Knowles Corp (KN) 2015 Q1 法說會逐字稿

Good afternoon and welcome to the Knowles Corporation first-quarter 2015 financial results conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) With that said, here with opening remarks is Knowles Vice President of Investor Relations Mike Knapp. Please go ahead.

Thanks, Kevin, and welcome to our first-quarter 2015 earnings call. I'm Mike Knapp, 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, 2014, 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 this date of the 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 Knowles.com, including reconciliation to the most directly comparable GAAP measures. Except for revenue, all financial references on this call will be non-GAAP unless otherwise indicated. Also, we have 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 some details on our first-quarter results. Jeff?

Thanks, Mike. Thanks to all of you for joining us today. For Q1 we reported revenue of $239 million. Gross margins and operating margins were approximately 25% and 4%, respectively. Revenue in our mobile consumer segment was down 21% sequentially, better than anticipated in the seasonally weak Q1 as we resumed shipments of microphones to a key customer platform earlier than expected. We also experienced stronger-than-expected demand during the quarter for speaker and receiver products. Revenue from MCE comprised 56% of total sales in the first quarter.

As I just noted, I was very pleased that we began shipping microphones on a current platform at a North American OEM that had been on hold since September 2014. While units shipped were still relatively low in Q1, I expect that microphone volumes for this platform will pick up in Q2 as we continue to regain share. Our goal is to get back to historical share levels with this customer and we are engaged across their next-generation platforms for mics, speakers, and receivers.

Revenue from Chinese OEMs declined sequentially in Q1 as expected due to the timing of product launches and Chinese new year but were up 9% from the year-ago period. As projected by industry analysts, the rate of growth of Chinese OEMs is expected to moderate in 2015. That said, we continue to believe that these OEMs will deliver significant growth for us this year as they expand beyond their domestic markets. In many emerging markets outside of China, 2G phones still constitute the majority of units shipped. These devices normally have lower acoustic content. We will benefit from unit growth as well as the conversion to 4G devices and the associated increase in audio content per device. These benefits comes from MEMS microphone share gains against older ECM technology, multi-mic adoption trends, and increased traction with higher value solutions. On a global basis this year, we project multi-mic adoption to drive more than five in the number of mics per device and expect sales of integrated modules to double versus 2014, driven by several product launches over the next few quarters.

In Q2, the mobile consumer segment we expect to have sequential revenue growth driven by share recovery at a major North American customer and growth at Chinese OEMs. This growth will be partially offset by an adjustment of speaker inventories at one major customer ahead of new operating system launch. Lastly, we are cautiously optimistic about the recent reviews of handsets introduced by a Korean OEM, where we continue to maintain strong market share.

In the specialty components segment Q1 sales were down 10% quarter over quarter and represented about 44% of the total Company revenue. Revenues were down more than projected, primarily due to lower timing sales into the wireless infrastructure market and slightly softer demand in our hearing health business. For Q2, we expect significant sequential revenue growth in specialty components, driven by broad based strength in hearing help partially offset by weaker timing sales into the wireless infrastructure market.

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

Thanks, Jeff. As Jeff mentioned earlier, we reported first-quarter revenues of $239 million, which was above the mid-point of our guidance. Mobile consumer electronic revenues of $135 million were down 21% sequentially, primarily due to normal seasonality. This was better than expected, driven by resumed microphone shipments to a North American OEM late in the quarter, which was originally forecasted for Q2. We also benefited from higher than expected demand for speaker and receiver products. Specialty Components revenues of $104 million were down 10% sequentially, lower than expected, driven primarily by weaker timing device sales in connection with the continued pause in China LTE infrastructure buildouts.

We also saw slightly softer demand in the quarter with a major hearing health OEM due to a work stoppage at their facility which has since been resolved. We expect to resume normal shipping levels with this customer in Q2.

First-quarter gross margins were flat sequentially at 24.6%, which was below our prior expectations. The variance in margins was primarily due to lower fixed overhead absorption in the specialty components segment and unfavorable product mix within mobile consumer. Specifically, we sold a higher proportion of speakers and receivers during the quarter.

Operating expense in the first quarter was approximately $52 million and lower than expected. This lower spending level was driven largely by the timing of new engineer hires, lower-than-expected legal costs due to the GoerTek settlement and tight control over non-R&D spending.

Adjusted EBIT margin was 3.6% and non-GAAP diluted EPS was $0.06 for the quarter, with both metrics coming close to the high-end of our guidance. 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 will turn to our balance sheet and cash flow. Cash and cash equivalents totaled $39 million at the end of March. For the quarter cash flow from operating activities was $7 million and includes payments related to restructuring and production transfer cost of $10 million. Capital spending in the quarter was $18 million. Our bank debt balance was $396 million at the end of the quarter, with the reduction from the prior-year end due to scheduled principal payments on our bank term loan. Interest expense was $2.4 million in the quarter.

Now, I will turn to our second-quarter guidance. We expect second-quarter revenue of $240 million to $260 million. MCE revenue is expected to be up sequentially 4% with increases in microphone shipments at a North American OEM. This will be partially offset by lower speaker shipments at a major customer in connection with their transition to a new operating system. Specialty components revenue is expected to be up 5% sequentially, driven by increased volumes from hearing health and capacitor customers. We expect incremental softness in China LTE infrastructure buildouts to impact second-quarter shipments.

We project non-GAAP gross margin to be approximately 25% to 27%, up 140 basis points sequentially at the midpoint. This margin improvement is driven by higher capacity utilization in our microphone business as we continue to regain share at a major North American OEM.

We also expect favorable product mix as demand and sales increase in our hearing health business. This improvement is partially offset by lower capacity utilization in our speaker business.

We expect customer product launches later this year along with optimization of our manufacturing footprint to drive sequential revenue growth and improved operating margins in the second half of the year. R&D spending in the quarter is expected to be nearly $24 million, up $4 million or 20% from Q1, driven by a higher level of activity related to our intelligent audio solutions and other new product development activities. Selling and administrative expenses expected to be approximately $33 million, essentially flat with Q1 levels.

For the full year, we expect R&D to be in the range of 8% to 8.5% of sales. We are projecting adjusted EBIT margin to be between 3% and 5% in the second quarter. We expect non-GAAP diluted EPS for the quarter to be within our range of $0.03 to $0.09 per share. This assumes weighted average shares outstanding during the quarter to be 86.1 million on a fully diluted basis. Please refer to our press release for a GAAP to non-GAAP reconciliation. For the second quarter, we expect cash flow from operating activities to be between $10 million and $20 million and include restructuring and production transfer payments of $9 million.

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

Thanks, John. In summary, I am increasingly confident that we will experience a strong revenue growth in the second half of 2015, driven by customer platform launches and adoption of our new products. The trends around multi-mic adoption and higher-value audio solutions remains strong and we expect our first intelligent audio sales to materialize in the second half of the year. This growth should drive improved capacity utilization, and coupled with optimization of our manufacturing footprint, improve operating margins in the back half of the year.

Operator, we can now take questions.

(Operator Instructions) Alex Gauna with JMP Securities.

I was wondering, Jeff, if you could give us some color around something you have said in the past in terms of the gross margin effect of resumed shipments into that large North American OEM as well as just more broadly would depend on how aggressively you were pricing your products in order to regain share. What are you doing on that front? The new pricing structure for some of these products -- what kind of headwind to gross margins is that? Thanks.

Let me start with ASP question first. There is, I would say -- on the ASPs we stated all along we were going to have to be a little bit more aggressive to get the share back. And we have had to, but it wasn't out of line with what we expected. So I think that's pretty in line with what we had expected. I think the bigger impact as we look at the gross margins in Q1 and Q2 is -- and John can, I think, expand a little bit upon this -- is the fact that we still have the sales and the absorption because -- it was still an issue because we are not back to the share that we were prior to September 2014.

John, do you want to expand a little bit about that?

Sure. Just to add a little bit of granularity to that, Alex, as Jeff indicated, we resumed shipments and production of the impacted microphone late in Q1. We expect to continue to recover share in Q2, but we do not expect to be fully back to the pre-September 2014 share levels in the second quarter. And this really negatively impacts our capacity utilization and our product mix, as we are producing and selling less new product, which typically carries a higher ASP. Just to quantify, I would estimate the impact of the mic issue on our gross profit margins in Q2 to be roughly 200 to 300 basis points. So again, if we were back to that pre-September share level, we would have an uplift in gross profit margin between -- call it 250 basis points.

Okay, that's fair enough, thank you, and very helpful. If I look into the back half of the year, when we start talking about the impact of intelligent audio and voice IQ as well as the next generation products that are out there, is it still your belief that the pricing structure of the industry hasn't changed? And can you give us an idea of the tailwind from the new products that you think there might be, either in a gross margin sense or in an ASP sense, exiting the year? And if you could, in that answer, talk about what you might think, as a result of all of this, your overall industry share loss might be for the year because of this effect. Thanks.

There's a lot of questions there. Let me try to take these one at a time. First, on intelligent audio, we don't expect that the sales that we get in intelligent audio in the back half of the year to be large enough to have a significant positive impact on gross margin. We are just rolling these products out and I would say that as we are rolling these intelligent audio products out, a lot of the target is, I would say, a little bit more nichier applications. We are spending a little bit more time with the Internet of Things, wearables, and there's a lot of great opportunities there. But I would say in general they are lower volumes. And so, we see that intelligent audio really starts having an impact on gross margin as we go into 2016.

As far as the share loss, I think it's a little too early to tell how we exit the year. But what I would definitely say is I feel strongly that we will have higher share in the back half of the year than we did in the front half of the year. We started off, although we shipped product to the North American customer in Q1, it wasn't a lot. In Q2 it increases significantly over Q1. But again, as John stated, we won't be back -- and I said -- we won't be back to the share level. We do anticipate the share will be higher in the back half than the front half.

So it's a little early because there's a number of, again, launches of product that are going to come in the back half of the year, to say what the share level would be, but it's definitely going to be higher than it was in the front half.

Okay, thank you. Congratulations on the requalification.

Harsh Kumar with Stephens.

Can I ask you, once you get past this current model that you just got back into with your North American customer and as you get back in with basically a brand-new microphone and even going forward, once you start shipping, let's just say, voice IQ broadly, is it possible for you to go back to that 55%, 60% level in the future, based on technology and just this model rolling off?

Well, as I stated in previous calls, that's our goal, Harsh. We are really trying to get back to that previous level. We've got some great new products and you guys are seeing a lot of the demos of what we are working on. And we think it's possible -- we've got to work real hard, we've got to get the new products out -- it is really the key thing -- get them out and make sure they are all accepted in the marketplace. But that's our stated goal. We got to get back to the share that we were pre- the album that we had in September of last year.

Got it. And then I wanted to ask about the ASP decline. You mentioned earlier, John gave some numbers about 200, 250 bps. As you get back on full bore with -- and engaged with this new customer, can you just talk about how that impacts as this model rolls off and the newer model comes on? Do you get an ASP benefit? Or is this ASP decline a permanent thing in the industry?

I think we will get some ASP benefit. Every time we introduce a new model we get some ASP benefit. So I would expect there would be some as -- again, kind of what you are saying -- there will be a new microphone designed in and it will have different features and different performance and different things. So we do anticipate there will be some ASP improvement based on the new product that we introduce in the back half of the year.

Fair enough. Thanks, guys. I'll get back.

If I could just add something, the margin improvement that we expect in the back half of the year is really driven by new product launches which create improved factory utilization in our facilities. And that's really driven sequentially in Q3.

It's worth highlighting it again. As we look at the price reductions we've had to give in order to get share back, that -- although there is some of this, a small amount of this in what has brought the margins down probably a little bit lower than people would have expected. But it's in line with what we expected. But the primary driver to getting the margins backup is getting the sales back and filling the factory. Those are much larger -- have much larger impact on the margins than the ASP decline.

Got it, guys.

The last major driver, too, is we do have additional plant consolidation in our hearing health business. We will have the production transferred into our Philippines facility completed in Q3. And so that will add some additional margin expansion.

Got it. Thanks. Thank you.

Bob Labick with CJS Securities.

Just want to follow up on that last answer you gave. Could you give us -- elaborate a little more on the trends in the specialty components, both hearing health and you mentioned the telecom infrastructure and other, both on the revenue side but also just remind us where we stand on the cost savings initiatives in hearing health and also in other components.

So you want to talk a little bit more about the -- okay, let me talk about the trends first. I don't think the trends have changed dramatically in the hearing health business. There was a little bit of, I'd say, a slight slowdown in Q1. We had one customer who was dealing with a work stoppage at one of his major manufacturing plants, so they didn't take as much product as we would have expected.

But I think, as we look to Q2, the trends in the market twice still are positive. So from the hearing health side I feel pretty good about the business.

When we think about the wireless infrastructure business, there I would just say, and I think you've probably seen it, there's been a fair number of people who have already been talking about the fact that there's this weakness in China, the rollout of LTE has kind of taken a pause. I would say this is not altogether unexpected. It's always hard to predict the timing of this, of when it slows down and when it picks back up. And what we are saying is at this point, in Q2, we just don't see a pickup back. We believe it will come back. It may take a couple more quarters. But we believe it will come back. And if you think back to 2014, the business was pretty strong.

The wireless infrastructure business was pretty strong in last year. And this year it looks like some of our customers that are rolling out the LTE infrastructure -- they may have gotten a little ahead of themselves and it has taken a pause. And again, it will come back. It's just a question of when.

Now just a little bit more on the financials would be --

Yes, Bob. Just in terms of updating where we are relative to the $50 million annualized savings target, as you recall, we exited 2014 with roughly $40 million in annualized savings. And that was primarily driven by the closure of our Vienna facility. That was $30 million of the $40 million. We are expecting an additional $10 million to $12 million in cost savings in 2015 to get to that $50 million target at the end of the year. And that's -- again, that's really driven by the move of our hearing health business from China to our existing facility in the Philippines. That will be completed in Q3 of this year. And that will drive another $10 million to $12 million.

Great, thanks very much.

Jaeson Schmidt with Lake Street Capital.

Jeff, wondering if you could just talk generally about what you are seeing in the competitive landscape, if you're seeing any new entrants into the market, and how do you guys think you are currently positioned overall?

Let me divide this probably into, first of all, the mobile consumer -- I assume you're talking about the mobile consumer. Correct?

Correct.

Okay. Let me divide into speakers and receivers and mics. I think that's the easiest way to talk about it. In the speaker and receiver market we are not really seeing any real new entrants in this. It's AAC, GoerTek, and Knowles. I think we've talked about it in the past. There are some other competitors in this marketplace but there's a dramatic difference in capability and technology between the top three and anyone below that. So there's really not a big difference.

In the microphone market it's really the same players, but I think what we may see as we go forward is that as we move towards things like intelligent audio and more advanced solutions we may be competing with different players that are already in the market for those different sockets. So as we look at a basic analog mic, we are primarily dealing with the AACs and GoerTeks of the world. But as we move towards much more significantly advanced microphones, it may change a little bit in terms of who we are competing against.

I think the positive story about this is, as the leader, we are prepared to compete in both these areas very well and position very well. We are really excited about intelligent audio, we've got products out there in the market. People want to buy them and we are first to market again with these products. So, I think we are pretty well positioned, no matter who it is or what segment of the market that we are competing in.

Okay. And John, how should we look at your tax rate for this year and next?

The tax rate in Q1 was a little -- that effective tax rate on our non-GAAP earnings was right around 19%, a little higher. That's really a result of having a lower-than-expected income in the zero tax rate jurisdiction. I wouldn't change your model, 12% to 14% on a long-term basis for an effective tax rate.

All right. Thanks a lot, guys.

Tristan Gerra with Baird.

You stated today that Q2 gross margin ex the impact of the microphone issue would be 28% to 29%. So basically you mentioned the 200 to 300 basis point impact on Q2 gross margin. Last quarter you mentioned that Q4 gross margin would have about 35% excluding the microphone issue. Is the difference between that inferred 28%, 29% range and the 35% driven by lower pricing alone?

And if you could also talk about the mix of the screening process that enabled you to come back in that leading customer in the US versus the re-spend and whether that screening process is basically resulting in lower gross margin than if you were just shipping the recent product?

Yes. So we were able to get back into the customer sooner than we expected. And I think that's a positive. They worked with us pretty closely in order to do that. I think -- I don't have the exact dates here, Tristan. But at some point we will be through all the re-screen product and using the re-spend product that has the fix it. I would anticipate that's sometime probably in Q2 where that happens.

I'll let John speak to this a little bit more, but the impact is not really about lower pricing. The margins, first of all, are typically higher in the back half of the year than the front half of the year. And that's driven by two things. One is sales are higher in the back half of the year, which drives capacity utilization. And so, I'm not going to say the pricing that we've had to give had no impact on the gross margin. But by far, the lost sales and the loss of capacity utilization has a significantly higher impact on the margins.

Yes, Tristan, just to add to that, you mentioned in Q4 -- you referenced margins of 35% versus the adjusted margin today that I mentioned of, call it, 28% to 29%. The difference is really two things. As Jeff mentioned, the back half of the year our capacity utilization is historically much higher. That typically can account for 300 to 400 basis points between first half of the year and second half of the year. And also, our ASPs are typically higher in that Q4 timeframe versus the Q1, Q2, just because of the normal adjustment in prices as the product is rolled out. Those are the two factors.

And the other thing just to remember, Q4 was, I'd say, the last quarter of our wireless infrastructure business where it was still -- we've seen weakness in Q1 and Q2. That had some impact on the difference in the gross margin as well. Our sales are down significantly in the wireless infrastructure business.

Okay, that's very useful. And then as a follow-up I think in the past you've mentioned your expectation to exit this year at a 35% gross margin run rate and that by end of next year you could be at 39%. Is it fair to assume that if you are looking at a 400 basis points in gross margin improvement next year, assuming that you are reiterating that expectation, does that imply some additional restructuring? Or is that on the basis of higher top line alone and mix?

No. As far as your first question, as far as exiting 2015, I don't see any major obstacle to exiting the year in the mid-30% gross margin range. It does include, though, the execution of the completion of our production transfer in our hearing health business. But I don't see any obstacle to that. You also referenced a 2016 number. I don't think we ever gave guidance. We pushed out our midterm target to 2017. And there, again, I don't see any obstacles to prevent us from achieving that 2017 midterm target of 39%.

Great, thank you very much.

Robert Sassoon with RF Lafferty.

One of your major Korean customers recently launched a new platform. I gather it contains two microphones instead of three. So is this something that we should be concerned about in terms of the multi-microphone platform growth story? Or is there a specific case with this particular customer that they have chosen to choose two instead of three microphones?

Here's what I'd say. They have a number of platforms that they ship on. And if you look at the Note 4 that was introduced late last fall, it had three microphones. The S6 has stayed with two microphones, like the S5 was. And I think a little of this is there is some, I think, some competition that Samsung is facing relative to Chinese OEMs. And they are looking at cost. Right? They are struggling on a cost basis.

But I don't think this is a trend overall that we see. In fact I would say that as we look to last year we had about 6% growth in units in microphones based on multi-mic adoption above the normal market rate growth. And this year we are projecting it's going to be 5% again. So I keep thinking, and I'm seeing this, we are not seeing anybody else who is making moves towards less microphones. In fact, as we go towards the back half of the year, we continue to see more people that are actually adding microphones, not taking them out. So in no way do we see this as a trend.

All right. And I know it's just because I know you can't speak on -- I notice that one of your competitors has been diversifying out of acoustics into non-acoustics in the last year. So I just wondered whether that was a sign also that the market for acoustics was not as exuberant going forward as you might have originally thought.

No, I don't think that. I can speak to what AAC -- I know it's AAC; they are looking into things like haptics. I can't speak to what made them decide to get into the haptics market. But as we look forward, if you think about our competitive differentiation, we talk about a fair amount -- I don't know if you remember the three circles of acoustics, mechanical integration, and intelligence. We talk about the fact that the AACs and the GoerTeks of the world are not as strong in the area of intelligence where we are really putting a big focus. And we see a lot of these new applications coming forward. We talk a lot about voice IQ. We talked about ultrasonics. We think there is a strong demand in the marketplace for higher-value acoustic solutions and that the growth rate is going to continue. We're going to be the agent of change. We're going to be the agent of bringing these new products out. But we are comfortable that when we talk to the customers that they are hungry for better performance and new applications enabled by acoustics.

All right. Okay, and just one more question. Do you have a D&A, depreciation and amortization, figure for the first quarter?

Robert, I can post that on the website.

Yes, if you can send me it by email, that would be great. Thank you very much.

Christopher Rolland with FBR Capital Markets.

I wanted to dig in for a second on packaging for a moment here. So my first question is, where were you guys on backend Q1 utilizations? And then my second question is, assume you guys had a normal utilization level, let's just say like 80% or something like that. What is the cost of packaging as a percentage of the total cost of the MEMS? And then finally, how many extra gross margin points do you think you get from doing the packaging yourself versus your competitors who are paying foundries? Is it 100 basis points or 300 or 600? How do you guys view that as an advantage?

Let me just take the first. We're not going to share our cost structure on this call. And we, on a regular basis, do do an assessment of whether we should be sourcing the packaging outside or doing it ourselves. There's the gross margin improvement. There is some. And I don't have it quantified right here to be able to answer that. But there's also the time to market, the ability to innovate in the area of packaging that allows us to -- when we have our own manufacturing, our own test structure that we set up. So we think it's pretty important. If you look at compared to the competitors that are in the marketplace, some have their own packaging. Some don't. Some have their own designs on their MEMS and ASICs and others don't. If you go back to the competitive analysis, we are very unique in the fact that we control the designs for the ASICs and the MEMS as well as the packaging. We do the whole thing.

And if you go back to our larger competitors in mics like AAC and GoerTek you can go through their reports, and they talk about how much lower their gross margin is on microphones compared to speakers. And a lot of this comes from the fact that we control the supply chain. So we think it's pretty important to do that.

As far as the capacity utilization, I don't have the exact figure. But normally, Q1 is a very low capacity utilization quarter. We have the Chinese new year, and having the experience of -- I have been there a number of times. It's kind of like Christmas in the United States where nobody works like three or four days before it starts, nobody really works three or four days after. So you end up with roughly 2 1/2 weeks of no production.

But on top of that, we didn't have as high a demand because of the North American platform that we were shipping a minimal amount to. So I don't have the exact figure but I would say the capacity was probably less than 50% in the first quarter. It was very low.

Just to add a little bit of granularity there, typically the second half of the year -- we are running 90% plus capacity utilization, sometimes in Q3 full out. In a typical year Q1 or the first half of the year, we can be in that 70%, 65% range. So on a full-year basis we are doing our capacity planning based on like an 85% utilization, just as a rule of thumb.

Okay, very useful. Thank you guys. In terms of total mobile mic industry growth, you mentioned a 5% boost from the mic-per-phone phenomenon. What are your views for total industry mic growth? And if you could break it up into the contribution from just general handset growth, this mic-per-phone phenomenon that you talked about, which is obviously 5%, and then the growth contribution from the movement from ECM mics to MEMS.

I'd have to look at this in a little more detail. I don't think I have this like those exact figures by the market. But the market itself is expected to grow about 5%, in total unit growth. And then you add in 5% for multi-mic adoption. And there is some amount, again, of conversion from ECMs, although the number is not, I would say, the primary driver. The bigger driver is really the multi-mic adoption and the industry growth. So if I were to look at it I'd probably say -- again, this is off the top of my head, and I don't want to be held to this -- it's somewhere north of 10%.

Okay, great. One last one, getting back to cost structure. So your largest Asian competitor has started a joint venture on the front end MEMS manufacturing side. And they actually believe that they can get another five or maybe even 10 additional gross margin points by capturing that foundry margin themselves. So first of all, I guess, does that sound right to you? And secondly, do you have any inclination at all to get into front end manufacturing yourself?

Well, let me make sure I understand where you are -- I'm assuming you are referring to AAC?

Yes.

The things I've seen is they are trying to design their own MEMS. And then they are going to source their wafers themselves, as opposed to rely on a third party for the design. And they've been working on that now for about four years they've been trying to bring that to market. And we have yet to see them sell one device using that. There is definitely, clearly, a margin issue that they are struggling with that they have talked about. I can only speak to what they've talked about. And there's clear value in owning your own design. But I think it's not a simple task. So they have been -- as far as I know they have been working on that for about three or four years. And we have yet to see that come to market.

Okay, great, guys. Thanks.

Suji DiSilva with Topeka.

So first of all, having gone through the requalification process, can you talk about some of the changes you've made, perhaps, that would reduce the risk of it recurring, just to understand some of that?

Yes. We talked a little about this, I think, on the last call. I think one of the primary things that we've done is, as our products have proliferated and so have handsets proliferated, we've really gone back and look at how we test our microphones in terms of through the qualification process in real-world use environments, as opposed to thinking of it as, well, here's a suite of tests that we just do and we've always done. So we started to adjust how we test microphones in terms of the qualification process to ensure that this doesn't happen.

The second thing is we've had a little bit of what I would call thinking about how we are structured as an engineering organization. And what we've realized as we thought about this a little bit more is we have great MEMS and great ASIC developers and great packaging guys and we have great test guys. And that was kind of like how you put a microphone together. But as the systems are becoming more complex we've added onto and started talking about more that we need system-level design as opposed to bringing individual components together. And we are starting to see that this has been really helpful, also potentially making us a fair bit more better at getting more products out, hopefully, over the long-term. So those are the two things that we've really focused on.

Very helpful answer. And then also on the intelligent audio, I know it's more of a 2016 opportunity. But I want to get a sense of how long design cycles are versus your typical products, when that process might have started to visibility for 2016, and what the financial impact of that ramping when it does wrap is in terms of revenues, pricing, and margins.

Yes, the margins will be higher in the prices higher for sure. The initial stuff that we are -- the initial product that we are coming out with, I would say they are somewhere between 20% and 50% higher in ASP. They are much more expensive. Now -- but the volumes are very low at the beginning. And the design cycles are longer. The reason the design cycles are longer than our typical products is in some cases, as we look at some of these products, we're talking about changing the structure of the device itself and where the processing is being done. So it takes a little bit more thoughtfulness on the side of the customer. So what we are seeing is the design cycles -- and this is not unexpected. I think I've been pretty clear that we probably wouldn't see intelligent audio having a big impact on 2015 but really starting to show results in 2016. And we still think that's the case. It's a little too early to start projecting exactly what the sales and margins impact it will have because it will be highly dependent on which designs we win and where we win. Again, our targets in the short term have been really around wearables and the Internet of Things, where there's a lot of great opportunities and some of our products bring real benefit to them.

Great. Thanks, guys.

Harsh Kumar with Stephens.

Thanks for giving me a follow-up. John, I had a quick question. So during the course of the call I've had a few calls on myself as I'm modeling this. I think everybody is struggling with the same thing. You are at 26% now. And I know you only give one-quarter guide but you are asking us to get to 35%. That's almost a 900-point, basis point increase in two quarters. I think I just want to understand what gets you there.

Why should we build that number? The part that I picked up was there was something about the 250-basis point improvement coming from, let's say, increased utilization. Could you maybe try to bridge that out for us so that we can adequately model? And then I had another follow-up.

Sure, Harsh. Again, the guide for Q2 was 25% to 27%. I also mentioned that we are still, in Q2, being negatively impact by capacity utilization, i.e., we still aren't back to pre- September 2014 levels on the impacted mic. If we were back to those levels, it would pick up another 250 basis points. So that gets you to a, I'll call it, guide of 27.5% to 29.5%.

If, then, you consider what we typically see seasonally, front half of the year to back half of the year, when the back half has much heavier product launches, we can typically see in a swing, if you go back to 2013 you can see a swing of 300 to 400 basis points between the first half and second half. So you've got that leg.

The last leg is, again, we are completing the production transfer in our hearing health business, which will be completed in Q3, which will give us another $10 million to $12 million in annualized savings. So it's really -- that's kind of the bridge to get to the -- as I said, I don't see a reason why we couldn't exit 2015 in the mid-30% gross margin.

Got it. So that was very helpful. I appreciate you letting me ask a follow-up. Thanks, guys.

Alex Gauna with JMP Securities.

Just another point of clarification for me on what Harsh just asked you, John. My understanding had been as we were heading into the June quarter that that was going to be, in your expectation, one of the biggest legs up because of some of the benefits from resumed shipments and from the manufacturing consolidation. Am I wrong in that supposition? And then also the hearing health manufacturing cost efficiencies that are coming on later in the year -- is that, then, the last of it that we should expect until you have announced any other new programs? Thanks.

Yes. With respect to Q2 I will say our margin, while it's improving 130 basis points improvement, we did expect slightly better margin improvement there. And that's really a result of we had some headwind in both the speaker business, where we moved, roughly, sales out of Q2 into Q3 due to their change to a new operating system. And we also continued to be unfavorably impacted by softness in the wireless infrastructure business and our timing. So margins that is fair that we expected, if you think back three months ago, our view of Q2 margins would have been a little better than what came into. But we haven't changed at all our view on the back half.

Okay. And then as far as the efforts that are in place for further cost savings that we get in the back half, that is, then, the completion of everything you've set out to do that we know about now. Right?

Yes. On completion, Alex, what I'll say is we are going to continue to evaluate. We've got a lot on our plates still that we have to execute and make it seamless to the customer. But once we get these initiatives done we are going to continually evaluate new opportunities for consolidation of our footprint and margin expansion.

Fair enough. Thanks again.

Harsh Kumar with Stephens.

Sorry to be tag teaming. Back here in line again. I just want to be really clear about understanding this portion. So going back to some of what Alex asked and some of what I was asking earlier, the 300 to 400 basis points increase in the back half that you get from utilization -- that's assuming a much higher share that you previously had at your top tier US-based customer. Because your share is in flux, can we make that assumption that you will get a similar effect in second half this year?

First of all, there is normal seasonality. Right? All things being equal, the back half of the year will be significantly better margins than the front half of the year. We do expect from where we are today in terms of the share that we will have higher share in the back half of the year. So we are expecting that. As I said in the script, we think we are pretty well positioned on new products with a number of new customers that will help drive the capacity utilization. That, coupled with the restructuring activity that we've been doing over the last year are what are going to get us to the better margins in the back half of the year.

Very helpful, guys. Thank you.

I'm not showing any further questions at this time. I'd like to turn the conference back over to our hosts for 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.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.