Knowles Knows Intelligent Audio

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Business Description

Company: Operating in the auditory technology industry, Knowles Corporation (KN) offers micro-acoustic, audio processing, and specialty component solutions. Knowles is the first company to make the best-performing MEMS microphones and voice processors to be used in mobile, Internet of Things (IoT), and artificially intelligent devices. It serves the consumer electronics, communications, medical, military, aerospace, and industrial markets. In 2001, Knowles developed and sold the world’s first surface-mounted microphone as a part of its SiSonic series, which is still preferred my most cell phone manufacturers, including Apple, Samsung, and LG. Today, Knowles is the largest supplier of MEMS microphones in the world. The company’s success with its advanced MEMS microphones and its focus on its Intelligent Audio division positions it on the forefront of the market for auditory components and software for the AI industry.

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Business Operations: The products and software that Knowles offers are managed through sales, support, and engineering facilities in North America, Europe, and Asia.  Sales in the Asian market sales decreased from 77% to 73% over the last three years. From 2013 through 2016, 74% of revenue was derived from Asia, on average. However, in 2016, this figure decreased slightly to 73%. The average over the last three years for the United States was 13%, but in 2016, the United States accounted for 14% of revenue. All of its manufacturing facilities are located in Asia. Knowles operates through two segments: Mobile Consumer Electronics (MCE) and Specialty Components (SC). The MCE segment designs and manufactures acoustic products for consumer electronic devices, including microphones and audio processing technologies. Its Intelligent Audio unit, which includes MEMS microphones (sometimes also referred to as “intelligent microphones”), voice detectors and processors, and their accompanying software, lies under the MCE segment. The SC segment designs and manufactures specialized electronic components, including transducers, oscillators, capacitators, and filters to be used in medical and life science applications.

Product Description: Knowles’s Specialty Components segment is comprised of speakers and receivers, oscillators and Surface Acoustic Wave filters, capacitators, and hearing aid components. Oscillators are electronic circuits that produce periodic, oscillating electronic signal. They are widely used in electronic media devices. Surface Acoustic Wave filters convert an electrical signal into an acoustic wave. Also used in the telecommunications industry, Surface Acoustic Wave filters are used in radio systems, mobile phone handsets, and in household televisions. A capacitator is an electronic component that is capable of storing electoral energy in an electric field. They can smooth energy waves, store energy, and convert voltages. Although these products are an important part of Knowles’s business, most of it revenue lies in the Mobile Consumer Electronics segment. Knowles is shifting its focus more towards the Mobile Consumer Electronics segment. Comprising 73% of Knowles’s 2017 revenue, the MCE segment is the largest segment and is the most applicable to the AI industry. See Appendix 4 for further details on the MCE segment’s product line.

There are several individual products in the MCE segment, but all of them fall under one of three categories:

Microphones: MEMS microphones are extremely small and powerful microphones that can pick up on an extremely wide range of sounds. They are more advanced than traditional microphones because of their sound-detecting capabilities and their audio processing technologies. They are used in smart phones, Internet of Things devices, artificially intelligent machines, cars, and hearing aids. Through constant innovation, Knowles has climbed its way to the top of the MEMS microphones market, offering the most advanced microphones with the most features available on the market. Its MEMS microphones are 25% smaller, use 50% less power, and have a longer battery life than others on the market. Knowles’s unique Inter-IC Sound (I2S) interface MEMS microphone allows manufacturers to connect directly to application processors or microcontrollers, a feature not available with other intelligent microphones. Knowles produces the highest-quality far field beam-forming microphone, which is capable of enabling a machine to hear the user as well as a human.

Voice detectors & voice processors: Knowles’s Voice IQ, Audience eS700 & eS800 series, and Acoustic Activity Detect technology are able to adapt to noise in the environment in order to detect the human voice. Once they collect the auditory information, they send it through the software so that it can be interpreted. They are used in many of the same products as MEMS microphones. Knowles sells the world’s first “always listening” voice detector, which is able to automatically adapt its performance to the user’s surrounding acoustic environment and enable voice wake-up solutions, while also having significant power savings over other voice detectors in the market.

Software: Often used supplementally with the microphones and voice detectors/processors, its patented software mimics the way the human brain processes sound in order to process and interpret the information received from the microphones and voice processors. The software is what enables artificially intelligent devices to understand and process spoken language, and respond aloud appropriately.

Revenue Breakdown: Over the past two years, the MCE segment has accounted for 58% of quarterly revenue, and the SC segment accounted for the other 42%. However, the MCE segment made up 73% of revenue for the first half of 2017, due to Knowles shifting its focus to its Intelligent Audio unit and its deals with Apple and Amazon to use Knowles’s microphones and software in new products. The percentage of revenue derived from the MCE segment has been increasing every quarter for the past year. Knowles is focusing on its Intelligent Audio unit because of those products’ central roles in the growing number of AI applications.
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Investment Rationale

Leader in a Next-Generation Industry: Knowles is the largest supplier of micro-electro mechanical systems (MEMS) microphones in the world, currently owning 59% of the MEMS microphone market. Knowles is poised to directly benefit from the rapid growth in the artificial intelligence (AI) industry, as it currently sells intelligent microphones and AI software to all of the largest tech companies. The AI industry is set to explode as applications for AI technology span across nearly every industry imaginable. Spending in the AI industry grew 54% since last year, and it is expected to increase economic growth rates by an average of 1.7% across all industries through 2035. According to UBS, the AI industry has the potential to increase profitability by an average of 38%, and lead to an economic boost of $14 trillion in 12 economies by 2035. The AI growth trend clearly supports the increased demand for the MEMS microphone produced by Knowles; furthermore, the increased functionality of AI nictitates the implementation of more sophisticated microphone technology of which Knowles is uniquely position to capture market share.

First in Modern Voice Processing Technology: MEMS microphones and voice processing technology has existed in some form for a number of years, but Knowles’s innovative, patent-protected technology changed the market for these products by being the first company to offer the most advanced voice processing technology available. Knowles’s VoiceIQ voice detector is the world’s first “always listening” voice detector able to automatically adapt its performance to the acoustic environment and enable voice wake-up solutions, while also having significant power savings over traditional voice detectors. Its MEMS microphones are 25% smaller and use 50% less power than competitive products. They are also more sensitive and have a longer battery life than other MEMS microphones on the market. Knowles’s unique I2S interface MEMS microphone allows manufacturers to connect directly to application processors or microcontrollers, a feature not available with other intelligent microphones. Knowles produces the highest-quality far field beam forming microphone, which is capable of enabling a machine to hear the user as well as a human.

Takeover Target: Knowles’s top customers include Apple, Samsung, Huawei, Amazon, Microsoft, LG, Qualcomm, Acer, Lenovo, Alphabet, Siemens, and Sony. These relationships provide Knowles with $375 million in annual revenue. It is very common for small, focused tech companies to be taken over by larger companies further down the supply chain. Knowles’s valuable relationships with powerful companies involved in AI, combined with its market share and specialty patent-protected technology that makes its microphones the best on the market for AI applications, make Knowles an attractive takeover target. The application of AI spreads across the healthcare, transportation, manufacturing industries the demand for AI companies to have control over their supply chains will increase. This results in an incentive for AI manufacturers to take over Knowles and companies like it.

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Growth Drivers

Next-Generation Multi Microphone Adoption Trend: As voice recognition technology becomes more popular in “smart” and artificially intelligent devices, tech companies are beginning to use multiple microphones per device to generate higher-quality recordings and increase accuracy for voice recognition. Amazon’s Echo and the Echo Dot both have seven microphones each, all of which are Knowles MEMS microphones. Apple was the first company to use multiple microphones in one smartphone, and they have since increased the number of microphones in their smartphones from two in the iPhone 4 to five in the iPhone X. The Apple Homepod, which will utilize Knowles’s microphones when it becomes available in November, features six microphones per device. Apple boasts that using Knowles’s technology, the “six far-field beam forming microphones” enable the Homepod to hear the user as well as a human, even over top of music playing. Knowles is poised to benefit more than its peers from the increased need for accuracy in voice recognition because it offers the best-performing microphones and voice processors in the market and has long-standing relationships with large smartphone and AI companies.

 

Supply the Highest Growth Industry: Knowles has ramped up its spending on research & development (R&D) over the past two quarters because of its focus on its Intelligent Audio products. Knowles has increased spending on R&D in the MCE segment by 32% in the past two years. The voice processors, MEMS microphones, and the software that comprise Knowles’s Intelligent Audio collection have several AI applications. The AI industry has already experiencing an extremely rapid spending growth rate of 20% per year in 2015 and 2016, and is then expected to double by the end of 2017. Moving forward, the AI industry is set to explode due to the fact that it has applications in nearly every industry, so the compound annual growth rate is expected to be 54% through 2020. This will spur growth for Knowles in coming years, especially since they are the world’s single largest player in the MEMS microphone market, and they offer auditory processing software that allows machines to function like a human brain. The long-term annual sustainable growth rate of the AI industry is 40%, meaning that spending in the industry will double every 1.75 years. In addition, the fact that Knowles’s microphones are smaller, cheaper, more sensitive, and use less energy than the competitions’ will be a valuable competitive advantage for Knowles as the AI industry takes off. One application for AI in the medical industry is for hearing aids. As the leading supplier of MEMS microphones and voice detectors for hearing aid manufacturers, Knowles will benefit both from the expansion of AI, as well as an aging population that will need better-performing hearing aids in the future. The MCE segment’s EBITDA margin has decreased in 2017, but this is due to the fact that Knowles has been spending significantly more on R&D for the Intelligent Audio unit to keep their technology ahead of the curve. Despite this, however, the MCE segment has accounted for 73% of 2017 revenue, as compared to its two-year average of 58%.

Supply the Largest Players: Exhibit 7B lists Knowles’s top ten customers and the percentage of Knowles’s revenue that each accounts for. Its top ten customers comprise 47% of Knowles’s revenue, with its largest customer being Apple. Knowles’s MEMS microphones were used in Apple’s iPhone X that was released in September. Knowles recently signed a deal with Apple to use Knowles’s microphones in Apple’s Homepod that will hit the market in November, in time for the holiday season. Knowles’s microphones are currently being used in Amazon’s artificially intelligent device, Echo, and rapidly growing demand for this product has spurred Amazon to develop plans to release newer versions in the future. It is highly likely that Knowles will land the contract with Amazon to include its microphones in these newer versions of the Echo, a promising source of future revenue. Knowles’s strong relationships with major AI players, like Apple, Microsoft, Amazon, and Alphabet will be a growth driver moving forward because these companies are very likely to use Knowles’s microphones, voice processors, software, and other intelligent audio products in their future AI devices, or acquire Knowles as a part of vertical integration.

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Industry and Peer Group Review

Industry: Artificial intelligence (AI) is a culmination of technologies that allows machines to perform tasks that were previously only able to be accomplished by humans, such as learning, recognizing and understanding language, image recognition, and developing original thoughts. Artificial intelligence is application-based, so companies develop AI devices and software in order to meet a purpose or perform a specific function. Tech companies do not “make AI,” they make hardware and software that are put into the artificially intelligent devices that are created to serve some purpose for a business or individual. Therefore, there are no pure play “AI companies” in the market, so the next-best option is to buy a company that is very focused in making components or software that are used in AI devices. One major factor behind the explosive growth in the AI industry is the fact that it has applications in nearly every industry. A few of the industries that will continue to be impacted the most by AI are the information and communication, manufacturing, financial services, agriculture, education, food services, construction, wholesale and retail, healthcare, social services, transportation and automotive, manufacturing, financial services, professional services, and communication industries. AI is expected to increase productivity by at least 35% by 2035, which would double the economic growth of twelve developed nations.

Competition: Analog Devices, MEMSTech, and Akustica are Knowles’s biggest competitors in the MCE space. Knowles has other competitors, but they compete in the SC space, which is less of a threat because of Knowles’s increased focus on its Intelligent Audio unit. After Akustica was acquired by Robert Bosch N.A., Knowles entered into a lawsuit with MEMSTech over a patent violation regarding their MEMS microphones and won. Knowles also has competitive advantages over its three competitors’ products because its microphones are more sensitive, more cost effective, use less energy, and are smaller than the other MEMS microphones on the market. Also, Knowles can compete with other hardware and software companies because its microphones are highly programmable due to the open-source nature of its products. Other major intelligent microphone companies do not make highly programmable products, which gives Knowles an important competitive advantage when selling to large technology companies such as Apple and Amazon. Apple has already signed contracts with Knowles to utilize this technology in its future devices. Larger tech companies that use artificial intelligence themselves are less of a threat to Knowles because of the highly specialized nature of Knowles’s products. Historically, large technology companies tend to be more likely to acquire an already-existing, specialized company in their supply chain instead of developing the technology themselves and competing in the space.

Economic Outlook: Annual GDP growth is expected to be 2.1% in 2017, which is up from 1.6% in 2016. Moving forward, the economy is expected to slowly improve, reaching 2.4% GDP growth in 2018. Inflation has been slow to rise, and it is currently at 1.7%. Consumer spending is expected to increase throughout 2017 due to continued, although slowing, employment growth and stronger wage growth. Unemployment is forecasted to drop to 4.3% in 2017 and 4.2% in 2018. This is positive for Knowles, because if the economy is growing, more businesses will have the means to improve on business processes and enter into contracts with Knowles to invest in AI that will make their businesses more efficient. Additionally, if consumers have more discretionary income, they will be able to spend more on technology which will entice larger companies to produce products such as smart phones, digital assistants, and other smart technology. Consumer spending on technology is forecasted to increase by 7.5% year-over-year in 2017.

Patent Protection: Knowles holds several groups of patents, including one for its “miniature silicon condenser microphone” used in MEMS microphones, which makes it difficult for other companies to imitate their MEMS microphone technology. Knowles has won ten legal battles against other tech companies, some of which including with their competitors MEMSTech and Akustica, which were attempting to develop a MEMS microphone on par with Knowles’s. Their patents help protect Knowles as the MEMS microphone industry leader, and allow them to innovate and capitalize on the rapidly growing demand for advanced MEMS microphones and their software. Knowles is in the process of obtaining new patents for more advanced technology in order to spur growth in the future.

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Financial Performance

Historical Revenue: Knowles has experienced a historical annual revenue growth rate of 4%. Last year, the consumer electronics industry grew by 1%. Although there is limited information on the AI industry because it is still so young, spending in the AI industry increased by 54% year-over-year. Over the past eight quarters, Knowles has beat revenue estimates six times and exactly met estimates once. On average, Knowles beat revenue estimates by 2%. Knowles’s revenue is highly seasonal; the company has historically performed much better during the last two quarters of every year than during the first half of the year. This is due to the seasonal nature of many consumer technology products, such as smart phones, home devices, cars, and Bluetooth headsets due to the fact that they are mainly sold during the holiday months. Although Knowles typically doesn’t sell its products directly to end users, technology companies are more likely to purchase more components from Knowles during the second half of the year to prepare for the increased holiday demand.

Gross Margin: Synaptics operates in the computer hardware industry and supplies major AI players, but is not a direct competitor with Knowles because Synaptics focuses on sensor and visual technology as opposed to auditory solutions. However, the two companies are very similar in the sense that they supply the largest AI companies with specialized computer hardware and software. In the third quarter of 2015, Knowles surpassed Synaptics in gross margin, and has remained on top for nearly two years. Knowles’s gross margin is currently at 39%, while Synaptics’s is at 31%.

Historical Earnings: Knowles has beat adjusted earnings for all of the past eight consecutive quarters. Earnings shrunk in the first half of 2017 due to losses in its underperforming speakers unit, but Knowles has since sold that unit off in June of 2017, and then proceeded to beat adjusted earnings per share estimates by 16.07% that quarter. The loss in Q3 2015 was due to losses in the speaker & receiver line, and Knowles’s acquisition of the failing small microphone and audio company, Audience. When the two entities’ earnings were combined, Knowles’s reported earnings dropped to -$16.1 million. However, their earnings without the unusual loss from Audience was positive, at $13.3 million, which is more indicative of Knowles’s performance that quarter. Earnings in Q2 2017 were also affected by increased research & development expenses. Since Knowles began increasing its research & development spending on the MCE segment, research & development expenses have grown from 9.44% to 14.04% of sales.

Future Revenue: The AI industry is widely expected to witness a compound annual growth rate of 54% for the next three years, and then possibly increase beyond that past 2020. As Knowles increases its focus on the AI market, its revenue is expected to grow at an annual rate of 13% throughout 2018, and 24% annually in 2019. Deals with Apple and Amazon to supply MEMS microphones, voice processors, and software for AI products being released in 2017 and 2018 will be a major contributor to revenue growth. In addition, demand for hearing aids as the United States population ages will be a source of steady revenue, as Knowles supplies MEMS microphones and hearing aid components to hearing aid manufacturers.

Future Earnings: Knowles is forecasted to experience a long-term earnings growth rate of 10%, but I expect earnings to grow by 7.5% in 2018 due to research & development spending, and because there is lag time before artificial intelligence will become widely adopted in every industry. Knowles’s profit margin is forecasted to increase steadily from 10% in 2016 and 2017 to 10.3% in 2018 and 11% in 2019.

2017 Highlights: For the first half of 2017, Knowles has beat adjusted earnings per share estimates by 13.6% and revenue estimates by 2%. The MCE segment, which includes the Intelligent Audio products that are used in AI devices, has accounted for 73% of 2017 revenue, as compared to the historical average of 58%. By the end of 2017, return on equity is forecasted to reach 9%, up significantly from 1.9% at the end of 2016. Knowles sold its underperforming speaker line in June 2017, which had significantly weighed down earnings in the past. KN stock has outperformed the comparable AI-supplier company, Synaptics, by 51% year-over-year.

2018 Outlook: Consumer spending has been steadily increasing, and is forecasted to increase by about 2.05% over the course of 2018. This will be beneficial for Knowles’s Mobile Consumer Electronics segment, as consumers will be more likely to buy the products that use Knowles’s microphones, software, and other hardware. The OECD forecasts that economic expansion will continue throughout 2018. The Organization for Economic Co-Operation and Development (OECD) Economic Outlook predicts that interest rates will rise in 2018, which will cause inflationary pressures that will “reduce the risk of financial market distortions.” Real household disposable income will increase by 2.8% in 2018, as compared to the 1.8% increase witnessed in 2017. This will all translate to customers having the money to purchase products that use Knowles’s products, such as the iPhone, Apple Homepod, and Amazon Echo. Knowles is focusing on the faster-growing and more profitable

unit, the MCE segment, but also hedges against risk by diversifying its revenue sources with the SC segment. An aging population will provide a source of stability for revenue moving forward, as the market for hearing aids grows and Knowles microphones and language detectors are used in these products. Knowles will benefit from exploding growth in the AI industry, as its products will increasingly be used in AI products and Knowles will continue winning contracts with large tech companies positioning themselves in the AI industry, like Apple, Amazon, and LG.

Analyst Recommendations: Analyst recommendations have remained unchanged since July, with 70% recommending to buy stock in Knowles, and 30% maintaining a “hold” recommendation. The average price target is $20, representing a 28% undervaluation.

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Pro Forma Income Statement

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Assumptions: I assumed a 13% revenue growth rate by multiplying together the AI industry growth rate of 54% and the computer hardware industry growth rate of 24%. I also assumed that cost of goods sold would be 40%-47% of revenues, consistent with historical percentages. In addition, I assumed that depreciation & amortization would remain constant at $15 million per quarter, and that the tax rate would remain around 13% on average, depending on the quarter.

Revenue Growth:  Analyst consensus estimates for revenue growth are around 12.5%, but I predict it to be slightly higher at 13% due to increasing potential in the AI industry and the fact that Knowles putting more emphasis on its Intelligent Audio line. In addition, contracts with companies like Apple, Amazon, LG, and Samsung will drive revenue growth. Knowles will develop stronger relationships with these AI players as artificial intelligence begins to grow rapidly, and the value of each of these contracts is also expected to increase.

Research & Development Expenses: I expect R&D expenses to grow 11% annually because Knowles’s focus on the MCE segment and Intelligent Audio requires higher research & development spending. Historically, since the company went public, Knowles’s research & development expenses have grown approximately 8% each year. I estimate this number to be slightly higher moving forward, as continued innovation will become a major growth driver as AI becomes more popular. Knowles’s management has identified research & development as a major growth strategy for the company, so I expect that research & development expenses will increase relatively significantly from 8% per year to 11% annually.

Earnings: I expect that earnings will grow 12.5% from 2018 to 2019, and over the longer-term the growth rate should level out to 10%. Two major earnings drivers should be new contracts with both AI companies and other businesses looking to use AI in their operations, and sales of hearing aids. Knowles’s profit margin is expected to be 10% in 2017, 10.4% in 2018, and 11% in 2019.

Valuation

Capital Asset Pricing Model: I used the Capital Asset Pricing Model to estimate the required rate of return to use in my valuations. I used the 10-year treasury yield of 2.3% for the risk-free rate of return, Knowles’s beta of 0.68, and the computer hardware industry growth rate of 23% as the market/industry return. These inputs yielded a 16% required rate of return for Knowles, which I used in the following valuations.

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Sales Franchise Value Model: A revenue valuation model is more accurate for smaller companies is young, industries because they may not have significant earnings yet (or they might even be operating at a loss), but they have promising outlooks because of the high-growth industry in which they operate. Therefore, an earnings valuation model would not be appropriate for a company such as Knowles. For this model, I used Knowles’s 5-year revenue growth rate of 13%, 2017 operating margin of 39%, and 2018 operating margin of 40%. I also used a required rate of return of 16%, a duration of 0.80, and sales per share of $2.68. Exhibit 15 shows the range of fair price values depending on changes in the required rate of return and the revenue growth rate. Using the most probable scenario in which the revenue growth rate is 13% and the required rate of return is 16%, I reached a fair value of $21, representing a current undervaluation of KN stock of 34%.

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Present Value of Growth Opportunity Model: Because Knowles is expected to experience higher-than-average growth due to its products’ numerous applications in the AI industry, it is appropriate to value the stock based on the present value of its future growth prospects. I used the forecasted 2018 earnings per share of $1.11, a required rate of return of 16%, an earnings growth rate for 2018 of 7.5%, the current stock price of $15.66, and a retention ratio of 1 because they do not pay dividends. Exhibit 16 shows the range of fair values depending on the earnings growth rate and the required rate of return. Using the most probable scenario in which the earnings growth rate is 7.5% and the required rate of return is 16%, I calculated a fair value of $21. This implies an undervaluation of 33%.

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Analyst Consensus: The consensus price target consensus among analysts listed on Bloomberg, Thompson Reuter’s, and NASDAQ is $20 per share. Since analysts generally believe that KN stock is undervalued by 28%, 70% of analysts maintain a “buy” recommendation, while the other 30% have a “hold” recommendation.

 

Fair Value: To reach a fair value estimate, I averaged the values from the Sales Franchise Value Model and the Present Value of Growth Opportunity Model to get an average fair value of $21 for Knowles’s stock, a current undervaluation of 34%.

 

Risks

 

Reliance on Specialty Suppliers: Knowles relies on a network of very specialized suppliers for a variety of highly engineered or specialized components in order to manufacture its advanced products. Often, it would be very difficult to obtain the needed components on short notice if one of these suppliers became unable or unwilling to supply Knowles with these specialized components. Because most of these suppliers are located in Asia, international tensions or international tax law changes could adversely affect Knowles’s ability to obtain the necessary materials to manufacture their microphones and voice processors.

 

Phasing-Out of Patents: Knowles’s group of U.S. patents, which protect their intellectual property, products, and technology, expire between 2016 and 2035. However, a there is no expected material effect on Knowles’s business due to any patents expiring in the next three years, and  Knowles is obtaining new patents through their ongoing research & development. Knowles strategically increased spending on research & development in its Mobile Consumer Electronics segment so that it can develop new technologies, obtain patents, and continue dominating the Intelligent Audio market. Patents are an important contributor to Knowles’s success, but its business as a whole doesn’t depend on any one patent or group of patents. Moving forward, Knowles will mitigate the risk of its patents expiring throughout the next 20 years by increasing research & development spending on its high-growth segments involved in the AI industry in order to develop  new technologies and obtain new patents.

 

Less-Than-Expected Growth in AI Industry: The 54% growth rate in the AI industry, which will eventually level out to 40% annually after several years of rapid expansion, is a major growth driver for Knowles because their products have several AI applications. If the AI industry underperformed expectations, it could hinder future expansion for Knowles and negatively affect their ability to earn revenue and make profits. However, the fat that artificial intelligence can be used in almost every industry and increase efficiency and profitability by 40%, it is difficult to imagine that artificial intelligence will not exhibit extremely rapid growth in the future. Knowles’s microphones, voice processors, software, and specialty components are already being used for other purposes that are independent of the AI industry, so if the AI industry didn’t meet forecasts, it wouldn’t be devastating to Knowles’s immediate growth.

 

Powerful Customers: Knowles’s top ten customers account for 46% of its annual revenue, and Apple and Samsung alone contribute 27% of revenue. If Knowles were to lose one of these important customers, it would materially affect Knowles’s revenue. Having powerful customers also means that Knowles is less able to demand higher prices if they need to increase revenues in the future. However, Knowles regains some of its bargaining power by producing very specialized technologies and having performance and cost advantages over its competitors. Knowles is the only company to produce Intelligent Audio hardware and software that has the advanced capabilities as its MEMS microphones, voice processors & detectors, software, and specialty components. Owning 59% of the MEMS microphone space, Knowles also regains some of its negotiating power by holding its rank as the single largest auditory processing company in the world.

 

Foreign Operations: Knowles mainly operates outside of the United States, with 73% of its revenue coming from Asia, 14% from the U.S., 11% from Europe, and 2% from other regions. Since a significant amount of Knowles’s cash is located outside of the United States, the company would endure unfavorable tax and earnings consequences if it needed to repatriate or access that cash from the United States. In addition, potential changes to United States tax law under President Trump could also make the penalties for operating outside the United States and repatriating that cash much higher in the President’s attempt to entice companies to bring manufacturing jobs back to the United States. Changes to foreign tax codes are also a risk in this area, as this could significantly affect Knowles’s tax liability, and therefore its earnings.

 

Buy Recommendation

 

Recommendation: Stetson University’s Roland George Investments Program should buy Knowles Corporation’s stock. KN stock is currently undervalued by 34%, given my calculated fair price of $21 per share. Knowles is poised to benefit from rapid growth in the artificial intelligence industry and the “multi microphone adoption” trend. Knowles’s contracts with Apple, Amazon, and other AI industry leaders, as well as an aging population which will continue to purchase hearing aids that use Knowles’s MEMS microphones, will provide Knowles with a reliable revenue source going into 2018. I don’t believe that the future explosion of the AI industry and the positive impact that it will have on Knowles’s growth has been fully factored into Knowles’s stock price, because we haven’t even come close to realizing the full potential of artificial intelligence and the impact that it will have on nearly every business process in every industry. KN stock is currently undervalued by 34%, so I recommend that the Roland George Investments Program should buy 5,100 shares of stock in Knowles Corporation.

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