Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 333-40076

Knowles Electronics Holdings, Inc.

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Title of Each Class

     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 þ          No o

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes o          No þ

          There is no voting stock held by non-affiliates of the registrant. This Annual Report is being filed by the registrant as a result of undertakings made pursuant to Section 15(d) of the Securities Exchange Act of 1934.

KNOWLES ELECTRONICS HOLDINGS, INC.

FORM 10-K

CONTENTS

1

Table of Contents

PART I

Overview

      We are a leading international manufacturer of technologically advanced products in micro-acoustics. Since our company was founded in 1946 by Hugh and Josephine Knowles, we have leveraged our core competency in acoustic technology to build expertise in hearing aid transducers, electromechanical components, low voltage integrated circuit design, micro-electrical mechanical systems (MEMS) and precision manufacturing. We have operations around the world with the largest facilities in the United States, China and Malaysia. During 2003, we sold our SSPI and Ruwido (“Infrared”) businesses, and in 2002 we sold Ruf Electronics allowing us to concentrate on our core Micro-acoustics business. Our 2003 results from continuing operations reflect revenue, operating income and EBITDA, of $154.0 million, $37.0 million and $44.4 million, respectively. We manufacture and market micro-acoustic products with strong market share positions in several key markets, including the hearing aid market. In December 2002 we introduced the world’s first silicon microphone, which gained commercial viability in 2003, reflecting its considerable opportunity for growth beyond our traditional markets. We believe that we have achieved these positions in our markets as a result of our strong customer base, technological expertise, international low cost manufacturing capability and capable management team. Our principal executive offices are located at 1151 Maplewood Drive, Itasca, Illinois 60143, and our telephone number is (630) 250-5100.

Products

      Knowles develops, manufactures, and supplies audio communications components, primarily miniaturized microphones and receivers used in hearing aids, microphones, headsets, and accessories for the computer and communication industries. The Company is the world’s largest manufacturer of high quality transducers, which are used for hearing aid and other high quality applications. We estimate our market share to be approximately 75% of the worldwide market for these sophisticated products, and have held a major share of the transducer market for over 30 years. The transducer is the name given to both the microphone and the receiver in a hearing aid and other acoustic products that require the accurate and controlled amplification of sound. The microphone converts surrounding sounds to electronic signals. Circuitry then modifies the signal over the audio frequency spectrum. These signals are transferred to the receiver, which then converts the signals to sound. Knowles often customizes transducers to meet the specifications of our customers, and in certain cases develops transducer designs in partnership with our customers. We have consistently and successfully maintained our market share over the years due to our long-standing relationships with a wide range of customers, value-added services and technological leadership.

      Knowles also provides a number of additional micro-acoustic devices that benefit from the company’s core competency in technology, design and manufacturing of subminiature acoustic products for applications outside the hearing aid industry. The company’s capabilities in MEMS (Micro Electro Mechanical Systems), software, and high volume electronic components make Knowles uniquely qualified to provide value added solutions for growth markets such as mobile communications and consumer electronics. We produce and develop a range of microphones, speakers, software, and custom acoustic assemblies primarily for sale to original equipment manufacturers in these markets. Products developed for these markets include the world’s first Silicon Microphones, ECMs (electret condenser microphones), and Custom microphone assemblies.

      Knowles also uses its knowledge of the hearing aid market, its engineering strengths and manufacturing expertise in the production of electromechanical components used in hearing aids including switches, trimmers, volume controls and telecoils.

2

Table of Contents

Competitive Strengths

      Our strong market position is attributable to the following competitive strengths:

	•	We have been a market leader in micro-acoustic transducers for the hearing aid industry for more than 30 years, and our worldwide market share of high quality transducers for hearing aid applications is approximately 75%. We protect our leading market share by maintaining strong relationships with all of the key manufacturers that require high quality transducers including hearing aid manufacturers, pro-audio manufacturers, manufacturers of security products and medical device manufacturers. We offer transducers for all categories and often customize models to meet the specifications of manufacturers.

	•	We believe that we are a technological leader in each of our products. We offer an advanced transducer product line that covers a variety of technologies, applications and markets including the most comprehensive product offering to the hearing aid industry and our recent introduction of a MEMS-based surface mount silicon microphone. The Company has been setting the standard for both miniaturization and performance as a technology leader in the transducer market for hearing aids for over 30 years. We are also at the forefront of the development of MEMS (micro electro mechanical systems) products as a result of our semiconductor knowledge and our 50 years of experience in acoustics. We believe that we are the first microphone maker to manufacture a MEMS-based surface mount silicon microphone.
	•	To enhance our technological expertise, we emphasize research and development investment. Our 2003 research and development expenditures were $10.2 million, or 6.6% of net sales. We have demonstrated leadership in developing new technologies and have the scale to devote substantial resources toward product development. In addition, we have strategically established patent protection for our products while creating manufacturing processes that competitors cannot readily replicate.

	•	Since our founding more than 50 years ago, we have developed an international network of well-equipped manufacturing facilities. We operate 5 manufacturing facilities in the United States, Malaysia and China. We have a proven capability of moving manufacturing to lower cost environments. Our manufacturing facilities are not unionized. In March 2000, we announced plans to consolidate our worldwide manufacturing operations. The consolidation plan included outsourcing some activities performed in our U.S. operation and ceasing production in the United Kingdom and Taiwan. Production from those operations was moved to China and Malaysia. In December 2003 we announced that our Elgin, Illinois facility will be closed by the end of 2004. The majority of manufacturing activity will be transferred from Elgin to our locations in China and Malaysia, which will be expanded to accommodate the additional volume. Certain high value operations will be consolidated into our headquarters facility in Itasca, Illinois. Our manufacturing operations operate at high quality levels while maintaining cost effectiveness.
	•	The manufacturing life cycles of some transducers, particularly models for less technologically advanced applications, have been as long as 25 years, reducing our production development costs and allowing us to improve the efficiency of our manufacturing processes. In general, we use automated sub-assembly operations and manual final assembly operations. For low volume products, we employ subcontractors, which provide us with cost structure flexibility and allow us to change capacity quickly based on product demand.

3

Table of Contents

Growth Strategy

      We set the standard for engineering excellence in our markets. Our principal objective is to increase revenues, cash flow and profitability by strengthening our leading market positions in our existing products in this core business and applying our technological expertise to new growth opportunities in related products and markets. The primary components of our strategy are to:

      Our worldwide share of the hearing aid transducer market is approximately 75% and we have been a market leader in transducer technology for over 30 years. We believe we will increase our sales as the hearing aid industry continues to expand. Hearing aid penetration into the market of potential users has historically been low, ranging from approximately 22% in the United States to less than 1% in some emerging economies. The hearing aid industry is projected to grow based on the following trends:

	•	Advances in the technology of hearings aids, leading to better customer satisfaction
	•	Improvement in the cosmetic appearance of hearing aids
	•	Growth in the elderly population
	•	Increases in the sale of binaural hearing aids
	•	Increases in the international penetration of hearing aids into developing economies

      Our strategy is designed to capitalize on these trends and develop products designed to expand the hearing aid and hearing aid component market. For example, we have developed transducers for directional hearing aids, which provide better performance than single microphone hearing aids and require three or more, rather than two, transducers per hearing aid. To increase hearing aid market growth, we also collect market data that identifies consumer needs and work with industry participants to improve market penetration.

      In addition to hearing aids, our transducers are used in pro-audio, broadcast and radio communications, and medical devices. We are expanding our product offering and using our application engineering expertise to solve customer needs in all of these growing markets that require high quality micro-acoustic solutions.

      We have introduced and begun to sell the world’s first high volume silicon surface mount microphone. This microphone’s environmental robustness enables it to perform in harsh environments such as automobiles. Since the SiSonic^TM Silicon Microphone can withstand high temperatures, it can be mounted to printed circuit boards using pick and place soldering equipment, thereby eliminating costly manual installations currently required for many microphone applications. It is ideal for high volume applications like mobile phones.

      We expect to continue combining our core competency in acoustics with other technologies such as MEMS and analog and digital electronics to provide technology solutions for high growth markets, including mobile communications and consumer electronics. We have developed several new technologies and products for these markets including:

      Intellisonic^TM Far-Field Microphone Software — To support emerging markets such as interactive video on demand and voice over internet protocol (VOIP) via portable devices, we have developed a signal processing software to enable clear processing of voice signals in a noisy environment, such as an automobile or within large crowds. This technology will facilitate clear voice communications and differentiate between audio inputs, an important feature in these growing markets.

4

Table of Contents

      Custom Acoustic Assemblies — we continue to introduce new acoustic assemblies, built to customer specification on an OEM basis. Examples of these are headsets produced for call center, cellular phone accessory, and PC markets.

      We have well-established customer relationships. We plan to continue to strengthen our existing relationships and develop new relationships through the following.

	•	Customizing the design of transducer models to meet the specifications of individual hearing aid manufacturers. We also conduct joint research and product development with selected customers.
	•	Continuing to expand our geographical presence around the world in order to better serve the increasing demand for micro-acoustical products from OEM electronics manufacturers.

      We believe that we are the lowest cost producer of hearing aid quality micro-acoustic transducers due to our significant market share, our relatively large volumes, our effective sourcing processes and our successful transfer of production to lower cost areas. We have more than 25 years of experience operating on a worldwide scale. During this time, we have developed manufacturing and management systems that allow us to operate low cost offshore facilities without compromising either quality or level of service. After the completion of our restructuring efforts in 2004, nearly all of our manufacturing activity will be located in China and Malaysia to benefit from both their lower cost labor markets and proximity to emerging product markets.

Products

      Microphones. We have leveraged our microphone technology to create the widest selection of subminiature microphones that we supply to original equipment manufacturers for a diverse set of applications. Our offering of microphones include: Silicon microphone, low cost electrets, world’s smallest microphone, ultra low noise microphones, low vibration microphones, noise canceling microphones, and waterproof microphones. Applications for our products include hearing aids, mobile phones, PDAs, tablets, cellular headsets, monitors, military, radio communications, and sensors.

      Receivers/ Speakers. We manufacture the largest offering of balanced armature receivers/speakers used in hearing aids, pro-audio, broadcast and radio communications, and medical devices. We are expanding our offering in high-end consumer electronics applications such as high fidelity MP3 earphones and cellular accessories.

      Custom Acoustic Assemblies. We manufacture (on an OEM basis) a variety of wired/noise canceling headsets used in general telephony markets such as mobile accessories and computer telephony applications, including internet based telephony and voice recognition. The company also markets boom-mounted microphones for use in conference rooms, helmets, aerospace and civil/military communications; condenser microphones assemblies for laptop computers, wireless phones and modem accessories; computer monitor microphones and lapel microphones.

      Software. We are developing and marketing a broad line of software products to improve the quality of the speech signal prior to transmission. Software under development includes: acoustic echo cancellation, noise suppression, interference canceling, and beam forming. These technologies can be used separately or together with one or more microphones (in an array) to enhance the user experience in applications where the user is not positioned close to the microphone and competing noises degrade voice quality.

      Electromechanical Controls. We have developed a broad line of electromechanical controls for hearing aid manufacturers including trimmers, switches, volume controls and connectors. Building on our strong customer relationships in transducers, our engineering capability in hearing aid components and our strength in low cost manufacturing, we expect these products will provide us with significant growth.

5

Table of Contents

Research and Development

      Our 2003 research and development expenditures were $10.2 million, or 6.6% of net sales. We have a team of 63 scientists, engineers and technicians located primarily in Itasca, Illinois and in Taiwan. Research and development efforts for transducers, micro-electro mechanical systems for the production of silicon microphones, signal processing technology and far field microphone technology are conducted in the United States. Custom acoustic assembly and microphone product development are conducted in Taiwan. In 2003, we focused our research and development activities in two key areas. First, we are intensely focused on providing the best technology in the world in high quality transducers for all applications. Secondly, we are carrying out extensive research and development on producing and expanding our product portfolio in silicon microphones using the micro machining of silicon (also referred to as micro-electro mechanical systems), MEMS packaging and integration of additional electronic functionality.

      We believe that our ability to rapidly develop new transducers with superior performance is critical to sustaining our market share and margins. Applied research and advanced modeling lead to new and creative products, which we believe gives us a competitive advantage as manufacturers who use micro-acoustic technology look to us for improvements in their components.

      New transducer products and improvements recently introduced include receivers with improved maximum power output and reduced vibration sensitivity using our unique and innovative Pantograph design; significantly reduced vibration with magnetic shield outer housing; and screenless damping using Ferrofluid®. Microphone improvements that have recently been introduced include a analog/digital (A/ D) signal converter, programmable digitally controlled gain amplifier, conjoined ultra-thin microphone pairs, noise reduction, improved electrostatic discharge thresholds and significantly reduced cellular telephone interference.

      Our research and development focus on the silicon microphone in 2003 allowed us to move this highly innovative product from design concept to the production quantities required from high volume markets such as cellphones and MP3 players. We believe that we have a leading position in this application of micro-electro mechanical systems. Additional research and development activities will focus on expanding the functionality of the Sisonic product to meet and exceed customer requirements and expand the applications to a wider market place.

Manufacturing

      We operate from five manufacturing facilities in the United States, Malaysia and China. We believe that our facilities meet our present needs and that our properties are generally well maintained and suitable for their intended uses. We believe that we generally have sufficient capacity to satisfy the demand for our products in the foreseeable future. We periodically evaluate the composition of our various manufacturing facilities in light of current and expected market conditions and demand. With the closure of our Elgin, Illinois facility at the end of 2004, we will be expanding our operations with additional facilities in our Penang, Malaysia and Suzhou, China locations. These new facilities will be in the place by the end of the second quarter of 2004 and will add approximately 55,000 square feet of assembly capacity and 25,000 square feet of metal fabrication capacity.

      In March 2000, we announced plans to consolidate our worldwide manufacturing operations, including the ceasing of production in the United Kingdom and Taiwan and outsourcing some activities performed in the United States. In December 2003 we announced that our Elgin, Illinois facility will be closed by the end of 2004. Certain high value manufacturing operations will be consolidated from Elgin into our headquarters facility in Itasca, Illinois with the balance of manufacturing operations transferred to our locations in China and Malaysia, which will be expanded to accommodate the additional activity. Our manufacturing operations operate at the highest quality levels and we believe our costs are significantly lower than our competitors.

      After the completion of our restructuring actions, our production space will be approximately 75% utilized. Our transducer manufacturing facilities are ISO 9001:2000 certified. Our manufacturing processes

6

Table of Contents

Sales and Marketing

      Sales and marketing efforts are organized to reflect the different markets of our customers. We serve the hearing aid industry through the 24 people in our direct sales group, which operates from offices in Illinois, United Kingdom and Japan. An independent sales representative covers Australia. Pricing of transducer products are based on a volume/price grid in which volume discounts are provided based on actual purchases. From time to time, we reduce prices to meet competition. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

      The markets for electro-acoustical products from the military, medical, professional audio, and OEM electronics manufacturers are sold through a direct sales force of 25 people and independent sales representatives. This sales force and independent sales representatives are located in the United States, Mexico, United Kingdom, Germany, France, Japan, Taiwan, China, Korea, and Australia.

Customers

      We are the principal transducer supplier worldwide to the major hearing aid manufacturers that include GN Resound, Interton, Oticon, Phonak, Rion, Siemens, Sonic Innovations, Starkey Laboratories and Widex; medical device manufactures such as Guidant; and pro-audio manufacturers such as Shure. In addition, we are a major supplier of micro-acoustic devices for electronics manufactures including Plantronics, Phillips and HTC. In 2003, we had four customers that each represented more than ten percent of our consolidated sales and accounts receivable. As a group, these four customers represented 60 percent of our consolidated sales.

Competition

      We have held a major share of the transducer market for hearing aids for over 30 years, holding an estimated worldwide market share of approximately 75% in 2003. Our principal competitor is SonionMicrotronic, which we believe had a significant portion of the remaining market share in 2003. SonionMicrotronic generally prices their products below our pricing levels, but the difference in prices has moderated with the increase in the value of the Euro compared to the U.S. Dollar since 2002.

      The markets for micro-acoustic products outside the hearing aid industry are highly competitive and in many cases highly fragmented. We compete with many companies using various technologies in these markets, generally on the basis of technological expertise, price, product quality, reliability and on-time delivery. These competitors include large consumer electronics, communications equipment and acoustic component product companies as well as a number of smaller specialized companies.

Patents, Copyrights and Trademarks

      Patents play an important role in the strategy for each of our business units. As a matter of practice, we follow an aggressive program of filing patent applications for all new design and development concepts as soon as practical, subject to review for patentability, technical and commercial feasibility and approval by the appropriate business unit. We currently have approximately 170 patents issued in 15 countries around the world. In addition, we have more than 70 patent applications pending, reflecting our high level of focused activity on improving key areas of micro-acoustic technology.

      In addition to patents, we have more than 50 trademarks registrations and applications for registration in 20 countries around the world and 8 registered domain names for Internet web sites.

      We have five registered copyrights, as well as a number of unregistered copyrights in our original works of authorship. In addition, we have in excess of 100 unregistered trade names used to identify our products and a number of trade secret processes used to design and manufacture our products.

7

Table of Contents

      Our patents and other intellectual property rights may not protect us from competition. In addition, patents by their nature are of limited duration, and several of our patents will expire during the next few years.

Employees

      We had 2,166 employees as of December 31, 2003. Of these, approximately 70% were direct production employees and 30% were staff. Geographically, 302 of our employees are based in North America, 26 in Europe and 1,838 are based in Asia. None of our employees belongs to a labor union. We have good relationships with our employees and turnover is relatively low.

Environmental Matters

      Our facilities, like similar manufacturing facilities, are subject to a range of stringent environmental laws and regulations, including those relating to air emissions, wastewater discharges, the handling and disposal of solid and hazardous waste, and the remediation of contamination associated with the current and historic use of hazardous substances or materials. Based on the information available to us, environmental laws currently in force and the advice and assessment of our environmental consultants, we do not consider that we have any material environmental liabilities or failures to comply with applicable environmental laws.

Regulation

      Hearing aid manufacturers are subject to a variety of regulatory agency requirements in the United States and in various other countries in which they sell hearing aids. Manufacturers of hearing aids are subject to the United States Food, Drug, and Cosmetic Act and other federal statutes and regulations governing, among other things, the design, manufacture, testing, safety, labeling, storage, record keeping, reporting, approval, advertising and promotion of medical devices.

      Sales of hearing aids outside the United States are also subject to regulatory requirements that vary from country to country. Similar requirements to those in place in the United States are imposed on hearing aid manufacturers by the European Union. All hearing aid manufacturers are required to obtain quality assurance certifications for their components to sell their products in the European Union. Accordingly, we maintain ISO 9001:2000 quality assurance certifications, which subject our operations to periodic surveillance audits.

INDUSTRY

      We apply our acoustic technology capabilities in several markets including:

Hearing Aids

      Hearing aids have three basic internal components: a microphone, signal processing and amplification circuitry, and a receiver. The microphone is located at the top of the hearing aid and converts surrounding sounds to electronic signals. The circuitry then modifies the signal over the audio frequency spectrum. These signals are transferred to the receiver, which then converts the signals to sounds in the ear. The transducer is the name given to both the microphone and the receiver. Transducers are critical to the performance capabilities of any hearing aid. Without high performance transducers, the processing capabilities of hearing devices are ineffective.

      The overall market for hearing aids improved in the second half of 2003 after stagnating in 2001 and 2002 and the first two quarters of 2003. The United States is currently the world’s largest market for hearing aids. Hearing aid sales in the U.S. increased by 12% and 10% in the third and fourth quarters of 2003, respectively, compared to the prior year period, according to the Hearing Industries Association, an industry trade group. For the total year 2003, hearing aid sales in the United States increased 4.9% over the prior year. The increased demand is caused by a combination of factors, including an improved economic outlook, technological advances in hearing aids, and a growing population in the target market.

8

Table of Contents

      In the longer term, a number of significant factors are expected to increase the demand for hearing aids including:

	•	Technological advances. Advances in recent years have increased consumer satisfaction by decreasing the size and improving the performance of hearing aids. The development of programmable, digital and multiple microphone devices, greater applicability of computer software, increased use of high technology circuitry, enhanced performance in noisy environments and improved hearing aid casings are expected to further improve product performance and increase consumer satisfaction.
	•	Fitting and after sales care. Improved fitting of hearing aids, both physically and audiologically, is an important factor affecting growth of the hearing aid market. Dispensers are improving after-sales care of patients and their hearing aids, including personal visits to older clients, which promises to improve customer satisfaction with hearing aids.
	•	Improvement in cosmetic appearance. Through technological advances, some higher priced hearing aids have become so small that they are virtually invisible, although occlusion or blockage in connection with their use must be managed.
	•	Growing elderly population. 30% of the population over the age of 65 has historically had a hearing loss problem. The 2000 U.S. Census indicated that 35 million people were age 65 or older. The U.S. Census Bureau also projects that the population age 65 or older will be 39.7 million people in 2010, and five years later in 2015, 46 million.
	•	Greater use of binaural hearing aids. Clinical data has demonstrated that the use of binaural hearing aids (i.e., two hearing aids per user) benefits individuals with a hearing loss in both ears. Increased use of binaural hearing aids would result in more transducer sales (four or more per hearing aid user instead of two). The increased use of binaural hearing aids represents a special opportunity in Europe, where the use of binaural is significantly lower than in the United States.
	•	Undiagnosed hearing loss. Approximately 10% of the U.S. population has some form of hearing loss, and a relatively high proportion of this population is either unaware of their hearing loss since it has occurred gradually over time or has not sought medical advice. There are considerable opportunities to increase sales to this group by educating them on the signs of hearing loss and encouraging them to visit physicians who can diagnose the hearing loss and recommend purchase of a hearing aid.

      The development of a systematic program of routine hearing screening could also lead to significantly more referrals for treatment.

	•	International penetration. According to industry studies, approximately 10% of the population in developed countries could benefit from hearing aids, but only approximately 2% of the population in developed countries owns them. Since two-thirds of the worldwide population over 65 will be in developing countries by 2025, there are substantial opportunities for increased use of hearing aids in developing economies such as China, India and Eastern Europe, especially as disposable incomes rise.

Mobile Communications

      Mobile communication devices continue to expand in prevalence world wide, with over 520 million mobile phones sold in 2003, with a constant upgrade of features and capabilities driving an increase in demand. Many of the services have new voice-driven communications applications, thus requiring vendors with high volume manufacturing, significant acoustic application support and a broad line of voice input solutions. We are well positioned to capitalize on this market by selling key products to original equipment manufacturers including Silicon microphones, ECMs, custom assemblies and software for elimination of ambient noise.

9

Table of Contents

High End Consumer Electronics

      We manufacture the largest offering of balance armature receiver/ speakers used in pro-audio, broadcast and radio communications. The market for high fidelity audio continues to expand through new technology (MP3 players, cellular accessories, etc.).

Security Applications

      We manufacture a variety of high quality boom-mounted microphones and customer acoustic assemblies for use in helmets, aerospace and civil/military communications that require high quality audio response.

Medical Devices

      We manufacture a variety of high quality audio products that are successfully used in manufacturing medical devices that apply high quality micro-acoustic capabilities to several medical applications.

PROPERTIES

(1)	This facility is expected to be closed in September 2004.
(2)	Lease will not be renewed.
(3)	Occupancy March 2004, lease or purchase terms under negotiation.
(4)	Land lease expires 09/18/2049
(5)	Lease will be renewed.

      The Company has no material pending or threatened litigation.

10

Table of Contents

      Not applicable.

PART II

      Not applicable.

11

Table of Contents

See accompanying notes.

	(1)	The “Recapitalization expenses” consisted primarily of bonuses, special one-time recognition payments to employees, termination costs of a supplemental executive retirement plan and legal, accounting, public relations and other professional fees.
	(2)	The “Restructuring expenses” for the year 2000 thru 2002 are related to the restructuring announced in March 2000. The Company consolidated 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. Through December 2002, these actions reduced our global workforce by about 20%. The restructuring expense in 2003 is primarily related to the closure of our Elgin, Illinois facility announced in November 2003.
	(3)	Net income from discontinued operations in 1999 thru 2003 represents the activities of the Synchro-Start and Infrared businesses sold during 2003, and in 1999, the Finance Company of Illinois, an equipment financing business that was distributed to our preexisting stockholders on June 29, 1999. Years 1999 thru 2002 have been restated to reflect these discontinued operations.
	(4)	Effective January 1, 1997, our stockholders elected under the S Corporation rules of the Internal Revenue Code to have Knowles’ income included in their own income for federal income tax purposes. As a result of the Recapitalization, we terminated our S Corporation status for federal income tax purposes effective June 29, 1999. For informational purposes, the selected historical consolidated financial data includes an unaudited pro forma presentation of income taxes which would have been recorded if we had been a C Corporation.
	(5)	“EBITDA” is defined as earnings before interest, taxes, depreciation and amortization. For the years 2000, 2001, 2002 and 2003 EBITDA includes restructuring charges of $14,858, ($179), $2,112 and $1,532 respectively. EBITDA should not be construed as an alternative to operating income, or net income, as 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 and because of debt covenants based on a defined EBITDA. Because EBITDA is not

12

Table of Contents

		calculated under GAAP, it may not be comparable to similarly titled measures reported by other companies.

       Reconciliation of operating income to EBITDA:

	(6)	The ratio of earnings to fixed charges has been computed by dividing earnings available for fixed charges (income from continuing operations before income taxes and fixed charges) by fixed charges interest expense plus one-third of rental expense (the portion deemed representative of the interest factor). Knowles earnings were inadequate to cover fixed charges for the twelve months ended December 31, 1999, 2000, 2001 and 2002 by approximately $2.6, $14.8, $2.2 and $19.2 million, respectively.
	(7)	During the fourth quarter of 2001, the Company changed its method of determining the cost of domestic inventories from the LIFO method to the FIFO method. Prior year results have been restated to reflect the retroactive application of this tax accounting change; 2000 and 1999 results were decreased by $1,011 and $1,674, respectively.
	(8)	In November 2002 the Company sold its Ruf Electronics operations, which were part of the Automotive Components segment, and recorded a loss of $16,736. The loss includes $1,186 transferred from accumulated other comprehensive income. The proceeds from the sale were not material. The Company may receive additional payment amounts in 2004 and 2005 if the Ruf operations meet certain financial targets.
	(9)	The results for 1999 and 2000 have been restated to correct an error in the pension expense recorded by our U.K. facility, increasing operating income by $267 and $300, respectively, and to reduce restructuring expense in 2000 to reflect the $1.0 million pension curtailment gain that should have been recorded. Appropriate balance sheet accounts have also been restated. See Consolidated Financial Statement Footnote 2.

(10)

“EBITDA as adjusted” is defined as earnings before interest, taxes, depreciation and amortization; and for the year 1999 recapitalization expense; for years 2000 thru 2003 restructuring charges; for years 1999 thru 2002 EBITDA from Ruf Electronics (sold in 2002); and for the year 2002 loss on sale of business. EBITDA as adjusted is a key measurement used by management and presented solely as a supplemental disclosure.

       Reconciliation of EBITDA to “EBITDA as adjusted”:

(11)	Represents total cash flow from continuing and discontinued operations.

      The following discussion should be read in conjunction with the “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this report on Form 10-K.

13

Table of Contents

Overview

      We are a leading international manufacturer of technologically advanced microacoustic products. Since we were founded in 1946, we have leveraged our core competence in acoustic technology to build expertise in hearing aid transducer and low voltage integrated circuit design, electronic controls and precision manufacturing in the United States and other countries. We have numerous international operations with our largest facilities in the United States, China and Malaysia. We are strongly focused on reducing costs while simultaneously increasing quality. See Part I — Business Description for more details.

      The Company divested its non-core businesses during the last two years and is now focused on its core microacoustics business. On July 29, 2003 the Company completed the sale of its Ruwido Austria GmbH subsidiary, whose operations made up the Infrared division, to FM Electronic Holdings. On May 30, 2003 the Company completed the sale of its Synchro-Start division to Woodward Governor Company. In November 2002 the Company sold Ruf Electronics, a manufacturer of automotive sensors and controls. The financial statements for the period ending December 31, 2003 have been prepared with Ruwido and Synchro-Start accounted for as discontinued operations under Generally Accepted Accounting Principles (GAAP). Accordingly, the Synchro-Start and Ruwido businesses have been removed from the Company’s results of continuing operations for all periods presented. The assets and liabilities of the discontinued operations have been summarized as current and netted together for presentation on the balance sheet. The sale of Ruf is not accounted for as a discontinued operation under GAAP, but is included in the period up to its sale in November 2002 as component of continuing operations. With the sale of these three business units, the Company has focused its product offering in one business segment — Microacoustics. For more detail on the divestitures, see Consolidated Financial Statements Footnote 3, Discontinued Operations.

      The Company is highly leveraged as a result of its 1999 recapitalization. During 2003, the Company reduced debt by $51.4 million, and refinanced the $31.8 million “A” portion of its bank debt. As of December 31, 2003, the Company had no short-term debt and Notes payable of $288.2 million. No principal payments are due in the next twelve months. The Company is required to maintain certain leverage and interest coverage ratios in order to be in compliance with its Credit Agreement covenants and to access its revolving credit facility. The Company was in compliance with its leverage and interest coverage ratios and its other covenant requirements as of December 31, 2003 and expects to be in compliance through December 31, 2004. For more detail, see the Liquidity and Capital resources section below.

      Our 2003 revenue, operating income and EBITDA, as reported, were $154.0 million, $37.0 million and $44.4 million, respectively. Our 2003 EBITDA as adjusted (defined in Item 6. Selected Consolidated Financial Data, Footnote 10) was $45.9 million.

      Sales decreased $10.1 million in the twelve months ending December 31, 2003 because of the sale of Ruf in November 2002. Excluding Ruf sales of $14.2 million from the 2002 results, sales increased by $4.1 million or 2.7% in 2003 with increases in transducers, silicon microphones and electromechanical devices for the hearing aid market. Gross margin rates improved in 2003 due to the sale of Ruf and due to improved product reliability, better inventory controls and on going cost improvement programs. Operating expenses decreased by $2.7 million due to the sale of Ruf, but increased by $2.2 million or 5.8% when Ruf is excluded from the prior year period. The Company reported restructuring expenses of $1.5 million in 2003 (primarily accruals for restructuring related to the scheduled closure of our Elgin, Illinois facility) and restructuring expenses of $2.1 million in 2002 (primarily the loss on the sale of a facility in Taiwan and severance). The Company reported a $16.7 million loss on the sale of Ruf in 2002. Operating income increased by $22.4 million in 2003, primarily because of the 2002 loss on the sale of Ruf and improved operating results in 2003. The Company’s key performance indicator is EBITDA as adjusted, which improved by $3.0 million in 2003 due to the improved sales and gross margin rates. The increase in EBITDA was realized in the fourth quarter, primarily due to improved conditions in the market for hearing aids and favorable manufacturing costs. For more detail, see the Consolidated Results from Operations, below.

14

Table of Contents

      Net sales. We recognize sales when title to the products transfers to the customer, which typically is upon the shipment of products to the customers, and when collectability is reasonably assured.

      Growth in net sales for transducers is generally driven by growth in the market for hearing aids and to a lesser extent by the market for high quality micro-acoustic products in the security, medical and professional audio markets. There has been growing price competition in the market for hearing aid components over the last several years. Unit volumes increased in the worldwide market for hearing aids in the second half of 2003. We believe that this improvement in the hearing aid markets will continue in 2004 and will more than offset any decline in transducer prices in 2004.

      Net sales for microacoustic devises other than transducers have been driven by the emergence of new markets for acoustic technologies and our penetration of those markets. These markets have been growing substantially due to technological advances in and increased penetration of mobile communication devices, high-end consumer electronics, security applications, medical device manufacturers and a variety of specialty applications that require high performance acoustic performance. We realized a major milestone in December, 2002 with what we believe was the first commercial shipment of the world’s first surface mount microphone, based on semiconductor technology. In 2003 we continued to refine this innovative product and developed manufacturing methods that allowed us to ship the Silicon Microphone into markets such as cell phones in commercial quantities.

      Cost of sales. Our cost of sales consists mainly of materials, direct and indirect labor costs and other overhead. Other overhead includes depreciation, equipment and tooling maintenance, shipping and manufacturing supplies. Indirect labor payroll expense and production overhead expense make up the largest component of cost of sales. Materials makes up the next largest and direct labor payroll expense is the smallest component of cost of sales. Depreciation is included as an expense in the line item that corresponds to the asset being depreciated (i.e. manufacturing facilities are depreciated in cost of sales, headquarter facilities are depreciated in general and administrative expense). About 57% of our depreciation expense in 2003 and 2002 is reflected in cost of sales.

      A semi-skilled workforce performs most of our direct labor. Therefore, we have emphasized moving manufacturing to lower wage locations, including China and Malaysia. In March 2000, we announced plans, which we executed in 2000 and 2001 to consolidate our worldwide manufacturing operations, with a strong focus on Asia. We outsourced manufacturing activities previously performed at our Itasca and Rolling Meadow, Illinois facilities and ceased production at our manufacturing facilities in the United Kingdom and Taiwan. In November 2003 we announced that our Elgin, Illinois facility will be closed by the end of 2004. The majority of manufacturing activity will be transferred from Elgin to our locations in China and Malaysia.

      Our material costs primarily relate to unprocessed materials, including steel, copper wire, and magnet bar stock. We purchase certain integrated circuits, magnets and diaphragm assemblies customized specifically for its products from outside suppliers, some of which are single sourced. Our materials costs generally relate to similar unprocessed materials or commodities.

      Research and development. Research and development costs consist mainly of personnel cost, facilities and contract costs. The principal purpose of our research and development efforts is to strengthen our product offering, provide technical expertise to our customers and to provide new products for growth markets.

      Sales and marketing expense. Our sales and marketing expenses consist of personnel costs, advertising, market research and occupancy expenses. Our selling expenses have not been a significant portion of our period expenses, but are increasing due to our expansion in markets beyond the hearing aid industry, which requires additional sales and product management infrastructure to support future growth. We sell most of our products to original equipment manufacturers and distributors, through internal sales forces and outside sales agents.

      General and administrative expense. Our general and administrative expenses consist of personnel costs, legal, accounting and other professional costs, management information systems and rent.

15

Table of Contents

      We have replaced certain management information systems, requiring expenditures of approximately $11 million from 2000 through 2003. Approximately $8 million was spent in 2001, of which $6.6 million was capitalized. All locations now are integrated into the Company’s ERP system.

      Other income (expense). Other income (expense) consists of interest income, interest expense and miscellaneous expenses. Due to our recapitalization, interest expense was $35.8 million in 2003, $33.9 million in 2002 and $37.7 million in 2001. The increase in interest expense in 2003 was caused by the refinancing of the “A” portion of the bank debt with the higher interest “C” loan.

      Income taxes. Effective June 30, 1999, Knowles became a C corporation and subsequently, has been subject to federal income taxes. Income taxes were a small net benefit in 2000 due to our ability to use a net loss carry forward from 1999. The provision for income taxes exceeded pretax income in 2001 due to not being able to offset the profitable foreign operations with the U.S. loss arising from the interest expense. In 2002 the Company provided for $11.7 million of taxes despite a pre-tax loss of $19.2 million primarily due to providing a valuation allowance against the net U.S. deferred income tax assets. The valuation allowance was recorded due to the uncertainty of realizing the benefit of deferred tax assets as a result of continued U.S. losses created by the significant interest expense associated with the Company’s debt. Income taxes in 2003 were an expense of $0.5 million, with taxes on profitable foreign operations partially offset by a favorable adjustment to the valuation adjustment against the U.S. deferred tax asset.

      Foreign exchange exposure. Our revenues are primarily denominated in the U.S. dollar. To a much lesser degree we also have revenues billed in the Japanese Yen and the British Pound. Our expenses are principally denominated in those currencies, but are also denominated in the local currencies of China, Malaysia, and Taiwan. We do not hedge our foreign exchange exposure, since we generally incur significant costs in the same currencies in which we have sales. China has had a managed floating exchange rate since 1994 and the exchange rate to the U.S. Dollar has been effectively fixed since 1996. Malaysia has practiced a fixed exchange rate regime since 1998 and the exchange rate to the U.S. Dollar has been effectively fixed since then. An increase in the value of the Chinese or Malaysia currency relative to the U.S. Dollar would have an adverse effect on the Company’s cost of sales.

16

Table of Contents

Consolidated Results of Operations

      The table below shows the principal line items from our historical consolidated income statements. For the twelve months ending December 31, 2002 and December 2001, the consolidated results are shown with and without the Ruf business, which was sold in November 2002.

Key Changes in 2003

      Excluding the decrease caused by the November 2002 sale of Ruf, sales increased by $4.1 million in 2003 compared to the year earlier due to increases in sale of transducers for hearing aid and security applications, increased sales of the silicon microphone and sales of electromechanical devices to the hearing aid market.

      Gross margins as a percentage of revenue in 2003 increased due to the sale of Ruf and due to improved manufacturing efficiencies, improved inventory controls and reduced costs of warranty.

      Operating expenses decreased by $2.8 million in 2003, with a $4.9 million decrease caused by the sale of Ruf only partially offset by a $2.1 million increase in ongoing expenses, primarily general and administrative expenses.

      The sale of Ruf in November 2002 resulted in a loss on the sale of the business of $16.7 million in 2002. Restructuring expenses of $1.5 million in 2003 were primarily an accrual for expected severance costs related to the Company’s expected closure of its Elgin, Illinois manufacturing facility in 2004. Restructuring expenses in 2002 of $2.1 million included a $1.2 million loss on the sale of a facility in Taiwan and severance expenses.

      Operating income increased by $22.4 million in 2003, primarily due to the $16.7 million loss on the sale of Ruf in the prior year and improved sales and margins, only partially offset by increased operating expenses.

      Interest expense increased by $2.0 million in 2003, primarily due to the refinancing of the $31.7 million “A” portion of the bank debt at a higher interest rate partially offset by reduced borrowing levels.

      Income from continuing operations before tax increased by $20.4 million, with $16.7 million of the increase due to the loss on the sale of Ruf that was recorded in 2002 and $1.3 million due to the operating loss associated with Ruf in 2002. In addition, income from continuing operations increased by $2.4 million due to improved sales and margins, partly offset by higher operating expenses and higher interest expenses.

17

Table of Contents

      EBITDA as adjusted increased from $42.9 million in 2002 to $45.9 million in 2003 primarily due to increased sales and improved gross margins.

      For more detail on results of operations, see the section below, “Year Ended December 31, 2003 Compared to Year Ended December 31, 2002”.

      As a percentage of net sales, results for the last three years were as follows —

      Operating income excluding Ruf was 24.0% in 2003 compared to 21.7% in 2002 and 24.1% in 2001. EBITDA as adjusted was 29.8% in 2003 compared to 28.6% in 2002 and 29.9% in 2001.

      The improved profitability as a percentage of sales in 2003 was due to the increased sales of transducers and electromechanical products; improved gross margin rates created by improved manufacturing efficiencies; improved inventory controls and reduced costs of warranty.

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002