KN - At Knowles The Worst Of The Smartphone Cycle Seems Priced In

Summary

• Knowles had mixed fourth quarter results, with worse sales and better margins, but guided down sharply for the first quarter.
• Smartphone demand is still very weak, and it has been joined by weak consumer demand across audio, compute, gaming, and smart home.
• The Precision Devices business offers interesting leverage to electronic warfare, med-tech, and electrification, and management is looking to build this through M&A.
• Knowles shares look undervalued on margins, with a fair value in the low-$20's, but I don't really like it beyond its rebound trade potential.

Weak demand in consumer markets, smartphones in particular, has been the bane of many semiconductor stocks for several quarters now, but Knowles ( KN ) has taken a worse beating than many, with the shares down more than 20% over the past year, though the shares had been recovering some over the last quarter on growing optimism that the worst of the smartphone and consumer device cycle is over.

Management’s guidance for the March quarter suggests another big step down and the guidance for 15% to 20% revenue growth in June could be a little too optimistic. Valuation here is interesting; I’m not all that bullish on the long-term growth potential here, but the valuation does still seem too conservative on a margin-driven multiples basis, and I could see Knowles as a potential takeout candidate.

Some Sequential Improvement, But A Lot Of Pressures In Q4 Results

Fourth quarter results at Knowles are a good example of a “mixed” quarter, with weaker revenue, better gross margin and better operating margin, but much weaker guidance for the March quarter – the latter not being as much of a surprise given commentary from companies like Qorvo ( QRVO ) and Silicon Labs ( SLAB ).

Revenue fell 16% year over year and rose almost 11% quarter over quarter, missing by about 6%. The Audio business declined 24% yoy and rebounded 18% qoq, with the MedTech and Specialty business down 13% yoy and up 31% yoy, while the Consumer MEMS business saw a 31% yoy decline and an 8% qoq rebound. The Precision Devices business rose 9% yoy and declined 2% qoq, with Knowles seeing some of the emerging weakness among industrial customers that other chip companies have called out.

Gross margin declined almost three points yoy, but improved almost two points qoq, to 40.4%, beating by almost three points. Knowles reported a 51.6% margin in MedTech/Specialty (up almost four points), a 24% margin in Consumer MEMS (down 10bp), and a 48.5% margin in Precision Devices (up 1 point).

Operating income fell 28% yoy and rebounded 44% sequentially, with margin declining about three points yoy and rebounding 450bp qoq to 19.1%. MedTech/Specialty margins were strong at almost 41%, and Precision Devices was quite good at 29%, while Consumer MEMS was a notable laggard at 5.7%.

Inventory days did improve by 18 days from the prior quarter, but were still up 35 days from the prior year to 139 days – a high level relative to other chip companies, driven by ongoing weakness in consumer markets but also inventory correction among MedTech/Specialty customers.

It’ll Get Worse Before It Gets Better

Guidance for the first quarter of 2023 was weak, even by the standards of some pretty ugly guidance revisions this quarter. Management guided to a 25% sequential decline in revenue for the March quarter, almost 20% below the prior Street expectation. Management does expect a meaningful improvement in the second quarter (up 15% to 20%), but that sharp a recovery could prove optimistic, particularly given what I expect will be a weaker year for Apple ( AAPL ) iPhone units. Management also guided to weaker gross margin, expecting a 690bp qoq drop to 33.5% (at the midpoint), 440bp below the prior Street expectation.

Readers who’ve seen my earlier articles on Cirrus ( CRUS ), Qorvo ( QRVO ) ( here and here ), and so on know that the smartphone market has been weak, with brutal unit volume declines among Chinese OEMs in 2022 and a still-weak outlook for 2023. Overall handset volumes are likely to be down mid-single-digits in 2023, and Apple (still a meaningful customer at 15% of revenue and most of the smartphone business) will likely be worse in terms of volumes.

It's not just smartphones that are weak, though. Multiple companies, including NXP ( NXPI ) and Silicon Labs, have pointed to weak consumer IoT/smart home demand, including products like Amazon ’s ( AMZN ) Alexa and Echo and Alphabet ’s ( GOOGL ) Google Nest that use Knowles microphones and components. Demand has also been weak for computer peripherals (as seen with Logitech ( LOGI ) earnings ), gaming products, and other consumer devices like watches and tablets.

Elsewhere in the business, hearing aid demand has slowed recently and a weaker macro in 2023 could impact sales, particularly with OTC options now available (customers who have once bought an expensive fully-featured hearing aid may now instead try a cheaper OTC model first). I also see some pressures in the near term in the defense, industrial, and communications end-markets, though more strength in auto (especially EVs).

An Ongoing Shift Should Drive Better Results

Knowles has made it clear that they don’t see their future in smartphones, and that this is likely to be the slowest-growing part of the business going forward. Hearing aids offer decent, albeit not spectacular growth potential around 3% to 5%. While OTC hearing aids could add meaningful volume, I’d expect a meaningfully lower bill of materials for Knowles here given the use of less sophisticated microphones, speakers, and other related technology.

Specialty markets like in-ear monitors and consumer audio have similar growth potential in my view, while consumer IoT likely has a stronger long-term growth rate potential off of a smaller base, but I’m not sure that this business will support exceptional margins.

To that point, shifting the mix to higher-value products is an ongoing part of the story, with the company looking to drive more and more of its mix from products earning 40%-plus gross margins (49% in 2017, 70% in 2021).

The Precision Devices business is one to watch. The company’s focus on high-spec capacitors gives it good leverage to growth in EVs, but I don’t expect this to become a 10% business over the next three years. The RF products give the company leverage to growth in military communications and e-warfare spending (a relatively better place to participate), as well as in medtech applications. All told, these markets should support 6%-plus growth, and it’s a business that Knowles is actively looking to augment with M&A.

The Outlook

I’m expecting around 4% long-term growth from Knowles, with stronger growth in areas like defense, med-tech, and consumer IoT offset by more moderate growth in hearing aids and relatively weak growth in smartphones. I do expect margin leverage from here, but I think meaningfully growing margins beyond the low-20%’s will be very challenging over the next three to five years.

I can’t really get to an attractive fair value on discounted cash flow, and that’s assuming long-term revenue growth of around 4% and FCF growth roughly double that, as the company benefits from those mix enhancements and shifts more capacity toward higher-potential products.

Mid-teens operating margin can support a fair value in the low-$20’s, though, given what the market has typically paid for similar operating margins in the past. That said, the market does often apply a discount to semiconductor stocks with relatively weaker growth outlooks (and 4% isn’t particularly strong).

M&A could also create some backstop for the company. Capacity underutilization has been a major factor in Knowles’ recent margin weakness and I do think a larger, more efficient buyer could reap a lot of financial synergies out of this business. There are larger players with presences in MEMS and/or RF, including Infineon ( OTCQX:IFNNY ) and STMicroelectronics ( STM ), but I don’t think either would be looking to make a financials-driven deal in the near term as they focus on building up their SiC power capabilities.

The Bottom Line

I don’t see that much downside from here, unless Knowles really starts to drop the ball on execution. I do think its weakest businesses are bottoming, and I think the valuation is undemanding. This isn’t a name I’d really want as a buy-and-hold investment, but I could understand looking at this as a trade on consumer demand coming up off the bottom later in 2023.

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