News Column

KNOWLES CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 7, 2014

The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes included elsewhere in this Quarterly Report on Form 10-Q. Unless the context otherwise requires, references to (i) "Knowles," the "Company," "we," "our" or "us" refer to Knowles Corporation and its consolidated subsidiaries, after giving effect to the spin-off of Knowles from Dover Corporation, (ii) "Former Parent" refers to Dover Corporation and (iii) the "Separation" or the "Distribution" refer to our spin-off from our Former Parent.



Overview

On February 28, 2014, our former parent company, Dover Corporation, completed the spin-off of Knowles into an independent, publicly-traded company.

We have a leading position in MicroElectroMechanical Systems ("MEMs") microphones, speakers and receivers which are used in mobile handsets, smartphones and tablets within the consumer electronics market. We are also a leading manufacturer of transducers used in the hearing health segment of the medical technology market and have a strong position in oscillator (timing devices) and capacitor components which serve the telecommunication infrastructure, military/space and other industrial markets. We are organized into two reportable segments based on how management analyzes performance, allocates capital and makes strategic and operational decisions. These segments were determined in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification Topic 280-Segment Reporting and are comprised of (i) Mobile Consumer Electronics ("MCE") and (ii) Specialty Components ("SC"). The segments are aligned around similar product applications serving our key end markets, to enhance focus on end market growth strategies.



MCE designs and manufactures innovative acoustic products, including

microphones, speakers, receivers and integrated audio solutions, used in

several applications that serve the handset, tablet and other consumer

electronic markets.

SC specializes in the design and manufacture of specialized electronic

components used in medical and life science applications, as well as high-performance solutions and components used in communications infrastructure and a wide variety of other markets. SC's transducer products are used principally in hearing aid applications within the



commercial audiology markets, while its oscillator products predominantly

serve the telecom infrastructure market and its capacitor products are

used in applications including radio, radar, satellite, power supplies,

transceivers and medical implants serving the defense, aerospace, telecommunication and life sciences markets.



Results of Operations

The Consolidated Financial Statements and segment information included in this Quarterly Report on Form 10-Q have been derived from the Consolidated Financial Statements of the Company, which prior to the Separation were prepared on a stand-alone basis and derived from Dover's consolidated financial statements and accounting records. The Consolidated Financial Statements may not necessarily reflect our results of operations, financial position and cash flows in the future, or what our results of operations, financial position and cash flows would have been had Knowles been a stand-alone company during all the periods presented. 18



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Results of Operations for the Three Months Ended June 30, 2014 Compared with the Three Months Ended June 30, 2013

In addition to the GAAP financial measures included herein, we have presented certain non-GAAP financial measures. We use non-GAAP measures as supplements to our GAAP results of operations in evaluating certain aspects of our business, and our Board of Directors and executive management team focus on non-GAAP items as key measures of our performance for business planning purposes. These measures assist us in comparing our performance between various reporting periods on a consistent basis, as these measures remove from operating results the impact of items that, in our opinion, do not reflect our core operating performance. We believe that our presentation of non-GAAP financial measures is useful because it provides investors and securities analysts with the same information that we use internally for purposes of assessing our core operating performance. For a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures, see the reconciliation included herein. Three Months Ended June 30, (in thousands, except per share amounts) 2014 2013 Revenues $ 281,033$ 296,709 Gross profit $ 33,785$ 101,228 Non-GAAP gross profit $ 82,078$ 105,666 (Loss) earnings before interest and income taxes $ (43,986 )$ 27,905 Adjusted earnings before interest and income taxes $ 21,545



$ 50,481

Provision for (benefit from) income taxes $ 33,097$ (835 ) Non-GAAP (benefit from) provision for income taxes $ (2,486 )$ 3,081 Net (loss) earnings $ (78,903 )$ 16,671 Non-GAAP net earnings $ 22,211$ 35,331 Diluted (loss) earnings per share (1) $ (0.93 )$ 0.20 Non-GAAP diluted earnings per share $ 0.26



$ 0.42

(1) On February 28, 2014, Dover shareholders of record as of the close of business on February 19, 2014 received one share of Knowles common stock for every two shares of Dover's common stock held as of the record date. The computation of diluted earnings per common share for all periods through December 31, 2013 were calculated using the shares distributed on February 28, 2014. See Note 10. Earnings per Share, to the Consolidated Financial Statements for information regarding earnings per share.



Revenues

Revenues for the second quarter of 2014 were $281.0 million, compared with $296.7 million for the second quarter of 2013, a decrease of $15.7 million or 5.3%. This was due to a decrease in Mobile Consumer Electronics revenues of $22.9 million, partially offset by an increase in Specialty Components revenues of $7.2 million. The decrease in Mobile Consumer Electronics revenues was a result of lower average selling prices on mature products, a design change at a smartphone original equipment manufacturer ("OEM") customer and lower shipments to three OEM customers in connection with their lower share of the handset market. These decreases were partially offset by an increase in revenues from Chinese OEM customers who gained market share during the quarter and new product sales with higher average selling prices. The increase in Specialty Components revenues was driven by improved demand for precision devices, due primarily to strength in the wireless communication infrastructure market, particularly in China. 19



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Table of Contents Cost of Goods Sold Cost of goods sold for the second quarter of 2014 were $230.8 million, compared with $191.4 million for the second quarter of 2013, an increase of $39.4 million or 20.6%. The increase was primarily due to fixed asset accelerated depreciation and related inventory charges of $25.8 million and production transfer costs of $4.0 million, mainly as a result of the cessation of manufacturing operations at our Vienna, Austria facility, and higher ramp up costs associated with new products. For additional information on our restructuring actions, refer to Restructuring Charges below and to Note 5. Restructuring and Related Activities to our Consolidated Financial Statements.



Restructuring Charges

On April 1, 2014, the Board of Directors authorized the cessation of manufacturing operations at our Vienna, Austria facility as part of our previously-announced plan to consolidate our manufacturing footprint ("Vienna action"). As a result of the Vienna action, which was substantially complete by the end of the second quarter of 2014, we recorded restructuring charges of $17.1 million. This included $12.6 million related to severance pay and benefits and $4.5 million related to contract termination and other costs. Of the total $17.1 million in restructuring charges, $12.5 million were classified as Cost of goods sold and $4.6 million were classified as Operating expenses. In conjunction with this restructuring action, we also accelerated depreciation on fixed assets and recorded inventory charges of $20.4 million and incurred production transfer costs of $1.3 million bringing the total recorded costs related to the Vienna action to $38.8 million. We anticipate to incur an additional $6 to $10 million of restructuring and related charges associated with this action, primarily over the second half of 2014. This is lower than our prior estimate primarily due to lower non-cash fixed asset costs. Of the total pre-tax costs of $45 to $49 million, we expect approximately $25 to $29 million will be cash expenditures, the majority of which will be paid during the remainder of 2014. We anticipate annual savings of $25 to $30 million associated with this action beginning during the the third quarter of 2014, mainly due to reduced salary and fixed asset depreciation expenses. In line with our previously announced plans to consolidate our manufacturing footprint, we also recorded restructuring charges of $3.6 million during the second quarter of 2014 related to other actions. These actions included programs to transfer our hearing health business and certain of our North American based capacitor business into new and existing lower-cost Asian manufacturing facilities as well as to reduce headcount in the consumer electronics business.



For those actions discussed above and other potential actions, we expect restructuring charges of $5 to $10 million during the third quarter of 2014.

During the three months ended June 30, 2013, we recorded restructuring charges of $9.5 million related to the reduction in headcount within our German and North American operations that serve the telecom infrastructure market in order to better align the business with current market dynamics, the migration of our U.K. based capacitor production into existing Asian manufacturing facilities, and integration of activities within the consumer electronics business.



Gross Profit and Non-GAAP Gross Profit

Gross profit for the second quarter of 2014 was $33.8 million, compared with $101.2 million for the second quarter of 2013, a decrease of $67.4 million or 66.6%. Gross profit margin (gross profit as a percentage of revenues) for the second quarter of 2014 was 12.0%, compared with 34.1% for the second quarter of 2013. The decline was primarily due to the restructuring and related charges associated with the Vienna action of $34.2 million. The decline was also due to unfavorable pricing on mature products, higher ramp up costs associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. These declines were partially offset by higher volumes within our Specialty Components segment and cost savings from restructuring actions taken in the prior year. Non-GAAP gross profit for the second quarter of 2014 was $82.1 million, compared with $105.7 million for the second quarter of 2013, a decrease of $23.6 million or 22.3%. Non-GAAP gross profit margin (non-GAAP gross profit as a percentage of revenues) for the second quarter of 2014 was 29.2%, as compared with 35.6% for the second quarter of 2013. The decline was primarily due to unfavorable pricing on mature products, higher ramp up costs associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. These declines were partially offset by higher volumes within our Specialty Components segment and cost savings from restructuring actions taken in the prior year. 20



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Research and Development Expenses

Research and development expenses for the second quarter of 2014 were $21.7 million, compared with $21.2 million for the second quarter of 2013, an increase of $0.5 million or 2.2%. Research and development expenses as a percentage of revenues for the second quarter of 2014 and 2013 were 7.7% and 7.2%, respectively.



Selling and Administrative Expenses

Selling and administrative expenses for the second quarter of 2014 were $52.0 million, compared with $45.8 million for the second quarter of 2013, an increase of $6.2 million or 13.6%. Selling and administrative expenses as a percentage of revenues for the second quarter of 2014 were 18.5%, compared with 15.4% for the second quarter of 2013. The increase was mainly due to increased legal expenses primarily in connection with the GoerTek intellectual property litigation. Included in selling and administrative expenses in the second quarter of 2013 were corporate allocations from our Former Parent of $6.0 million, which represent administration of treasury, employee compensation and benefits, public and investor relations, internal audit, corporate income tax, supply chain and legal services. As a stand-alone public company, our total costs related to such support functions may differ from the costs that were historically allocated to us from our Former Parent. We estimate that these costs may exceed the allocated amount for full year 2013 of $23.6 million by a range of approximately $3 million to $5 million in 2014. Selling and administrative expenses are expected to be lower in the third quarter of 2014 with the sequential reduction driven primarily by the timing of legal spending.



(Loss) Earnings Before Interest and Income Taxes and Adjusted Earnings Before Interest and Income Taxes

(Loss) earnings before interest and income taxes ("EBIT") for the second quarter of 2014 was $(44.0) million, compared with $27.9 million for the second quarter of 2013, a decrease of $71.9 million. EBIT (loss) margin (EBIT as a percentage of revenues) for the second quarter of 2014 was (15.7)%, compared with 9.4% for the second quarter of 2013. This decrease was primarily due to the restructuring and related charges associated with the Vienna action of $38.8 million, unfavorable pricing on mature products, increased legal expenses primarily in connection with the GoerTek intellectual property litigation, higher ramp up costs associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. This decrease was partially offset by cost savings from restructuring actions taken in the prior year. Adjusted EBIT for the second quarter of 2014 was $21.5 million, compared with $50.5 million for the second quarter of 2013, a decrease of $28.9 million or 57.3%. Adjusted EBIT margin (adjusted EBIT as a percentage of revenues) for the second quarter of 2014 was 7.7%, as compared with 17.0% for the second quarter of 2013. This decrease was primarily due to unfavorable pricing on mature products, increased legal expenses primarily in connection with the Goertek intellectual property litigation, higher ramp up costs associated with new products, and reduced fixed cost leverage within our Mobile Consumer Electronics segment. This decrease was partially offset by cost savings from restructuring actions taken in the prior year.



Interest Expense, net

Interest expense, net for the second quarter of 2014 was $1.8 million, compared with $12.1 million for the second quarter of 2013, a decrease of $10.2 million or 84.9%. During the first quarter of 2014, we entered into a $500.0 million five-year credit facility and borrowed $400.0 million on February 28, 2014 to finance a cash payment to Dover in connection with the Separation. The interest expense, net for the second quarter of 2014 relates to these borrowings. The interest expense, net during the second quarter of 2013 relates to interest expense on the net notes payable to Dover that were settled during the fourth quarter of 2013 in anticipation of the Separation.



Provision for Income Taxes and Non-GAAP Provision for Income Taxes

The effective tax rate ("ETR") for the second quarter of 2014 was (72.3)%, compared with (5.3)% for the second quarter of 2013. The ETR for the second quarter of 2014 was impacted by net discrete items of $32.7 million. The discrete items recorded during the second quarter of 2014 was primarily due to the recognition of a valuation allowance on certain foreign subsidiaries' net deferred tax assets of $36.8 million, partially offset by a benefit related to an additional Malaysian tax holiday of $4.4 million. The benefit from the tax holiday primarily relates to 2013; however, it was recorded in the second quarter of 2014 because that is when we received approval of the tax holiday from the relevant taxing authority. For additional information on this tax holiday, refer to Note 8. Income Taxes to our Consolidated Financial Statements. 21



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The ETR for the second quarter of 2013 was impacted by net discrete tax items, principally the conclusion of certain international tax audits. Absent the discrete items, the ETR for the second quarter of 2014 was (0.8)%, compared with (2.8)% for the second quarter of 2013. The non-GAAP ETR for the second quarter of 2014 was (12.6)%, compared with 8.0% for the second quarter of 2013. The change in the non-GAAP ETR was due to the mix of earnings and losses by taxing jurisdictions. The year-to-date ETR and non-GAAP ETR deviates from the statutory U.S. federal income tax rate, mainly due to the taxing jurisdictions in which we generate taxable income or loss, the favorable impact of our significant tax holiday in Malaysia and judgments as to the realizability of our deferred tax assets. A significant portion of our pre-tax income is not subject to tax as a result of our Malaysian tax holiday, subject to our satisfaction of certain conditions that we expect to continue to satisfy. Unless extended or otherwise renegotiated, our existing significant tax holiday in Malaysia will expire December 31, 2021.



Diluted (Loss) Earnings per Share and Non-GAAP Diluted Earnings per Share

Diluted (loss) earnings per share were $(0.93) for the second quarter of 2014, compared with $0.20 for the second quarter of 2013. The decrease in diluted earnings per share was primarily due to restructuring and related charges associated with the Vienna action of $38.8 million, a discrete tax expense resulting from the recognition of a valuation allowance on certain foreign subsidiaries' net deferred tax assets of $36.8 million and reduced revenues. This decrease was partially offset by lower interest expense and the discrete Malaysia tax holiday benefit recorded during the second quarter of 2014. Non-GAAP diluted earnings per share for the second quarter of 2014 was $0.26, compared with $0.42 for the second quarter of 2013. Non-GAAP diluted earnings per share included $0.05 related to the discrete Malaysia tax holiday benefit recorded during the second quarter of 2014. Excluding the discrete tax benefit, the decrease in non-GAAP diluted earnings per share was mainly driven by lower adjusted EBIT, partially offset by a reduction in interest expense. 22



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Results of Operations for the Six Months Ended June 30, 2014 Compared with the Six Months Ended June 30, 2013

Six Months Ended June 30, (in thousands, except per share amounts) 2014 2013 Revenues $ 554,418$ 572,827 Gross profit $ 116,843$ 195,789 Non-GAAP gross profit $ 171,037$ 203,208



(Loss) earnings before interest and income taxes $ (33,169 )$ 51,957 Adjusted earnings before interest and income taxes $ 53,666$ 91,464

Provision for (benefit from) income taxes $ 35,597$ (626 ) Non-GAAP provision for income taxes $ 1,423$ 5,409 Net (loss) earnings $ (71,258 )$ 28,566 Non-GAAP net earnings $ 49,751$ 62,038 Diluted (loss) earnings per share (1) $ (0.84 ) $



0.34

Non-GAAP diluted earnings per share $ 0.58 $



0.73

(1) On February 28, 2014, Dover shareholders of record as of the close of business on February 19, 2014 received one share of Knowles common stock for every two shares of Dover's common stock held as of the record date. The computation of diluted earnings per common share for all periods through December 31, 2013 were calculated using the shares distributed on February 28, 2014. See Note 10. Earnings per Share, to the Consolidated Financial Statements for information regarding earnings per share.



Revenues

Revenues for the six months ended June 30, 2014 were $554.4 million, compared with $572.8 million for the six months ended June 30, 2013, a decrease of $18.4 million or 3.2%. This was due to a decrease in Mobile Consumer Electronics revenues of $28.7 million, partially offset by an increase in Specialty Components revenues of $10.3 million. The decrease in Mobile Consumer Electronics revenues was a result of lower average selling prices on mature products, a design change at a smartphone OEM customer and lower shipments to three OEM customers in connection with their lower share of the handset market. These decreases were partially offset by an increase in revenues from Chinese OEM customers who gained market share year-over-year and new product sales with higher average selling prices. The increase in Specialty Components revenues was driven by improved demand for precision devices, due primarily to strength in the wireless communication infrastructure market, particularly in China.



Cost of Goods Sold

Cost of goods sold for the six months ended June 30, 2014 were $421.2 million, compared with $371.2 million for the six months ended June 30, 2013, an increase of $50.0 million or 13.5%. The increase was primarily due to fixed asset accelerated depreciation and related inventory charges of $26.1 million mainly associated with the Vienna action and production transfer costs of $8.5 million to support the migration of operations into new and existing Asian lower-cost manufacturing facilities. For additional information on our restructuring actions, refer to Restructuring Charges below and to Note 5. Restructuring and Related Activities to our Consolidated Financial Statements. 23



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Table of Contents Restructuring Charges During the six months ended June 30, 2014, we recorded restructuring charges of $17.1 million related to the Vienna action. This included $12.6 million related to severance pay and benefits and $4.5 million related to contract termination and other costs, of which $12.5 million were classified as Cost of goods sold and $4.6 million were classified as Operating expenses. In conjunction with this restructuring action, we also accelerated depreciation on fixed assets and recorded inventory charges of $20.4 million and incurred production transfer costs of $1.3 million bringing the total recorded costs related to the Vienna action to $38.8 million. We also recorded restructuring charges of $3.8 million during the six months ended June 30, 2014 related to other actions. These actions included programs to transfer our hearing health business and our North American based capacitor business into new and existing lower-cost Asian manufacturing facilities as well as to reduce headcount in the consumer electronics business. During the six months ended June 30, 2013, we recorded restructuring charges of $12.8 million related to the reduction in headcount within our German and North American operations that serve the telecom infrastructure market in order to better align the business with current market dynamics, the migration of our U.K. based capacitor production into existing Asian manufacturing facilities, and integration of activities within the consumer electronics business.



Gross Profit and Non-GAAP Gross Profit

Gross profit for the six months ended June 30, 2014 was $116.8 million, compared with $195.8 million for the six months ended June 30, 2013, a decrease of $78.9 million or 40.3%. Gross profit margin (gross profit as a percentage of revenues) for the six months ended June 30, 2014 was 21.1%, compared with 34.2% for the six months ended June 30, 2013. The decline was primarily due to the restructuring and related charges associated with the Vienna action of $34.2 million. The decline was also due to unfavorable pricing on mature products, higher ramp up costs associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. These declines were partially offset by higher volumes within our Specialty Components segment and cost savings from restructuring actions taken in the prior year. Non-GAAP gross profit for the six months ended June 30, 2014 was $171.0 million, compared with $203.2 million for the six months ended June 30, 2013, a decrease of $32.2 million or 15.8%. Non-GAAP gross profit margin (non-GAAP gross profit as a percentage of revenues) for the six months ended June 30, 2014 was 30.8%, as compared with 35.5% for the six months ended June 30, 2013. The decline was primarily due to unfavorable pricing on mature products, higher ramp up costs associated associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. These declines were partially offset by higher volumes within our Specialty Components segment and cost savings from restructuring actions taken in the prior year.



Research and Development Expenses

Research and development expenses for the six months ended June 30, 2014 were $40.9 million, compared with $42.2 million for the six months ended June 30, 2013, a decrease of $1.2 million or 2.9%. Research and development expenses as a percentage of revenues for the six months ended June 30, 2014 was 7.4%, flat compared with the six months ended June 30, 2013.



Selling and Administrative Expenses

Selling and administrative expenses for the six months ended June 30, 2014 were $104.4 million, compared with $95.8 million for the six months ended June 30, 2013, an increase of $8.6 million or 9.0%. Selling and administrative expenses as a percentage of revenues for the six months ended June 30, 2014 were 18.8%, compared with 16.7% for the six months ended June 30, 2013.The increase was mainly due to increased legal expenses primarily in connection with the GoerTek intellectual property litigation, partially offset by cost savings from restructuring actions taken in the prior year. Included in selling and administrative expenses were corporate allocations from our Former Parent of $3.4 million and $12.0 million for the six months ended June 30, 2014 and 2013, respectively, which represent administration of treasury, employee compensation and benefits, public and investor relations, internal audit, corporate income tax, supply chain and legal services through the Separation date. As a stand-alone public company, our total costs related to such support functions may differ from the costs that were historically allocated to us from our Former Parent. We estimate that these costs may exceed the allocated amount for full year 2013 of $23.6 million by a range of approximately $3 million to $5 million in 2014. 24



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(Loss) Earnings Before Interest and Income Taxes and Adjusted Earnings Before Interest and Income Taxes

(Loss) earnings before interest and income taxes ("EBIT") for the six months ended June 30, 2014 was $(33.2) million, compared with $52.0 million for the six months ended June 30, 2013, a decrease of $85.1 million. EBIT (loss) margin (EBIT as a percentage of revenues) for the six months ended June 30, 2014 was (6.0)%, compared with 9.1% for the six months ended June 30, 2013. This decrease was primarily due to the restructuring and related charges associated with the Vienna action of $38.8 million, unfavorable pricing on mature products, increased legal expenses primarily in connection with the GoerTek intellectual property litigation, higher ramp up costs associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. This decrease was partially offset by cost savings from restructuring actions taken in the prior year. Adjusted EBIT for the six months ended June 30, 2014 were $53.7 million, compared with $91.5 million for the six months ended June 30, 2013, a decrease of $37.8 million or 41.3%. Adjusted EBIT margin (adjusted EBIT as a percentage of revenues) for the six months ended June 30, 2014 was 9.7%, as compared with 16.0% for the six months ended June 30, 2013. This decrease was primarily due to unfavorable pricing on mature products, increased legal expenses primarily in connection with the GoerTek intellectual property litigation, higher ramp up costs associated with new products and reduced fixed cost leverage within our Mobile Consumer Electronics segment. This decrease was partially offset by cost savings from restructuring actions taken in the prior year.



Interest Expense, net

Interest expense, net for the six months ended June 30, 2014 was $2.5 million, compared with $24.0 million for the six months ended June 30, 2013, a decrease of $21.5 million or 89.6%. During the first quarter of 2014, we entered into a $500.0 million five-year credit facility and borrowed $400.0 million on February 28, 2014 to finance a cash payment to Dover in connection with the Separation. The interest expense, net for the six months ended June 30, 2014 relates to these borrowings. The interest expense, net during the six months ended June 30, 2013 relates to interest expense on the net notes payable to Dover that were settled during the fourth quarter of 2013 in anticipation of the Separation.



Provision for Income Taxes and Non-GAAP Provision for Income Taxes

The effective tax rate ("ETR") for the six months ended June 30, 2014 was (99.8)%, compared with (2.2)% for the six months ended June 30, 2013. The ETR for the six months ended June 30, 2014 was impacted by net discrete items of $35.7 million. The discrete items recorded during the six months ended June 30, 2014 was primarily due to the recognition of a valuation allowance on certain foreign subsidiaries' net deferred tax assets of $36.8 million, partially offset by a benefit related to an additional Malaysian tax holiday of $4.4 million. The benefit from the tax holiday primarily relates to 2013; however, it was recorded in the second quarter of 2014 because that is when we received approval of the tax holiday from the relevant taxing authority. For additional information on this tax holiday, refer to Note 8. Income Taxes to our Consolidated Financial Statements. The ETR for the six months ended June 30, 2013 was impacted by net discrete tax items, principally the conclusion of certain international tax audits. Absent the discrete items, the ETR for the six months ended June 30, 2014 was 0.3%, compared with (2.8)% for the six months ended June 30, 2013. The non-GAAP ETR for the six months ended June 30, 2014 was 2.8%, compared with 8.0% for the six months ended June 30, 2013. The change in the non-GAAP ETR was due to the mix of earnings and losses by taxing jurisdictions. The year-to-date ETR and non-GAAP ETR deviates from the statutory U.S. federal income tax rate, mainly due to the taxing jurisdictions in which we generate taxable income or loss and the favorable impact of our significant tax holiday in Malaysia. A significant portion of our pre-tax income is not subject to tax as a result of our Malaysian tax holiday, subject to our satisfaction of certain conditions that we expect to continue to satisfy. Unless extended or otherwise renegotiated, our existing significant tax holiday in Malaysia will expire December 31, 2021. 25



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Diluted (Loss) Earnings per Share and Non-GAAP Diluted Earnings per Share

Diluted (loss) earnings per share were $(0.84) for the six months ended June 30, 2014, compared with $0.34 for the six months ended June 30, 2013. The decrease in diluted earnings per share was primarily due to restructuring and related charges associated with the Vienna action of $38.8 million, a discrete tax expense resulting from the recognition of a valuation allowance on certain foreign subsidiaries' net deferred tax assets of $36.8 million and reduced revenues. This decrease was partially offset by lower interest expense and the discrete Malaysia tax holiday benefit recorded during the second quarter of 2014. Non-GAAP diluted earnings per share for the six months ended June 30, 2014 was $0.58, compared with $0.73 for the six months ended June 30, 2013. Non-GAAP diluted earnings per share included $0.05 related to the discrete Malaysia tax holiday benefit recorded during the second quarter of 2014. Excluding the discrete tax benefit, the decrease in non-GAAP diluted earnings per share was mainly driven by lower adjusted EBIT, partially offset by a reduction in interest expense. 26



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Reconciliation of GAAP Financial Measures to Non-GAAP Financial Measures

Three Months Ended June 30, Six Months Ended June 30, (in thousands, except share and per share amounts) 2014 2013 2014 2013 Gross profit $ 33,785$ 101,228$ 116,843$ 195,789 Stock-based compensation expense 288 - 288 - Fixed asset and related inventory charges 25,799 - 26,580 490 Restructuring charges 16,417 4,041 16,417 5,864 Production transfers costs (1) 5,789 1,768 10,909 2,436 Other - (1,371 ) - (1,371 ) Non-GAAP gross profit $ 82,078$ 105,666$ 171,037$ 203,208 Net (loss) earnings $ (78,903 )$ 16,671$ (71,258 )$ 28,566 Interest expense, net 1,820 12,069 2,492 24,017 Provision for (benefit from) income taxes 33,097 (835 ) 35,597 (626 ) (Loss) earnings before interest and income taxes (43,986 ) 27,905 (33,169 ) 51,957 Stock-based compensation expense 2,417 564 3,903 1,129 Intangibles amortization expense 10,826 12,271 21,537 23,984 Fixed asset and related inventory charges 25,799 - 26,580 490 Restructuring charges 20,700 9,517 20,943 12,832 Production transfers costs (1) 5,789 1,595 11,574 2,443 Other - (1,371 ) 2,298 (1,371 ) Adjusted earnings before interest and income taxes $ 21,545$ 50,481



$ 53,666$ 91,464

Provision for (benefit from) income taxes $ 33,097$ (835 )$ 35,597$ (626 ) Income tax effects of non-GAAP reconciling adjustments 35,583 (3,916 ) 34,174 (6,035 ) Non-GAAP (benefit from) provision for income taxes $ (2,486 )$ 3,081$ 1,423$ 5,409 Net (loss) earnings $ (78,903 )$ 16,671$ (71,258 )$ 28,566 Non-GAAP reconciling adjustments 65,531 22,576 86,835 39,507 Income tax effects of non-GAAP reconciling adjustments 35,583 (3,916 ) 34,174 (6,035 ) Non-GAAP net earnings $ 22,211$ 35,331$ 49,751$ 62,038 Non-GAAP diluted earnings per share (2) $ 0.26$ 0.42



$ 0.58$ 0.73

Diluted average shares outstanding (2) 85,042,334 85,019,159 85,033,149 85,019,159 Non-GAAP adjustment (3) 755,153 - 492,478 - Non-GAAP diluted average shares outstanding (2) (3) 85,797,487 85,019,159



85,525,627 85,019,159

(1) Production Transfer Costs represent one-time and duplicate costs incurred to migrate manufacturing to new or existing facilities in Asia, primarily for speakers, hearing health products, and capacitors. These amounts are included in the corresponding gross profit and earnings before interest and income taxes for each period presented. (2) On February 28, 2014, Dover shareholders of record as of the close of business on February 19, 2014 received one share of Knowles common stock for every two shares of Dover's common stock held as of the record date. The computation of diluted earnings per common share for all periods through December 31, 2013 was calculated using the shares distributed on February 28, 2014. (3) The number of shares used in the diluted per share calculations on a non-GAAP basis excludes the impact of stock-based compensation expense expected to be incurred in future periods and not yet recognized in the financial statements, which would otherwise be assumed to be used to repurchase shares under the GAAP treasury stock method. 27



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Segment Results of Operations for the Three Months Ended June 30, 2014 Compared with the Three Months Ended June 30, 2013

The following is a summary of the results of operations of our two reportable segments: Mobile Consumer Electronics and Specialty Components.

In addition to the GAAP financial measures included herein, we have presented certain non-GAAP financial measures. We use non-GAAP measures as supplements to our GAAP results of operations in evaluating certain aspects of our business, and our Board of Directors and executive management team focus on non-GAAP items as key measures of our performance for business planning purposes. These measures assist us in comparing our performance between various reporting periods on a consistent basis, as these measures remove from operating results the impact of items that, in our management's opinion, do not reflect our core operating performance. We believe that our presentation of non-GAAP financial measures is useful because it provides investors and securities analysts with the same information that we use internally for purposes of assessing our core operating performance. See Note 12. Segment Information to the Consolidated Financial Statements for (i) a reconciliation of segment revenues to our consolidated revenues and (ii) a reconciliation of segment earnings before interest and income taxes to our consolidated net earnings. Mobile Consumer Electronics Three Months Ended June 30, Percent Percent of of (in thousands) 2014 Revenues 2013 Revenues Revenues $ 166,743$ 189,655 Operating (loss) earnings $ (47,630 ) (28.6)% $ 27,759 14.6% Other (income) expense, net (95 ) 766 (Loss) earnings before interest and income taxes $ (47,535 ) (28.5)% $ 26,993 14.2% Stock-based compensation expense 497 78 Intangibles amortization expense 8,079



8,008

Fixed asset and related inventory charges 25,799 - Restructuring charges 18,111 4,718 Production transfer costs (1) 2,361 750 Adjusted earnings before interest and income taxes $ 7,312 4.4%



$ 40,547 21.4%

(1) Production transfer costs represent one-time and duplicate costs incurred to migrate manufacturing to new or existing facilities in Asia, primarily for speakers, hearing health products, and capacitors. These amounts are included in earnings before interest and income taxes for each period presented. Revenues Mobile Consumer Electronics revenues were $166.7 million for the second quarter of 2014, compared with $189.7 million for the second quarter of 2013, a decrease of $22.9 million or 12.1%. This was due to lower average selling prices on mature products, a design change at a smartphone OEM customer and lower shipments to three OEM customers in connection with their lower share of the handset market. These decreases were partially offset by an increase in revenues from Chinese OEM customers who gained market share during the quarter and new product sales with higher average selling prices.



Operating (Loss) Earnings and Adjusted Earnings Before Interest and Income Taxes

Mobile Consumer Electronics operating (loss) earnings were $(47.6) million for the second quarter of 2014, compared with $27.8 million for the second quarter of 2013, a decrease of $75.4 million. This decrease was primarily due to the restructuring and related charges associated with the Vienna action of $38.8 million, lower revenues, unfavorable pricing on mature products, higher ramp up costs associated with new products, reduced fixed cost leverage, and increased legal expenses primarily in connection with the GoerTek intellectual property litigation. This decrease was partially offset by cost savings from restructuring actions taken in the prior year. 28



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Mobile Consumer Electronics adjusted EBIT was $7.3 million for the second quarter of 2014, compared with $40.5 million for the second quarter of 2013, a decrease of $33.2 million. Adjusted EBIT margin for the second quarter of 2014 was 4.4%, compared with 21.4% for the second quarter of 2013. The decrease was primarily due to lower revenues, unfavorable pricing on mature products, higher ramp up costs associated with new products, reduced fixed cost leverage, and increased legal expenses primarily in connection with the GoerTek intellectual property litigation. This decrease was partially offset by cost savings from restructuring actions taken in the prior year. Specialty Components Three Months Ended June 30, Percent Percent of of (in thousands) 2014 Revenues 2013 Revenues Revenues $ 114,300$ 107,063 Operating earnings $ 15,797 13.8% $ 12,153 11.4% Other expense, net 965 405



Earnings before interest and income taxes $ 14,832 13.0% $ 11,748 11.0% Stock-based compensation expense

448



265

Intangibles amortization expense 2,748 4,263 Restructuring charges 2,589 4,799 Production transfer costs (1) 3,429 845 Other - (1,371 ) Adjusted earnings before interest and income taxes $ 24,046 21.0%



$ 20,549 19.2%

(1) Production transfer costs represent one-time and duplicate costs incurred to migrate manufacturing to new or existing facilities in Asia, primarily for speakers, hearing health products, and capacitors. These amounts are included in earnings before interest and income taxes for each period presented. Revenues Specialty Components revenues were $114.3 million for the second quarter of 2014, compared with $107.1 million for the second quarter of 2013, an increase of $7.2 million or 6.8%. The increase in revenues was primarily due to improved demand for precision devices as a result of strength in the wireless communication infrastructure market, particularly in China.



Operating Earnings and Adjusted Earnings Before Interest and Income Taxes

Specialty Components operating earnings were $15.8 million for the second quarter of 2014, compared with $12.2 million for the second quarter of 2013, an increase of $3.6 million. Specialty Components adjusted EBIT was $24.0 million for the second quarter of 2014, compared with $20.5 million for the second quarter of 2013, an increase of $3.5 million. Adjusted EBIT margin for the second quarter of 2014 was 21.0% compared with 19.2% for the second quarter of 2013. The increase was primarily due to higher volumes and cost savings from restructuring actions taken in the prior year. 29



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Segment Results of Operations for the Six Months Ended June 30, 2014 Compared with the Six Months Ended June 30, 2013

Mobile Consumer Electronics

Six Months Ended June 30, Percent Percent of of (in thousands) 2014 Revenues 2013 Revenues Revenues $ 330,733$ 359,426 Operating (loss) earnings $ (41,172 ) (12.4)% $ 47,206 13.1% Other income, net (489 ) (183 ) (Loss) earnings before interest and income taxes $ (40,683 ) (12.3)% $ 47,389 13.2% Stock-based compensation expense 673 141 Intangibles amortization expense 15,711



15,696

Fixed asset and related inventory charges 26,580 490 Restructuring charges 18,111 6,916 Production transfer costs (1) 4,045 1,453 Adjusted earnings before interest and income taxes $ 24,437 7.4%



$ 72,085 20.1%

(1) Production transfer costs represent one-time and duplicate costs incurred to migrate manufacturing to new or existing facilities in Asia, primarily for speakers, hearing health products, and capacitors. These amounts are included in earnings before interest and income taxes for each period presented. Revenues Mobile Consumer Electronics revenues were $330.7 million for the six months ended June 30, 2014, compared with $359.4 million for the six months ended June 30, 2013, a decrease of $28.7 million or 8.0%. This was due to lower average selling prices on mature products, a design change at a smartphone OEM customer and lower shipments to three OEM customers in connection with their lower share of the handset market. These decreases were partially offset by an increase in revenues from Chinese OEM customers who gained market share year-over-year and new product sales with higher average selling prices.



Operating (Loss) Earnings and Adjusted Earnings Before Interest and Income Taxes

Mobile Consumer Electronics operating (loss) earnings were $(41.2) million for the six months ended June 30, 2014, compared with $47.2 million for the six months ended June 30, 2013, a decrease of $88.4 million. This decrease was primarily due to the restructuring and related charges associated with the Vienna action of $38.8 million, lower revenues, unfavorable pricing on mature products, higher ramp up costs associated with new products, reduced fixed cost leverage, and increased legal expenses primarily in connection with the GoerTek intellectual property litigation. This decrease was partially offset by cost savings from restructuring actions taken in the prior year. Mobile Consumer Electronics adjusted EBIT was $24.4 million for the six months ended June 30, 2014, compared with $72.1 million for the six months ended June 30, 2013, a decrease of $47.6 million. Adjusted EBIT margin for the six months ended June 30, 2014 was 7.4%, compared with 20.1% for the six months ended June 30, 2013. The decrease was primarily due to lower revenues, unfavorable pricing on mature products, higher ramp up costs associated with new products, reduced fixed cost leverage, and increased legal expenses primarily in connection with the GoerTek intellectual property litigation. This decrease was partially offset by cost savings from restructuring actions taken in the prior year. 30



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Table of Contents Specialty Components Six Months Ended June 30, Percent Percent of of (in thousands) 2014 Revenues 2013 Revenues Revenues $ 223,706$ 213,427 Operating earnings $ 32,450 14.5% $ 25,480 11.9% Other expense (income), net 1,918 (1,058 ) Earnings before interest and income taxes $ 30,532 13.6% $ 26,538 12.4% Stock-based compensation expense 654



528

Intangibles amortization expense 5,827 8,287 Restructuring charges 2,832 5,916 Production transfer costs (1) 7,530 991 Other - (1,371 ) Adjusted earnings before interest and income taxes $ 47,375 21.2%



$ 40,889 19.2%

(1) Production transfer costs represent one-time and duplicate costs incurred to migrate manufacturing to new or existing facilities in Asia, primarily for speakers, hearing health products, and capacitors. These amounts are included in earnings before interest and income taxes for each period presented. Revenues Specialty Components revenues were $223.7 million for the six months ended June 30, 2014, compared with $213.4 million for the six months ended June 30, 2013, an increase of $10.3 million or 4.8%. The increase in revenues was primarily due to improved demand for precision devices as a result of strength in the wireless communication infrastructure market, particularly in China.



Operating Earnings and Adjusted Earnings Before Interest and Income Taxes

Specialty Components operating earnings were $32.5 million for the six months ended June 30, 2014, compared with $25.5 million for the six months ended June 30, 2013, an increase of $7.0 million. Specialty Components adjusted EBIT was $47.4 million for the six months ended June 30, 2014, compared with $40.9 million for the six months ended June 30, 2013, an increase of $6.5 million. Adjusted EBIT margin for the six months ended June 30, 2014 was 21.2%, compared with 19.2% for the six months ended June 30, 2013. The increase was primarily due to higher volumes and cost savings from restructuring actions taken in the prior year. 31



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Liquidity and Capital Resources

We believe that our cash flow from operations and access to capital markets will provide adequate resources to fund our working capital needs, dividends (if any), capital expenditures and strategic investments for at least the next twelve months. We have secured a revolving line of credit in the U.S. from a syndicate of commercial banks to provide additional liquidity. Furthermore, if we were to require additional cash in the U.S. above and beyond our domestic cash on the balance sheet, the free cash flow generated by the domestic businesses and availability under our revolving credit facility, we would most likely seek to raise long-term financing through the U.S. debt or bank markets. Our ability to make payments on and to refinance our indebtedness, including third party debt incurred in connection with the Separation, as well as any debt that we may incur in the future, will depend on our ability in the future to generate cash from operations, financings or asset sales and the tax consequences of our repatriation of overseas cash. Our cash and cash equivalents totaled $44.6 million and $105.6 million at June 30, 2014 and December 31, 2013, respectively. Of these amounts, cash held by our non-U.S. operations totaled $35.4 million and $95.0 million as of June 30, 2014 and December 31, 2013, respectively.


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