Good afternoon and welcome to the Knowles Corporation Fourth Quarter and Full Year 2019 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.

Thanks, Christine and welcome to our 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, 2018, 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 references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. Also, we have made selected financial information available in 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?

Thanks Mike, and thanks to all of you for joining us today. For the quarter, we reported revenue of $234 million within our guidance range, and up 5% from the year ago period as strong sales into the Ear and IoT markets were offset by continued soft trends in mobile. Precision device sales were up double digits year-over-year. However, unanticipated operational challenges in this segment pressured gross margins resulting in EPS of $0.35 that was below our guidance range. John will cover this in greater detail in a moment, but we anticipate total company gross margin improvement in 2020. In our audio segment, Q4 revenue was up 3% from the year-ago period driven by strong sales of microphones and increasing shipments of balanced armature speakers into the ear and IoT markets, partially offset by softer demand for high-end handsets. In the precision device segment, sales were up 13% from the year ago period as continued demand for our differentiated products across multiple end markets and a tuck-in acquisition was partially offset by timing of shipments for mmWave filters and weakness in industrial demand for our capacitors. We ended 2019 with total company revenue up 3% and earnings up 6% during the year characterized by particularly weak demand for handsets, which highlights the benefit of our strategy to deliver high value differentiated solutions to a diverse set of growing end markets. Q4 sales in audio demonstrates the benefits of our diversified portfolio of solutions for the mobile, ear, and IoT markets. In mobile, worldwide shipments of smartphones continued to serve as a headwind for our audio business with particular weakness in the premium portion of the Android ecosystem. Despite lower handset sales worldwide, revenue from our largest customer grew double-digits year-over-year driven by this OEM’s non-mobile platforms. Sales to Chinese OEMs…

Thanks, Jeff. We reported fourth quarter revenues of $234 million, up 5% from the year ago period driven by increased shipments in both the audio and precision device segments. Audio revenues of $190 million were up 3% from the year ago period with shipments of MEMS microphones and balanced armature speakers into the ear and IoT markets up more than 60% from the same period a year ago. The strong growth in ear and IoT was partially offset by weaker demand for MEMS microphones and Intelligent Audio solutions for the premium smartphone market. Hearing health sales were flat with the year ago period. The precision device segment delivered revenues of $44 million, up 13% from the year ago period, which was the result of 6% organic growth driven by continued solid demand across multiple end markets and an acquisition completed early in the first quarter of 2019. Fourth quarter gross profit margins were 38.9%, below our guidance range and down 370 basis points from the year ago period. Precision device segment gross margins were well below our expectations entering the quarter. Operational challenges negatively affecting gross margins include unfavorable product mix, lower factory output resulting in reduced fixed overhead absorption and an adjustment to inventory. In the audio segment, gross margins also finished unfavorable to expectations due to higher MEMS microphone sales of mature products into mid and low-end handsets and lower intelligent audio shipments. Operating expenses in the quarter were just under $51 million, down 4% from the year ago period and largely in line with our guidance. The expense reductions were driven by lower R&D spending within the audio segment and a decrease in total company incentive compensation costs. For the quarter, adjusted EBIT margin was 17% below our guidance range and down 200 basis points from the…

Thanks, John. We ended 2019 with total company revenue up 3% and earnings up 6% during the year characterized by particularly weak demand for handsets. Our 2019 results reaffirmed that our strategy to invest in high-value differentiated solutions and diversify our end markets is delivering shareholder value. I am pleased with the progress we have made to increase our exposure to growth markets. Revenues from non-mobile markets represented over 70% of our total company sales in 2019 growing at greater than 10% from the prior year with above corporate average gross margin. In addition, we delivered record free cash flow, representing nearly 10% of total company sales. As we enter 2020, our company remains uniquely positioned across the markets we serve. We expect sales growth to be driven by the ear, defense, electric vehicle and 5G handset markets. I am confident we can continue to deliver shareholder value by driving revenue growth with strong operating leverage and cash flow for full year 2020 and beyond. Operator, we can now take questions.

Thank you. [Operator instructions] Your first question comes from the line of Suji Desilva from ROTH Capital. Your line is open.

Hi, Jeff. Hi, John. And talking about the 2020 guidance you have laid out the first quarter with conservatism, I am curious how much of the quarantine effect and the shutting down of the factory, and if you could quantify the impact in the first quarter? And then would that effect carry-forward into the second quarter or is it too early to call that as you talk about the full year? And with second half ‘20 with all of the tailwinds be up year-over-year, just to get some idea of how you are seeing this year shape out versus the prior year? Thanks.

Yes, yes, okay. Suji, so first let me just start with the premise that even before the coronavirus started, our China business has been weak. I think we talked about that last quarter. It is still weak. Our business with our largest customer still remains very strong in Q1. And I think, what I guess would say is I wouldn’t put an exact number on how much of our guide in Q1 is related to the coronavirus. But needless to say, I think I will start with the fact that it primarily affects our microphone business on the production side, which we are going to be shut down longer than we expected. And part of the high-performance capacitor business, specifically more I would say the generic, more industrial-type products. So, we are still planning to reopen again next Monday and start producing again out of these facilities. I think it’s hard to get a read on what the demand looks like, and my anticipation and I can only take history, Suji is that there is always this risk on timing. If you think back to like – things like the SARS virus in 2002, 2003, demand came back very strong, but the question is when it comes back. And so, I think it’s more about timing, and I would hope that the demand would come back once this is all resolved in China.

Okay, that’s fair enough. I mean there are a lot of unknowns here obviously. And then maybe just as you made comments on the second half, I would ask specifically about balanced armature and then mmWave into 5G. What kind of visibility do you have into design wins? Have you already secured those or are those coming in the first half of this year, and how confident are you in the tailwind for the second half for those two segments?

So for mmWave 5G specifically, I would say that we don’t see that this being a big growth driver in 2020, and we still view this as a long-term opportunity. But in our RF filter business, we still expect strong growth this year. I think last year, in 2019, we had over $30 million in sales. I would project that will be well over $40 million in sales primarily on the basis of defense and aerospace with a little bit of 5G mmWave. But I would say, we still view the mmWave 5G base station as a longer-term opportunity. So, we still expect strong growth on mmWave, primarily driven by defense. If you look to the balanced armature, I would say that right now, as I view the roll-up in terms of what we see, I would say we have a very good opportunity to fill that automated line in the back half of the year. In other words, as we’re starting to talk to customers, there’s definitely the demand out there, and we will be sampling off that line in Q2, that for stuff that will start production in Q3, right? So, Q2 -- we will be sampling in Q2 and for production in Q3. In the meantime, we’re going to continue to work to try to service a lot of these customers with our manual product category, balanced armature. So, I would say that the automation line is on target. We’re going to have that in-house in Q2 bringing it up in Q2 kind of like we’ve all talked about all along, and then the design pipeline is full.

Last quick question on the ams acquisition, you talked about having product opportunities from the ASIC being in-house. Can you differentiate those from what you have already done with things like IA to understand kind of the thumbnail of what the product opportunity can be another different? Thanks.

Sure. So, the IA is specifically focused on digital signal processors and the algorithms that would go with it. What the ams acquisition brings along with our own design team that we had already is the ASIC that goes in the standard analog and digital mics. And so, I guess what I would say is, there had been some duplication of efforts between what ams was doing and what we were doing internally, although we primarily were doing digital and ams was primarily doing the analog mics. I think what we see and having owned this now probably about a month or so is that we get to choose the best of both worlds. And if we think about what we’re focused on, we’re focused on high signal to noise ratio, analog and digital mics, and extremely low power analog and digital mics. And each one of these design centers have certain levels of expertise, and we won’t be having to duplicate a lot of this. So, first we’re going to get some benefit, obviously from buying the wafers directly from the foundry partners. But secondly, we are going to become more efficient in not having to duplicate efforts, both internally and externally.

Helpful clarifications. Thanks, Jeff.

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

Hey, guys. Thanks for the question. Just trying to understand the guide for Q1 particularly around audio, I mean it’s pretty well-known that your largest customer numbers are coming in from some other guys, and Q1 looks okay, better than this guidance would imply. China has probably been bad for some while now. So maybe I don’t understand why it’s coming in, in Q1 so hard? And maybe you guys can add any other details. I mean IA wasn’t particularly big to begin with. So, I don’t think it would be responsible for this as well. Are there any share shifts or anything else we should be thinking about? Thanks.

Yes, Chris. So I would start with the premise that before the coronavirus started, China was already down pretty significantly in our forecast for Q1 year over year. We do agree with you on the demand, the largest customer and we do expect our sales to be up pretty nicely in Q1. But China is down. And if I think about how we look at this going forward relative to the coronavirus concerns, the largest customer, majority of their business is not inside China. So we expect that the demand, as much as they can build, we’ll be able to supply. But the other – the Chinese customers, the typical names you hear, the Oppos, Vivos, those type of guys, we’re not really clear yet on what the demand is going to be like, and they’re primarily providing into the Chinese economy. And so I would say that China was weak to begin with, and this adds another layer, and again, you mentioned it, it’s not huge, but intelligent audio was down year over year.

Okay. And then on the precision devices side of things, I think op margin was a little bit under 19% soft quite a bit from where it’s been. It seems like we’re kind of on an up cycle here for a lot of components, including the regular capacitor market. Maybe talk about what’s going on there? Is it a pricing thing, how should we think about that? I know there’s palladium involved but outside of that, why our revenue is down and then why are margins compressing? Thanks.

Yes. So if I’m looking at the – at our numbers for PD. So our business is going to be up year over year in Q1. So the revenue is going to be up. Probably, I would say there’s a little bit of that industrial portion of the business that comes out of our China facility. There is some concerns there. But the revenue is up in both high-performance capacitors and mmWave RF solutions. So I mean I would say that some of the key designs that we see that are going to production and some of the things are really going to start showing up more in Q2. And I would expect that there will be a stronger growth in Q2 than Q1.

Okay. Thanks guys.

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

Good afternoon. Just going back to the guide, obviously, I was wondering if you could remind us how big is China as a percent of total overall sales in audio, maybe annually and maybe seasonally, just to get a sense of that kind of change there? And has there been share or price changes or again, just trying to get a sense of the underlying market and what’s changing and driving the expected declines?

Yes. So I would start with last year, China was about 14% of revenue. And as I look right now to Q1 and this is again, the forecast we had before the coronavirus. Our China business is probably looking at these numbers, just to be sure I got them correct here.

Less than 10.

Less than 10 in Q1. So, it is down pretty significantly. I would just say that the only customer, which was not a huge customer, but I would say there has been some share losses, Huawei. We are qualified there, and we do have licenses to sell into Huawei. But I would say that there has been a little bit of push to source more from non-U.S. suppliers. But other than that account, I would sit there and say there has not been share losses. I would say it’s weakness in the higher end portion of the market, and specifically in handsets. And I think what that leads to is that a lot of the Chinese OEMs are selling more mid-range and low end phones, which typically use less mics and they also use, I would call, mature mics that have been around for a while. So there is a number of headwinds right now in China from demand to what phones that they’re buying. There has been some share loss at Huawei. But I wouldn’t say that’s the primary driver. That’s one of the drivers. I would say it’s more that the move toward phones that use lesser mics and use more mature products.

Got it. Great. And then just a follow-up, in addition to expected growth in BA in the back half of the year, what are the necessary kind of drivers that you need to see to get audio back to growth?

Yes, yes. So that is a good question. I would say that there’s probably three things, right? We’ve got to continue to grow our ear and IoT business within the microphone business. You mentioned the BA and while – and we have not talked – touched on this yet, we have reduced the amount of spend we have on intelligent audio. But the – we are expecting that, hopefully, that sales will be up year over year in the back half of the year. And so we will obviously be monitoring that very closely, but those are the three things that get us back to growth. And then, of course, I mentioned 5G phones. There is expectation that 5G phones will help the mobile portion of our microphone business.

Got it. Okay, thank you very much.

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

Yes. Hi and thanks for taking the question. Maybe sticking on intelligent audio, you obviously had some good design wins last year and a few of the Chinese makers and also as Google. Do you have visibility to at least see that this repeats in 5G? You mentioned that 5G can lead to some more content I think, specifically, in regards to the mics, digital versus analog but do you see any sort of IA content in addition to the conventional mic content uplift as we look a little later in the year?

Well, I don’t – in IA, I don’t necessarily see 5G driving additional content. We continue to pursue the customers in the mobile arena but I guess, what I would say is increasingly, Bill, we are seeing a much fuller pipeline on the IoT side. And that the mobile market is something we are going to continue to pursue more opportunistically. So I think that is what I would say relative to that. As far as the mic business, I think it’s – we’re in kind of the design phase right now, and we’re hopeful that there is a, I would say, a resurgence of the high end handsets in China due to 5G, that would – if you think of some of the customers that we have, a lot of them did not even introduce like premium handsets in 2019 at all. And so we are hopeful that as the 5G comes out, that’s a premium handset, and that we are getting a lot of requests to look at higher performance mics to look at more microphones, to add more features to those higher-end phones that are 5G.

Okay, thanks for that. And I guess, the second question is mmWave filters I guess, at the Investor Day, most of the growth is going to be in the wireless infrastructure, and now it’s clearly you’re kind of calling for defense that’s going to be driving this growth. Is this a matter that these type of filters are not being acquired for mmWave or you’re not seeing the investments made by the carriers, I guess, particularly in the U.S. in mmWave or is there some competitive things going on that it’s just not going to be in your business just curious on why it is not so much contributing this year?

Yes. So I think first of all, that we are not seeing, I would say, the rollout that we expected in 5G. But I would also say is that the farther it gets out, I think there may be the risk that there is some more competition coming in the space, maybe not of a different technology. I don’t think we say – we see that for sure today, but I think there’s some risk to that. But we still see it as a great opportunity. But I would also say that defense is better than we expected. We continue to see extremely strong demand from – on the defense side. And that again, I think we will be well over $40 million from less in 2018.

Okay. Thanks.

Your next question comes from the line of Anthony Stoss from Craig-Hallum. Your line is open.

Hey guys. So Jeff, on the VA automation side, I know your comments were that you’re on track. Can you confirm at this point, you have got enough confidence in it that you are already out quoting lower ASPs for your potential customers to try to enter into design conversations already? And then secondly, you mentioned $15 million in shift in OpEx out of Intelligent Audio, why shift and why not just cut and then maybe John would have how much is left being spent within Intelligent Audio? Then I had one last follow-up after those.

Yes. So your first question around VA automation. I would say that we’re definitely starting to price forward based on the automation, but saying that until we are shipping off the automation that is what is going to be difficult to support that price. So we are definitely at that point now. We are in the middle of Q1, right. And we expect to start handing samples out in Q2, design wins in Q2, with production starting in Q3. So I think we’re on a good path there. And so I think I feel comfortable right now that we can fill that line in the back half of the year. I think the next decision point for us Tony, is when do we – when and if do we pull a trigger on the second line. I don’t have an answer on that yet, but I think that’s going to be the next question. As far as the OpEx in IA, I respect the comment. We will spend well less than $20 million in R&D on IA in 2020. And so if you remember a few quarters ago, we were talking about numbers in the $35 million range. So, we did make cuts in 2019 and we did another cut at the beginning of 2020, which we are talking about right now. And I think as I see and John can cover kind of the bridge in a second, but the way I see it is, there are some other areas that we want to invest, right and invest more. And so I think this is a normal process that we go through on a regular basis of looking at where we are investing our dollars and that we expect that R&D is going to stay in that 10% to 11% range, right. And that question is what do we spend that 10% to 11% on?

And just to bridge, Tony, for you, I mean, Jeff mentioned in the script that we are going to cut overall spending in IA, a little more than $15 million year-over-year, but there is a couple of adds coming in, in 2020, first of all, the ams acquisition. While it’s accretive by more than $0.05, we have significant improvement call it 200 basis points in the microphone – MEMS microphone gross margins, but we are taking on about $4 million of R&D expenses. So net accretion, we are very confident at more than 5% in 2020 – or $0.05 in 2020. So add $4 million of OpEx for – little more than $4 million of OpEx for the ams acquisition. On top of that, I mentioned significant uptick in legal spending in the first half of the year. It’s about $3 million in Q1. I am not going to tell you what the spend will be in Q2, but it could be at similar levels. And then we expect it to go down significantly in the back half, but think of it as $4 million to $6 million incremental legal spending in 2020 versus 2019. And then the last is incentive comp cost, we plan those at the target level. And so there is an increase about $3 million or $4 million versus what we are projecting to pay out in 2019, so overall incentives are relatively flat.

And one more piece I would add that to John is that our R&D spending in PD is going up as well. I mean, it’s still relatively low as a percentage of the total sales, but it’s going to be up a couple of million dollars year-over-year from ‘19 to ‘20.

And as a follow-up, Jeff, how many BA units can one line produce in any given year, what are the lead times like on the equipment, let’s say, you start sampling in Q2 and you realize you are going to need a second line, could you get enough coming in to have a second line up by late Q2?

Yes, I am not going to comment on the lead time. I think there is some competitive information there that I wouldn’t want to provide at this moment, but what I would comment is this first line depending on yields somewhere around 1 million units a month. That’s what our projection is right now that it should be able to build, but it will be yield dependent, especially at the front end of this, Tony. Because I anticipate – we have that factored into our – and what we are thinking is that the yields will be lower at the beginning.

Okay. And then my last question for, John, on the PD poor gross margins, how many quarters do you think it will take to bounce back either to clear out inventory or to fix utilization?

Yes. No, it’s a good question. And let me just start and give a little more granularity on the miss for Q4. I mean, our gross margins came in at, as I mentioned 38.9% versus the guidance range. The midpoint of the guidance range was 41%. The miss was really primarily driven by the PD segment, where gross margins were almost 600 basis points below what we expected going into the quarter. And the shortfall was really driven by a few things. First of all, labor inefficiencies and unfavorable fixed overhead absorption, I think we talked about it before. Within our thin film business, we made major investments and kind of changed the process flow in that business pretty significantly in the second and third quarter of ‘19. And so we still aren’t getting back to the yields and the efficiencies we expect, but we do think significant improvements have been made already and will be made as we exit Q1. The one headwind we still have though is palladium. The palladium costs are significant, up almost double Q1-over-Q1, so Q1 ‘20 versus Q1 ‘19. We are starting a pretty aggressive action plan to go after whether its surcharges with our customers, look at substituting products. So, we are expecting a pretty significant sequential improvement beginning in Q2. So, long answer to get to your original question when will we see the improvement? But we are pretty confident at seeing some improvement in PD margins beginning in Q2 of this year.

Thanks guys.

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

Hi, good afternoon. Just back on the Q1 revenue guidance, you said it was conservative to account for the manufacturing disruptions in China. Could you give us a sense of where your revenue guidance will be without those disruptions?

Yes. Chris, I knew we are going to get this question. I wouldn’t say that it was like exactly. I would just say we built in a little bit more cushion than we normally would, because I mean there is a lot – normally, I just would say – normally when we get on this call for Q1, we already have I would say a little bit of unsurety about what post Chinese New Year is going to be. This has added a whole another level up to what’s going to happen. As I said earlier, I think our largest customer, because majority of their sales are not in China, I think their demand will come back very strong once this is resolved. But on the reverse side is what I am more concerned about is we have a fair amount of customers we sell to that sells into the Chinese market, right and it’s primarily Chinese consumer demand. It’s really hard for us to predict. So I am not going to give an exact number here, but we definitely build more conservatism into the forecast.

Okay. And then could you remind us the dollar content opportunity you have for capacitors in EVs?

EVs, I don’t know if I have that in front of me. We could take that offline, but I mean we will see this in the dollar content per car. So I am not sure I have that right in front of me. Maybe we could take that offline, but – because I don’t have the exact number, but it’s not insignificant. We are not talking about here like $0.50 or $1. If it recollects me, there could be $10 to $15 per car of content, but don’t hold me that, maybe we could take that offline, I could cover that a little bit more if that’s okay, Tristan.

Okay. No, that’s very useful. Thank you.

Your next question comes from the line of Charlie Anderson from Dougherty & Company. Your line is open.

Yes, thanks for taking my questions. I think we sort of heard the big picture view on the full year as it relates to revenue and EPS and OpEx. But on gross margin, I think you guys mentioned sort of a recovery here and then there is the ams acquisition. So I just wonder, maybe a big picture if you had any views on gross margin for the year and then the cadence of getting to that 42 plus that you outlined at the end whatnot? And I’ve got a follow-up.

Yes, Charlie. In my script, I mentioned improving gross margins. We finished 2019 at about 38.9%. I mentioned we are confident that we can exceed 40% for full year 2020. And that’s really driven by again addressing the operational issues within PD, aggressively pursuing surcharge and recovery of palladium and then it’s really scaling up the thin film business. Jeff mentioned it’s going from $30 million to $40 million. We don’t have to add anymore overhead to do that. So you get really good drop-through on that business. And similarly with the BA business as that kind of scales up, that should improve profitability and gross margins in the back half of the year.

And again, Charlie, what I would say is relative to achieving the 42, I mean I would sit there and say that it does come down to new products, right. I mean our new products, whether it be Intelligent Audio, thin film, mics for the ear and IoT, balanced armature in EV, we expect the gross margins to be above the corporate average. And the success of those will dictate how fast we can get to the $42 million. What I would make the comment more on the short-term is a lot of the shortfall in PD was not – it’s not in the gross margin of high-performance capacitors, it’s primarily in thin film, right, with the changes that we have made to the manufacturing process. We still have expectations that the thin film business will be above the corporate average, but it’s below the corporate average right now in Q4 and in Q1. And so as we grow that business, we solved some of the issues that we had operationally in Q4 that we will see that, that gross margin will improve to be above corporate average.

Okay, great. And then for my follow-up, you are spending significantly less than you were a year ago on IA. So I wonder in terms of – what does that mean in terms of the product portfolio there, what portions of the portfolio do you have sort of less emphasis on now going forward? Thanks so much.

Yes, here is I would say. I would say we are definitely not jeopardizing the long-term of our thought process where we want to go. What we have focused on is reducing the new products that we come out with that are – we are going to have impact in 2020, realign the team for 2021 and beyond in terms of R&D. The second thing is I think we have a fair amount of people who are working on the opportunity today. I think we just right-sized that size. That’s more on the like, I would say, the algos, the firmware, we have right-sized that to be more aligned with the size and the number of opportunities we have today. So short-term, I don’t think it has like a big impact on our expectations for what we are hoping for in terms of what products we were going to do. Longer term, we are not jeopardizing that, but we are setup to handle the customers that we see are very interested in our product today.

Great. Thank you so much.

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

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 goodbye.

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