Description

We recommend purchase of Knowles Corporation (NYSE-KN):

• Niche electronic component businesses with 20%+ EBITDA margins, low cap-ex, great FCF
• Net debt free, trading for less than 12x 2024 earnings/FCF, half of FCF going towards share buybacks
• Volatile consumer MEMS distracting from Precision Device/Hearing Health segments – both gems

Itasca, Illinois based Knowles Corporation is a developer and manufacturer of electronic components with a strong focus/heritage in the audio (microphone/speakers) space.  The company was spun out of Dover Corporation in February 2014 and began trading at an initial share price of $28.  Remarkably, after nearly ten years, Knowles has not seen its initial share price since then. 

We think that a number of things have lined up to create a very interesting opportunity from today: These include a more shareholder friendly attitude from management (significant cost reductions + commitment to utilize half of FCF to buy-back stock), the natural ongoing growth of the better PD/HH businesses producing a far better overall company profile, the re-segmentation of the company financials into three segments from two previously which has been very helpful in understanding the audio business, the introduction of long-term guidance, the elimination of all debt, and the indication from management that M&A will be focused on tuck-ins in the incredibly successful Precision Devices segment.  All this at 11x-12x 2024e EPS strikes us as very interesting from here.

Knowles operates in two audio segments and separately in the unrelated Precision Devices segment:

The Medtech and Specialty Audio segment is a dominant (50%+ share) and core supplier of microphones and speakers to manufacturers of hearing aids.  This is a relatively slow growth but highly profitable business with 40% segment EBITDA margins and a customer base that serves a steadily aging population many with the asset/income base to support the purchase of hearing aids.  Management is targeting 2% - 5% annual revenue growth with margins likely to remain at these levels so we don’t expect much growth overall in this segment.  That said, there is potential for better growth given a new law in the United States enabling hearing aids to be sold over the counter – that could serve to increase this segment's growth rate.    

The Consumer MEMS Microphones segment sells microphones and speakers utilized in mobile phones, PCs, laptops, earbuds, smart home devices etc.  This is a competitive business and Knowles has been walking away from some low margin mobile phone business in recent quarters while also incurring charges to reduce manufacturing capacity and overhead.  Management is expecting low growth going forward but with significantly improved profitability.  In 2022 this segment should generate $300m in revenue (down from $435m in 2021) with EBITDA of $45m - we think the business is stabilizing and EBITDA margins should approach the mid-20% range by 2024 which would bring a significant improvement in EBITDA to the $75m level.

The Precision Devices segment sells high performance capacitors and RF filters that are designed into high value, highly sensitive products in the defense, medical and electric vehicle industries among others.  This segment, unrelated to the core audio business, has been a stunning success with revenue and EBITDA growing from the $100m/$25m range in 2017 to what should be $250m/$75m range for the 2022 year.  Management is guiding to mid to high single-digit revenue growth going forward – this should result in high single digit EBITDA growth.

As mentioned above, the audio segment formerly included both consumer MEMS and hearing health – those are now two different segments.  The precision devices segment is completely unrelated to the audio part of Knowles and is run as a standalone business with its own management team from Upstate New York.

Here are the segment financials as they are now reported:

Medtech: Guiding to 2% - 5% organic growth

Consumer MEMS: Guiding to 0% - 4% organic revenue growth going forward - though with far greater profitability

Precision Devices:  Guiding to 5% - 8% organic revenue growth + tuck-in M&A

Consolidated:

Management put out long term guidance November 29, 2022 – the deck is here: https://s29.q4cdn.com/538730168/files/doc_presentation/2022/11/Knowles-Investor-Update-November-2022-(FINAL).pdf

As you can see, Precision Devices is a gem, MedTech is immensely profitable with a very strong market position and could possibly grow at better than a 2% rate going forward if over the counter hearing is successful.  The weak point here is consumer MEMS - the good news there is that the business which has been walked away from is lower margin and commodity like (mobile phones) and what remains is higher margin and hopefully more stable (PC’s, laptops, earbuds, smart home etc.).

With a net debt free balance sheet and half of FCF being utilized to buy back stock, the share count likely goes down by about 1.5 million shares or so annually.  2024 EBITDA of $218m should bring about $178m of EBIT and close to $150m of net income on about 91m shares that would bring about $1.60 in EPS and without M&A (but with the buybacks) the balance sheet would show $130m in net cash by year end – about $1.40 per share.  From $18.75 today with an expected $1.40 in net cash – the PE is less than 11x on 2024, this strikes us as very moderate.

The configuration of this company is a bit strange and a result of its legacy as a spin-out from Dover Corp.  A stand alone Precision Devices segment probably makes a ton of sense, particularly as it grows (organically + M&A) to a bigger size…….within the audio business we’d love to see a sale of the consumer MEMS business, if there is a buyer, but if that happened you’d still be left with two distinctly different albeit excellent businesses, Medtech and precision devices.  A 10x multiple on 2024 EBITDA would bring a year end 2024 value of $25, a 17% IRR from here.  Corporate expenses seem high and perhaps there is more cost reduction to be done withing the segments – as well, the buyback could be a lot more aggressive.  This should probably be sold to a private equity firm who operate it more profitably and likely monetize the pieces over time. 

Lastly, for what its worth, the company feels good enough about the business  to have a put out a long term target of $2.50 in annual EPS, this is likely several years out and certainly involves M&A/Buybacks but it may also reflect some conservatism in their gross margin targets laid out at their investor day.  Any way you look at it, we don’t see much downside from the current valuation.

Catalyst

Resumption of consolidated revenue growth following rationalization of the more commoditized consumer MEMs segment revenues