Knowles Corporation (KN) Q1 2020 Earnings Call Transcript

Knowles Corporation (KN -1.55%)
Q1 2020 Earnings Call
May 04, 2020, 4:30 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good afternoon, and welcome to the Knowles Corporation first-quarter 2020 financial results conference call. [Operator instructions] With that said, here with opening remarks is Knowles' vice president of investor relations, Mike Knapp. Please go ahead.

Mike Knapp -- Vice President of Investor Relations

Thanks, Christine, and welcome to our Q1 2020 earnings call. I'm Mike Knapp, and presenting with me on the call today are Jeff Niew, our president and chief executive officer; and John Anderson, our senior vice president and chief financial officer. Our call today will include remarks about future expectations, plans and prospects for Knowles, which constitute forward-looking statements for purposes of the safe harbor provisions under applicable federal securities laws. Forward-looking statements in this call will include comments about demand for company products, anticipated trends in company sales, expenses and profits and involve a number of risks and uncertainties that could cause actual results to differ materially from current expectations.

The company urges investors to review the risks and uncertainties in the company's SEC filings, including, but not limited to, the annual report on Form 10-K for the fiscal year ended December 31, 2019, periodic reports filed from time to time with the SEC and the risks and uncertainties identified in today's earnings release. All forward-looking statements are made as of the date of this call, and Knowles disclaims any duty to update such statements, except as required by law. In addition, pursuant to Reg G, any non-GAAP financial measures referenced during today's call can be found in our press release posted on our website at knowles.com, including a reconciliation to the most directly comparable GAAP measures. All financial references on this call will be on a non-GAAP continuing operations basis, unless otherwise indicated.

Also, we've made selected financial information available on webcast slides, which can be found in the IR section of our website. With that, let me turn the call over to Jeff, who will provide some details on our results. Jeff?

Jeff Niew -- President and Chief Executive Officer

Thanks, Mike, and thanks to all of you for joining us today. I hope all of you and your families are healthy and safe. This is no doubt an unprecedented and challenging time, and we continue to focus on the health and safety of our employees, customers and partners worldwide. I'm very proud of our employees around the globe for stepping up to help solve the challenges we're currently facing and appreciate their efforts as we continue to execute our strategy.

I believe that our strong balance sheet and diversified customer base and end markets will enable us to weather this difficult period and allow us to continue to invest to support future growth when the markets return to a more normalized level. In my prepared remarks, I will briefly discuss the Q1 financial results and then talk about what we are seeing in terms of demand across our end markets and products. After that, I'll discuss the operational challenges we are encountering, as well as the actions we are taking to mitigate near-term impacts on our business. I will then turn it over to John for more detail on the actions we have taken or will be taking to ensure we maintain liquidity while still investing in our core business and growth opportunities.

For Q1, we reported revenue of $163 million, in line with our updated guidance and down 9% from the year-ago period. Audio sales were down, partially offset by stronger precision device sales. Gross margins were 35.7%, and EPS was $0.03 as COVID-19 caused significant disruptions within our manufacturing operations across Asia, which negatively impacted labor productivity and factory utilization. As I move into the demand and operational portion of my prepared remarks, I want to note that the ultimate impact COVID-19 will have on our business in Q2 is very difficult to estimate this time.

I will try to provide as much detail as possible to help investors understand how I see things today, knowing that the situation remains very dynamic. Let me begin with an update on our customer demand across our end markets. In our audio segment, Q1 revenue was down 14% from the year-ago period, driven by weaker demand for hearing health products and softer sales into mobile, ear and IoT markets. While Q1 audio demand was weaker than our original projections, much of the weakness hit later in the quarter, and we are anticipating continued softer demand trends throughout Q2.

In hearing health, we began to see a significant slowdown in orders late in the quarter based on end market demand in Europe and the U.S., which represents approximately 85% of the global hearing aid market. This slowdown corresponds to countries that adopted COVID-19 movement restrictions later than Asia, with the U.S. lagging Europe by several weeks. Given many audiologists' office remain closed, coupled with hearing health's heavy reliance on demand from people over the age of 65 who are at higher risk from COVID-19, we anticipate our hearing health business in Q2 will be down significantly from the year-ago period.

Despite this near-term weakness, we know from prior downturns that hearing health demand is reasonably insulated from economic declines. Since hearing health customers are older and generally less exposed to equity markets, own their homes and have the income to purchase hearing aids, we expect demand to improve as people feel comfortable that COVID-19 is under control. Based on discussion with our customers who are assuming improving trends related to virus movement restrictions, we expect the second quarter to mark the bottom in demand for this market, with sequential improvement in the second half of 2020. However, it may take until 2021 to get back to 2019 run rates.

Moving on to the mobile, ear and IoT markets. The mobile market represented less than 30% of total company sales in Q1 as smartphone demand trends weakened throughout the quarter. Sales to our largest U.S. and Korean customers were higher than the year-ago period, while sales to Chinese volumes were down significantly.

Demand has begun to stabilize in China, and we currently expect sales into the mobile market to remain lower than the year-ago period. We are talking to all of our mobile customers and the industry experts. At this point, many are expecting smartphone units worldwide in 2020 to be down as much as 15% from 2019. Revenue from ear and IoT also declined year over year but represented greater than 30% of sales in Q1.

As growth rates are reset across consumer electronics, we expect true wireless will remain the best-performing segment within the ear market. We continue to invest in MEMS microphones and balanced armature solutions to support this market. In early April, IDC said that it expects demand for smart home product to decline year over year in the second quarter, and we expect similar trends in our business. We expect to remain the leader in the MEMS microphone business.

As we have previously discussed, improved voice communication and speech recognition are driving the need for more microphones with increased performance, lower power, higher robustness and smaller size. Our new products and programs across ear, IoT & Mobile are expected to extend our differentiation and competitive position to drive long-term sales growth with higher gross margins as we continue to increase investment in this business. Overall, our microphone revenue in Q2 is expected to be flat with sales in Q1. Moving to precision devices segment.

In Q1, sales were up 6% from the year-ago period, driven by continued demand for our differentiated products across defense, medtech and the electric vehicle end markets. We also made good progress fixing the operational issues we experienced in Q4 of 2019. We anticipate sales in precision devices to grow more than 5% sequentially in Q2 and expect gross margins to increase as operational improvements continue to take hold despite increases in palladium prices. Now let me discuss where we stand from an operations perspective.

For our manufacturing facilities, we remain focused on aligning the output -- aligning output with our customers' demand as we continue to protect our employees. Most of our nonmanufacturing employees now work from home, and travel throughout the company has been restricted. In China, where our manufacturing supports MEMS and microphones and high-performance capacitor products, Q1 was extremely challenging with the extended Chinese New Year, followed by a slow ramp back to normal production levels as travel restrictions were lifted, and our employees were allowed to return to work. Our China operations are now running without production constraints.

In the Philippines, where most of our hearing health solutions are produced, the government has implemented enhanced community quarantine until mid-May. Due to the government restrictions and significant demand weakness in the hearing aid market, we anticipate very low capacity utilization as we align our output with the demand in the quarter. In Malaysia, where we make microphones for both the consumer and the hearing health market, the government has implemented a movement control order until mid-May. As with our Philippines operation, because of the government restrictions and significant demand weakness in hearing aid market, we expect very low utilization in Q2 to align output with demand.

In the U.S. and Dominican Republic, where the bulk of our precision device solutions are produced, we have seen limited impact to date, and we continue to monitor the situation daily. Lastly, in response to these market conditions, we are taking significant actions to reduce operating expenses, control capex and manage working capital. We are reevaluating all the projects across the company, identifying those projects with the best potential given the adjusted market conditions.

Where appropriate, we are taking steps to reduce costs this year. The goal is to make sure we maintain a strong balance sheet with ample liquidity, while meeting our short-term commitments and supporting the long-term potential of the business. All these actions -- as these actions are ongoing, we will provide additional details as they're completed, but I wanted to specifically address one area. In intelligent audio, demand has been below expectation, and we are further reducing the allocation of resources to this product line to align with the growth potential and the challenging market conditions.

We will continue to support existing products and customer programs. John will provide additional details on how we expect these, and other changes will impact operating expense for the balance of the year. Overall, the primary short-term issue we face today is related to demand rather than supply, especially in our hearing health market. Our company remains uniquely positioned across the markets we serve, and I believe our strategy to deliver high-value, differentiated solutions to a diverse set of growing end markets will enable us to come out of this pandemic well-positioned to take advantage of future growth.

With that, I'll turn it over to John to expound on our financial results and provide our details for the second quarter. John?

John Anderson -- Senior Vice President and Chief Financial Officer

Thanks, Jeff. We reported first-quarter revenues of $163 million, down 9% from the year-ago period as lower shipments in audio were partially offset by increased sales in precision devices. Audio revenues of $120 million were down 14% from the year-ago period, with lower shipments of balanced armature speakers and MEMS microphones associated with weaker-than-expected demand in hearing health and mobile consumer markets due to the COVID-19 pandemic. The precision device segment delivered revenues of $43 million, up 6% from the year-ago period, driven by continued robust demand in the defense, medtech and electric vehicle markets.

First-quarter gross margins were 35.7%, down 320 basis points from the year-ago period. In the audio segment, gross margins were 350 basis points lower due to production-related disruptions associated with the COVID-19 pandemic. Specifically, Q1 2020 gross profit margins were negatively impacted by more than 500 basis points due to lower productivity -- due to lower labor productivity and capacity utilization in our China manufacturing facility. In addition, during the quarter, we realized greater than 400 basis points in material savings associated with the ASIC design business acquisition completed late in Q4.

This was partially offset by a charge of $2.8 million related to the final settlement of a customer warranty claim. Precision device gross margins finished slightly ahead of our forecast, which was 240 basis points lower than the prior year as increased palladium cost negatively impacted margins by more than 500 basis points, partially offset by operational improvements, improved pricing and favorable product mix. R&D expense in the quarter was $22 million, down 3% from the year-ago period, with lower spending in intelligent audio, partially offset by increased spending in our core MEMS microphone and precision device businesses. SG&A expenses were $34 million, up 13% from the year-ago period, driven by a $4 million increase in legal costs as we aggressively defend our intellectual property.

This increase was partially offset by reduced spending in intelligent audio. For the quarter, adjusted EBIT margin was 3.4%, down 590 basis points from the year-ago period on lower revenue and gross profit margins, as well as higher legal costs. EPS for the quarter was $0.03. Further information, including a detailed reconciliation of GAAP to non-GAAP results is provided in the financial tables of today's press release and can also be found on our website at knowles.com.

Now I'll turn to our balance sheet and cash flow. We continue to maintain a strong financial position, with liquidity of nearly $450 million at the end of the first quarter, including $148 million in cash and borrowing capacity of $300 million. During the quarter, we increased our cash balance by drawing $100 million on our revolving credit facility, leaving $300 million in availability. Cash used by operations was $2 million and capital spending was $8 million.

The first quarter is typically our seasonal low in terms of cash generation, and I'm confident in our ability to generate free cash flow for the full-year 2020. During the quarter, we repurchased roughly 1 million shares of our common stock at an average price of $15.06. In the spirit of proactive and prudent liquidity management, we are temporarily suspending our share repurchase program. Given the relatively short-cycle nature of our business and recent global events, visibility in the second quarter is challenging, especially as it relates to our hearing health business.

In addition, there's a significant amount of uncertainty related to the duration of government workforce restrictions currently affecting our manufacturing operations in both the Philippines and Malaysia. Based on the current circumstances, we will be providing limited guidance for Q2. Our objective is to reinstate revenue, gross profit and EPS guidance for the third quarter, along with our Q2 2020 earnings announcement. I would now like to provide some insight into actions we are taking, which will help mitigate the financial impacts of the COVID-19 pandemic.

In April, we implemented a temporary 10% pay reduction for all salaried employees and a 15% reduction to CEO and board cash compensation. In addition, we are further reducing operating expenses related to the intelligent audio business, and we expect to have completed these actions as we exit the second quarter. These actions, along with other cost-reduction measures we're taking across the company, are expected to result in cost savings of more than $20 million in 2020. While some of these savings will be reinvested in our core businesses, we now estimate operating expenses to be $50 million in Q2, which is down more than $5 million sequentially, and we expect to exit 2020 at a quarterly run rate of $42 million to $44 million.

Finally, we are reducing our capital expenditure plan and expect 2020 capital investments to be in the range of $35 million to $45 million. I'm confident that our strong financial position, combined with the cost actions we are taking in response to current market conditions, will position the company well to serve our customers' needs, generate free cash flow and deliver strong operating leverage over the long term. I'll now turn the call back over to Jeff for closing remarks, and then we'll move to the Q&A portion of the call. Jeff?

Jeff Niew -- President and Chief Executive Officer

Thanks, John. Our company remains uniquely positioned across the markets we serve, and the diversification of end markets that we've put in place is enabling us to weather the storm while still investing in new growth categories. We expect to maintain or extend our leadership across the end markets we serve. We remain the leader in hearing health solutions and expect recovery in -- to 2019 levels in the next nine to 12 months.

We expect ear and IoT to drive growth in the future and mobile market to stabilize as 5G phones are introduced. Precision device growth is expected to continue, and we anticipate 2020 to be another good year for this segment. With that, we'll open it up for questions.

Questions & Answers:

Operator

Thank you. [Operator instructions] Your first question comes from the line of Anthony Stoss from Craig-Hallum. Your line is open.

Anthony Stoss -- Craig-Hallum Capital Group -- Analyst

Hi, guys. A couple of quick ones here. John, maybe can you give us the percent of revenues that hearing health was in 2019? Just so we can size up to that for Q2. Also, given your Chinese facility is now up and that affected gross margins in Q1, while I know you're not guiding for Q2, do you think your gross margins will be up sequentially in Q2? And then lastly, for Jeff, the BA opportunity, the funnel, the automated pressure process.

Maybe you could just bring us through where you are at right now, what you think will happen for the second half of this year.

Jeff Niew -- President and Chief Executive Officer

Sure. I'll let John go first.

John Anderson -- Senior Vice President and Chief Financial Officer

Sure, Tony. In respect to the first question, I think the question was what percentage of total company revenues is hearing health. It's roughly 25% in 2019.

Anthony Stoss -- Craig-Hallum Capital Group -- Analyst

And then gross margins, up still in Q2, John, do you think?

John Anderson -- Senior Vice President and Chief Financial Officer

Yes. In terms of gross margins, I mean, as I mentioned, in Q1, we had gross margins of roughly 35%, 35.7%. We were really impacted in our -- specifically in our audio segment due to elongated Chinese New Year. We had several workforce restrictions in both our Malaysia and Philippine facilities.

Jeff Niew -- President and Chief Executive Officer

End of the quarter, especially.

John Anderson -- Senior Vice President and Chief Financial Officer

Especially at the end of the quarter, while our China facility is back up and running at close to full capacity, there are still currently restrictions in both Philippines and Malaysia. It's very difficult to quantify. It's a very fluid situation, how long those will last. In addition, I think it's important.

We did have, I'll call it, an unusually high warranty claim in the first quarter, which was about 170 basis point impact. So I would say, as we look into Q2, we'll probably see sequentially similar gross margins. But remember, the utilization, as Jeff mentioned, in our hearing health business, very likely to be lower than it was in Q1.

Jeff Niew -- President and Chief Executive Officer

Significantly.

John Anderson -- Senior Vice President and Chief Financial Officer

And then the offset is we won't have this charge in warranty that we had in Q1. So I think sequentially, similar margins.

Jeff Niew -- President and Chief Executive Officer

And I would just add one more piece of color to that, Tony, is that our goal here is not to build inventory through the quarter, right? So I mean, we are keeping, especially in the hearing health business, the utilization at a very low level until the market starts to return.

John Anderson -- Senior Vice President and Chief Financial Officer

But I will say, though, this is -- the gross margins in Q2 and looking out, this is probably one of the hardest things for us to have real clear visibility on, both the demand in the hearing health market, as well as the duration of workforce restrictions at two of our more significant plants is very dynamic.

Jeff Niew -- President and Chief Executive Officer

All right. And let me give you a little color on the BA, the automation line. I would say that there has been some impact from COVID-19, especially with the travel restrictions and working at the automation supplier. But I would say it hasn't been overly burdensome, the delays.

And right now, I think we've said in the past, we said it would be ramping with full production in Q3. I would say it's now more ramping in Q3. So I would say we're probably one to two months behind what I said before. It will have some impact on this year, but on the long term, obviously, that doesn't have much impact at all.

As far as the opportunities, I review with the team every other week, the funnel of opportunities. I'd say the funnel opportunities look very good, Tony, as we -- how we'll exit 2020 and into 2021. We still feel very comfortable with the reasons we invested in this automation line and where we're headed with it.

Anthony Stoss -- Craig-Hallum Capital Group -- Analyst

If I could sneak in just one more. The bulk of the opex cost cuts, would you say that's primarily the intelligent audio group?

Jeff Niew -- President and Chief Executive Officer

Tony, at this point, I guess what you'd say, we'll go through more detail as we -- others go through this. But there's a lot of moving parts. Some of this is temporary, which obviously will not be what we're talking about at the end of the year, like the salary reductions, which we hope to eventually give back to people. So there's a lot of moving parts here.

What I would just say is, as we get through this and we implement everything we're going to do, we'll go into more detail about how we got there.

Anthony Stoss -- Craig-Hallum Capital Group -- Analyst

Thanks, Jeff.

Operator

Your next question comes from the line of Bob Labick from CJS Securities. Your line is open.

Bob Labick -- CJS Securities -- Analyst

Good afternoon. Thanks for taking the questions. I just wanted to follow-up on the BA automation. I don't know that this is possible at all, but I figured I'd ask, is it possible to repurpose some of the hearing health BA and hold that for more of a consumer product or configure it slightly differently so they can go into the consumer ear market? Or could you describe how the two might be different?

Jeff Niew -- President and Chief Executive Officer

Yes. I think it's a good question, Bob, and thanks for the question. I guess what I'd say is, remember, when we did the balance -- new balance armature automation, we also redesigned the receivers from the ground up. They're totally different designs, and that was in order to reduce the cost to make them, as well as for the purposes of automation.

We do have some manual capacity put in place for these new designs, I would say, a limited amount, and that's mainly just to prove out the designs and maybe have a little bit of start-up sampling. But they're not really interchangeable. Remember, the hearing health, how I describe it always is it's lower-volume, high-mix. So it's very manual intensive versus the automated has been designed to be low-mix but very high-volumes.

Bob Labick -- CJS Securities -- Analyst

OK. Got it, great. And then just one other for me. Can you talk about -- I think you alluded to a little bit, but the new product areas for your future investment? And then also, as it relates to new products, can you talk about your customer new product road maps, if there's been any significant change in time lines that might impact this year?

Jeff Niew -- President and Chief Executive Officer

I'll answer that first. I mean, I would sit there and say there's no doubt, across the globe, that there's been impact on new products. I mean, I think that wouldn't take place. How that ultimately affects what's introduced this year, I think it's too early to tell, Bob.

We're working very hard with our customers. I would say our employees have been extremely productive working from home. I've been very impressed, and I thank all the employees that have been working from home in order to get things done on new products. But some of our customers have been impacted.

Too early to tell how that impacts this year yet. And then your new products, yes. I would say the one thing that -- we did mention intelligent audio. But maybe you didn't kind of catch this in my prepared remarks, which is we are increasing the amount of money we're spending on R&D in the MEMS microphone space.

First of all, when we had the acquisition last year from ams, we took on some R&D spend that was associated with that, which obviously has been a very successful acquisition even in the very short time we've had the design group and the product portfolio. But even beyond that, we're seeing more opportunities to invest in new products in MEMS microphone. And to that end, we have been increasing the amount of money spent on R&D and MEMS mics. And by the way, there has been probably not as big, also R&D spending increase in precision devices.

Bob Labick -- CJS Securities -- Analyst

OK. Super. Thanks very much.

Operator

Your next question comes from the line of Christopher Rolland from Susquehanna. Your line is open.

Christopher Rolland -- Susquehanna International Group -- Analyst

Hey, guys, thanks for the question. I believe, in your remarks, you mentioned minus 15% year-over-year handset expectation for Q2. And I guess, obviously, you guys aren't guiding. But as we're thinking about this, should that be a starting point for us for next quarter? And would you expect yourselves to be better or worse than that expectation?

Jeff Niew -- President and Chief Executive Officer

So first of all, just to kind of think what I said was it could be as high as 15%, and I was actually referring to the full year. I didn't really say anything specifically about Q2. I think our expectation right now, I think, in the mobile market is this, is that China will be recovering. We're definitely expecting some recovery in China in the mobile market.

Q1 was extremely weak for our China business within mobile. And then I think -- now I'm kind of like starting to go into discussions about stuff that's more public information. But you saw Samsung results. They were saying handsets are very, very difficult going into Q2.

And I think the wildcard here, which I think you saw one of our largest customer made their announcement, they didn't really give much guidance about Q2. So I'm not trying to punt on this, but I think our position in the market still remains the same. I don't think we view that there's a big change in position, but there is a fair amount of volatility in terms of what's going to happen in Q2. But again, I think the number one thing we see is China will be a lot stronger in Q2 than Q1.

Christopher Rolland -- Susquehanna International Group -- Analyst

I guess just more broadly, I think the street was kind of looking for a large sequential increase. Would you still expect a sequential increase for Q2?

Jeff Niew -- President and Chief Executive Officer

In terms of specifically mobile? Or was it...

Christopher Rolland -- Susquehanna International Group -- Analyst

You can do it however you want, whole business or just mobile.

Jeff Niew -- President and Chief Executive Officer

Let me start with -- we have a very significant reduction in hearing health. I mean, it's very significant. This is not like down 5% or something like that, sequentially. It's very significant.

I think I talked about it in the prepared remarks that most of the audiologists in Europe and North America have been closed, plus you add on the fact that COVID has outsized impact on older people. So we are concerned that -- when will people really start going back out in terms of -- especially people who are in the age range who would buy a hearing aid. As far as our -- specifically, our microphone business, like what we said is, right now, we expect it sequentially to be flat.

Christopher Rolland -- Susquehanna International Group -- Analyst

OK, great. And then maybe a few more details on this warranty claim. Is it just a onetime issue? And I don't know if it's related or not, but Infineon, I think I've mentioned this before, claims they're going to grow 50% in their MEMS business. Do we have any more clarity into what that meant? I think you previously talked about that business being $200 million, growing 50%.

So that's $100 million, what could be into your market. I'm just wondering if you have any other details there or any thoughts on what they were talking about.

Jeff Niew -- President and Chief Executive Officer

I'll let John handle the warranty claim for a moment. John, do you want to just talk about the warranty claim?

John Anderson -- Senior Vice President and Chief Financial Officer

Sure. This was a full settlement of a warranty claim with a customer in our MEMS microphone business. It was roughly -- it was $2.8 million in the quarter, roughly 170 basis point negative impact to gross margins, and I expect that to be behind us. We always have some level of warranty claims, but the reason I called out Q1 is it's much higher than normal in Q1.

Jeff Niew -- President and Chief Executive Officer

And then secondly, regarding Infineon, I mean, I don't want to overly speculate here as to what they're talking about. We do know, and I think the market knows that Infineon has begun to sell finished mics, the full microphones versus bare die. And there's a pretty significant difference in revenue associated with selling a finished microphone versus a bare die. So I think they're definitely is what we are hearing and seeing in the market, they're starting to do that.

Christopher Rolland -- Susquehanna International Group -- Analyst

Great. Thanks for the clarity, guys.

Operator

Your next question comes from the line of Bill Peterson from JP Morgan. Your line is open.

Alex Kim -- J.P. Morgan -- Analyst

Hi. This is Alex Kim dialing on behalf of Peterson. A quick question in terms of the palladium cost. You talked about being an impact for gross margins for 2Q.

What's your outlook on palladium costs going forward? Is this going to continue to have an impact on gross margins, or do you have any thoughts about the market right now?

Jeff Niew -- President and Chief Executive Officer

So I'll let John to go into the specific details. But I mean, I think how we look at palladium is what's the market price today. There are opportunities for us to pre-buy some palladium, which, depending on when we do it, could have a positive impact. But overall, I would say that for the full year, palladium will have an impact -- a negative impact on gross margin for the full year.

But John, can you speak...

John Anderson -- Senior Vice President and Chief Financial Officer

Year over year. But the prices that -- as Jeff mentioned, we did enter into some pre-buys and the prices that we realized in Q1 will be similar to the prices that we'll have over the rest of the year. So again, we don't expect further increases, but we did have a year-over-year headwind in palladium costs.

Alex Kim -- J.P. Morgan -- Analyst

OK. Got it. And then in terms of the mobile market, is the high-end portion of the handset market still being affected more relative to the mid-range and low-end phones, so like the China mobile market? Can you talk about that as well?

Jeff Niew -- President and Chief Executive Officer

Yes. I think that's a little hard to say right now because, again, I think there was such a dramatic reduction in demand in China in Q1. We're starting to see that come back. I think it's a little too premature to say how the high end versus the mid-range versus the low end was going because there's just so much noise in all these numbers now.

I wouldn't say anything's changed, that we sit there, and we say, all of a sudden, the high-end hands, that's our -- are much stronger. But I honestly can't say that are much weaker either. So I mean, there's a lot of volatility in these numbers by like location. Obviously, it was China first in Q1, most in Q1.

As we moved into Q2, now we're seeing more volatility that -- where demand is going to come from Europe and North America. So I think we're going to have to see how that plays out. But I think it's a good question. We're definitely monitoring to see where that goes.

Alex Kim -- J.P. Morgan -- Analyst

OK. Got it. That's it for me. Thank you.

Operator

Your next question comes from the line of Tristan Gerra from Baird. Your line is open.

Tristan Gerra -- Baird -- Analyst

Hi, good afternoon. Given your guidance for your microphone business to be flat sequentially in Q2, is that really the impact of supply disruption given that mobile phone units are expected to actually increase sequentially in Q2 worldwide? And you've mentioned also China recovering. Or is there a market share impact? And then also, have you seen some of your largest smartphone customers changing their forecast either for Q2 or the second half?

Jeff Niew -- President and Chief Executive Officer

Tristan, I would sit there and say, right now, we see flat, sequentially, overall for the microphone business. But I mean, first of all, it's moving around a lot. I mean, I would say is when I look at the markets that we hear, our ear and IoT business, we expect it to be slightly up -- be up sequentially. Yes, and I would say the mobile, more like flattish.

But one thing that we are concerned about, we had a reasonably strong, which we didn't talk about that, a reasonably strong tablet and notebook market in Q1. And we're starting to see that start to slow down somewhat. I think people talk about this in terms of that -- with the work-at-home orders, tablets and notebooks were really moving very quickly in Q1. We are concerned there's going to be some decline in Q2.

Tristan Gerra -- Baird -- Analyst

OK. Any quantification of the mix from tablets and notebooks versus smartphone in Q1 for your mic business?

Jeff Niew -- President and Chief Executive Officer

Yes. I mean, again, it's a little too early to say here. But I mean, in Q1, tablets and notebooks were about 15% of our total business. I could see that possibly declining some.

When you look at our notebook, tablet, and I call -- we call it the other category. There's other stuff in here. I could see that declining to being, let's move these numbers, probably like 11%, 12% of the total.

Tristan Gerra -- Baird -- Analyst

OK, great. And then last question. So you mentioned how you're going to keep your own inventories at the current level, not trying to rebuild. What do you see in supply chain, notably in smartphone, are people trying to rebuild? Or what are the levels relative to what you see historically?

Jeff Niew -- President and Chief Executive Officer

Well, I mean, I think what we're trying to do is -- when I say this is really applicable to the hearing health market. With such a significant decline, we just didn't want to end up with a ton of inventory in our facility. Because right now, there's a fair amount of data out there from third parties that's talking about what's going on with our hearing health customers. If you're aware, Tristan, there's three hearing health customers in Europe who are three of our largest hearing health customers that are publicly traded.

And they're struggling, the people who have already spoken have not given any guidance as to what they see in Q2, and so I think that's really the area. We are watching the inventory pretty closely on the microphone side. But I would say we're probably a little bit more optimistic, and we have to be looking a little bit forward there because of normal seasonality in the back half of the year. Q2 would typically be a quarter where we've built some inventory for the Q3 and Q4 ramp.

But as you know, it's going to be hard to say, is it going to really happen in Q3 or Q4, with some of these seasonal ramps. So it's really about hearing health, making sure we align the output to demand.

Tristan Gerra -- Baird -- Analyst

Great. Thank you.

Operator

[Operator instructions] Your next question comes from the line of Charlie Anderson from Dougherty & Co. Your line is open.

Charlie Anderson -- Dougherty and Company -- Analyst

Yes. Thank you for taking my question. A 2-parter on hearing health. It sounded like you believe Q2 could potentially be a trough.

I wonder what gives you the confidence that we'd sort of trough out in Q2. Is it simply some of the shelter-in-place being lifted? Or is the industry getting creative in how we diagnose and supply? And then as it relates to gross margin impacts from hearing health, I wonder if you could maybe speak to the interplay between revenue and gross margin there, fixed cost. Any way you can quantify just to help us think about how that will be impacted going forward? And I've got a follow-up.

Jeff Niew -- President and Chief Executive Officer

Sure. Let me take the first one first. I would say what's very different about us in the hearing health market, Charlie, is that unlike the mobile market, we're a reasonably small supplier in a much larger market. We're one of the largest suppliers to the hearing health market.

And so we have, I would say, pretty good access to high-level people within -- in the hearing aid market. Secondly, we watch very diligently third parties that are looking at these markets. As I mentioned, we have three customers in Europe that are publicly traded, that there's a fair amount of data on. And I think you're right.

The first thing is the shelter-in-place orders have to come off, and we're starting to see that, right? We're starting to see that. I think I've read this morning, Italy is starting to reopen, right? You're starting to see states in the U.S. start to open, obviously, with restrictions. But I think the big wildcard here -- so that's better, right away, because audiologists will start to reopen their offices.

But I think the bigger wild card, where we're kind of like saying, OK, how much better does it get? And how long does it take, is when do older people feel more comfortable leaving their house and going out to get a hearing aid. Obviously, there are some things that people are doing to try to mitigate that in terms of fitting at home and, longer term, there's over-the-counter hearing aids. But shorter term, I think the primary method for getting hearing aid is still going to an audiologist's office and getting fitted. And so I think what we kind of hear in the marketplace, and that's kind of what we're modeling is, is that Q2 is the trough as audiology office opens.

And then as people become more, what do you call it, confident in not getting sick, there are more people who will go out and get a hearing aid. I would add one last thing to this is, we've had a fair amount of, obviously, experience with hearing aid markets. It's one of our core markets for 40-plus years, is that we don't think this is an economic issue. A lot of the markets, what we're talking about in the consumer space is like when are people going to get their jobs back and are they going to be willing to spend.

What our history tells us is that it's not economic in nature. People who are older, typically, are not highly invested in equity markets. They typically own their home, they're typically on some type of fixed income, so they know how much money is coming in, whether it be from self-security or pensions. And so it's usually, as we saw in '08, '09, there was very minor impact on that recession on the hearing aid market.

So it really comes down to audiologists reopening. And number two, people feeling comfortable, and that means either some type of treatment, vaccine or reduction in a number of cases. And then I think the market will return to normal. And then I've got a...

John Anderson -- Senior Vice President and Chief Financial Officer

Sure, Charlie. I mean, we don't typically give gross profit margins by product line, but I can talk a little bit to our fixed cost and capacity utilization from a segment standpoint. So our audio segment, capacity utilization was lower than planned in Q1. We typically are in the kind of low 80% in Q1 due to Chinese New Year that always occurs.

Well, because of the elongated Chinese New Year and the other workforce disruptions we experienced, we were probably closer to 70% capacity utilization in audio in Q1. I expect, as we mentioned earlier, the microphone business will continue similar capacity utilization. But we are expecting a pretty significant downturn in capacity utilization for our hearing health business. And that, as we said earlier, that comprises about 25% of the total business.

Jeff Niew -- President and Chief Executive Officer

And again, Charlie, luckily, the way we view this is this is temporary. I don't think we view the hearing health market as this is a permanently impaired market. We view this as that once people -- whether it's treatments or the curve starts to change or vaccine, this will not be an economic issue and people will return to the market at 2019 levels.

Charlie Anderson -- Dougherty and Company -- Analyst

OK, great. And then for my follow-up, on the opex reductions. You do have this abnormally high opex right now because of the legal expense that vary from quarter to quarter. I'm curious, those numbers you gave us, does it include continued -- these elevated legal expenses or not? Thanks.

John Anderson -- Senior Vice President and Chief Financial Officer

No. We expect a fair amount with this quarter. We had between $4 million and $5 million of legal expenses. We expect a similar amount in Q2 and then a pretty significant drop off.

Again, with COVID-19, the discovery process that we're going through, it's really difficult to nail the timing, but we do expect this to be behind us by the end of Q3. And so when I talk about that Q4 run rate of $42 million to $44 million, we aren't envisioning any legal costs by the end of the year because we do expect this should get behind us.

Charlie Anderson -- Dougherty and Company -- Analyst

OK. Great. Thanks so much.

Operator

There are no further questions at this time. Mr. Mike Knapp, I turn the call back over to you.

Mike Knapp -- Vice President of Investor Relations

Great. Thanks very much for joining us today. As always, we appreciate your interest in Knowles, and look forward to speaking with you on our next earnings call. Thanks and goodbye.

Operator

[Operator signoff]

Duration: 45 minutes

Call participants:

Mike Knapp -- Vice President of Investor Relations

Jeff Niew -- President and Chief Executive Officer

John Anderson -- Senior Vice President and Chief Financial Officer

Anthony Stoss -- Craig-Hallum Capital Group -- Analyst

Bob Labick -- CJS Securities -- Analyst

Christopher Rolland -- Susquehanna International Group -- Analyst

Alex Kim -- J.P. Morgan -- Analyst

Tristan Gerra -- Baird -- Analyst

Charlie Anderson -- Dougherty and Company -- Analyst

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