Michael J. Knapp - Knowles Corp. Jeffrey S. Niew - Knowles Corp. John S. Anderson - Knowles Corp..

Charlie Lowell Anderson - Dougherty & Co. LLC Suji Desilva - ROTH Capital Partners LLC Robert Labick - CJS Securities, Inc. Harsh V. Kumar - Piper Jaffray & Co. Bill Peterson - JPMorgan Christopher Rolland - Susquehanna International Group Anthony Joseph Stoss - Craig-Hallum Capital Group LLC.

Good afternoon and welcome to the Knowles Corporation Fourth Quarter and Full Year 2017 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

With that said, here with opening remarks is Knowles' Vice President of Investor Relations, Mike Knapp. Please go ahead..

Thanks, Emily, and welcome to our Q4 2017 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 Andersen, 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, 2016, 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 conference 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 financial references on this call will be on a non-GAAP continuing operations basis, unless otherwise indicated. Also, we've made selected financial information available in 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 the results.

Jeff?.

Thanks, Mike, and thanks to all of you for joining us here today. For Q4 we reported revenue of $216 million, gross margins of 43% and earnings per share of $0.40.

Keep in mind these results exclude the timing business, which we divested during Q4 and were positively impacted by a royalty settlement which John will cover in greater detail in just a moment.

In our Audio segment, MEMS microphone revenue increase sequentially driven by improved shipments to our largest customer and strong demand in our IoT end market. Sales into China handset market were weaker than expected due to continued customer softness. Overall, revenue from Audio comprised 87% of total sales in the fourth quarter.

In the Precision Device segment, sales were consistent with the prior quarter and up 25% from the year-ago period due to stronger demand for capacitor devices. We continue to see robust order trends in our defense, medical and industrial markets driving demand for these products.

As I mentioned, we are pleased to complete the divestiture of our timing business during the quarter. The sale of this non-strategic business has sharpened our focus on growth platforms where we have strong market positions and attractive margin profile. Precision Devices represented about 13% of total company revenue in Q4.

Our Audio segment continues to benefit from demand for voice enabled devices. Microphone sales into our IoT and headset markets both doubled in 2017 versus the prior year. And we now see a much more diverse base of customers driving growth in 2018 for both of these markets.

I mentioned that MEMS microphone revenue was up from the prior quarter, but sales in the mobile market were challenged as China handset demand remained weak. We continue to see positive multi-mic adoption trends across China and we expect design wins of smart microphones to drive greater dollar content for handsets at several OEMs.

DSP-based mics are also driving the need for high performance digital mics in the same system and will improve our share on each socket. The first of these design wins will begin production in Q2. At our largest customer, shipments increased in Q4 driven by the launch of their new flagship models.

During the quarter, sales were within the range of expectations, but upside was limited due to constraints in our supply chain. Our share across all products at this customer remained strong and we expect solid year-over-year growth in Q1 driven by increased shipments across their handsets, ear and IoT devices.

In Korea, after launch of the Galaxy S8 last year which incorporates a new microphone, we anticipate continued momentum with the launch of this customer's new flagship handset this quarter. It will use a new high performance microphone platform for the second consecutive year.

This continues to demonstrate that customers are placing greater emphasis on better acoustic performance. As growth in the mobile handset market moderates, we are increasingly focused on growing our audio content per device.

A common thread across our customers in this space is that they are adopting higher value solutions, which enable new features and drive revenue growth through increased audio content. Where it's new advanced digital mics, DSP-based mics or open multi-core processors, we are seeing adoption of higher value solutions accelerate.

This trend is enabling higher ASPs and margins on new products. In the ear market, our year finished strongly as we doubled sales into the headset market from the prior year. While the base of revenue is currently small relative to mobile and IoT, we see great potential for it to become a large market for us.

The move to our powered headsets, both wired and wireless, is a very important and positive trend for us. Powered headsets opens the door to more audio features like noise suppression, active noise cancellation, as well as improved voice input. All of these features drive the need for a greater number of high performance MEMS microphones.

It's also leading to discussions around how our intelligent audio solutions can be used to enable voice wake, keyboard detection, simple commands and other features.

Smart mic design activity in the Bluetooth headset market has been strong across many customers, as voice has embraced as the best method for controlling your own devices versus tapping or pressing a button.

Our core capabilities in acoustics combined with our open, intelligent audio platforms, allows OEMs to enable features they deem most important and run them all simultaneously.

While the headset market remains fragmented, the common theme we see emerging is that all these features require more microphones and more processing power and we are in prime position to deliver these solutions.

At CES this year, we continue to see voice highlighted as a critical feature that is being added across all different types of IoT applications. It seems like many of the new products announced whether they were TVs, toys, kitchen appliances or smart displays, contain a voice interface.

Smart speakers are now one of the fastest growing consumer products. 2017 was clearly a breakout year for our design wins with new smart speakers, and while Amazon continued to command its leading market share, there are more than a dozen models of smart speaker shipping today.

They include Google Home, Mini and Max, The Sonos One, Baidu's Raven, Xiaomi's Mi AI, and the soon to be shipping Apple HomePod. These devices use arrays of MEMS microphones to enable better voice input.

Juniper Research believes that by 2022 over 70 million households will have at least one of these smart speakers in their home, and the total number of installed devices will top 175 million. That's just in the U.S. and we'd expect similar penetration globally.

We continue to demonstrate our new intelligent audio products with our software partners at CES, including our smart microphones and multi-core DSP products targeting IoT applications. These solutions can enable voice control for a variety of devices with very low power consumption in a cost-effective manner.

We see several makers of IoT devices evaluating our smart microphones to enable local processing of keywords without having to go to the cloud to identify the commands.

We are also seeing large, sophisticated audio teams interested in our multi-core DSP product given its capabilities to enable multiple features through its open quad-core processor designed specifically for audio applications.

We are getting a strong response from OEMs for this solution because of its design flexibility, processing power and power efficiency. Our alpha customer will be the first to market with our solution remains on track to launch its product in Q2.

Companies and consumers understand the power of voice control and how it facilitates interaction with technology around us. We remain the premier supplier of audio input technology across our three target markets.

Our core capabilities in acoustics, digital signal processing and algorithms are unparalleled and place us in an ideal position to enable voice technology. With that, I'll turn it over to John to expand on our financial results and provide our guidance for the first quarter.

John?.

Thanks, Jeff. Before jumping into our Q4 financial results, I want to comment on two positive events, which impacted our quarter. In November, we completed the divestiture of our low-margin timing device business for $130 million.

As we noted, when we closed the transaction, our continuing operations Q4 revenue guidance was reduced by $26 million and non-GAAP EPS was reduced by $0.02, as the results of the timing device business have been reclassified to discontinued operations.

Additionally, in December, we settled a royalty dispute related to a licensing agreement with one of our Audio segment competitors for $19.2 million. For purposes of my Q4 commentary related to our results, I've excluded $10 million in revenues and $3 million of recovered legal expenses, as these amounts relate to prior years.

Fourth quarter revenues were $206 million, up 5% sequentially and down 3% from the year-ago period. Audio revenues of $177 million were up 6% sequentially, lower than expected due to weaker than expected demand in China. Precision Device revenues of $28 million were flat sequentially, in line with expectations.

Fourth quarter gross margins were 40%, at the midpoint of our guidance. The favorable impact related to the divestiture of our lower gross margin timing device business was offset by the unfavorable impact of lower than expected microphone volume.

Operating expenses in the quarter were $45.3 million, down $5 million from the year ago period on lower incentive compensation cost, lower legal expenses and our ongoing efforts to reduce general and administrative expense.

For the quarter, adjusted EBIT margin and non-GAAP diluted EPS, excluding the prior year benefit of the royalty settlement, was 19% and $0.28, respectively.

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 $112 million at December 31.

For the quarter, cash flow from operations was $62 million and capital spending was $8 million.

The cash generated from operations in the quarter, combined with the net proceeds from the sale of our timing device business, totaled $185 million, and we used a significant portion of this cash to reduce borrowings under our bank revolving credit facility.

We ended 2017 with net debt of $110 million and a leverage ratio of less than 1.5 times, with both metrics at the lowest levels since the spin-off from Dover. Before moving to our Q1 guidance, I want to comment on the impact to the company of the U.S. Tax Cuts and Jobs Act of 2017.

The company expects to pay approximately $18 million in cash taxes related to the deemed repatriation of historical foreign earnings, which will be payable over eight years beginning in 2018.

In addition, beginning this year, we expect our effective tax rate will increase to a range of 15% to 19% to reflect the reduced benefits associated with future U.S. tax losses, a U.S. minimum tax on future offshore profits and other provisions of the recently enacted tax legislation. Moving to our first quarter guidance.

We expect total company revenue for the quarter to be between $170 million and $190 million, with the midpoint up 7% from the year ago period.

Revenue from the Audio segment is expected to be down 16% sequentially, better than typical seasonal trends and an increase of 4% over the prior year driven by growth in IoT devices and an increase in shipments to our largest North American customer, partially offset by continued weakness in China.

Precision Device revenue is expected to be up 7% sequentially and up 25% from the year ago period driven by increased capacitor demand across several end markets and the impact of a small capacitor acquisition which closed earlier this quarter. We're projecting non-GAAP gross margin in Q1 to be between 37% and 39%.

R&D expenses are expected to be $21 million to $23 million and SG&A expense is expected to be $28 million to $30 million. We're projecting adjusted EBIT margin for the quarter to be in the range of 9% to 11% and expect non-GAAP diluted EPS to be within a range of $0.10 to $0.14 per share.

This assumes weighted average share outstanding during the quarter of approximately 93 million on a fully diluted basis. We're forecasting an effective non-GAAP tax rate of 15% to 19%. Please refer to our press release for a GAAP to non-GAAP reconciliation.

For the first quarter, we expect cash utilized in operations to be between $5 million and $15 million. Capital spending in the quarter is expected to be approximately $30 million and includes $10 million of spending which was originally planned for the fourth quarter of 2017.

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?.

In 2017, we doubled microphone sales into IoT and headset markets. We also introduced a full line of open DSP solutions that are gaining traction across our three core markets. This positions us for growth in 2018 and beyond.

In addition, we delivered strong cash generation in the back half of the year, and exited our lower margin timing business which enabled us to strengthen our balance sheet by paying down debt to the lowest levels since the spin.

As we enter 2018, I anticipate rapid growth in microphone sales into IoT and headset markets, coupled with strong growth in precision devices to drive favorable results. In addition, intelligent audio solutions are gaining traction across our mobile, ear and IoT markets as we continue our transition to an audio solutions provider.

I believe that the number and quality of engagement we are seeing serves as confirmation of our intelligent audio strategy. We remain uniquely positioned across our end markets to deliver best-in-class audio input solutions for our customers that leverage our leading-edge acoustics with digital single processing and algorithms.

Operator, we can now take questions..

Our first question comes from the line of Charlie Anderson with Dougherty & Company. Your line is open. Please go ahead..

Yeah, thanks for taking my question. Jeff, I wondered if you wanted to offer any review on the full year. You've got a lot of moving parts here between all the segments and the sort of a different model post the divestiture, so wondered if you want to offer any commentary there.

And then similarly on the margins, you should have sort of a new gross margin structure, new EBIT margin. Just any sort of full year view or maybe short-term operating model comments you might have? And then I have a follow-up..

Yeah.

I assume you're referring to 2018 in terms of what you're looking for some thoughts on, correct?.

Correct..

Yeah. So I think from 2018 standpoint, I think we've got a couple of pieces that are showing very strong growth. And the IoT market continues to be very strong for us. I discuss this now last call, this call, and it's not just our largest IoT customer. We're seeing a lot of traction across, what I would say is multiple customers now with IoT devices.

Our headset market, we're starting a small base. I'm very optimistic about the headset market going in 2018. And in both those markets, I would also add that, while I don't expect significant revenue, we do see intelligent audio revenue coming in those two segments.

I think the one segment that I think I'm a little bit more cautious about is that the handset space, I think our largest customer as I mentioned, we're starting off Q1 very strong, in Q1 with our largest customer year-over-year. And so we're very pleased.

But that is a function, not only of handsets, but it's also a function of – that we're in all other products, whether it be ear products or IoT products. There's a lot of optimism around that largest customer. I'd say the one area that we continue to monitor and while the trends for audio are strong, with digital mics, DSP-based mics, is China.

I think China is in Q1 and it's reflected in our guidance, is week. But it is reflected in our guidance. So overall I would say that's the one piece that I feel that I'm a little bit I wouldn't say negative about, we expect growth. But I'd say after seeing what's happened in Q4, we're going to wait and see what happens a little more with China.

On the gross margins, I'll let John make a few comments on that..

Okay. Yeah Charlie, for the year on a reported basis, we ended up with gross margins just a little above 40%. I think 40.3% you'll see in the supplemental schedules. Those amounts are excluding the timing device business. The divestiture of timing device business increased our overall margins by almost 100 points. So from 39% to 40%.

I would think as we go into 2018, you should think gross margins are going to be pretty stable. In terms of operating expenses, I mentioned the range of operating expenses in Q1. I would think R&D, continue to see R&D at 10% to 12% of sales and then SG&A that run rate we have in Q1, I really see that as a good run rate going over the course of 2018..

Great. And then for my follow-up, I think you guys mentioned some supply constraints in Q4. I wonder if you could quantify what kind of impact that had and kind of where we stand with that.

Does that persist into 2018 at all?.

Yeah. So I'm not going to go into a lot of specific details on what the supply constraint was, but I think we could have delivered some more in Q4. I don't think it would have been huge, but it would have been more. The situation is definitely improving in Q1 and it's reflected in our guidance..

Okay. Thanks so much..

Thanks, Charlie..

Our next question comes from the line of Suji Desilva with ROTH Capital. Your line is open. Please go ahead..

Hi, Jeff. Hi, John. Just to follow-up on Charlie's question on China and the 2018 outlook.

I understand near term you're cautious, but if the China OEMs are launching phones into the Barcelona Show coming up here, would that have the potential to get that segment going, or are you concerned about the overall demand pattern regardless of new China phone launches?.

Yeah. Here's what I would say is our product roadmap and our design wins are very well aligned with the China customers. So I know I'm not concerned from the perspective of where our position is with the Chinese customers. I'm more concerned is how these phones sell in the end market. I think I mentioned this. We're very excited.

The multi-mic adoption in China continues to expand. Number two is we're seeing more customers adopt digital mics in the China market, which is also good for us in terms of ASPs. And as I said, we will start to see shipments of our DSP-based smart mics in Q2 to a number of Chinese OEMs.

So all the things are aligning from a perspective of audio and the importance.

What I'm more cautious on is, well how many phones did they really sell?.

Fair enough. And then my other question's on the multi-core DSP part. I know that's ways out in terms of designs and it's a long designing cycle, but you have a lead customer already.

What's the order of magnitude of customers we could think of adopting that product in the 2018 timeframe? Is it possible to have handful of customers there or is it really just one you're focused on? And what's the ASP opportunity there versus your typical products?.

Yeah. I think we talked a little bit about the ASP in the past. Our expectation depending on the amount of work and algorithm work we have to do versus what they do versus what third parties do, I think we're thinking in the neighborhood of $3 to $5. That's what we're thinking.

And I would say at this point that we're getting what I would say is, as kind of I said in my close, the number and quality of engagements that we're getting is very, very good. And this is not with start-up companies that are just starting off and expressing interest.

We're getting interest from tier 1 people in looking at this and across mobile, IoT and the ear market. And I would anticipate that as we go into 2019, we would have multiple design wins going to production on that multi-core DSP..

Very helpful, Jeff. Thank you..

Your next question comes from the line of Bob Labick with CJS Securities. Your line is open. Please go ahead..

Thank you. Just wanted to take a step back on China.

If you can give us a sense of context about how much – what percent of sales was in the Chinese OEMs in 2017? And then what was the driver of the weakness, kind of, in the fourth quarter? And if you can give some kind of outlook for 2018 on how that may shift?.

Yeah. So if you remember, when we talked earlier in the year, well first let me give you the number, it's about 11% or so in 2017, the China market. And let me talk about the full year. I think we had extremely strong 2016 with them. I mean extremely strong.

If you remember, I think we're – in fact, I don't hold these numbers, but I think we're up like 60% in 2016 over 2015. And what we suffered through, we think, in the front half of the year is a fair amount of inventory correction where we over-shipped in the back half of 2016.

What we're seeing now in the back half of 2017 is, and I think Suji referred to this, is that a lot of the handsets they did not introduce and they have a lot, I would say, reasonably stale portfolio of products. And the shipments were not up to expectation of what we were hoping for in Q4.

I would say, Q1 continues to remain weak, but that is factored into our guidance that we're expecting a weak Q1..

Got it. Okay. And previously, I think maybe it was last caller before you said you expect about 10% volume growth in mics this year and you were building out capacity, obviously, to do so.

Could you just tie those two things together? Do you still expect about 10% volume in mics or is it going to be slightly lower now with a weaker China? And where do you stand on your capacity additions?.

Yeah. So I mean, I think we're doing a lot of planning on the capacity adds. So I'm not going to speak specifically to the capacity. We're spending a fair amount of CapEx early in the year. That was already kind of planned to help us position for 2018.

I would expect, though, the mic volume would be up in terms of, if you – at least 7% or 8% in terms of volume, year-over-year. That's what I expect right now. And that would include, I would say, some recovery in China in the back half of the year, not a huge recovery back to like 2016 levels, but some recovery in China in the back half of the year.

I think here's what you got – we think about is. Our largest customer is actually quite strong for us in Q1. And whereas we look at our forecast going forward, it looks pretty positive in 2018 with our largest customer. You've got IoT, which is going to have a significant growth for us in microphones.

You have headset market, again, starting at a small base, but growing pretty significantly in 2018. And I guess what I would just say is that's partially offset by that we're not going to get overly optimistic on China at this point..

Just to add some clarity on the capacity utilization. If you think of full year 2017, we were right around 90% capacity utilization, but in the first half of the year, we were running much closer to 95%, even 100% in some months. The back half was impacted a bit by the supply chain constraints we had.

So full year, we were right at a little – maybe 91%, 92%..

Okay, great. Then, one last one if I could sneak it in. Obviously, the balance sheet improved materially with the divestiture and then the strong cash flow in Q4.

Can you just talk about expectations for cash flow going forward and what leverage you're looking to target?.

Yeah. I mean, as we've noted – as you noted, the balance sheet improved significantly. We reduced net debt by over $160 million from end of 2016 levels. Our leverage ratio is below 1.5 times as we exit 2017, but our priorities for capital allocation continue to be consistent.

First, it's funding internal growth initiatives and capacity expansion, which I do expect to be higher than normal this year, given a very positive outlook for MEMS microphone and our thin film product line in capacitors. So there is the potential where our CapEx could be above the normal 6% to 8% of revenue range for full year 2018.

Second, we will continue to pay down bank borrowings. We have $51 million still outstanding under our revolver. Third, we will look at accretive bolt-on acquisitions. As I mentioned, we made a small acquisition in our capacitor – in our PD segment earlier this quarter. And so those really continue to be the priorities for capital allocation..

Great. Thanks very much..

Your next question comes from the line of Harsh Kumar with Piper Jaffray. Your line is open. Please go ahead..

Yeah. Hey, guys. A couple of quick questions. John, I was wondering if you could give us a sense of what your interest expense income line will look like, post this paydown that you guys did. And then, I've got a couple more..

Sure. Sure. You can think of interest expense in 2018 to be kind of right around the $11 million range, down about $3 million or so from 2017 levels. And it's really – that's assuming modest rate increases over the course of 2018.

I think that would factor in, call it, 25 basis points increases, but really the reduction is due to the lower outstanding balances..

Understood. That's very helpful. And then, what level of CapEx – I mean, so 90% is pretty close to full and if you get a little bit of uptick, you're back to the sort of the high-90s, which becomes a headache to run a business with.

You're having some CapEx, I think $20 million on a standalone basis for 1Q outside of the $10 million, but how should we think of CapEx or maybe capacity adds as the year rolls along? Maybe, if you guys have a number for 2018, that would be helpful..

Yeah. Harsh, I'm not going to give a number for 2018 because it really – we're closely monitoring the market, especially the development in the back half of 2018 as well as the early part of 2019, but I would say that there is a possibility that our CapEx for full year spending could be higher than our historic range of 6% to 8% of revenues..

But if that will be the case, we'd also expect more growth as well..

Correct..

Sure. Thank you. And then last thing, I know your IoT business is now becoming meaningful. Your headset business is ramping.

Jeff, I was wondering if you would be willing to give us the dollar numbers on what IoT business, how much it is, perhaps last quarter or full year however you want to slice it and then even the headset business?.

So let me just kind of give you more percentage of sales numbers and so exact numbers and dollars....

Sure..

In 2016, because we looked at this, we know we've gotten this question from you guys before. In 2016, the ear and IoT market was about 7% of our mic sales. We expect in 2018, if things go as we're expecting, that it'll be over 20% of our mic sales will be in ear and IoT..

Wow. Interesting. Okay that's it for me. Thanks, guys..

Your next question comes from the line of Bill Peterson with JPMorgan. Your line is open. Please go ahead..

Yeah. Thanks for taking the questions. And I guess maybe first, in light of the, I guess, still weak demand environment especially China, it sounds like your overall business at your largest customer is strong, but presumably some of that is due to uplift in other products.

How can you characterize the competitive environment in light of a still fairly weak demand environment especially for handsets?.

Yeah. So let me just walk back just first on the largest customer. I think it's worthwhile just taking a few moments here. I think one of the differences – and maybe not to the positive for us in the past, but now it comes back as positive is our content across handsets with our largest customer is roughly the same.

So whether it be a generation ago or two generations ago, our content is roughly the same. So when there's shifts in mix, that may cause us some issues relative to supply constraints if there's last minute shifts in mix. It doesn't really change our total content per device. So I'd make that comment first.

The second, you are correct with our largest customer, that we do have a fair amount of new business across some of these other segments that have not been that large in the past. And that's driving some nice growth in Q1 year-over-year, of both those items. The second question you asked about was the competitive environment. I think this is evolving.

We've talked about it on a quarter-by-quarter basis. We tried to keep you up to-date.

I still think the bottom line is, is there's us and one primary competitor and then you see a number of other people who either falling out and saying that they're no longer going to participate in this market, defocused on this market, and/or saying this is a lot harder market to enter than I anticipated.

And so what I'd say is, is the competitive environment seems to be moving more favorable. And how does that work in terms of – from our perspective, how would we see that showing up? We've talked about ASPs in the past, Bill.

And what we said was, in 2016, our ASP on mature products was down at the higher end of our range, on mature products its 6% to 10%. Last year it was in 7% to 8%. And I guess right now if I were to guess, I would say it would fall below the low end of that range on mature products in 2018. That's how it's coming out.

The second thing I would add in about the competitive environment is the more advancements that are coming in microphones, whether it be digital, DSP-based mics, new interfaces, it's making it increasingly difficult for second-tier players to compete on the stage with the tier 1 suppliers. So I think what I would say is we always got to be cognizant.

We do have one very serious competitor that we take very seriously, but I think the tier 2 people are becoming less, having a less of an impact on our business..

Okay. That's helpful color. And I guess maybe trying to reconcile that with what seems to be maybe a modest uplift or flattish gross margin profile taking into account, I guess, at least some design wins taking office here, you already mentioned smart mics with China.

Why shouldn't we see some uplift in gross margin? And if we do, how should we think about that going back to earlier question?.

Yeah. I understand where you're coming from. I guess what we say is that in the core market, we still have one strong competitor. And I would say is that – what we said is, until we get larger traction on intelligent audio, like meaningful traction in terms of dollars, the gross margin's probably going to hover in that same range of, like, 40%.

I think as we go forward, especially as we start seeing more revenue into 2019 out of intelligent audio, and again, I expressed we're getting more confident based on the engagements, with Hoover engagements and design wins, I think there is the opportunity to improve it.

I also think is over time as more of these tier 2 guys start to fall out, officially fall out, there may be some opportunity in 2019 and beyond in the core business to improve the margins..

Okay. Okay. Great. And I guess last one for me. I don't think you mentioned too much about hearing health. Maybe how should we think about that business this year? And then your capacitor business is showing some very nice and very strong year-on-year growth trends.

I mean, do you expect it to moderate? I mean how should we model that business or think about that business potential in 2018?.

Yeah.

So let me – can I cover the capacitor business first, if that's okay?.

Sure. Sure..

Yeah, I would agree with you. Our capacitor business is doing extremely well.

And it's really nice because its broad strength across a lot of customers and a number of markets from defense, medical, industrial, if you probably remember – or it was in – we didn't really highlight because it was very small in Q1 of 2017, we did a small acquisition in this business, a very small acquisition. We just kind of – John mentioned it.

We did another slightly larger one, but still very small acquisition in earlier this quarter, in 2018. Both deals were immediately accretive. So we're real positive about this. But the core itself is growing as well. So when I look at the numbers, in Q1 we're up 25% year-over-year.

Our expectation is about two-thirds of the growth is coming from the core. And about a third of it is coming from the acquisitions. And as we look through 2018, I would sit there and say our expectations are that the business should be up year-over-year roughly in that 20% to 25% range.

Now that's maybe a little bit of a stretch, but what I'd say is, there is the opportunity, so..

Okay.

And hearing health?.

Hearing health. So here's what I'd say on hearing health is, we have definitely, from our perspective, stabilized the business. We're seeing quarter-to-quarter that the sales are relatively stable which is important for us. And I think the key for us in 2018; we got three things that we're focused on.

Number one is that we got to win new platforms in the hearing aid business. So we're working diligently on new platforms that will start production late in the year in 2018 and into 2019. We continue to work on MEMS mic penetration where we have a very, very strong competitive advantage in the hearing health market.

And then last piece is in our balanced armature receivers, which the speakers that go into hearing health, we're increasing our focus on selling that technology and capability outside of the hearing health market into things like hearables.

And so I'd say 2018 is a year of stable, and I would hope that as we go into 2019, we would be able to start seeing some growth resuming in the hearing health business..

Okay. Thanks for the color and good luck on the execution..

Yes. Thank you..

Your next question comes from the line of Christopher Rolland with Susquehanna International Group. Your line is open..

Yeah it's Susquehanna. Thanks. Thanks for letting me ask the question. So in your prepared remarks, you talked about one of your customers moving to a new high-performance mic platform.

So is that just higher SNR, or is there something else there, DSP or some other kind of architecture? And then how do we compare ASPs for their old solution versus what they want now?.

So I'm not going to really talk to ASPs at a specific customer, but it is another digital platform. It's not a DSP-based platform, but it is another digital platform that moves up in a number of areas. It's, I believe, all my technical guys would probably have to hold me to this. I believe it's lower power, it's smaller in size, it's higher in SNR.

It is more robust in terms of its performance and reliability. So it's got multiple things that it does. And so what we're excited about is, if you remember, if you go back a couple of years ago, we were kind of lamenting the fact that that customer had used the same microphone for three years in a row.

What we feel good about now is, in 2017, we got to work with the new microphone. In 2018, we got – going to work on another microphone. And that our goal always is going to be is another microphone and hopefully, if we're really successful, we can get them to increase the number of mics..

And it is at a higher ASP..

It is at a higher – I am sorry. I'd say it's at a higher ASP..

Okay, great. And then, in terms of your expectations for intelligent audio, I mean you can define it however you want to define it, multi-core DSP or any other way you want to define it.

But if I think about 2018, and particularly 2019, what do you think this could be as a percentage of revenue? Are we talking, like, 5%, 10%? Could it be 20%? How aggressive do you think you guys can build on?.

Well, I'm not prepared to give a number for 2019 in February, but I would say is that we're not making this investment for this to be an incremental amount of revenue in the long-term. We're making this because we believe that there is a large business opportunity, large business opportunity, that's I guess what I would say right now.

The second piece I would say is that how we're seeing this, at least starting to impact our business, is in a couple ways, is let's use the example of the smart mic design wins that we have. In the past, a lot of these phones used two analog mics. Now, they're moving to a third mic, which is the DSP-based mic.

And then, because they're starting with DSP-based mic, they're also being forced to move to two other digital mics. And once we have the sole source position on the digital – or the DSP-based mics, it's much easier to close very high share on the digital mic that we have. So we're seeing that.

The second thing on the quad-core processor, this is a much higher ASP, a much more complicated device, but the things that we're excited about is this has the potential to run a significant amount of the audio functions that are running inside of a device.

And one of the things we're learning more about as we've introduced this is one of the exciting areas is artificial intelligence. There's a lot of work being done in this area around audio, and our product has been specifically tuned to run those type of algorithms. So we are actually quite excited about these products.

And we're not making this investment for a small return..

Okay, great. And then one quick housekeeping and then a real question, the capacitor acquisition. How much revenue would that drive for 2018? And then the real question, I guess, is on the powered headset side. You talked about that driving extra content for you. Apple's kind of moved that way.

Can you talk about what you guys are seeing in terms of designs for powered headsets? I guess you kind of have to eliminate the power jack and move to the USB Type-C.

Are you seeing those designs starting to inflect in 2018?.

Let me take the headset question first. Here's what I'd say is, so far I would say is we've been, I'd say, somewhat disappointed by the number of products that have come to market with wired powered headsets. We have not seen as many as we would like.

On the reverse, Bluetooth headsets, wireless headsets seem to be really taking off and that's you kind of referred to the Apple version. And what we're seeing is more and more people thinking about adding features to Bluetooth headsets, to wireless headsets that allow you to do a lot more with audio input.

And we've kind of referred to that as keyword detect, simple voice commands. And what they're looking for is solutions that have multiple mics in order to make it work really well, but secondly processing power in order to location to do that type of processing.

And what I'd say is we're not ready to announce a lot today, but I'd say in the Bluetooth headset market, there's a lot of interest in smart microphones, a lot of interest in the DSP-based smart microphones to do a lot of this function.

And so what we're hopeful is that toward the back half in the early 2019 that there's quite a few manufacturers who are really embracing the idea of DSP-based smart mics for the Bluetooth headset market. As far as the caps revenue, its sub $15-million.

I mean, you can kind of look at the growth numbers that were based on what we're talking about that could come. And so it's something sub-$15 million..

Yeah, a little more than $10 million. And I think the positive is we expect it to be accretive in 2018 to our earnings..

Awesome. Thank you, guys..

Your next question comes from the line of Anthony Stoss with Craig-Hallum. Your line is open..

Hey, Jeff, a couple questions. First off, related to you DSP. You talked about gaining a lot of traction. I know you've been sampling and showing it off for some time.

What are those potential customers most interested in? And then secondly, what's preventing them so far from really signing on with you folks and it being a more 2019 event, especially in the ear market? And then I had two follow-ups for John..

Yeah. I would say, again, kind of what I referred to on the last question is in the ear market, I think it's a little different from market-to-market. I thought just would say that. In the IoT market, there's a lot of interest in both the smart mics, the DSP is a smart mic as well as the multi-core DSP.

In the ear market, I would say the initial interest is more on the side of the DSP-based smart mics today. And what I would say is there is smart mic interest in the mobile market for sure, and there is, I'd say, with some interest in the multi-core DSP that they're starting to assess on.

I think the number one thing that slows us down in the space is not the hardware. The hardware's done. It's ready to ship.

We can sample as many as we want, but I think what the issue is, is when the customers start thinking about what they want or what they could do with these devices, it requires a fair amount of algorithm and software integration within their existing platforms. Now we're getting there.

We expect that stuff is going to start on the multi-core DSP, start shipping in Q2. We expect smart microphone, DSP-based microphones start shipping in Q2 as well. And so I keep coming back to at this moment that the quality and the number of engagements that we have with tier 1 guys in each one of these markets is very, very good.

It's a matter of now moving them forward in thinking about how and what features they want and how they integrate it into their systems..

Okay. And then John, as a follow-up.

It might be helpful if you can tell us how much China is expected to be down sequentially in Q1? And also your OpEx being down a bit here in Q1, is that largely just the sale of a timing division, and what are your thoughts on continuing to kind of tweak down OpEx throughout the year?.

Yeah no, with respect to China we do expect it to be down sequentially kind of in the range of $4 million to $5 million quarter-over-quarter. And again that's reflected in our Q1 guidance. From a SG&A standpoint, again, like the midpoint of my guide for Q1 was I think $29 million.

There's some movement amongst the quarters, but I really think that's a pretty good run rate for the remainder of the year. Again, there's things like, you'll have higher payroll taxes in Q1 but you have lower incentive comp typically in Q1 which we match with our earnings by quarter.

So again, I would expect that SG&A to be pretty stable over the course of 2018..

Okay. Thanks..

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

Yeah. Hey, Jeff. I wanted to see if I could ask this and maybe you take a shot at it. I'm trying to model out the rest of the year and I'm curious if you would be willing to provide us with some commentary on how you think June looks like given all the volatility with the ramp at your largest customer, China, IoT growing things like that.

And maybe even back half, would you expect full year to be at least up year-over-year on an apples-to-apples basis? And any color you'll provide would be very helpful..

I mean Harsh, I hate to make this call. There are people who are more intelligent on what's going to happen with the China headset market than me. I can just tell you is I know we kind of referred to this. There are a lot of new phones going to be launching.

And we're well-positioned with them, whether it be with the standard analog mic, digital mic, some with DSP-based smart mics. We're very well-positioned in this market. It's very hard for me to predict where this all goes beyond.

I guess, what I would say is and I said this before, but it come back kind of not say to burn me, but that I haven't been right. I'm cautiously optimistic but I'm not necessarily feeling like I've heard this story before. And so what we're trying to do is be conservative in our outlook here.

And knowing that we're starting the year with our largest customer, we're continuing very strong in ear and IoT. We have our hearing aid business being stable and our capacitor business looks pretty good. So this is the one area where I'm more cautious.

And it's very difficult for me to sit there and say, what's going to happen with China at this early stage in the year, but we are well-positioned..

That's fair. Thanks, Jeff..

We have no further questions at this time. I'll turn the call back over to the presenters..

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

This concludes today's conference, and you may now disconnect..