I would have said a quarter ago for this year. One of the reasons that the MSA business has been doing a little bit better. But I would just say they're still concerned it could be channel filling in how that's actually going to sell in the end market. So I'm still holding my breath here, but I'd say I'm incrementally more optimistic about the over-the-counter market. As far as the BA line, I think I mentioned this last quarter, we have not filled this line yet. I would say part of it is the reason is a lot of the designs that we've been working on with customers in China have been slower to come to production. Now with China reopening, we are starting to see more activity. But I think what we are surprised at and happy about is the ASPs are significantly higher than we would have expected a year and a half ago. to the tune of 30%, 40% higher than we were expecting. So the revenue coming off this line is approaching what we would have expected a year and a half ago at the lower ASPs. I think there's three ways that we're going to fill this line, which is probably a little different than we would have talked about two years ago. You know, this high definition audio, which is expanding the range of what you can listen to in a high frequency band where you can only use a BA really to get that really great high definition at high frequency. Number two, we are starting to see some of these over-the-counter hearing aid customers use our balanced armature line. And third, even some of our traditional hearing aid manufacturers are starting to use this as well. So we're very confident of filling this line and then hopefully buying another line. I would say the other thing, which has benefited the hearing aid business, which you can kind of see in the MSA margins, which is a lot of the learnings that we got off the automated line have and are being applied to our manual lines, which is helping our gross margin in that business as well.

Great. Yeah, that's really helpful. And then just for my follow-up, can you just provide an outlook on what you're seeing in China in the smartphone market and then if there's anything you, any signs you're seeing for a second half recovery there?

You know, I think there's going to be some recovery in China. The mobile market in the back half, I just don't know the size of it. But I would just sit there and say is it's not – great right now, the mobile market overall. I would say that's not just China. I would say that's the overall mobile market. I think it's a tough market. A lot of people, our customers don't make money in this market, coupled with there's very little growth. We still see this as a challenge, and I think it just continues to confirm what we've been talking about for two plus years about our desire and our efforts to diversify away from mobile over the long term. I think we've talked about this in the past in terms of mobile. I think last year mobile was about 16% of our total company revenue. I would say this year we're probably looking at less than 15% this year. We continue to execute on that strategy of diversifying away. And as our other markets recover, ear, IoT, compute in the MEMS microphone business, I think, you know, hopefully we'll be able to even reduce mobile to make even smaller percentage of the total business.

Great. Thanks again for taking the questions.

Thanks, Todd.

Thank you. The next question is from the line of Anthony Stoss with Craig Hallam. You may proceed.

Hey, Jeff and John. I'm curious if you've made any down shifts to your CapEx plans for the second half of the year. And maybe, John, you can comment about your expected free cash flow in 2023 over 2022. Then I had a couple of follow-ups.

Yeah, sure, Tony. In terms of CapEx, you know, I'd say two things. One, there's a shift. More of our CapEx will be tilted toward the MSA segment and the PD segment. Overall spend, it's coming down a bit. We're kind of in the 4% of revenue range is what I would say for 23. If you think back a few years, we were higher. We were kind of in the 5% to 7% of revenue. And again, it's less capital that we're putting into the CMM segment. In terms of free cash flow, I think It's important. We had a decent free cash flow above our guidance in Q1. Q2 is a bit more muted, but I think you really have to look at cash flow over a longer period than a quarter because it can really be influenced by timing, customer collections, payments at the end of the quarter. But for full year 23, you know, we feel really good of free cash flow. I feel really good about free cash flow generation of 15% or more revenues in 2023.

Thank you. Jeff, clearly you've upticked quite a bit your excitement related to the EV side of the business. I know it's got great gross margins. I'm curious if you want to share how big that business is or how big do you think it can become over the next several years for Knowles?

Yeah, I think this year will probably be roughly about 3% of our company revenue this year, probably around $20 million, somewhere in that range. you know, probably, you know, up probably 30 to 40% over last year. And I think what I guess what I would say my caution is with this business is we've got a lot of design wins, but the content level with each customer is different. And we have some platforms where we have $20 worth of content per car, other platforms where it's more like, you know, five. And I guess what's hard for me to kind of gauge at this point is, you know, in five years, three years, who are going to be the big winners and losers, you know, in the end market, in the EB market. And so to that extent, I guess I would sit there and say, you know, I would be disappointed if in a couple years this business is, you know, $40 million to $50 million. But on the other side, you know, with some of the winners, you know, it could be $60 million, $70 million, you know, in two to three years. So I think it's a little early to call how big this is going to be, but I think what we like about this business is the macro of this market is it's going to grow. The question is how fast is it going to grow and what our content per vehicle is going to be.

Got it. And the last question for John, I think I heard this correctly. You expect total revenues to be down 2% to 3% year-over-year. Can you maybe help us understand, you know, Sometimes Q4, the December quarter, is up. Sometimes it's down. What do you think Q4 shakes out versus Q3?

Well, let me just take that, Tony. So, you know, again, I kind of mentioned it. I would sit there and say right now we see kind of Q4 being the peak this year. And it varies from year to year. But I think what we kind of would add just the normal, the variance from year to year, but we'd also add the, what do you call it, the recovery period. you know, that we are seeing, you know, and how it's happening. You know, as I said, you know, last quarter we gave some, I would say, some soft guidance on the sequential improvement we were going to see in Q2, which, you know, we're right on kind of what we said we were going to do. Actually, on the high end of what we said, we took 15 to 20 levels to 29. Correct, correct. And I would just say right now we see Q3 being up 8% to 10% sequentially from Q2. And then, you know, I think with seasonality and further recovery, you know, we see Q4 will be the peak. Got it. All right.

Thanks, guys. Appreciate it.

Thanks, Tony. Thanks, Tony.

Thank you. There are no further questions in queue, so as a final reminder, if you would like to ask a question on today's call, please dial star 1.

There are no further questions in queue. With that, we will conclude today's NOLS earning conference call.

Thanks for your participation. Please enjoy the rest of your day.