Knowles Corp (KN) 2014 Q2 法說會逐字稿

Good afternoon and welcome to the Knowles Corporation second-quarter 2014 financial results conference call.

(Operator Instructions)

As a reminder, this program is being recorded. With that said, here with opening remarks is Knowles' Vice President of Investor Relations, Michael Knapp. Please go ahead.

Thanks, Jonathan and welcome to our second quarter 2014 earnings call. I'm Mike Knapp, Knowles' Vice President of Investor Relations, 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, included but not limited to the annual report on Form 10-K for the fiscal year ended December 31, 2013, and periodic reports filed from time to time with the SEC. 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 Regulation G, any non-GAAP financial measures referenced during today's conference call can be found in our Press Release posted on our website at www.Knowles.com, including a reconciliation to the most directly comparable GAAP measures. All financial references on this call will be non-GAAP unless otherwise indicated. Also, we've made selected financial information available in webcast slides which can be found in the Investor Relations section of our website.

With that, let me turn the call over to Jeff who will provide second-quarter highlights. Jeff?

Thanks, Mike. Thanks to all of you for joining us today. I'm happy to report we delivered revenue of $281 million, above the high end of our prior projections, driven by better than expected sales in both of our segments. In addition, operating margins of 7.7% were at the high end of the range we projected on our April earnings call. Now I will provide an overview of the trends we saw in our segments and end markets and discuss some of the design activities with our new products that we expect will fuel future growth. After that, John will provide financial highlights for Q2 and our guidance for Q3.

In our mobile consumer electronics segment, Q2 revenue decreased by 12% from a year ago at the upper end of our prior projections. The year-over-year decline was due to weaker demand and an inventory correction at Samsung as well as BlackBerry and Nokia's market share loss. This was partially offset by stronger sales to North American and Chinese OEMs. In fact, sales to our Chinese OEMs more than doubled from a year-ago period. Revenue from the mobile consumer electronics group comprised 59% of total sales in Q2. Based on our current expectations for customer product launches an projected builds in the second half of the year, we continue to anticipate that 2014 will be a year of modest growth.

In addition, there are several trends we see today in the mobile consumer space that we believe will drive accelerated growth in the next several years. One of the important trends we're seeing is the rise of Chinese OEMs and their focus on high-quality devices with greatly improved acoustic performance. Many of these smartphones are selling well in China and other regions. Xiaomi said earlier this month it sold more than 26 million smartphones in the first six months of the year for year-on-year growth of over 200%. We fully expect Xiaomi will be a Top 10 customer for us in 2014.

Also, companies like Huawei recently reported a 19% jump in sales for the first half of the year helped by worldwide smartphone sales. This is another large opportunity for us. These phones are incorporating high-end features with increased acoustic content. We expect the average number of mics per phone built by Chinese OEMs to increase more than 10% in 2014 versus 2013. Knowles is well positioned with these OEMs particularly with our integrated audio solutions and our microphone technology.

As we mentioned last quarter, these integrated solutions deliver superior acoustics and ease of implementation using a space efficient module. Many of these customers rely on us to deliver premium acoustics, so this is an ideal solution to improve the performance, accelerate time to market and help them differentiate their products. And it isn't just smartphones that are adopting our technology. We recently began shipping our integrated audio solution and microphones on the new Xiaomi tablet, the Mipad, which sold off its initial 50,000 unit allotment less than four minutes after being introduced.

This solution incorporates our revolutionary end-based technology which doubles the effective air volume in our loudspeaker system. The result is better speakers with more bass in the smallest possible design. This Xiaomi product incorporates two speakers and two mics to combine for almost $4 in content per device. We expect to secure additional designs in the near future. Building on the IS and microphone platforms, we are seeing a definitive trend towards adoption of new intelligent audio solutions. These will further enhance performance, enable new features for consumers while increasing our acoustic content per device. We will be talking more about this as the market develops.

I also want to spend a brief moment to talk about a new technology we recently pioneered. We leveraged our MEMs technology leadership to develop the world's first digital microphone supporting ultrasonic bandwidth. While in the very early days of adoption, this technology has a broad range of uses, including touchless gesture recognition, data transmission, and positioning input. We are excited about the opportunity associated with this technology, and we look forward to working with our customers to define and enable new applications.

Overall, the trend in our mobile consumer electronics market remains very positive. We are working closely with our customers in this market to develop products that enhance the user experience. Our technology, coupled with our strong engineering relationships, creates a platform to deliver high-quality solutions to these customers and puts us in an excellent position to deliver growth over the next several years. In the specialty component segment, Q2 sales were up 7% from a year ago and represented about 41% of the total Company revenue. The growth was better than our prior projections. Strength was primarily driven by sales in precision devices aided by continued 4G LTE infrastructure spending primarily in China. We remain well positioned in a number of wireless infrastructure providers supporting these bills.

Revenue in our capacitor business was strong in the quarter due to solid demand primarily from medical customers. In addition, we have completed the transfer of our capacitor production from our UK facility and shipped about 300 million units from our Suzhou facility since the transfer began. Within our acoustic component business, we continue to be the leader for all of our top hearing aid manufacturing customers. We mentioned on the last call that we are seeing adoption of our MEMs solutions in the hearing aid market.

Last week we announced we shipped our 2 millionth MEMs microphone to the hearing health industry. This product provides best-in-class acoustic performance for users including a high signal noise ratio, ultra low power and unmatched environmental robustness, all-in the world's smallest package. This small size positions as an attractive solution for designers and simplifies the hearing aid assembly process. Overall growth in this market remains stable, and we expect moderate long-term growth in the years to come. We are also on track with the ramp up of our Philippines facility supporting the production transfers in this business.

As we've discussed, both of our segments will benefit from our continuing effort to optimize our global manufacturing footprint. I noted that our restructuring initiatives for our capacitor and hearing health businesses are tracking as planned. In addition, we have ceased production at our Vienna facility, and this restructuring is on track. We expect the benefits to contribute significantly to our fourth quarter operating margin this year.

With that I will turn it over to John to expand on our financial results and provide our guidance for the September quarter. John?

Thanks, Jeff. As Jeff mentioned earlier, we've reported second quarter revenue of $281 million, above the high end of guidance provided on our April earnings call. Mobile consumer electronics or MCE revenues of $166.7 million were at the high end of our prior projections. Strong demand from a North American OEM and significant growth across multiple Chinese OEMs was driven by an increase in shipments of both components and integrated audio solutions. This strength was more than offset by lower demand at Samsung and lower year-over-year shipments to Nokia and BlackBerry in connection with their lower share in the handset market.

We were pleased with specialty component revenues of $114.3 million, above the high end of our prior projections. The increase was driven by stronger demand for precision devices in 4G LTE communication infrastructure, particularly in China. Second quarter gross margin of 29.2% was within our projected range and down from the prior year quarter, driven by lower volume, reduced fixed cost leverage within mobile consumer, primarily in our Vienna facility, and higher ramp costs associated with new products. We expect significant improvement in gross margins as we move through the second half of 2014.

Operating expense in the second quarter was $60.8 million or 21.6% of sales, which is was above prior year levels, driven by higher R&D and legal expense, partially offset by savings from prior restructuring activities. R&D spending during the second quarter was $21.5 million, higher than year-ago levels to support increased new Product Development activities including integrated and intelligent audio solutions. EBIT margin on an adjusted basis was 7.7% in the quarter versus 17.1% in the year ago period with the second quarter of 2014 impacted by lower gross margin and higher operating expenses.

Non-GAAP diluted EPS was $0.26 during the quarter and includes a $0.05 discrete tax benefit relating to our Malaysian tax holiday. This discrete tax benefit was not reflected in the $0.15 to $0.19 second quarter EPS range previously provided. The tax holiday benefit relates to prior periods and is reflected in the second quarter as US GAAP requires such benefits to be recorded upon receipt of the final approval from the relevant tax authority which occurred during the quarter. 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 www.Knowles.com.

Now I will turn to our balance sheet and cash flow. Cash and cash equivalents totaled $44.6 million at the end of June. For the quarter, cash flow from operating activities was $21.6 million before spending related to capital expenditures of $17.2 million. The majority of spending relates to new product introductions which we expect our customers to launch in the second half of this year. We expect capital expenditures for the full year to be between $90 million and $100 million. Our bank debt balance was unchanged during the quarter at $400 million, and interest expense related to this debt was $1.8 million. With that, I will turn to our third quarter projections.

Based on our current expectations related to customer product launches in the second half of the year, we expect positive demand trends resulting in third quarter revenue of $310 million to $330 million, up 10% to 17% sequentially. Sales from MCE products are expected to increase approximately 24% sequentially at the mid point with growth driven by product launches at a North American OEM and increased shipments to Chinese OEMs. Specialty component sales are expected to remain consistent with Q2 levels with a higher run rate experienced in Q2 expected to continue. We are projecting non-GAAP gross margin to be approximately 32% to 34% with the mid point up almost 400 basis points sequentially on higher production volumes and lower fixed overhead as we begin to realize the financial benefits from our restructuring initiative in Vienna.

We have stopped all manufacturing activities in Vienna and expect the production transfer to be completed in Q3 with full financial benefits being realized in Q4. We continue to make progress on our manufacturing footprint consolidation initiatives which will enable us to improve year-over-year operating margins in Q4 of this year. Further, we now expect to realize $50 million in annualized cost savings by the end of 2015, at the high end of our prior range of $40 million to $50 million and earlier than previously communicated. R&D spending in the quarter is expected to increase to $22 million, up from Q2 driven by a higher level of activity related to integrated and intelligent audio solutions.

Selling and administrative expense is expected to be roughly $36 million, lower than Q2 levels with the sequential reduction driven primarily by the timing of legal spending. We are projecting adjusted EBIT margin to be between 14% and 15% with an effective tax rate in the rage of 8% to 12%. In 2015 and beyond, we believe the tax rate will increase slightly over current year levels to 12% to 14% to reflect changes in our global manufacturing footprint. We expect non-GAAP diluted EPS for the third quarter to be within a range of $0.45 to $0.52 per share. This assumes weighted average shares outstanding during the quarter to be $85.8 million on a fully diluted basis. GAAP results are expected to include approximately $3 million in stock based compensation, $11 million in amortization of intangibles, $7 million in production transfer related cost, $5 million to $10 million in restructuring cost and the related tax effects on these items.

With that summary, I will turn the call over to Jeff for closing remarks and then we will turn to the Q&A portion of the call. Jeff?

Thanks, John. In summary, I expect new product launches to enable significant sequential revenue growth and operating margin expansion. In addition, I expect benefits from the restructuring initiatives will lead to year-over-year operating margin expansion in Q4. As we look forward, our new product pipeline is full, and I'm excited about the opportunity to increase content and drive growth for Knowles in 2015 and beyond.

Operator, we can now open it up for questions.

Certainly.

(Operator Instructions)

Our first question comes from the line of Harsh Kumar from Stephens.

This is Richard in for Harsh. I wanted to congratulate you on the quarter and the guide. Wanted to follow-up on China.

Could you please talk about what you're seeing in this market in general? We've heard of a transition from 2G to 3G and 4G and also how your content increases as we go from 2G phones up to 3G and 4G smartphones.

Yes, just to answer your question, first I'd say I'm real pleased with our results in China. We've done a positive job, and it's because we made the investment in China a number of years ago seeing as a potential.

And as we talked about at Investor Day and we go around, clearly people whether you're in China or India or the US, you want better acoustics. And we're starting to see this start to show through, especially with two things, the acceleration of multi-mic adoption.

We're actually seeing more multi-mic adoption with the Chinese OEMs than we've seen in previous years improve performance. And we've invested in this integrated audio solutions over the last year and a half, and now we're starting to see the dividend start to pay back in terms of sales.

So as I said in my opening remarks, our sales are going to double from 2013 to 2014 in Chinese OEMs, and we're expecting significant growth in 2015 again. And as I said, I'm very pleased with the results, and we see this trend continuing.

Great, and then following up to that, I was wondering if there were any changes in the competitive landscape, and as you get more revenue from China, if there are any other competitive dynamics going on over there.

Actually, what I would say is the competitive dynamics haven't changed dramatically from what we've talked about in the past, which is we see people coming in trying to be second sourced at the major OEMs. I actually see the Chinese OEMs being a little bit more challenging for the competitors. It's not one platform or two or three different part numbers.

What we see with the Chinese OEMs there's many customers and many projects. And with our broad product portfolio, it really serves us well because we can come into these guys and say if you want an analog mic or a digital mic, multi-mode mic, top port, bottom port, it really serves us well. So in some ways, the Chinese OEMs being that they are not one real large opportunity, we even see a little bit less competition from the second sourcing than we do at the major OEMs.

And then if I can sneak one more in, wanted to talk about past the September quarter, you guided for modest growth for 2014. Is there anything in particular that gives you that confidence, and then also looking at gross margins, do you still expect in the December quarter for those to increase year-over-year?

So let me answer the first question first, and then I will turn it over to John to talk a little bit more about the gross margins. We do expect modest growth this year, again driven by the product launches within the year that are back half of the year from our customers, specifically in China and North America.

I would just say that people may say something that we have a little bit wider guide on revenue in the third quarter. It's really hard for us to tell exactly when certain platforms are going to launch and at what volume, will there be any supply chain constraints from some other supplier.

So assuming the builds project as we're being told, coupled with the introductions happening as they do, we have a level of confidence we should be able to achieve this modest growth for 2014. Out of the gross margin, let me turn it over to John and talk about where the improvement in gross margin comes from and how we get there.

Yes, Richard as I mentioned, we had gross margins in Q2 of 29.2%. We're projecting 400 basis point improvement in Q3 gross margins.

It's really driven by a couple things. It's the stronger volume coming in in Q3, and it's also we're starting to realize the benefits of our Vienna restructuring.

We will get the full benefit in Q4, so to your question, yes we expect significant sequential improvement in Q3. We also expect improvement in margins in Q4, and as we stated on our last call, we are expecting an increase in year-over-year operating margins in Q4.

Great guys, thank you and good luck.

Thanks.

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

Good afternoon.

Good afternoon.

Hi. Just wanted to start -- you've obviously touched on a little bit here, but key to the investment thesis in your growth is this increased content per phone on mics. You'd mentioned a stat earlier, I was wondering if you could clarify on the 10% growth in Chinese, is that mics per phone or could you just expand on that, please? Yes, let me expand a little bit more. How we measure this is the number of mics per phone on the overall market, and then we can narrow it down by either by customer or the specific end applications, whether it be smartphones or tablets. But within the Chinese OEMs, what we're seeing is a 10% increase in the number of mics per phone.

So that's what we're seeing, so the actual number of mics per phone is going up on average per phone. And that's to improve the performance, enable new applications.

And it's not altogether different than we've seen in the rest of the market where once you start off with is people start with one mic and they realize they can't get great performance, and they might add a second mic. And then they want to do voice recognition or they want to do high-quality video recording, and then they add a third mic.

And so what you see is this proliferation of the number of mics. No matter where you are, you're starting from one; you can't go to zero obviously. You have to have a mic. But a lot of people are moving towards two and even some are moving towards three depending on the platform. Okay, great, so where would you say overall that market is in general? Is that a couple more years of this growth or is this a multi-year trend or towards the beginning, the end?

I would say we're right in the middle. I'd say the high-end phones that are in the marketplace primarily have three microphones already today. So I'd say we're right in the middle and probably a five year cycle, so we probably see another 2.5 years of growth.

And again, I think as we will talk more about this as we move forward in future calls and future Investor Day, but there's still the possibility of even moving towards more mics in the future and that's one side of the content increase. The other side of content increase it goes to our integrated audio where the customers are asking us to design entire acoustic module which also raises acoustic content.

Okay, great, and then just touching on that, integrated audio obviously came out of your R&D process and everything. Just taking a step back, could you talk a little bit about the R&D process and how the ideas you have are generated and how decisions are made to fund certain projects and scrap other projects?

Sure. Obviously we have -- I always tell people we have a full group of ideas, more ideas than we probably have people to fund. And we've always got to make sure we're following the right path.

But it starts with we've got our guys in the back who have been working on really new and interesting technology, and we're very lucky with our position in the marketplace that we have almost quarterly meetings with every one of the major OEMs discussing things that we're working on, stuff that they're interested in, and that really drives our product road map. We don't tend to do this in a vacuum where we're developing stuff, introduce it to market. Usually when we introduce new products, we have a launch customer the day we introduce the product taking it in very high volumes.

I think we talked about our multi-mode digital microphone in the first quarter which we shipped 30 million in the quarter we actually introduced it. So it's a fair amount of going back and forth with the customer with what we have to offer and coming up with the solution.

What's interesting from my perspective is you don't see necessarily every customer wanting the exact same thing. They put different priorities on different things, and that's how we fund things is we look at it by either the market or the individual customers that are large enough in order to drive our R&D spend.

I think one thing to add too is we do have a very rigorous gating process, and once a project is initially improved, it still goes through a review process several times a year to determine if funding is still warranted going forward.

For sure.

Okay great. That's extremely helpful answer, thank you very much.

Our next question comes from the line of Alex Gauna from JMP Securities.

Hi good afternoon guys. Thanks for taking my question and nice quarter.

Was wondering, Jeff, you talked about this a little bit already, but in terms of going forward here and your much better than seasonal guide in mobility at least relative to most normal expectations in the market, can you maybe break down the drivers between either share gains or TAM expansion and the new internet of things opportunities and maybe what's going on on some of your higher ASP products with your multi-mode mics or integrated modules? Thanks.

Yes, let me try to take that in a couple different pieces. Let me take internet of things first. I think what we're seeing is there's definite demand for acoustic content, specifically in the wearables market. We still have, are tending to be cautious on forecasting large volumes from that market, as we have yet to sit there and say that there's a killer app that people sit there and they say they have to have.

I just continue to believe that we have the right products, and we will be positioned very well if one of those things is successful. But to date we've seen limited high volume success, and I always draw Alex, the thought process is if there were 50 million smart watches sold in one year, that still pales in comparison to the phone market which is roughly 2 billion with multi-mic adoption. Just repeat the first part of the question again so I have it correct?

You started answering it then, but also tied into that, you talked about it some of the modules and integrated solutions, some of your higher performing products, how much is that contributing to your optimism in the outlook?

I would say that it is a significant contributor especially the back half, and as we look into next year, we seen a fair amount of adoption. We talked about Xiaomi which was a customer that two years ago didn't really exist, and now it's a Top 10 customer for us.

And so what we see is that we've taken this integrated audio to many customers, specifically to Chinese OEMs, and we're rarely getting anybody who says I'm not interested. And the reason is is it goes back to this driver, right?

They really want better acoustics, but they aren't in the same position with some of the larger OEMs where they introduce one phone and that drives all their growth. So we tend to do is we're taking a lot of design efforts that they would have to take our speakers, our microphones, integrate them into plastic with an antenna.

And we're taking a lot of that off of their hands, doing it for them faster, at better performance. And although it's more content for us, our belief is that the overall system costs because we're managing a lot for them goes down.

That's helpful, thanks, Jeff and can you tell me--

Alex, one other point to add to this, the Q3 is we stated at the outset, we had a fairly significant headwind with Nokia and BlackBerry, and that headwind was roughly $20 million a quarter in Q1 and Q2. And that headwind is coming down.

As Q3 of last year sales -- we took Nokia and BlackBerry lessons, that delta year-over-year is coming down. I think the delta in Q3 is going to be closer to $10 million versus the $20 million in Q1 and Q2.

That's great. You started answering it before I asked it, the question which can you tell me how big Nokia and BlackBerry are combined at this juncture?

And then also I'm wondering if there have been any changes in your greater than 10% with two greater than 10% customers or is it down to one? And then also you mentioned Xiaomi a number of times. Is that getting close to being a 10% customer or are there any others?

No, there's no real big change in our 10% customers at this point. As I said in Chinese OEMs, there really isn't one guy whose individually big enough to be that large. It's a combination of all of them together that becomes a big nice opportunity for us, especially we've got this really nice infrastructure in Asia in order to support all these OEMs and their projects.

As far as BlackBerry, I can tell you they are pretty much zero. There's a little bit, but in comparison to what they were a year ago, they are pretty close to zero.

In terms of Nokia, we just sit there and I would just say that it's not anywhere near a 10% customer anymore, but what we have seen is there is stabilization in their business in comparison to what we have been telling or talking about of 2013 to 2014. It has stabilized. Obviously there's still a lot of question marks around the Nokia acquisition by Microsoft, but again, it has stabilized at albeit at a lower level and it's nowhere near a 10% customer anymore.

Okay, well one more if I could. I'm wondering on the gross margin front, I know you're going to be getting a big benefit from your manufacturing consolidation, but I'm wondering with the new product, the modules, higher end microphones, are those creating a little bit of a head wind as those ramp in the second half of the year because they are lower yield until they get up into full volume? Or because they come in at a higher price are those actually being -- proving a tail wind to your gross margins right now, thank you.

Well, we talked about it, John talked about it. He could expand on this when I'm done, but we do have these periods of time at the front end where we've got a ramp, and this is one of our advantages, ramping significant volumes in very short periods of time.

And there's always challenges, and we do expect yields will be lower at the front end of these ramps. That's just a fact of life. Offset partially of course by the higher ASPs that we get for doing that.

So I guess the way I'd frame it, Alex is this is no different than any other ramp than we've had in previous years. We just got to make sure we get all the products out on time and deliver all of the product which I think we will.

I'm not saying I'm overly worried about it, but this is just the business that we live in, and we've got to make sure we get that out. And that will drive the gross margin up as we start to improve those yields in Q3 and Q4.

Alex to add to that, you did see our gross margin came in at 29.2%, slightly below the mid point. The biggest driver of that was ramp cost in the quarter. Not necessarily related to IAS, but to other OEM product launches scheduled for the second half of this year.

Okay, thanks so much again.

Our next question comes from the line of Jaeson Schmidt from Lake Street Capital.

Congrats on the good quarter and guide. John, just wanted to get back to you that China question, as far as how much is China as a whole for your revenue these days?

I've got to look at the numbers here. I would say all combined, it's over a 10% of our revenue now for 2014, so it's the first time that its been over 10% of our revenue. That's what I said is there's no one guy in there that dominates and says that's driving all of our revenue, but it's over 10% of our sales.

Of total Company. 10% of total Company.

Of total Company for 2014.

Okay, and then are you guys at all concerned about a potential inventory glut in China, or how confident are you that you're going to see continued strong traction in that market going forward?

Well, I think we're going to see continued strong traction in -- with the OEMs in terms of design activity. There's been some talk about inventory glut in phones, but we aren't yet seeing anything like that in our projections at this point.

I think we always -- the way I always think of the business is there's always some risk after the holiday season in the United States and Europe and some risk after Chinese New Year because everybody builds more than they need, and the question is how large that is. But so far what we see is stuff that people are building are being bought.

I think the market will continue to develop, and we watch this as we go, and the real positive thing for me for the Chinese OEM is this. There's somewhat obviously lesser customer concentration. We've got a lot of customers that make up that 10% to 11%, and from that standpoint, I would say you're looking for more pockets of one guide doing worse than the other as opposed to an overall inventory glut.

Okay, and then finally, I know a large North American platform is going to help drive your Q3, but wondering if you could provide your current backlog coverage to your guide?

I'm not sure we provide that, but I don't even have that right in front of me at this moment. I don't have that, and just so you realize, most of our customers don't work on an order backlog basis.

Most of our customers are on a hub pull system. So it's a combination of forecast and filling the hub. So when you look at those formal orders, that's why we tend not to talk too much about book-to-bill because it's really hard to measure that when all we're getting is a forecast and we have to fill a hub with inventory.

Thanks guys.

Our next question comes from the line of Robert Sassoon from RF Lafferty.

Thank you for taking my questions. It's really only one question related to your midterm growth targets. Whether you think the growth from the Chinese OEMs is going to be better than you had initially anticipated.

And on the other side of the equation, you mentioned that your restructuring has really resulted in cost savings at the high end of the range that you previously had given and earlier. Whether there's any potential for actually upgrading those savings as you go into 2016 and whether your overall midterm targets have a potential for actually some upside.

I will let John expand upon this, but we're sticking with our midterm targets we've given for sales growth as well as margins. John I don't know if you want to make a comment?

With respect to the cost savings initiatives and our restructuring, if I go back to Investor Day, we talked about and kicked off our global footprint consolidation initiative in 2013. And we identified an opportunity to reduce our annualized cost by $40 million to $50 million. And I guess I'm pleased to report that by the end of Q3, we will have taken actions resulting in annualized savings of $35 million to $40 million, which will be reflected in our operating margins in Q4.

We further identified actions related to our specialty components business that are expected to result in annualized savings of $10 million to $15 million beginning in the second half of 2015. That gets us to the high end of $50 million in savings.

Obviously our plate is full today executing these, When we get to the second half of 2015, we will continually explore opportunities to further increase margins, but we aren't changing the midterm outlook that we gave in February.

And just going back to the Chinese OEMs, that your increased penetration in that segment of the market, is that better than you expect at this stage or on track with what you were budgeting for?

I think it's better than we would have expected, the penetration and the uptake in terms of premium audio, but on the reverse side, there's just winners and losers in this market. And I guess the thing that we positively talked about, we were overweight on Nokia and BlackBerry. And you're going to see that come to an end as we get into the back half of this year.

But what we see is that the Chinese OEMs are obviously taking share from other businesses, and we're well positioned there. So we still look at the overall market growth rate coupled then with our acoustic content growth rate.

And what we really like to see as positive is the acoustic content growth story is playing out the Chinese OEMs. It's not just the big guys that we normally talk about.

So are you actually just wanting to suggest that maybe the better than expected growth you're seeing in the Chinese OEMs is slower than expected growth that you probably initially anticipated from other clients in the career?

Yes. I think that's the way of saying it, which is again, we're well positioned. It doesn't matter -- we want to get to a point in an ideal world where it doesn't matter who wins.

It's that the market grows at an X percent rate, and our acoustic content growth. We're seeing acoustic content growing in the Chinese OEMs, and we aren't overweight, too much into any one business compared to what the market dynamics would dictate.

Okay, and just one final question. The hearing aid market, how is that panning out? Is that in line with your expectations -- or the penetration in that market, is that paying faster or in line?

I wouldn't say it's going faster. I would say it's accelerating, and we expected that for awhile. And as we portrayed this business, this is a GDP growth business in the short-term to midterm.

In the midterm beyond, we do see there's opportunities that this business could grow faster than GDP, again based on the aging population, emerging markets and some of the new products that you've seen introduced for the LINX product we talked about last quarter as at they become more acceptable in the market. But the short-term, the market dynamics in the hearing market don't change dramatically from quarter to quarter.

It's really a thought process of when do the baby boomers start hitting the age when hearing aids are typically bought, and we're still a ways off from that, so we aren't seeing anything special here. We're still a leader in this market. We feel good about where we are, but it's a stable GDP growth type business right now.

Okay thanks very much, and I'm done, thanks very much.

Our next question comes from the line of Tristan Gerra from Robert W. Baird.

Good afternoon. Could you talk about the integrated audio solution gross margin relative to your corporate average, and what is the percent adoption rate today, and what's the potential outlook for as part of the mix a few years out?

The second part of the question, just gross margin but what was the second part again?

And then how should we look at the potential for the mix of that product to increase? Where is it today as a percent of mix and where could it go a few years from now.

I will answer the second question first. It's not a significant driver of total revenue, but it's a big part of the growth dynamic, the integrated audio because what we're seeing and again in the Chinese OEMs is they are uptaking this business, this product at a very, very rapid rate in order to catch up on acoustics compared to where they've been in the past.

As far as the gross margins, our expectation is this would be very similar to where we are on the corporate level. Clearly we're still a little bit in the ramp phase at the low end, and we don't have all the benefits of scale, but our expectation is that this will be very similar in terms of gross margin and everything else that we saw.

Okay, and then as a follow-up question, that took place earlier in the Q&A, what percentage is coming from hub arrangements with some of your large customers? And also if you could remind us the percentage of revenue coming from distribution?

The percentage coming from distribution is relatively small. We don't have a lot going through distribution. We have some in our precision devises and a little bit from catalog houses, so it's very, very small distribution.

The other question was about the hub? I don't know the exact number, Tristan, but I would just say that I would say there's almost no major OEM that's not in a hub agreement. They are almost all on hub agreements now.

That transition took place over the last four to five years where we get forecasts, fill a hub, and they pull from the hub. So I would say it's relative on the MCE, a relatively large percentage.

On our acoustics business or hearing health it's also relatively a large amount. Same thing in our precision devises in the oscillator. and capacitors where we have a much broader group of customers, it's more standard ordering.

Okay and then last question, are there any specific clause that said above a certain number of days the customer needs to take the product from the hub whether or not there is a need for it? Is there any limits in terms of how many days of inventory can be at the hub?

I mean, I'm sure there are those things in our agreements. I don't know, I haven't read them recently.

I'm sure there are, but I would just say that we work very closely with every one of these customers. And as we know that they move towards end of life on a product or they are ramping a new product, we talk about with them on a regular basis because we have very lucky we have in this case a number of larger customers we spend a lot of time with.

We have teams that call on them on a daily basis, and we're always adjusting the build plans in order to make sure that we don't end up with any excess and obsolete. And I think if you look at -- we don't look at it as excess and obsolete. Its been a real big issue for us, but -- because we monitor on a daily basis.

Great. Thanks a lot.

(Operator Instructions)

Our next question comes from the line of Zach Amsel from Evercore.

Hi guys, good afternoon. I was wondering if you could elaborate on the competitive environment you're seeing when you're bidding for slots?

Yes, I don't think that it's altogether that different than we've seen in the past. You know, we are typically the primary supplier in microphones, a secondary supplier on speakers and receivers, and there's various different second sources depending on the application, depending on the type of product people are looking for and depending on the customer.

I alluded to it in one of the first questions which it's a little bit more challenging for our competitors to serve the Chinese market because there's a lot more customers and there's a lot more projects. And with not having the broad portfolio that we had especially on mics, it's a little bit more challenging. So I wouldn't say the competitive dynamics have changed dramatically.

I think it's more of a discussion of account by account. And we see different second sources depending on which project we are on like if you look at some of the major OEMs, they use one second source on one project and they use another one on another. And it depends on who brings the product to them that can be the second source.

Okay that's very helpful, thanks guys. That's it.

Our next question is a follow-up question from the line of Alex Gauna from JMP Securities.

Thanks so much. Was just wondering if you could follow-up on your commentary earlier on the strength you saw in wireless infrastructure out of China and how you're feeling about that participation going forward into the second half of the year. It's been something of a mixed bag in terms of other component suppliers seeing ongoing strength and others seeing a pause?

Yes, I mean what I would say Alex is this. I'd say in a sequential basis, we have seen a little softening in the 4G LTE business, but that's reflected in our guidance already as we look towards Q3. We had this 4G LTE buildout, but we still framed the overall story of the precision devices as a GDP type business, and we don't expect that we're going to see 7% year-over-year growth on a continuing basis.

Okay, and then I'm wondering also though, there's been some framing of this sounds like what you're seeing is the pause some of the others are, but Chinese unicom and telecom have their licenses now. I know you aren't forecasting on an ongoing basis strength, but do you have enough visibility to think you're going to get some of that Chinese unicom/telecom strength later in the year?

I think our belief is we're well positioned with a number of OEMs. We think we will get our share of what we expect, but again, we have seen a little bit of softening. I wouldn't say it's dramatic, but there has been some softening, and again, we embedded that into the guidance that we've given.

Okay, and you've made a number of comments throughout the call on the success you're enjoying with the Chinese OEMs and integrated components. And I'm wondering at this juncture based on this outlook, do you think that you're going to be gaining share through the module approach in speakers as we exit the year? And is it safe to say your share gains in speakers would be larger than anything you might see in terms of share losses in mics if there are any at all?

Here is what I'd say. It's the same thing I would say about mics and the same thing I'd say about speakers and receivers which is we aren't expecting major share shifts in either one of these.

It's a little early days to predict that, but what you're going to see is just like we talk about last year, we might see a slight rise in share one year, a slight fall the next. So at this point, we're not predicting major share changes.

Now that may change as we get into next year, but right now what we see is the share remaining relatively stable, both microphones and speakers and receivers. Obviously we are happy about the decline or I would say the exposure in China to multiple OEMs.

I continue to stress that with the team is it's a little bit different than some obviously our other customers where there's we have I would say 8 to10 customers in China that with no one guide is dominant. And we really like that in that business because we aren't reliant on one specific customer.

That's all I've got, thank you.

Okay.

Thank you. Our next question is a follow-up question from the line of Harsh Kumar from Stephens.

Real quickly I just wanted to jump in and see where we stand in terms of your legal expense and how we should think about that going forward.

Here is what I'd just say is we are committed to vigorously defending our IP. Clearly, as John said in his comments, we see a slowdown of legal spending in Q3, but we wouldn't put that as a permanent slowdown, so I can't give you much more detail than that. We have ongoing litigation that everyone is aware of that we won't comment specifically on that, but I would not count on that legal spending staying at that level that it's at in Q3.

Fair enough. Thanks guys.

Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Michael Knapp for any closing comments.

Great. Well thanks everybody 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.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.