KNOWLES ELECTRONICS HOLDINGS INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 333-40076

KNOWLES ELECTRONICS HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 36-2270096
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

1151 MAPLEWOOD DRIVE 60143
ITASCA, ILLINOIS (Zip Code)
(Address of principal executive offices)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(630) 250-5100

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

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TABLE OF CONTENTS

1

KNOWLES ELECTRONICS HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

2

KNOWLES ELECTRONICS HOLDINGS, INC.

CONSOLIDATED BALANCE SHEETS

3

KNOWLES ELECTRONICS HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

4

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA)
SEPTEMBER 30, 2002 AND 2001
(UNAUDITED)

1. BASIS OF RECAPITALIZATION AND PRESENTATION

On June 23, 1999, the Company entered into a recapitalization agreement
with Key Acquisition L.L.C. (the Investor), and the preexisting common
stockholders' of the Company. All of the membership interests of Key Acquisition
LLC are held by limited partnerships for which Doughty Hanson & Co. Limited or
its affiliates ("Doughty Hanson") act as general partner. The recapitalization
transaction (the Recapitalization) closed on June 30, 1999.

On June 29, 1999 the Company distributed the equipment financing business
and certain real estate of the Company to certain preexisting stockholders in
exchange for 10% of the common stock. On June 30, 1999 the Company used the
proceeds from the sale of the preferred and common stock in addition to funds
obtained from a senior credit facility and bridge notes to finance the purchase
of 90% of the remaining 90% of the preexisting stockholders' common shares.

The Recapitalization has been treated as a leveraged recapitalization in
which the issuance of the debt has been accounted for as a financing
transaction, the sales and purchases of the Company's stock have been accounted
for as capital transactions at amounts paid or received, and no changes were
made to the carrying values of the Company's assets and liabilities.

The amount payable to our preexisting stockholders for the repurchase of
their common stock in the Recapitalization was subject to a post-closing
adjustment. As a result, the Company paid the preexisting stockholders
approximately $8.3 million, plus $0.7 million in interest. The price adjustment
was recorded as a reduction to stockholders' equity.

For the nine months ended September 30, 2002 and 2001, total comprehensive
income (loss) amounted to ($7,273) and $143, respectively. For the three months
ended September 30, 2002 and 2001, total comprehensive income (loss) amounted to
($1,391) and $324, respectively. The difference between net income (loss) and
comprehensive income (loss) is related primarily to the Company's foreign
currency translation.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets, which the Company adopted on January 1, 2002.
The impact of the adoption was not significant to the Company's results of
operations or financial condition. Separately, based on current and expected
market conditions, the Company recorded an $8,683 impairment of the assets held
for disposal related to the Ruf Electronics division in the quarter ended June
30, 2002, and an additional $4,175 in the quarter ended September 30, 2002.
These assets were designated as held for sale prior to January 1, 2002, and
therefore the Company continues to account for these assets under the previous
impairment guidance of SFAS No. 121. The Company completed the sale of the Ruf
Electronics division effective November 1, 2002 and expects to record a loss on
the sale, including previously recorded impairment charges of approximately $16
million.

The accompanying unaudited consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. In the opinion of our
management, all adjustments, consisting of normal recurring accruals, necessary
for a fair presentation have been included. Certain prior year amounts have been
reclassified to conform to current year presentation. The financial statements
for the first three quarters of 2001 were restated due to the significance of
two fourth quarter adjustments, namely the capitalization of $3.3 million of ERP
software implementation costs previously expensed in those quarters and the
identification of a $4.0 million unanticipated reduction in inventory in the
fourth quarter that related to previous quarters. The results for the period
ended September 30, 2002 do not necessarily indicate the results that may be
expected for the full year ending December 31, 2002. For further information,
refer to the Company's

5

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

consolidated financial statements and notes thereto included in the Company's
Form 10-K dated for the year ended December 31, 2001.

2. INVENTORY

Inventories are as follows:

3. NOTES PAYABLE

As part of the Recapitalization transaction, the Company entered into a
senior credit agreement dated June 28, 1999 and amended and restated as of July
21, 1999, and further amended as of December 23, 1999, April 10, 2000, December
12, 2001 and May 10, 2002 with certain lenders ("Senior Credit Agreement"). The
Senior Credit Agreement consists of $218,250 (as amended May 10, 2002), which
provides for revolving loans of $18,250 (Revolving Credit Facility) for a period
of seven years, a Term A Facility of $50,000 (Term A Facility), which has a
maturity of seven years, and a Term B Facility of $150,000 (Term B Facility),
which has a maturity of eight years. The Term A Facility and the Revolving
Credit facility bear interest, at the Company's option, at either (1) one-,
two-, three-, or six month LIBOR plus 3.50% (as amended May 10, 2002) or (2) the
greater of the prime rate, a base certificate of deposit rate plus 1.00%, or the
federal funds effective rate plus 0.50% (the Alternate Base Rate), in each case
plus an initial margin of 2.50%. The Term B Facility bears interest, at the
Company's option, at either (1) one-, two-, three-, or six-month LIBOR plus
4.50% (as amended May 10, 2002) or (2) Alternate Base Rate plus an initial
margin on 3.50%. The amendment to the Senior Credit Agreement dated May 10, 2002
increased the interest rate spread for each of the Term A Facility and Term B
Facility by 0.50%. At September 30, 2002, the weighted average interest rate was
5.54% for the Term A Facility and 6.51% for the Term B Facility.

The balance under the Term A Facility, Term B Facility, the 13 1/8% Senior
Subordinated Notes ("13 1/8% Notes") and the 10% Senior Subordinated Notes ("10%
Notes") is as follows:

6

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

At September 30, 2002 short-term debt includes $3,753 drawn against a line
of credit by our Austrian subsidiary.

The 13 1/8% Notes were issued in a private placement on October 1, 1999 and
are due October 15, 2009 with interest payable semiannually at 13 1/8%
commencing April 15, 2000. The Company subsequently exchanged all of the
privately placed 13 1/8% Notes for a like amount of identical 13 1/8% Notes
registered with the Securities and Exchange Commission on October 20, 2000. The
13 1/8% Notes rank equally with all other unsecured senior subordinated
indebtedness of the Company. The 13 1/8% Notes are junior to all of the
Company's current and future indebtedness, except indebtedness which is
expressly not senior to the 13 1/8% Notes.

The 10% Notes were issued in a private placement on August 29, 2002 and are
due October 15, 2009 with interest payable semiannually at 10% commencing April
15, 2003. The 10% Notes rank equally with all other unsecured senior
subordinated indebtedness of the Company. The 10% Notes were purchased by an
affiliate of Doughty Hanson & Co., Ltd., a private equity concern which controls
the equity of Knowles.

The Company's Senior Credit Agreement requires that the Company comply with
certain covenants and restrictions, including specific financial ratios that
must be maintained. The Company was not in compliance with the required leverage
ratio and interest coverage ratio under the Senior Credit Agreement as of March
31, 2002. Additionally, the Company did not make the interest payment on the
senior subordinated notes scheduled for April 15, 2002 on that date. An
Amendment and Waiver to the Senior Credit Agreement was obtained dated as of May
10, 2002 and the Company made the interest payment on the senior subordinated
notes that was scheduled for April 15, 2002 on May 14, 2002. The Amendment and
Waiver waived the Company's non-compliance with the required interest coverage
ratio for the period ended March 31, 2002 and the leverage ratio for the period
January 1, 2002 through March 31, 2002, and amended these required ratios for
the periods after March 31, 2002 through the first quarter of 2003. This
Amendment and Waiver also limits capital expenditures for the year 2002 to $15
million, prevents any acquisitions of another company or business, decreases the
revolving credit facility to $18.25 million (from $25 million), caps at $2
million the amount of net cash proceeds from asset sales that can be applied to
buying new assets and requires the Company to receive additional funding of at
least $10 million by September 3, 2002 which must be used to pay down the
outstanding balance on the revolving credit facility to $8.25 million. The
Company received the additional $10 million funding from the issuance of the 10%
Notes on August 29, 2002. Based on current forecasts, the Company expects to
remain in compliance with the amended covenants through December 30, 2002.
However, the Company cannot be certain that it will remain in compliance with
the more stringent covenants thereafter, beginning December 31, 2002. The
Company does expect to renegotiate its loan agreements prior to April, 2003. If
future actual results are lower than planned or the Company is unable to
renegotiate its loan agreements, the Company may be unable to comply with the
debt covenants or make required debt service payments. Such inability could have
a material adverse impact on the Company's financial condition, results of
operations or liquidity. There are no assurances that the Company could
favorably resolve such a situation.

As security for the obligations under the Senior Credit Agreement the
Company has pledged all of the shares of its U.S. subsidiaries and 65% of the
shares of its non-U.S. subsidiaries and has granted the lenders a security
interest in substantially all of its assets and the assets of its U.S.
subsidiaries.

The 13 1/8% Notes and 10% Notes (collectively "Subordinated Notes") are
unconditionally guaranteed, on a joint and several basis, by the following
wholly owned U.S. subsidiaries of the Company: Knowles Electronics LLC, Knowles
Intermediate Holding, Inc., Emkay Innovative Products, Inc., Knowles
Manufacturing Ltd., and Synchro-Start Products, Inc. The following tables
present summarized balance sheet information of the Company as of September 30,
2002 and December 31, 2001, summarized income statements for the three and nine
months ended September 30, 2002 and 2001, and summarized cash flow

7

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

information for the nine months ended September 30, 2002 and 2001. The column
labeled "Parent Company" represents the holding company for each of the
Company's direct subsidiaries, which are guarantors of the Subordinated Notes,
all of which are wholly owned by the parent company; and the column labeled
"Non-guarantors" represents wholly owned subsidiaries of the Guarantors, which
are not guarantors of the Subordinated Notes. Pursuant to a contribution
agreement effective August 30, 1999, Knowles Electronics, Inc., recognized in
prior periods as the parent company, contributed substantially all of its
operating assets and liabilities (other than the capital stock of Knowles
Intermediate Holding Company, Inc. and certain foreign subsidiaries and Knowles
Electronics, Inc.'s liabilities under the Senior Credit Agreement and
Subordinated Notes) to Knowles Electronics, LLC, a newly created Delaware
limited liability company. As a result of this reorganization, Knowles
Electronics, Inc., which changed its name to Knowles Electronics Holdings, Inc.,
is now a holding company that does not conduct any significant operations. The
Company believes that separate financial statements and other disclosures
regarding the Guarantors, except as otherwise required under Regulation S-X, are
not material to investors.

Summarized balance sheet information as of September 30, 2002 and December
31, 2001, summarized income statement for the three and nine months ended
September 30, 2002 and 2001, and summarized cash flow information for the nine
months ended September 30, 2002 and 2001 is as follows:

8

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

9

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

10

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

11

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

4. SEGMENTS AND GEOGRAPHICAL INFORMATION

The Company's continuing business consists of three operating segments:
hearing aid components, acoustic and infrared technology, and automotive
components. These three operating segments were determined based on the
applications and markets for the Company's products.

The hearing aid components operating segment utilizes the Company's
acoustic technologies to design, manufacture, and market transducers and other
components for hearing aids. The acoustic and infrared technology operating
segment utilizes the Company's acoustic and infrared technologies to design,
manufacture, and market products for high growth markets, including mobile
communications, computer telephony integration telematics (voice controlled
wireless services delivered to an automobile environment) and home

12

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

entertainment systems. The automotive component operating segment designs,
manufactures, and markets diesel engine solenoids, electronic governors, and
position sensors primarily for use in automobiles, trucks, and off road
vehicles.

The Company uses the following financial information presented below to
assess performance and make resource allocation decisions:

13

KNOWLES ELECTRONICS HOLDINGS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE DATA) -- (CONTINUED)

The following is a reconciliation of segment operating income to the
Company's consolidated totals:

5. RESTRUCTURING EXPENSES

The Company announced a major restructuring in March 2000, resulting in a
first quarter 2000 charge of $20.1 million. Under the restructuring plan, the
Company is consolidating its worldwide manufacturing operations by ending
production at five manufacturing facilities and either outsourcing component
production or moving final assembly to lower cost locations in Malaysia, China
and Hungary. The restructuring charge consists primarily of severance payments
to terminated employees and outplacement expenses. As of September 30, 2002,
1,028 positions have been eliminated of the 1,047 total positions that were
expected to be eliminated in the restructuring, thereby reducing our headcount
related to operations that existed in March 2000 by 18%. In the quarter ending
September 30, 2002 the Company identified an additional 22 positions at its U.S.
locations to be included in the restructuring, resulting in a third quarter 2002
charge of $0.5 million consisting of severance related payments. $20.4 million
has been spent on severance and outplacement costs through September 30, 2002.
The Company also reversed $0.6 million of severance related expenses no longer
required due to the sale of Ruf Electronics and recorded a restructuring charge
of $1.2 million related to a writedown on a building held for sale in Taiwan.

14

KNOWLES ELECTRONICS HOLDINGS, INC.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW

The following table shows our net sales growth for the third quarter and
first nine months of 2002 and 2001 compared to the same periods of their
respective prior years for each of our three operating segments.

Overall, sales in the third quarter were below the second quarter and
declined in the third quarter of this year compared to the prior year primarily
due to declines in the transducer and infrared businesses.

Sales for the third quarter of 2002 decreased six percent compared to the
third quarter of 2001. The KE Group sales were down eight percent in the third
quarter due to lower demand and unfavorable sale price and mix. This decrease in
sales in the core business was only partially offset by an increase in Deltek
sales. The Emkay Group sales decreased three percent in the third quarter due to
lower sales in the infrared business that were partly offset by higher sales in
the components business. The Automotive Components Group sales were flat for the
quarter with an increase at SSPI offsetting a decline at Ruf.

Sales for the first nine months of 2002 declined four percent compared to
the first nine months of 2001. The KE Group sales were down four percent in the
first nine months, primarily due to the decline in the core transducer business.
KE transducer unit sales actually increased low single digits, but the increase
was offset by unfavorable sales price and mix. Emkay Group sales increased two
percent in the first nine months with higher sales in components and condensor
microphone businesses partially offset by a decline in the finished goods and
infrared businesses. The Automotive Components Group sales declined seven
percent for the first nine months with declines in the Ruf and the SSPI
businesses of 11% and 5%, respectively.

CONSOLIDATED RESULTS OF OPERATIONS

The following table shows the principal line items from our consolidated
statements of operations, as a percentage of our net sales, for the three months
and nine months ended September 30, 2002 and 2001.

"EBITA" is defined as earnings before interest, taxes, depreciation,
amortization, and miscellaneous income/expense. EBITDA should not be construed
as an alternative to operating income, or net income, as

15

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONSOLIDATED RESULTS OF OPERATIONS -- (CONTINUED)

determined in accordance with GAAP, as an indicator of our operating
performance, or as an alternative to cash flows generated by operating,
investing and financing activities. EBITDA is presented solely as a supplemental
disclosure because we believe that it is a widely used measure of operating
performance. Because EBITDA is not calculated under GAAP, it may not be
comparable to similarly titled measures reported by other companies.

Operating income and EBITDA, as a percentage of net sales, excluding
impairment and restructuring charges, were 20.5% and 25.7%, respectively, for
the quarter ended September 30, 2002. Operating income and EBITDA, as a
percentage of net sales, excluding impairment and restructuring charges, were
20.6% and 26.7%, respectively, for the quarter ended September 30, 2001.
Operating income and EBITDA, as a percentage of net sales, as reported, were
10.4% and 15.6%, respectively, for the quarter ended September 30, 2002.
Operating income and EBITDA, as a percentage of net sales, as reported, were
20.3% and 26.4%, respectively, for the quarter ended September 30, 2001. The
lower operating income and EBITDA, as reported, in the third quarter of 2002
compared to 2001 is due to the asset impairment charge for Ruf discussed below,
lower operating income at the KE Group and restructuring charges, primarily
related to a writedown on a building held for sale in Taiwan.

Operating income and EBITDA, as a percentage of net sales, excluding
impairment and restructuring charges, were 18.1% and 23.7%, respectively, for
the nine months ended September 30, 2002. Operating income and EBITDA, as a
percentage of net sales, excluding impairment and restructuring charges, were
20.5% and 25.7%, respectively, for the nine months ended September 30, 2001.
Operating income and EBITDA, as a percentage of net sales, as reported, were
9.1% and 14.7%, respectively, for the nine months ended September 30, 2002.
Operating income and EBITDA, as a percentage of net sales, as reported, were
20.6% and 25.7%, respectively, for the nine months ended September 30, 2001. The
lower operating income and EBITDA in the first months of 2002 compared to 2001,
as reported, is primarily due to the asset impairment charge for Ruf discussed
below, lower operating income at the KE and ACG Groups and restructuring
charges.

QUARTER ENDED SEPTEMBER 30, 2002 AND SEPTEMBER 30, 2001

The following table sets forth net sales by segment and segment net sales
as a percent of total sales.

Consolidated sales decreased by $3.0 million or six percent the third
quarter 2002 compared to the same quarter of 2001. KE Group sales declined $2.8
million or eight percent compared to the third quarter of last year. The KE
sales declined due to lower demand and unfavorable pricing and mix in the
transducer product line, which were only partly offset by a sales increase in
Deltek. The Emkay Group sales decreased $0.2 million or three percent in the
third quarter of this year compared to the same quarter last year. The decrease
occurred in the infrared business, partially offset by increases in the
components and finished goods product lines. The Automotive Components Group
sales were flat in the third quarter, with a one percent increase in the SSPI
sales product line offsetting a two percent decline at Ruf.

16

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
QUARTER ENDED SEPTEMBER 30, 2002 AND 2001 -- (CONTINUED)

The following table sets forth cost of sales by segment and segment cost of
sales as a percent of segment net sales.

Consolidated cost of sales increased as a percent of sales in the third
quarter 2002 compared to the same period the prior year by 3.2%. The KE Group's
cost of sales increased by $1.2 million despite a decline in sales, resulting in
an increase in cost of sales as a percentage of revenue of 8.0 percentage
points. Cost of sales as a percent of revenue increased due to the effect of
lower production levels on costs and lower selling prices. The Emkay Group's
cost of sales decreased by $0.5 million with a decrease of 5.1 percentage points
in margins due to improved margins in the Infrared division and a favorable mix.
The Automotive Components Group cost of sales decreased by $0.7 million or 5.6
percentage points, with an increase in higher margin SSPI sales and a decline in
lower margin Ruf sales.

The following table sets forth operating income by segment and segment
operating income as a percentage of segment net sales.

Operating income decreased by $5.7 million in the third quarter 2002
compared to the same quarter in 2001. The primary cause of the decrease was an
additional $4.2 million non-cash charge for impairment of assets held for sale
at Ruf and $1.1 million in restructuring charges, primarily related to a
writedown on a building held for sale in Taiwan. Lower sales and margins at KE
reduced operating income by $3.0 million, despite reductions in operating
expenses. Operating loss from Emkay Group increased by $0.4 million in the third
quarter 2002 compared to the same period in 2001 due to the restructuring
charge, partially offset by favorable margins and reduced operating expenses.
The Automotive Group operating income declined by $3.5 million due to the $4.2
million asset impairment charge for Ruf. On November 1, 2002, the Company
announced the sale of its Ruf Electronics operations to W.E.T. Automotive
Systems AG, an automotive systems supplier. In connection with the sale, the
Company expects to record a loss on the sale, including previously recorded
impairment charges of approximately $16 million. In the third quarter 2002,
operating income from the SSPI portion of the Automotive Group showed an
increase over the same quarter in 2001 primarily due to improved margins.

17

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
QUARTER ENDED SEPTEMBER 30, 2002 AND 2001 -- (CONTINUED)

Unallocated corporate expenses decreased by $1.2 million in the third
quarter of 2002 compared to the prior year. The decrease was due to a $0.6
million reduction in Corporate expenses and a restructuring benefit of $0.6
million due to a reversal of severance expenses that are no longer required due
to the sale of Ruf Electronics.

We had operating income of $5.4 million in the third quarter 2002 compared
to operating income of $11.1 million the same quarter last year. The decline was
primarily a result of the Ruf impairment charge and the restructuring charge and
the decline in margins at KE, partially offset by improved margins in the
Automotive Components Group and reduced research, selling and administrative
expenses. After adjusting out the impairment and restructuring charges, we had
adjusted operating income of $10.7 million in the third quarter this year
compared to $11.3 million the same quarter last year. On an adjusted basis our
operating income decreased $0.6 million in the quarter, due to the decline in
sales and margins, only partially offset by reduced operating expenses.

In connection with our September 1999 recapitalization, we currently have
significant senior debt and senior subordinated debt. As a result, interest
expense was $8.8 million the third quarter of this year compared to $9.1 million
the same quarter last year. The reduction in interest expense is due primarily
to lower interest rates on the senior debt.

Income tax expense was a $2.1 million benefit the third quarter this year
compared to $2.4 million expense in the third quarter last year. We are
providing for tax at this year's expected worldwide effective tax rate of
approximately 20%.

After interest expense and taxes, we reported a net loss of $1.4 million in
the third quarter of this year compared to net loss of $0.4 million for the same
period last year.

NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001

The following table sets forth net sales by segment and segment net sales
as a percent of total sales.

18

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001 -- (CONTINUED)

Consolidated sales declined $5.8 million or 3.5 percent in the first nine
months 2002 compared to the same period of 2001 due to declines in KE and the
Automotive Components Group. KE Group sales declined $3.7 million or 3.6 percent
primarily due to unfavorable pricing and mix as unit volumes increased in the
low single digits. The Emkay Group sales increased $0.6 million or 2.2 percent
due to increases in components and condensor microphones. The Automotive
Components Group sales declined $2.6 million or 6.6 percent in the first nine
months, with Ruf sales down approximately eleven percent in the first nine
months compared to the same period last year, and sales at the SSPI division
were down five percent.

The following table sets forth cost of sales by segment and segment cost of
sales as a percent of segment net sales.

Consolidated cost of sales decreased by $0.8 million, but increased by 1.6
percent of sales in the first nine months of 2002 compared to the same period
the prior year. The KE Group's cost of sales decreased by $0.7 million but
increased as a percentage of sales by 1.2 percentage points, primarily due to a
decline in margin rates caused by a reduction in average selling prices. The
Emkay Group cost of sales increased by $0.5 million or 1.0 percentage points due
to a decrease in margins at the infrared division. The Automotive Components
Group cost of sales decreased $0.6 million due to a decline in sales but
increased as a percentage of sales by 2.9 percentage points primarily due to the
loss of high margin SSPI sales compared to the prior year.

The following table sets forth operating income by segment and segment
operating income as a percentage of segment net sales.

Operating income declined in the first nine months of 2002 compared to the
first nine months of 2001 due to the asset impairment charge, the swing in
restructuring from benefit to expense, lower KE and Automotive Component sales,
and lower margins rates in each business segment that were only partially offset
by lower operating expenses. Operating income declined $19.8 million or 11.5
percentage points in the first nine months of 2002 compared to the same period
of 2001. The Ruf impairment charge accounted for $12.9 million of the difference
and the swing in the restructuring activity from $1.7 million credit in 2001 to
$1.7 million expense

19

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001 -- (CONTINUED)

in 2002 accounted for another $3.4 million. After adjusting for these two
charges the difference in the first nine months of 2002 compared to the same
period of 2001 is a $3.5 million decline in operating income. Decreases in sales
and margin rates resulted in a decline of $5.0 million but was partly offset by
a decrease in selling and administrative expenses of $1.5 million in the first
nine months of 2002 compared to the same period in the prior year.

The KE Group operating income declined by $4.9 million due to the
fluctuation in restructuring expense and a decline in revenues and margins,
partially offset by reduced research, selling and administrative expenses. If
the restructuring expense is added back, the KE operating income declined by
$1.9 million despite the lower research, selling and administrative expense.

The Emkay Group operating loss increased by $0.8 million the first nine
months due to the restructuring charge in the third quarter 2002. Operating
results excluding the restructuring charge increased by $0.4 million in the nine
months ending 2002 due to slightly higher sales and reduced operating expenses.

The Automotive Components Group operating income decreased by $14.7
million. If the Ruf impairment charge and restructuring charges are added back,
the Automotive Components operating income declined by $2.2 million primarily
due to the margin effect of lower sales.

Unallocated corporate expenses decreased by $0.5 million in the nine months
compared to the same nine months last year. Corporate general and administrative
expense decreased by $0.1 million and restructuring activity decreased by $0.4
million primarily due to a reversal of restructure charges no longer required
due to the sale of Ruf.

We had operating income of $14.6 million in the first nine months 2002
compared to operating income of $34.4 million the same period last year,
primarily as a result of the Ruf impairment charge, the unfavorable swing in
restructuring, and sales and margins in the KE and Automotive Components Groups.
After adjusting out the impairment and restructuring charges, we had adjusted
operating income of $29.1 million the first nine months this year compared to
$32.7 million the same period last year. On an adjusted basis operating income
declined $3.6 million or 11.1 percentage points in the first nine months this
year compared to the same period last year, with most of the decline occurring
in the first quarter.

In connection with our June 1999 recapitalization, we currently have
significant senior debt and senior subordinated debt. As a result, interest
expense was $26.5 million the first nine months this year compared to $29.0
million the same period last year. The reduction in interest expense is due
primarily to lower interest rates on the senior debt.

Income tax expense was a $2.3 million benefit the first nine months this
year compared to $4.9 million expense the first nine months last year. We are
providing for tax at this year's expected worldwide effective tax rate of
approximately 20%.

After interest expense and taxes, we reported a net loss of $9.6 million in
the first nine months this year compared to net income of $0.7 million for the
same period last year.

LIQUIDITY AND CAPITAL RESOURCES

We have historically used available funds for capital expenditures,
inventory, accounts receivable and acquisitions. These funds have been obtained
from operating activities and from lines of credit. In the future, we will
continue to have these funding needs, and we will also need to fund repayments
of principal under our term loans (Annual amounts of $9.0 million in 2002,
$10.25 million in 2003, and additional amounts thereafter). We also will have
substantial interest expense of approximately $35 million each year.

We are a holding company. Our subsidiaries conduct substantially all of our
consolidated operations and own substantially all of our consolidated assets.
Consequently, our cash flow and our ability to meet our debt service obligations
depends substantially upon the cash flow of our subsidiaries and the payment of
funds by our subsidiaries to us in the form of loans, dividends or otherwise.
20

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
LIQUIDITY AND CAPITAL RESOURCES -- (CONTINUED)

The Company borrowed $200 million under a bank credit agreement plus $153.2
million under a senior subordinated note agreement associated with its
recapitalization June 30, 1999. In addition, the Company received $10.0 million
in August, 2002 from the issuance of a senior subordinated note that was
purchased by an affiliate of Doughty Hanson & Co., Ltd., a private equity
concern that controls the equity of Knowles. The Company is required to maintain
certain ratios of EBITDA in order to be in compliance with its bank credit
agreement covenants and to access its $18.25 million revolving credit facility
(as amended). The two primary ratios the Company must maintain are the leverage
ratio, which is total net debt divided by EBITDA, and the interest coverage
ratio, which is EBITDA, divided by net cash interest expense. The Company is
required to maintain its leverage ratio below a specified level and its interest
coverage ratio above a specified level.

First quarter 2002 sales and resulting EBITDA were considerably less than
projected at the time of the December 2001 amendment to the bank credit
agreement, resulting in $6 million less cash collections and higher payable
disbursements than expected. Therefore, we were not in compliance with our
required leverage ratio and interest coverage ratio under the bank credit
agreement as of March 31, 2002. As a result, we did not make the interest
payment on our senior subordinated notes scheduled for April 15, 2002 on that
date. We subsequently obtained an Amendment and Waiver dated as of May 10, 2002
to our Credit Agreement and on May 14, 2002 made the interest payment on our
senior subordinated notes that were scheduled for April 15, 2002.

The Company is required to maintain the following amended leverage ratios
and interest coverage ratios for 2002 as follows:

We did meet the financial ratios required at the end of the third quarter.
Our leverage ratio was 6.39 and our interest expense coverage ratio was 1.57. We
also were in compliance with the capital expenditure limit and other terms and
conditions of our credit agreement.

Based on current forecasts, the Company expects that it will remain in
compliance with the amended covenants through December 30, 2002. However, the
Company cannot be certain that it will remain in compliance with the more
stringent covenants thereafter, beginning December 31, 2002. The Company does
expect to renegotiate its loan agreements prior to April, 2003. If future actual
results are lower than planned or the Company is unable to renegotiate its loan
agreements, the Company may be unable to comply with the debt covenants or make
required debt service payments. Such inability could have a material adverse
impact on the Company's financial condition, results of operations or liquidity.
There are no assurances that the Company could favorably resolve such a
situation.

Net cash provided by operating activities was $19.7 million in the third
quarter of 2002 compared to $9.0 million in the third quarter of 2001 or $10.7
million better. An $11.6 million reduction in accounts receivable in the current
year compared to an increase in accounts receivable in the prior year provided
the biggest change in working capital year over year.

Net cash used in investing activities was $1.9 million in the third quarter
this year compared to a net usage of $5.0 million in the third quarter of last
year due to a reduction in capital expenditures. The major reason for the
reduction in capital expenditures in both the third quarter and the nine months
ending September 30, 2002 was the significant ERP related investment and
automation equipment spending last year.

21

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
LIQUIDITY AND CAPITAL RESOURCES -- (CONTINUED)

Net cash used by financing activities was $3.0 million in the third quarter
of 2002, as compared to a $1.4 million use in the third quarter of last year.
Net cash used in the quarter is net of $10.0 million received from the issuance
of a senior subordinated note in August 2002, partially offset by $8.2 million
in payments made to reduce short-term debt, primarily reductions in the balance
of the Revolving Credit facility. The effect of exchange rates on cash was a
$0.7 million decrease in the third quarter this year compared to a $0.1 million
decrease the third quarter of last year.

The net result of the cash provided by operating activities, investing
activities and financing activities was a $14.1 million increase in cash the
third quarter of this year, compared to a $2.5 million increase in cash for the
same period last year. Our cash balance was $19.8 million at September 30 this
year compared to $7.5 million at September 30 last year.

Net cash provided by operating activities was $24.2 million in the first
nine months of 2002 compared to $8.3 million for the first nine months of 2001
or $15.9 million better. Although income was a net loss of $9.6 million in the
first nine months of this year compared to net income of $0.7 million the first
nine months of last year, after adjusting for the non cash items, cash earnings
from operations were $4.6 million higher for the first nine months of 2002
compared to the first nine months of 2001. Items consuming working capital
included accounts payable of $6.9 million and income taxes payable of $5.4
million. Major sources of cash in the nine months ending September 30, 2002
included a swing of $12.1 million in accounts receivable, $4.1 million in
inventory and $2.8 million in restructuring costs. Compared to the prior year,
net cash from operating activities increased by $15.9 million due primarily to
the additional cash generated from reducing receivables and inventory, partly
offset by the decline in payables.

Net cash used in investing activities was $7.1 million in the first nine
months this year compared to $13.8 million the first nine months of last year.
Capital expenditures were $17.3 million the first nine months last year offset
by $3.5 million provided by the sale of the United Kingdom building. Investing
activities for both years is primarily net purchases of property, plant and
equipment. The major reason purchases of plant, property and equipment were
higher in the nine months ending September 30, 2001 than in the current year was
the significant ERP related investment and automation project in the prior year.

Net cash from financing activities was $0.8 million in the first nine
months of 2002, due to the $10.0 million proceeds from the 10% Senior
Subordinated Notes, partially offset by the $6.8 million in principal payments
on other long term debt, $1.5 million in payments of short term debt, and $0.5
million of costs associated with the May, 2002 Credit Agreement amendment
discussed above.

The net result of the cash provided by operating activities, investing
activities and financing activities was a $17.3 million increase in cash the
first nine months of this year, compared to a $9.5 million reduction in cash for
the same period last year. Our cash balance was $19.8 million at September 30
this year compared to $7.5 million at September 30 last year.

We expect capital expenditures of approximately $10 million in 2002. We
expect our major capital expenditures in 2002 will be to support new product
introductions for Emkay, for new production equipment for KE, and for new
product introductions for SSPI. The amount and timing of actual capital
expenditures may be different than our current expectations.

22

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS -- (CONTINUED)

PENSION INFORMATION

The funded status of the Company's pension plans is dependent upon many
factors, including the actual return on the invested assets and the level of
long-term market interest rates. Recent declines in the market value of the
equity securities coupled with declines in long-term interest rates have had a
negative impact on the funded status on the Company's U.S. pension plan (the
Company's primary plan). The Company expects that it will be required to make
pre-tax U.S. pension plan contributions of approximately $0.6 million in 2003,
$2.0 million in 2004 and $3.3 million in 2005.

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
These statements are based on the Company's current plans and expectations as of
the date of this document and involve risks and uncertainties that may cause
actual results to differ materially from the forward-looking statements.
Generally, the words "believe," "expect," "estimate," "anticipate," "will" and
similar expressions identify forward-looking statements.

Important factors that could cause such differences include, among others:
general economic conditions in the U.S. and worldwide; fluctuations in currency
exchange rates and interest rates; implementation of new software systems;
dependence on our largest customers and key suppliers; the competitive
environment applicable to the Company's operations; greater than expected
expenses associated with the Company's activities or personnel needs; changes in
accounting assumptions; changes in customers' business environments; regulatory,
legislative and judicial developments, including environmental regulations;
ability to generate sufficient liquidity to service debt obligations; and
ability to maintain compliance with debt covenants.

The risks included here are not exhaustive. New risk factors emerge from
time to time and it is not possible for management to predict all such risk
factors or to assess the impact of such risk factors on the Company's business.
Accordingly, the Company undertakes no obligation to publicly update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise.

ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk from changes in foreign exchange
rates and interest rates.

We do not hedge our foreign currency exchange rate exposure. Therefore, we
are exposed to foreign currency exchange rate risks. Our revenues are primarily
denominated in the U.S. dollar and the Euro. During the first nine months of
2002, approximately 77% of our revenue was denominated in U.S. dollars,
approximately 16% of our revenue was denominated in Euros, and the balance was
denominated in other foreign currencies including the British pound and the
Japanese yen. Our expenses are principally denominated in the same currencies,
in which we have sales, allowing us to essentially hedge through offsetting
revenue and expense exposures. As a result, during the first nine months of
2002, our operating income and margins were not significantly affected by the
change in the Euro exchange rate. We believe currency changes added about $0.4
million to income in the first nine months. Some of our expenses are denominated
in the local currencies of Austria, the United Kingdom, Hungary, China, Japan,
Malaysia and Taiwan, some of which are closely tied to the U.S. dollar and Euro.
Our primary exposure longer term is the relation of the Euro to the U.S. dollar
and major Asian currencies.

We do not invest in speculative or derivative financial instruments. We
have significant amounts of debt that are subject to interest rate fluctuation
risk. The amounts outstanding under the term loans of the Credit Agreement have
variable interest rates and, therefore, adjust to market conditions. An increase
or a decrease of one percentage point in the interest rate of the loans under
the Credit Agreement would change our annual
23

KNOWLES ELECTRONICS HOLDINGS, INC.
ITEM 3. QUANTITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET
RISKS -- (CONTINUED)

interest expense by $1.8 million. The amount outstanding under the existing
Subordinated Notes accrues interest at a weighted average fixed rate of 12.93%.
Based on market conditions, we have estimated the fair value of the 13 1/8%
Notes as of September 30, 2002 to be $109.6 million. As of November 4, 2002 we
estimate the fair value of the 13 1/8% Notes to be $94.3 million.

ITEM 4. CONTROLS AND PROCEDURES

Within the 90 days prior to the date of this Quarterly Report, the Company
carried out an evaluation, under the supervision and with the participation of
the Company's management, including the Company's Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures (as defined in Rules 13a-14(c) and
15d-14(c) under the Securities Exchange Act of 1934). Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company's disclosure controls and procedures are effective in ensuring
that information required to be disclosed in the reports the Company files and
submits under the Exchange Act is recorded, processed, summarized and reported
as and when required.

There were no significant changes in the Company's internal controls or in
other factors that could significantly affect such internal controls subsequent
to the date of the evaluation described in the paragraph above, including any
corrective actions with regard to significant deficiencies and material
weaknesses.

24

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Quarterly Report on Form 10-Q for the quarter
ended September 30, 2002, to be signed on its behalf by the undersigned
thereunto duly authorized.

KNOWLES ELECTRONICS HOLDINGS, INC.

By /s/ JAMES H. MOYLE
------------------------------------
James H. Moyle,
Vice President & CFO,
(As duly authorized officer and as
the principal financial and
accounting officer)

Date: November 14, 2002

25

CERTIFICATION

I, John J. Zei, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Knowles
Electronics Holdings, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of material fact or omit to state any material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have;

a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;

b. evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and

c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrants auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent function);

a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date: November 14, 2002

/s/ JOHN J. ZEI
--------------------------------------
John J. Zei
President and Chief Executive Officer

26

CERTIFICATION

I, James H. Moyle, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Knowles
Electronics Holdings, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of material fact or omit to state any material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have;

a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;

b. evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and

c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrants auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent function);

a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date: November 14, 2002

/s/ JAMES H. MOYLE
--------------------------------------
James H. Moyle
Vice President and Chief Financial
Officer

27

EXHIBIT INDEX

4.5 Note Purchase Agreement dated August 28, 2002 between
Knowles Electronics Holdings, Inc., the Subsidiary
Guarantors and Key Acquisition LLC
10.23 Employment Agreement between Knowles Electronics Holdings,
Inc. and James H. Moyle