December 14, 2017 - 10:39am EST by
2017 2018
Price: 14.64 EPS 0 0
Shares Out. (in M): 92 P/E 0 0
Market Cap (in $M): 1,350 P/FCF 0 0
Net Debt (in $M): 143 EBIT 0 0
TEV ($): 1,493 TEV/EBIT 0 0

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Knowles Corp (“KN”) designs and manufactures advanced acoustic components.  It has dominant market share for components in hearings aids and in MEMS microphones that are used in mobile phones, smart speakers and other consumer electronics.  The stock is down about 12% year-to-date compared to the SOX which is up close to 40%.  KN is also down almost 60% from mid-2014.  Several headwinds that negatively impacted the company have disappeared.  At the same time, new secular growth drivers are taking shape and the company’s competitive environment has improved.  Street revenue estimates for 2018 are easily beatable.  Finally, the company is a strategic asset to several potential acquirers in an industry that has been consolidating.  The company could be an interesting target for activist investors. 

Investment highlights include:

New Secular Growth Drivers.  Speech recognition is becoming more important.  Improvements in artificial intelligence have dramatically improved a computer’s understanding of human language and have improved the value one can get from digital personal assistants like Alexa and Siri.  However, these improvements in software are useless if the hardware used to capture voice signals is poor.  Consequently, there is increased importance by consumer electronics and phone OEMs on the quality of mics used as well as the number of mics.  This is improving Knowles’ volume, market share and average selling prices.  In 2016, Samsung used 3 year old microphone technology in its flagship phones.  The company recently went with Knowles’ latest generation chips for its flagship models.  We estimate that the pricing for these latest generation chips are at least 15-20% higher than what Samsung was previously buying.  The Iphone has 4 mics.  Samsung and several Chinese phone OEMs still only include 2 mics but are likely to increase the number of Mics over time to match AAPL.  Where quality matters most, we see KN’s share extremely high.  After all, as the clear industry leader, nobody invests anywhere close to the amount KN does in MEMS mic R&D.  For example, in the smart speaker segment, KN has well over 80% share.  Amazon’s Echo currently dominates the smart speaker market.  Each Echo comes with 6-7 mics from KN.  Our checks also indicate that KN’s has been designed into virtually all the new entrants into the smart speaker market including Baidu (reportedly using 8 mics), Facebook and Sonos.  Google’s Home product previously used 2 Mic’s from GoerTeck (#2 player based in China).  According to Craig-Hallum’s analyst Tony Stoss, Google has decided to switch to Knowles as well.  While Google has great AI technology, the main critique of its Home product has been relatively worse voice recognition when compared to the Echo.  We expect that future generations of Google’s smart speaker will likely also use more mics.  KN’s internet of things (“IOT”) segment, which is currently mainly represented by the Amazon Echo will be about $40m of sales or a little over 5% of pro forma revenue in 2017 (the company is divesting a non-core business).  IOT segment revenue is up 100% vs 2016.  Expectations are that Amazon will likely grow sales of the echo units by around 100% again in 2018.  On top of Amazon, other new entrants into the smart speaker market and a long tail of new IOT devices (such as refrigerators, remote controls, cars, etc…) should drive very strong unit growth.  Finally, KN’s is benefiting from the proliferation of blue tooth headsets.  For example, each of AAPL’s Airpods use 2 mics.  After a very slow start, penetration of Airpods are rising.  If everyone who buys an Iphone also buys a pair of Airpods, the volume opportunity through AAPL for mics almost doubles.    

Dominant Market Share and Improving Competitive Environment.  The company has over 55% share in MEMS mics and is multiple times larger than the next biggest competitor (GoerTek has about 20% share).  KN’s has about 45% share in hearing aids, which represent about 25% of revenue.  As with many niches in technology, this is a natural winner-take-all industry.  KN’s larger relative scale gives it the lowest manufacturing cost and allows it to invest the most in R&D.  Several competitors have been retreating from the market.  AAC Technologies, the #3 player, wrote in its 2016 annual report that it is purposely deemphasizing its MEMS microphone business due to “declining profitability.”  During the Q3 earnings call, Knowles’ CEO stated, “The competitive environment seems to be becoming more favorable for us.  We’ve seen a few people who have exited the microphone market.  We’ve seen a few people who have kind of reduced their focus on this space.”  The company has stated that normal like-for-like price declines of mature MEMS mics are in the 6-10% range.  After being at the high end of this range in 2016, the company expects to be at the low end or possibly below the low end of this range in 2018.              

Several Headwinds Going Away.  The company has been experiencing several headwinds that are abating and setting up for easy comparisons in 2018.  Hearing health, which is about 25% of revenues declined about 10% this year as a low-end competitor took share.  KN basically decided to walk away this business.  Its share has now stabilized, and we expect hearing health to be flattish in 2018.  We estimate that Chinese handset OEMs were about 12% of revenue in 2016.  Given excess inventories at the start of 2017, KN’s business with these Chinese OEMs was likely down about 10% in 2017.  Now that excess inventory has been cleared, KN’s shipments to these customers should grow in line with end consumption.  In addition, the company acquired Audience a few years ago.  Since making the acquisition, revenue significantly declined.  We estimate that Audience (now described by the Company as its “Intelligent Audio” segment) declined from about $40m of revenue in 2015 to less than $10m this year.  The company is also optimistic about design win activity in this segment.  We expect that it will at least stay stable going into 2018.  As mentioned previously, Samsung was using 3 year old technology until recently in its phones.  The company only had a partial benefit from the higher ASPs in 2017 and should get the full benefit in 2018.  We estimate Samsung to be about 20% of total revenue in 2017 excluding Samsung’s share of the Intelligent Audio segment.  Finally, Apple’s delayed launch of the Iphone X effectively pushed revenue that would have been generated in 2017 into 2018.  We estimate AAPL to be 18% of revenue in 2017.    

Recent Sale of non-core and low margin timing business.  The company recently sold a non-core asset that represented about 12% of sales.  Proceeds will be used to pay down debt and will take net debt to ebitda less than 1x.  The business was also had lower profitability than the corporate average. 

Potential strategic asset.  The company would be a great fit with a company like Cirrus Logic (“CRUS”) which also makes audio IC’s but has no exposure to Mics.  Other potential acquirers include Broadcom (“AVGO”), STM and Infineon or several Japanese, Taiwanese or Chinese companies that also sell components into mobile phones and consumer electronics.  SG&A is about 15% of sales and most of this can be eliminated by the virtually any of these potential acquirers.  They all sell to the same customers.  The combined company would be able to offer integrated solutions and modules that would allow it to gain overall market share of the semiconductor industry.  At the same time, it would become an even more strategic supplier.    

Street estimates too low.  Not everyone on the Street has updated their models for the divestiture.  Therefore, average consensus estimates are stale.  However, when comparing to individual sell side models, we believe that there is AT LEAST 5-10% upside to Street revenue expectations and AT LEAST 10-15% upside to Street EPS for 2018.  Most are modeling pro forma revenue to grow just mid-single digits.  Since the IOT segment is over 5% of revenue in 2017 and is likely to double again in 2018, this segment alone should enable the company to meet street revenue estimates. 

Reasonable valuation.  The stock trades at about 12x our 2018 EPS estimate excluding options stock comp (stock comp adds a couple of multiple points).    

Execution Risk and Stock Being Ripe for Activist Involvement: The biggest issue with this stock is subpar management.  As mentioned before, the company did a bad job integrating Audience.  It also did not execute well with a speaker business it had.  After declining for a couple of years, the speaker business was sold.  We take some comfort in the fact that management is not looking to do any big acquisitions.  The recent sale of the non-core oscillator business and using proceeds to pay down debt are other indicators that the company is becoming more focused.  We believe that the stock is ripe for activist involvement.  Not only can an activist push for a sale of the company, it can also make sure management does not do anything stupid with respect to capital allocation and can potentially even replace management. 

Other Risks. Market share loss in the hearing health segment may start again.  As of now, we believe share has stabilized.  There is some concern about Iphone demand being weaker than expected.  All the AAPL suppliers have been weak recently on these rumors.  This is now largely reflected in the stock in my opinion, but if one wanted to hedge, there are many stocks to short like CRUS that has over 80% exposure to AAPL.  By the way, the same rumors regarding weakness in AAPL's supply chain occured last year at this time and proved to be just noise.  



I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Catalysts: Consumer Electronics Show in early Jan (likely many smart speakers and IOT devices with KN chips), upside to numbers, potential acquisition, potential activist involvement. 

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