Value Line has initiated coverage of Knowles Corporation (KN) in its flagship product, The Value Line Investment Survey. Knowles Corporation became an independent, publicly-traded company on February 28, 2014 when it was spun off from Dover Corporation (DOV). Dover shareholders received one share of KN stock for every two shares of Dover common stock held at the close of the business day on February 19, 2014. Knowles’ stock began trading on the New York Stock Exchange on March 3, 2014 under the ticker symbol “KN”.
Knowles designs and manufactures products and components which serve mobile consumer electronics, medical technology, telecommunications infrastructure, military, space, and an assortment of other end markets. It now holds a leading position in microphones, speakers, and receivers that are used in mobile handsets, smartphones, and tablets (thanks to its 20-year history under Dover’s wing). Knowles is also recognized as a leading manufacturer of transducers used in the medical technology market for hearing health. Furthermore, the company competes in the telecommunication infrastructure and military/space markets with its oscillators and capacitors.
Its two reportable business segments are Mobile Consumer Electronics (MCE, 64% of ’13 revenue) and Specialty Components (SC, 36%). MCE designs and manufactures acoustic products for consumer electronic markets, while SC specializes in electronic components for medical and life science applications, such as hearing aids, and high performance components in communications and other markets. Key competitors in the MCE segment are AAC Technologies (AACAY) and Goertek, with Sonion competing in the SC segment.
Most notably, the company is a leading supplier of acoustic components to all major handset original equipment manufacturers (OEMs). While Knowles mostly sells its products directly to OEMs and to their contracted manufacturers, it also generates a smaller portion of its sales through distributors.
Knowles strives to maintain its manufacturing facilities in close proximity to its direct customers, in order to cut down lead times. In that vein, the majority of its manufacturing capacity is located in Asia, with several facilities in the United States and Europe, too. Sales are heavily weighted in Asia at 78% of 2013 revenue, while the U.S. and Europe make up approximately 10% each. The other Americas and its remaining markets comprise the remainder. The company employs 10,000 individuals in 14 countries, 79% of whom work in Asian facilities.
Fast product development cycles and high volume manufacturing capabilities are crucial mechanisms that the company utilizes to stay competitive. To do this, Knowles invests in research and development. To wit, over the last three years, it increased its R&D spending by over 50%, to nearly 7% of the top line each year.
Acoustic component sales are driven by developments in smartphone and tablet innovation and demand trends. Higher-performance passive acoustic components and active audio chipsets are needed to keep up with discriminating consumer expectations. Over the past five years, the rapid growth of smartphones increased the demand for high-value audio components, much more so than the earlier generations of cellphones. Newer adopted standards, like 4G technology, also buoy the need for high-end chipsets. The rollout of 4G in China and expansion of the coverage profile in the U.S., Japan, Korea, and Northern Europe should foster demand for Knowles’ inventory, even though there is already deep market penetration in some developed regions.
Not only does the company benefit from higher value-added components, which command loftier premiums and margins, but OEMs have also been integrating multiple acoustic components per device for improved functionality and performance, further improving sales volume. These trends may proliferate into the wearable technology market that many deem to be the next area of rapid expansion.
Each new generation of consumer electronics typically allow for higher selling prices than the inferior or outdated products it subsequently replaces. After their introduction, these components typically exhibit downward pricing tendencies. Downward pricing pressure on devices lends to similar pressure on the associated components. However, the company is able to offset price erosion through material cost reductions, yield improvements, and labor reductions as these products progress through their lifecycles. Electronic markets have relatively short product cycles due to the technical nature of the industry which fosters frequent new OEM product launches. The SC market is more cyclical as it is more exposed to government spending. But, these end markets are also more stable and less prone to swift product turnover.
The company’s competitive position rests on its ability to continue successfully innovating widely adapted products. Because many of its components are designed specifically for an OEM’s product, Knowles is relying on that finished product to be commercially successful. Changes in usage or expected end-user demand can lead to obsolete inventory lingering on the balance sheet.
Apple (AAPL) and Samsung account for about 25% and 15% of total revenues, respectively. Although no other customer contributed more than 10% to the company’s top line, the top ten customers account for 65% of the total. As a result, Knowles is highly exposed to loss-of-customer risk. Struggling developers Nokia (NOK) and BlackBerry (BBRY) are also large customers, although they both represent a smaller portion of Knowles’ revenues than in years past. It is expected that a significant percentage of revenue will continue to come from a relatively small number of key customers. Moreover, Knowles does not have long-term agreements or purchase orders with any of its customers, so a sudden blow remains an ever-present possibility. Furthermore, incoming order patterns can be unpredictable.
The company plans to streamline its current 18 facilities to 11 by the end of 2016 to reduce costs. The planned restructuring will consolidate facilities, close others, and reduce staff levels. Simultaneously, it expects to pursue a variety of accretive bolt-on style acquisitions to enhance its competitive position. We suspect these acquisitions will be small scale, but management has indicated it is open to pursuing complimentary markets via a larger acquisition if an attractive opportunity is present.
As a result of the spinoff, Knowles incurred $400 million of indebtedness that was distributed to its former parent company. Still, its debt level should be manageable, currently at 22% of capitalization. There is no dividend in place, and management has no plans to initiate one in the foreseeable future. In all, this issue is best suited for growth investors.
Subscribers interested in Knowles Corp. are advised to consult Value Line’s quarterly reports for a more in-depth look at the particular merits of the stock, as well as any supplemental reports and relevant articles as important news items arise.
At the time of this article’s writing, the author had positions in: AAPL.