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Edited Transcript of KN earnings conference call or presentation 24-Oct-19 8:30pm GMT

Q3 2019 Knowles Corp Earnings Call

Itasca Oct 31, 2019 (Thomson StreetEvents) -- Edited Transcript of Knowles Corp earnings conference call or presentation Thursday, October 24, 2019 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeffrey S. Niew

Knowles Corporation - President, CEO & Director

* John S. Anderson

Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer

* Michael J. Knapp

Knowles Corporation - VP of IR

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Conference Call Participants

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* Alexander Kim

JP Morgan Chase & Co, Research Division - Research Analyst

* Anthony Joseph Stoss

Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst

* Charles Lowell Anderson

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst

* Christopher Adam Jackson Rolland

Susquehanna Financial Group, LLLP, Research Division - Senior Analyst

* Harsh V. Kumar

Piper Jaffray Companies, Research Division - MD & Senior Research Analyst

* Robert James Labick

CJS Securities, Inc. - President & Director of Research

* Sujeeva Desilva

Roth Capital Partners, LLC, Research Division - Senior Research Analyst

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Presentation

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Operator [1]

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Good afternoon and welcome to the Knowles Corporation Third Quarter 2019 Financial Results Conference Call. (Operator Instructions) Here with opening remarks is Knowles' Vice President of Investor Relations, Mike Knapp. Please go ahead.

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Michael J. Knapp, Knowles Corporation - VP of IR [2]

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Thanks, Christine, and welcome to our Q3 2019 Earnings Call. I'm Mike Knapp and presenting with me on the call today are Jeff Niew, our President and Chief Executive Officer; and John Anderson, our Senior Vice President and Chief Financial Officer.

Our call today will include remarks about future expectations, plans and prospects for Knowles, which constitute forward-looking statements for purposes of the Safe Harbor provisions under applicable federal securities laws. Forward-looking statements in this call will include comments about demand for company products, anticipated trends in company sales, expenses and profits, and involve a number of risks and uncertainties that could cause actual results to differ materially from current expectations.

The company urges investors to review the risks and uncertainties in the company's SEC filings including but not limited to the annual report on Form 10-K for the fiscal year ended December 31, 2018; periodic reports filed from time to time with the SEC; and the risks and uncertainties identified in today's earnings release. All forward-looking statements are made as of the date of this call and Knowles disclaims any duty to update such statements except as required by law.

In addition, pursuant to Reg G, any non-GAAP financial measures referenced during today's call can be found in our press release, posted on our website, at Knowles.com, including a reconciliation to the most directly comparable GAAP measures. All references on this call will be on a non-GAAP continuing operations basis unless otherwise indicated. Also we've made selected financial information available on webcast slides which can be found in the IR section of our website.

With that, let me turn the call over to Jeff who will provide some details on our results. Jeff?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [3]

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Thanks, Mike, and thanks to all of you for joining us today.

In Q3 we continued to make solid progress against our strategy to deliver high value, differentiated solutions to a diverse set of growing end markets. For the quarter, we reported revenue of $236 million, above the midpoint of our guidance range, and flat from the year-ago period as strong sales into the ear and IoT markets, and solid demand for precision devices were offset by continued soft trends in mobile. EPS of $0.38 was in line with our expectation.

In our audio segment, Q3 revenue was down 3% from the year-ago period due to softer demand for high-end handsets in China that leverage our MEMS microphones and intelligent audio solutions, largely offset by record sales of microphones and increasing shipments of balanced armature speakers into the ear and IoT markets.

In the precision device segment, sales were up 13% from the year-ago period due to continued demand for our differentiated products across multiple end markets and a tuck-in acquisition.

Q3 sales in audio continues to highlight the benefit of our diversified portfolio of solutions for the mobile, ear, and IoT markets. In mobile, worldwide shipments of smartphones served as a headwind for our audio business in Q3. Citi now estimates the smartphone shipments in North America will be down 5% in 2019 versus the prior year and down 9% in China. We see these downward trends to be even more pronounced for high-end smartphones. That said, at our largest customer we experienced stable mobile trends in Q3 and are seeing year-over-year growth in this OEM's nonmobile platforms.

Though this OEM's mobile business is expected to be down year-over-year we anticipate full-year revenue growth from this customer in 2019 given our increasing sales to their ear, IoT and computing applications, with higher-value microphone solutions. Sales to Chinese OEMs were lower than the year-ago period and while we are seeing weakness in this market, the positive macro trends continue to be favorable for our audio solutions.

I am increasingly optimistic that the mobile market will start to grow again as our customers begin to roll out 5G phones in 2020. We see an opportunity to increase content per device and improve performance through multimic adoption and higher performance mics including the transition from analog to digital. In addition, we continue to discuss moving more processing to the edge of the network with our customers in mobile, which represents an opportunity for our edge processors.

We are very pleased to build on the success we see in the mobile market with the recent launch of a customer's flagship handset. It uses our MEMS microphones and are the first handsets to leverage our quad-core audio edge processor to enable context-aware audio applications and exciting new nonaudio features. This customer chose to run these complex algorithms on our open DSP platform due to its high performance at very low power.

In addition, processing has been moved from the cloud to the edge of the network and many applications that have historically had only been available when connected to the internet can now work offline. Our platform also allows for complex actions with no latency and because it processes audio locally, it keeps more of the consumer's information private.

This is one of several platforms we expect to be introduced over the next several years with advanced edge processing capabilities. I continue to believe that intelligent audio is an important growth opportunity for us that's synergistic with our acoustic products.

Moving to ear and IoT, we were pleased to see Amazon launch their new Echo Buzz, the company's first true wireless headphones. These headphones use six MEMS microphones and four balanced armature speakers to enable better voice control, active noise reduction, and superior audio quality. Balanced armatures are seeing adoption in consumer wireless headphones because they are the world's smallest speakers, delivering stunning clarity and twice the battery life at a fraction of the size and weight of traditional dynamic speakers. In addition to Amazon, Anker recently launched a new true wireless headset leveraging our balanced armature drivers to deliver crisp treble with full and rich bass. We'll discuss more BA wins in the future as these products are launched.

In IoT, Amazon launched new products including Echos, Dots, and the Loop, all using MEMS microphones. Beyond Amazon, nearly every consumer device you can think of from smart TVs, smartwatches, wearables, to cars and other devices inside and outside the home are adopting voice-enabled applications with the use of MEMS microphones. Knowles is well positioned to enable voice control across a diverse set of end market applications. We are diversifying our business beyond mobile and the investments we are making in growth markets like ear and IoT are enabling us to deliver solid financial performance in spite of a weak handset market.

In our precision device segment, we continue to see sales growth from our high-performance capacitors and mmWave RF solutions for a diverse set of end markets. This business remains essential to our ability to increase exposure to fast growing end markets and enhance shareholder value.

Demand for our high-performance capacitors remains robust in the defense and med tech end markets. Despite a broader slowdown in our industrial markets, our differentiated solutions have seen sustained demand achieved through a combination of ceramic leadership, customization, high-reliability production, and a skilled sales and application team that has built close relationships with our key customers to solve problems for their mission-critical applications.

In mmWave RF solutions, we are seeing solid demand from the defense end markets for radar systems. And we recently were awarded a multimillion-dollar contract with BAE for Lockheed Martin's F35 Joint Strike Fighter program. We are also starting to ship solutions into the 5G mmWave base stations which will serve as a large growth opportunity for us over the next several years.

While we are at the very early stages of the mmWave 5G rollout, we see continued growth in military demand and expect revenue from mmWave RF solutions to grow over $30 million in 2019 from less than $20 million in 2018.

With that, I'll turn it over to John to expand on our financial results and provide our guidance for the fourth quarter. John.

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [4]

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Thanks, Jeff. We reported third quarter revenues of $236 million, above the midpoint of our guidance range and flat from the year-ago period. Record microphone shipments in the ear and IoT markets and continued growth in precision devices was offset by lower shipments of microphone and intelligent audio solutions into the smartphone market.

Audio revenues of $194 million were down 3% from the year-ago period due to weaker demand for high-end smartphones in China that use our MEMS microphones and intelligent audio solutions. These declines were largely offset by increased shipments of microphones and balanced armature speakers into the ear and IoT markets.

Hearing health sales were up slightly from the year-ago period. The precision device segment delivered revenues of $42 million, up 13% from the third quarter of 2018 which was the result of 8% organic growth driven by strong demand for high-performance capacitors in the defense and medtech end markets, and an acquisition completed early in the first quarter of 2019.

Third quarter gross profit margins were 40.1%, within our guidance range and up 170 basis points from the year-ago period, driven by favorable product mix within audio, specifically higher microphone sales to the ear and IoT markets. Precision device segment margins were flat year-over-year as improved pricing on high-performance capacitors was offset by higher raw material costs and increased manufacturing capacity to support future growth in our mmWave filtering solutions.

Operating expenses in the quarter were $51 million, down 2% from the year-ago period due to reductions in R&D spending within the audio segment. For the quarter, adjusted EBIT margin was 19%, at the midpoint of our guidance range, up 250 basis points from the year-ago period on higher gross profit margins and reduced operating expense. EPS was $0.38, at the midpoint of our guidance range and up 12% over the third quarter of 2018. Further information including a detailed reconciliation of GAAP to non-GAAP results is provided in the financial tables of today's press release and can also be found on our website at Knowles.com.

Now, I'll turn to our balance sheet and cash flow. Cash and cash equivalents totaled $70 million at the end of Q3. For the third quarter, cash generated from operations was $40 million, at the low end of our guidance range due to timing of receivable collections within the year. Capital spending was $8 million in the quarter. Also during the quarter we repaid all outstanding bank borrowings.

Moving to the fourth quarter, we expect total company revenue to be between $225 million and $250 million. Revenue from the audio segment is expected to be between $185 million and $200 million, up 4% from Q4 2018 due to higher shipments of mics into ear and IoT applications, partially offset by weaker handset demand in China.

Precision device revenue is expected to be between $40 million and $50 million, up 16% over prior-year levels, driven by organic growth across telecom, defense and medtech markets and the impact of an acquisition which was completed earlier this year. We project gross profit margins for the fourth quarter to be approximately 39.5% to 42.5%, down more than 160 basis points from the year-ago period due to a supplier credit recorded in Q4 2018 that will not repeat.

R&D spending in Q4 is expected to be between $20 million and $22 million, down $2 million from prior-year levels due to optimization of R&D spending within the audio segment. We are projecting selling and administrative expense to be between $29 million and $31 million, up $1 million from the year-ago period due to higher anticipated legal expense.

We are projecting adjusted EBIT margin for the quarter to be in the range of 19% to 21% and expect EPS to be within a range of $0.37 to $0.43 per share. This assumes weighted average shares outstanding during the quarter of 95.7 million on a fully diluted basis. We are forecasting an effective tax rate of 13% to 16% for the quarter. Please refer to our press release for a GAAP to non-GAAP reconciliation.

For the fourth quarter, we expect cash generated from operations to be between $60 million and $70 million, and capital spending to be between $10 million and $20 million. Full-year 2019 capital spending is now expected to be slightly below 6% of revenues. For the full year, revenue growth is expected to be between 3% to 4% with gross profit margins near 40%. R&D and SG&A are expected to be approximately 10% and 14% of revenues respectively. Lastly, we're forecasting an effective tax rate to be between 13% and 17% for the full year.

I'll now turn the call back over to Jeff for closing remarks and then we'll move to the Q&A portion of the call. Jeff?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [5]

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Thanks, John. Our Q3 results and our Q4 guidance reaffirms our strategy to invest in high value, differentiated solutions and diversify our end markets to deliver shareholder value. I'm pleased with the continued progress we've made to increase our exposure to growth markets like ear, IoT, 5G infrastructure and edge processing. We expect that revenues from nonmobile markets will represent over 70% of our total company revenue in 2019, growing at greater than 10% from the prior year with above corporate average gross margins. For 2019 we expect our full-year company revenue to increase by approximately 4% and EPS to increase by 12%.

As we look towards 2020, our company remains uniquely positioned across the markets we serve. In audio, macro trends around better acoustic performance and edge processing remain positive and are enabling us to increase our content per device. In precision devices, we continue to deliver strong revenue and earnings growth, both organically and through tuck-in acquisitions. With our strong positions in core markets, coupled with the investments we are making in growth products, I am increasingly confident that we can drive continued revenue growth with strong operating leverage in 2020.

Operator, we can now take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Sujeeva Desilva from ROTH Capital.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [2]

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Congratulations on the progress here. Just a couple of questions on the end markets. Do you still expect in the ear and IoT part of the business that IoT would be stable relatively, and ear would be the growth driver? Is that still the expectation?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [3]

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Yes, good question. I would say generally speaking, I think IoT will still be up but nowhere near the rate of ear this year. You know, that's kind of been flipping and flopping from year-to-year. I would just make the comment, I think we've talked about this in past calls, that in 2016, the ear and IoT revenue in our mic business was about 7% of the revenue in mics. This year, it's going to come in over 30% of the revenue this year, will actually -- in mics will be in ear and IoT. Yes, I would say the majority of growth is coming from ear but there still is growth in IoT.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [4]

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Okay. And then congratulations on the win at Amazon. The wins, content-wise. Should we think the content you described for Amazon there is a typical headset going forward? Is that a premium headset? How can we compare the Amazon content to what may be the typical true wireless headset content for you guys?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [5]

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Yes. I mean I think that's a little bit of a tougher question to answer entirely, to this day, so let me just take it in pieces. I would say on the balanced armature side, I would say this is probably premium. Two balanced armatures per ear, we're probably talking premium. On the microphones, when you have three per ear, I would say it's premium today.

But I think if you look at the design pipeline and what people are talking about, having three microphones per ear is probably going to become pretty standard in the longer term. And that's -- you know, mainly the third mic is being added on the inside of the ear for active noise cancellation. With the two microphones on the outside primarily to improve voice communication, improve anything you're doing in terms of with voice recognition.

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Sujeeva Desilva, Roth Capital Partners, LLC, Research Division - Senior Research Analyst [6]

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Okay. And then one quick question on the IA. I didn't hear if there was an update on the 20 million, 25 million expectation for '19. Is that still the range you're expecting?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [7]

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Yes. I would say it's going to be tough for us to get to the low end of that range. But with that said, we're pretty excited about the products, the handsets, that were introduced in the last week that are using our quad-core DSP. I think this is like, a pretty important moment for us from the perspective of all the things that you can do with our quad-core DSP. Some of it's audio and actually now some of it's nonaudio. So we're pretty excited about this opportunity and we're pretty excited about 2020.

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Operator [8]

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Your next question comes from the line of Christopher Rolland from Susquehanna.

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Christopher Adam Jackson Rolland, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [9]

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Good execution on the quarter here. In terms of the balanced armature speaker market, perhaps you can talk about what those revenues were in 3Q and your expectation for 4Q. Also perhaps if you can discuss, I know you said you'd talk about them when they were released. But just generally what that pipeline looks like for you guys, and how it sizes up to that roughly I guess, call it $90 million extra ear opportunity that you guys highlighted in your Analyst Day?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [10]

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Yes. So let me start by just breaking out. We have a pretty robust balanced armature business overall to begin with. And that's divided up between our hearing health market, which you know, we do very well in, and then there's balanced armature, what I would call to the premium -- the really premium headphone market. You know, the guys that are in the $300, $400, $500 range. That's a pretty robust business for us.

Now, as we start talking about the true wireless opportunity, as I said in the past, if you look at these true wireless headsets they are looking more and more like a hearing aid. I mean they are looking more and more like that. Now that being said, we are kind of limited in terms of I would say the capacity now and probably until into mid -- into late Q2 is when all that capacity will be going online. And that's when we would really expect to see the revenue from balanced armature in the true wireless market, start to accelerate.

So we're not going to break out the exact number at this moment for true wireless. It's relatively small. I'm not going to say it's very large. But what I would say is we have a lot of interest. We have a lot of customers are interested in moving forward. And I think we're preparing for the back half of next year is when we really see the growth is going to come.

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Christopher Adam Jackson Rolland, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [11]

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Great. And then on precision devices, it was maybe a tad bit softer than I expected. I think you guys talked about pricing on high-performance capacitors there. Obviously, the MLCC market has moved through a super bubble, obviously lower-end products there. But maybe pricing starting to firm there. Is this just a lag there on this side? Do you expect any more changes in pricing? And then within precision devices, I don't know if you said it or not. Your 5G filters. What's the timing on when you might ship your first?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [12]

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So first, let me take the first question. I would say it was a little softer than we expected going into the quarter. And as I kind of said in my script, the industrial market, we have seen a little bit of a slowdown. But that, with that being said, we still had, I want to say it was a 13% growth overall year-over-year. So not too shabby still. So we were expecting a little bit more. As I looked at Q4, I think it's a little bit better than what we had in Q3 in terms of the year-over-year growth as well as it's a pretty good step up in terms of the sequential as well.

So I would say that we're seeing some weakness in industrial and that's -- I would say that general marketplace that you kind of referred to. But still, when I say weakness, this is not like it's down significantly. It's still growing, just modestly versus it was growing pretty quickly in the past. Now you asked, your second question was related to the 5G mmWave base stations. We are already shipping into 5G mmWave base stations for production units. So we started shipping for that. And we expect that will continue.

I think what we've kind of said, and we'll continue to say this, is the military demand continues to be very strong in this space. And the design activity around the 5G mmWave base stations still is strong. Although I think we're seeing a small push-out to the right in terms of the actual demand for the 5 mmWave base stations. But we are shipping into production units right now.

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Operator [13]

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Your next question comes from the line of Anthony Stoss from Craig Hallum.

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Anthony Joseph Stoss, Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst [14]

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My congrats as well. You're one of the few chip companies that are actually growing this year, year over year. Two-part question. If you were to strip away just the IoT and ear segment, what kind of growth rate do you think you could see in 2020 or even in the immediate term? And then now that iFixit has got the Google Pixel 4 teardown showing your DSP, love to hear your thoughts. And I know, Jeff, you mentioned you've got design traction for 2020. Can you quantify that at all?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [15]

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Yes. So let me take the first question. I'm not really sure I understand the first question. Are you asking me about the mobile market for microphones versus the ear and IoT for microphones? Is that what you're asking me about?

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Anthony Joseph Stoss, Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst [16]

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Nonmobile ear and IoT.

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [17]

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Nonmobile ear and IoT, we would expect to grow again in 2020. I would say what's changed is, I'm cautiously optimistic about the mobile market. I mean it's been a pretty big headwind for us for the full year 2019, from the perspective, you know, we know what happened at the largest customer earlier in the year. There's been weakness, a fair amount of weakness in China.

But I think what we're starting to see is that as 5G starts to roll out in a bigger way next year, there's some 5G this year but realistically it's more next year. Even if we can get this, which we're hopeful of, to a flat market year-over-year, it no longer becomes a headwind to our business. And that's why I think we highlighted, Tony, that about -- we have over 70% of our business is nonmobile now. And that 30% was a headwind in 2019. But we think it could be flattish in 2020, which would be really great for us to see that number being flat.

Second question you asked me about the quad-core DSP, let me just make a couple more comments on this. You know, just generally speaking. We're pretty excited about this and I want to just kind of lay this out for a moment. It just may take a moment, Tony. But think about what they're doing with the device. First, where you need real-time processing, like actually like, no latency in processing, where you need the device to be always-on, right. And then there's a combination of what I would call pre-processing before it goes -- keeping the AP off before it -- the AP or the application processor gets turned on. But there's also pieces where the full application is running on our chip now.

And so let me give you a couple of applications. One you've heard of, is the keyword detection. You've heard of that. That's running on this device. Another one is like, echo cancellation and barge-in, running on this device. So if you have music on, and you want to barge into the device, it can do that, right. The third thing which is kind of interesting is there are other sensors in this platform that need real-time -- need always-on power that are now being processed through our device as well. And this just has to do with the gesture recognition.

So what you're starting to see is, is that customers are starting to say to themselves is, yes, audio has to be real-time. Yes, audio has to be always-on. But there's other sensors that need it to, and this device is pretty valuable for this device. As far as the design pipeline, we're working really, really hard here, Tony, for next year to continue this momentum we're having in the back half of the year on the design side. And I think that's kind of where I'd leave it for right now.

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Anthony Joseph Stoss, Craig-Hallum Capital Group LLC, Research Division - Partner & Senior Research Analyst [18]

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Can I follow up on that? Is there any quantification on the amount you're saving the device maker from handling everything in the handset itself versus hitting the cloud? Is there a cost savings, have you quantified any of that and do they recognize that?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [19]

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Yes. I think that's pretty hard to quantify. I think there's a couple things. I would say that that's kind of like I think a secondary from their perspective. They see the cloud as not being taxed as much. I think they're focused on this idea of real-time processing with no latency, having multiple sensors including microphones being one of them on all the time for contextual awareness and do a lot of different things. And then the third is, is that ultimately I think you if look at this, the real thought players, they want to have more things done locally from the perspective also of privacy.

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Operator [20]

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Your next question comes from the line of Bob Labick from CJS Securities.

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Robert James Labick, CJS Securities, Inc. - President & Director of Research [21]

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Just wanted to stick with BA for a minute here. Can you talk about your current manufacturing. And given the growth in ear that's just starting and the nice win with the Echo Buds and others, how are you managing the inventory for BA and towards the -- with this growth and the path towards the automation which I think you expect in the first half of next year, to have a new automated line. Just talk about the process of the inventory management and the expected growth for this category.

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [22]

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Sure. So I wouldn't expect in the short term that we'd have a significantly a lot more inventory to do this. I would say it's probably the opposite here is, as demand increases we're trying to balance the demands that are out there against the fact that we don't really want to have to add a lot more manual assembly in order to do this knowing, and this kind of leads, that the automation is coming online.

I was -- I viewed the automation this week. It's on track to be ready in the first half. And we're excited to get that installed. Because I think one thing that has come out of this, those Echo Buds for us, is it's getting a lot of, I would say, second-tier players to say hmm, this is kind of interesting. When can we start having more discussions. And so I think there's going to be a real balance here in the next six months of design wins and revenue relative to the fact that we don't really have the capacity in place to handle this yet until the back half of the year.

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [23]

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One thing to add, Bob, too is as Jeff said, we'll have that first automated line in place at some point in Q2. And if we see demand increasing here we'll kind of pull things forward on a second line and we could have that probably in place back late 2020.

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [24]

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Let me temper that. Let me temper that, though. Just saying is that the issue -- I'm just a little bit -- I want to make sure is, is that this is a brand-new design for our balanced armature, a brand-new production process. We've got to make sure it all works properly before we would order the second line.

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Operator [25]

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Your next question comes from the line of Harsh Kumar from Piper Jaffray.

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Harsh V. Kumar, Piper Jaffray Companies, Research Division - MD & Senior Research Analyst [26]

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Great job once again managing expectations and earnings in a tough environment. Jeff, I had one for you. I look at your guidance for the audio business. Compared to September numbers you're basically calling for flattish kind of trends.

I know that we're going into the Christmas build and then we have Chinese New Year a little bit early this year. I believe it's January 25. So I expect kind of like a double dive, if you will, in consumer stuff including handsets. How do I think of your guidance for December audio business versus the Chinese New Year being sort of earlier this year, on top of Christmas?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [27]

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So I'm kind of looking at the numbers here. You know, I mean we usually have seen a dip in Q4 versus Q3. Because of that large customer that has that big ramp and it kind of tempers in the third. I would say kind of looking at the numbers. If I look at last year, we had a pretty large, sequential down in Q4 last year. And this year, it's a lot smaller this year. And you know, and again, I would say is, ear and IoT are a much larger portion of the business than they were a year ago. And to the extent that that's the case, we're not seeing as much of this downward trend in Q4.

Now I think you're starting to now move into Q1 and I'm not -- I can't -- it's really hard for me to give you a lot of guidance into Q1. But I will say this. We usually have a pretty strong build to Chinese New Year and then we have a drop-off and then we see how it resumes at the end of Q1. I guess all I would say is is that it's a little early.

My biggest concern right now is in terms of you want to talk about the audio business overall. China has been weak overall. I mean I said that in the call, that -- or in the remarks. It has been weak. And so I think we want to see how this goes up to Chinese New Year, but then I would say that's my one concern. Just overall, China's been weak, especially high-end handsets.

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Harsh V. Kumar, Piper Jaffray Companies, Research Division - MD & Senior Research Analyst [28]

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Can I -- for my follow-up, I know you probably have seen the initial order runs or order book for the Amazon headset. Have you gotten an indication of how they're thinking about ramping that -- that particular piece? Or they want to evaluate how things go through Christmas and then come back to you guys?

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [29]

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I'm going to punt on that. I mean I think you know, that -- you know, now we're talking about really specifically about a customer's product, and I think it's pretty confidential at this point, Harsh. I just really can't comment on that.

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Operator [30]

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Your next question comes from the line of Charlie Anderson from Dougherty.

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Charles Lowell Anderson, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [31]

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My congrats on the strong results. The first one on BA, obviously a really strong product for you, strong product cycle here and you do get the added volume next year with the automated line. I guess I'm curious, if you could maybe just speak to some of the competitive differentiation long term. Do you expect to hold very high market share here? Do you have some -- in terms of whether manufacturing process or IP, kind of a moat. Do you expect second sources at some point, just any additional color there? And then I've got a follow-up.

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [32]

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I think it's a little too early to say. I mean there is, we do have some competition in the hearing aid side today. And I think that there's no reason why that competition would be into this market if we develop it. But I also do think, is you know, we are pioneering this market. And the moat that we're building around this market is very different than the moat we have in the hearing health side. The hearing health side generally speaking is a lower volume, high-mix business. And this is going to be what we think is going to be a higher volume, lower mix business.

And that's why when we decided we wanted to go after this market, we said, we're going to redesign these products specifically for this higher volume market. And so what does that do? It allows us, number one -- and there is IP around this -- it allows us, number one, to ramp it faster when we want to. It allows it to have less labor in order to do it. It targets a much more, I would say, aggressive cost structure than we typically have had in the hearing health side.

So I think we're building a competitive moat for the commercial market, or the true wireless market, similar to what we have on the hearing health side. But with, quite frankly, similar technology but a different set of products.

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Charles Lowell Anderson, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [33]

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Perfect. And then for my follow-up, on the precision devices gross margin, I think there was a reference in the script to a few elevated costs there. I think one was putting in capacity, the other was maybe higher raw materials or something like that. I wonder if you maybe just kind of speak to the outlook for the next year or so and (inaudible) gross margin.

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [34]

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I'm going to let John -- all right. I'm going to let John speak.

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [35]

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Yes, Charlie, PD gross margins were -- they were lower than expected in Q3 and they were flat with Q3 of 2018 levels. It was really due to a little lower than anticipated production volume, so we had unfavorable fixed overhead absorption due to softening industrial end market. We also had some manufacturing inefficiencies at one of our facilities. We expect these manufacturing issues to be fully addressed early in the current quarter and expect a sequential improvement, pretty significant improvement in gross margins at PD in Q4. So I would kind of call this a one time in Q3 impact.

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Operator [36]

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Your next question comes from the line of Bill Peterson from JPMorgan.

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Alexander Kim, JP Morgan Chase & Co, Research Division - Research Analyst [37]

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Hi. This is Alex Kim dialing on behalf of Bill Peterson. I want to ask about CapEx first. So last quarter you mentioned CapEx would be about 6% to 7% of revenue and 20% of that CapEx was going to your balanced armature business. Are you sticking to that 20% number, and do you anticipate that number going up potentially to more quickly ramp BAs and to also address potential supply issues to meet the demand for BAs? And also how should we think about CapEx for 2020 and the breakdown between microphones and balanced armatures?

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [38]

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Yes, in terms of the first question, I'd say that assumptions are still valid, what I provided earlier. We may be a little below 6% as a total company in 2019, but that amount related to the balanced armature business is unchanged at this point. It's a little early to give guidance for 2020 but I would expect as a percent of revenue, to be kind of very similar range in 2020 versus 2019, kind of around this 6% or so. But we'll provide more guidance later.

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Alexander Kim, JP Morgan Chase & Co, Research Division - Research Analyst [39]

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Okay. And also how should we think about OpEx for 2020, the trajectory?

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [40]

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You know, in terms of OpEx it's too early to go into 2020. But if you look at what our trend has been in OpEx over the last I'll call it three years, we've been pretty good at holding OpEx very -- to very, very modest increases. And as a result with revenue growth in the 4% to 5%, or 3% to 4% this year, higher than that last year, we've gotten very good operating leverage. I would expect the same trends to continue moving forward.

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Jeffrey S. Niew, Knowles Corporation - President, CEO & Director [41]

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I think what we generally said is is that we're really trying to control SG&A on the R&D side. As John said we're going to keep that in the 11% range of sales. I still think those things hold. That's what we've been kind of trying to do over the last two years.

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [42]

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One thing I think is important just to give a little granularity, in Q3 and Q4 of this year, we did have increased legal spend. If you take that, relating to a specific IP dispute that we're pursuing, if you take that out our year-over-year SG&A is flat if not slightly down year-over-year.

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Alexander Kim, JP Morgan Chase & Co, Research Division - Research Analyst [43]

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Okay. And just to clarify, you said R&D 11% of sales, and then SG&A being flat?

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [44]

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A little less. A little...

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Alexander Kim, JP Morgan Chase & Co, Research Division - Research Analyst [45]

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If you take legal spend?

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [46]

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R&D a little less than that. We originally early in the year, were estimating 11%. It's coming down closer to 10% as we optimize R&D spending in the audio segment.

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Alexander Kim, JP Morgan Chase & Co, Research Division - Research Analyst [47]

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Okay. And then SG&A flat if you take out the legal spend?

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John S. Anderson, Knowles Corporation - Senior VP, CFO & Interim Principal Accounting Officer [48]

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Correct.

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Operator [49]

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There are no further questions at this time. Mr. Mike Knapp, I turn the call back over to you.

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Michael J. Knapp, Knowles Corporation - VP of IR [50]

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Great. Thanks very much for joining us today. As always, we appreciate your interest in Knowles and look forward to speaking with you on our next earnings call. Thanks and goodbye.

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Operator [51]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.