Knowles Corporation — Q2 2016 Form 10-Q
Reporting period: Three and six months ended June 30, 2016. Knowles supplies micro-acoustic, audio-processing and specialty components through its Mobile Consumer Electronics (MCE) and Specialty Components (SC) segments. Figures below are in U.S. dollars; financial statements are unaudited.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue from continuing operations | $190.3 million | $192.8 million | $375.6 million | $379.4 million |
| Gross profit / margin | $72.9 million / 38.3% | $71.4 million / 37.0% | $139.7 million / 37.2% | $133.9 million / 35.3% |
| Operating income (loss) | $(1.8) million | $16.3 million | $(7.7) million | $26.6 million |
| Continuing-operations income (loss) | $(6.8) million | $13.3 million | $(19.3) million | $18.3 million |
| Net income (loss), including discontinued operations | $(24.6) million | $(16.1) million | $(54.0) million | $(31.9) million |
| Diluted continuing-operations EPS | $(0.08) | $0.16 | $(0.22) | $0.22 |
Q2 adjusted EBIT was $15.4 million (8.1% margin), versus $31.2 million (16.2%) a year earlier; six-month adjusted EBIT was $26.1 million (6.9%), versus $54.5 million (14.4%). Management’s non-GAAP net earnings were $11.7 million for Q2 and $19.2 million for the half year; non-GAAP diluted EPS was $0.13 and $0.21, respectively. These measures exclude specified costs and other adjustments and are not GAAP results.
Q2 revenue fell 1.3% year over year. MCE revenue declined 2.4% to $82.2 million, while SC declined 0.5% to $108.1 million. For the first half, MCE revenue was $165.5 million and SC was $210.1 million. MCE’s six-month segment result before interest and taxes swung to a $14.5 million loss from $23.9 million of earnings; SC earnings increased to $33.6 million from $29.0 million.
Cash flow, balance sheet and debt
- Six-month operating cash flow was $10.2 million, down from $24.3 million. Investing used $17.5 million (versus $39.7 million); financing used $8.6 million (versus $2.5 million). Cash decreased $16.1 million to $47.2 million at June 30, 2016.
- Capital expenditures were $20.2 million in the first half. Management expected 2016 capital expenditures of 5%–6% of revenue.
- Current assets were $324.0 million and current liabilities $139.8 million. Inventory rose to $139.0 million from $118.4 million at year-end; cash fell from $63.3 million.
- Debt carrying value was $394.8 million, including $131.8 million for the new convertible notes and $263.0 million under the term loan and revolving facility. Long-term debt was $392.2 million. Cash held outside the U.S. was $43.2 million.
- In May, Knowles issued $172.5 million of 3.25% convertible senior notes due 2021. It used note hedges costing $44.5 million and sold warrants for $39.1 million; the hedges are intended to offset conversion dilution, while the warrants may dilute shares above their $21.105 strike price. The notes’ initial conversion price is $18.425.
- Knowles paid down $166.5 million of term-loan principal during the half. It reported compliance with debt covenants at June 30 and expected to remain compliant over the following 12 months. Management said operating cash flow and access to capital were expected to cover needs for at least 12 months.
Changes, outlook and risks
- Gross margin improved year over year, supported by productivity, manufacturing-transfer savings, foreign exchange and product mix/cost factors. However, increased R&D and selling and administrative expenses—primarily associated with Audience, acquired in July 2015—and new-product development substantially reduced earnings. Interest expense also increased, partly due to the convertible notes and higher average debt.
- Restructuring charges were $8.6 million in the first half, primarily related to Audience integration, capacitor manufacturing transfers and timing-device headcount reductions. The speaker and receiver product line recorded a $34.7 million discontinued-operations loss for the half, compared with $50.2 million in 2015.
- Knowles completed the sale of that product line on July 7, 2016, for $45.0 million before purchase-price adjustments and received $40.6 million net. It planned to use the proceeds to reduce term-loan borrowings.
- The sale affects conditions for a Malaysian tax holiday scheduled to begin January 1, 2017. Knowles was negotiating revised conditions; there was no assurance of extension beyond December 31, 2016, and failure could increase future effective tax rates. Existing tax holidays materially reduced reported tax expense.
- No earnings or revenue guidance was provided in the filing. Key stated business risks include mobile-device launch timing and customer purchasing patterns, pricing pressure, product mix, inventory built ahead of anticipated demand, customer concentration, competition, product quality, foreign exchange, litigation and execution of restructuring and acquisition integration.
- Management stated that it did not expect asserted or unasserted legal matters, individually or in aggregate, to have a material adverse effect. An Audience acquisition-related lawsuit settlement was approved after quarter-end; the company had accrued $0.5 million at June 30 for legal reserves. Management reported effective disclosure controls and no material change in internal control during the quarter.
Important facts for investors to verify
- Whether Audience integration, product development spending and cost reductions improve MCE profitability after the sharp year-over-year decline.
- Cash conversion and working-capital trends, particularly the inventory increase and lower operating cash flow.
- Use of the $40.6 million net divestiture proceeds and subsequent debt levels, covenant headroom and interest costs.
- Outcome of Malaysian tax-holiday negotiations and potential effect on future effective tax rates.
- Potential dilution under the convertible notes and warrants, and the assumptions behind management’s non-GAAP adjustments.