The smartphone market growth will be phenomenal. As shown in the chart below, the CAGR is expected to be 15% until 2016.
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Source: Company Presentation
Most investors will immediately think of Apple (AAPL, Financial) or Samsung to take advantage of the growth in the smartphone market. However, there is one little-known company inside many smartphones that is going to ride this outstanding growth, too. The company is Knowles (KN, Financial). It controls 70% of the microphone market for smartphones and tablets, and it is a major supplier for both Apple and Samsung. Therefore, no matter which brands smartphones consumers choose, there is a good chance that they have already purchased KN's microphone inside their smartphone. If you want to take a slice of the profits earned by KN, the manufacturing issue in KN should provide a great entry point for patient investors with long term investment horizons.
Company Overview
Knowle is a recent spin off from its parent, Dover Corporation (DOV). KN has two segments: Mobile Consumer Electronics with $778 million sales, and specialty components with $437 million sales. The Mobile Consumer Electronics segment designs and manufactures acoustic products, including microphones, speakers, and receivers for the handset, tablet, and other consumer electronic markets. The acoustic components comprise analog and digital microphones, micro-electronic mechanical systems microphones, surface mounted device microphones, receivers, speakers, speaker modules, multi-functional devices, ultrasonic sensors, and integrated audio sub-systems.
Since I believe a picture is worth more than thousand words, I utilize the company presentation slide below to paint a picture about how microphones and speakers/receivers are incorporated into the smartphones:
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Source: Company Presentation
KN is the number one global supplier of microphones, and one of the top three suppliers of speakers and receivers. Its partners and suppliers include Nokia, Samsung, Qualcomm, Huawei, Lenovo, Dell, ZTE, and HTC.
I can summarize the strengths of KN by the following: differentiated products, properietary manufacturing processes, entrenched customer relationships, pioneering acoustics expertise, and the culture of innovation. In addition, KN has more than 500 patents to protect its innovative technology.
Self-Help Cost Savings Initiative
Whenever I look at any undervalued stocks, I frequently ask myself whether there is any self-help cost savings program. KN has such a program. Relative to the EBITDA of $260 million, KN targeted to save $40-50 milllion annually. KN would reduce its global manufacturing footprint from 18 to 11. This will help to reduce cost for sourcing and increase productivity.
Financial Strengths
KN has net debt at about $360 million. This translates to approximately 1.3x debt/adjusted EBITDA. With the adjusted EBITDA almost covering all the debts, KN has investment grade like credit metrics. The financial condition of KN is fine.
Valuation
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KN is well positioned. It not only has stable revenues and cash flow from specialty components, but also has high growth derived from mobile consumer electronics business. However, due to the recent production defect in MEMS microphones, I would like to conservatively assume that the EBITDA will stay at $280 million, which was the EBITDA of 2013, and apply 11x EV/EBITDA to value KN instead of more bullish multiples. This results in my target price of $31, implying approximately 37% upside potential.
Indeed, KN not only has an appealing upside potential but also a sticky microphone business with years of profits in the future. Its microphone found inside most smartphones is indispensable for consumers. Since KN has the patents and manufacturing capabilities to satisfy for the gigantic demand from both Apple and Samsung, KN is well positioned to enjoy the profits brought by the high growth rate in the smartphone market for the foreseeable future.
To be fair, I would like to touch upon the revenue decline in the specialty components business, with negative 4% CAGR since 2011 and adjusted EBITDA declining from 27% in 2011 to 24% in 2013. If we just look at the historical performance of the specialty components business, it is not that good. Nevertheless, if we look into the future of the specialty components business consisting of the hearing health acoustics, the outlook is much better. In fact, there has been growth in the worldwide hearing aid units sold. As one of the macro trends is aging population in the world, there will be more and more demand for the hearing devices. Therefore, there is favorable macro trend for the hearing health acoustics business.
Now, let's turn to the bright segment of KN: the mobile consumer electronics.
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Source: Company Presentation
With the phenomenal growth in the smartphone market, it is no wonder that there has been 24% CAGR in the mobile consumer electronic revenues. Because of the bright prospect of the mobile consumer electronic business, I believe that is why KN can rebound from its trough near $19 in the morning to today's closing price of about $22.50.
Management Team
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Source: Company Presentation
The presentation gives us a good sense about the experience of the management team of KN. They have more than 15 years of industry experience on average. Plus, seven team members have more than 10 years of experience with KN.
According to the latest proxy statement, the ownership of corporate insiders are very low and might be a disappointment to prospective KN investors. Details are shown below:
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Source: Proxy Statement
However, since KN is a spin off from a strong parent Dover Corporation, KN's management team has a chance to nurture their management skill under the leadership of DOV. In general, I like management team coming from strong disciplined parent companies like DOV.
Jeffrey Niew is the CEO of KN. He joined Knowles back in November 2002 while it was still a subsidary of DOV. He has served several different senior roles within KN which made him well-rounded. Niew now has a chance to run a stand-alone company, and I will keep track of his future performance to see whether he serves the CEO of KN role well. But as far as what I have read, his credential and performance seem to be very solid.
Risks
First, the MEMS microphone market is very competitive. If different suppliers start to aggressively lower selling prices to take market shares, KN can be adversely affected as profit margins will definitely be under pressure. Second, the hearing units demand can be lower than anticipated. This can lead to lower demand and affect the profitability of the specialty components segment. Third, as Apple and Samsung are the biggest smartphone manufacturers, KN has customer concentration risk, especially for the mobile consumer electronics business. This pose additional risk for prospective KN shareholders to consider.
The Bottom Line
As KN declined to approximately $19 today, prepared investors should be able to buy at today's low level with good margin of safety. As the market can be very volatile, our assessment of the intrinsic value of KN can be objective and very useful. Sometimes because of such fear, there will be lucrative investment opportunity. For well-prepared investors, it is always important to do independent work and take advantage of any market opportunities provided to you. Today, it is such a good day for prepared investors to buy KN at the low morning price.
Disclosure: I am not a securities broker/dealer or an investment adviser. You are responsible for your own investment decisions. All information contained should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.
