KNOWLES ELECTRONICS HOLDINGS INC - 10-Q Quarterly Report

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, 2004


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


1151 Maplewood Drive Itasca, Illinois (Address of principal executive offices)		60143 (Zip Code)

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 o

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

Part I — Financial Information

KNOWLES ELECTRONICS HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)


	Three months ended						Nine months ended
	September 30,						September 30,
	2004			2003			2004			2003
	(In thousands)						(In thousands)
Net sales	$	46,511		$	34,660		$	136,613		$	111,070
Cost of sales		27,109			17,483			76,154			55,357

Gross margin		19,402			17,177			60,459			55,713
Research and development		2,906			2,538			8,485			7,708
Selling and marketing		2,940			2,260			8,270			6,682
General and administrative		5,082			4,343			16,468			14,870
Impairment of assets held for sale		—			—			850			—
Restructuring activities		2,320			—			2,250			—

Operating income		6,154			8,036			24,136			26,453
Other income (expense):
Interest income		16			23			47			63
Interest expense		(8,176	)		(8,669	)		(24,980	)		(26,524	)
Loss on extinguishment of debt		—			—			(2,256	)		(1,100	)

Loss from continuing operations before income taxes		(2,006	)		(610	)		(3,053	)		(1,108	)
Income tax (benefit)		(203	)		567			1,015			1,854

Loss from continuing operations		(1,803	)		(1,177	)		(4,068	)		(2,962	)
Income from discontinued operations:
Income from discontinued operations		—			1,091			—			27,825

Net income (loss)	$	(1,803	)	$	(86	)	$	(4,068	)	$	24,863

Knowles Electronics Holdings, Inc.

Consolidated Balance Sheets

(In thousands except share data)


	September 30,			December 31,
	2004,			2003,
	(unaudited)
Assets
Cash & cash equivalents	$	8,762		$	11,227
Accounts receivable, net		21,680			23,128
Inventories, net		24,685			17,373
Prepaid expenses and other		5,290			5,023

Total current assets		60,417			56,751
Property, plant and equipment, at cost:
Land		2,688			2,787
Building and improvements		12,454			19,273
Machinery and equipment		62,014			48,750
Furniture and fixtures		26,270			24,104
Construction in progress		10,936			11,743

Total property, plant and equipment		114,362			106,657
Accumulated depreciation		(62,798	)		(61,152	)

Property, plant and equipment less accumulated depreciation		51,564			45,505
Net assets held for sale		3,263			—
Other assets, net		1,473			3,149
Deferred finance costs, net		6,370			7,168

Total assets	$	123,087		$	112,573

Liabilities and stockholders’ deficit
Accounts payable	$	15,803		$	11,272
Accrued compensation and employee benefits		7,807			8,681
Accrued interest payable		9,615			4,868
Accrued warranty and rebates		2,570			5,902
Accrued restructuring costs		1,165			1,490
Other liabilities		1,952			2,645
Income taxes		1,792			3,784
Deferred income taxes		962			968

Total current liabilities		41,666			39,610
Accrued pension liability		13,287			12,350
Other noncurrent liabilities		1,624			407
Notes payable		298,719			288,180
Preferred stock mandatorily redeemable in 2019 including accumulating dividends of: $120,394 September 2004; $99,401 December 2003		305,393			284,401
Stockholders’ equity (deficit):
Common stock, Class A, $0.001 par value, 1,052,632 shares authorized, outstanding: 952,500 September 2004; 957,500 December 2003		1			1
Common stock, Class B, $0.001 par value, 52,632 shares authorized: none ever issued		—			—
Capital in excess of par value		16,337			16,487
Accumulated deficit		(545,887	)		(520,826	)
Accumulated other comprehensive loss		(8,053	)		(8,037	)

Total stockholders’ deficit		(537,602	)		(512,375	)

Total liabilities and stockholders’ deficit	$	123,087		$	112,573

Knowles Electronics Holdings, Inc.

Consolidated Statement of Cash Flows

(unaudited)


	Nine Months Ended September 30,
	2004			2003
	(in thousands)
Operating Activities
Net loss from continuing operations	($	4,068	)	($	2,962	)
Adjustments to reconcile net loss from continuing operations to net cash provided by operating activities:
Depreciation and amortization		5,766			5,617
Restructuring activities		(325	)		(1,015	)
Amortization of deferred financing fees and debt discount		1,461			1,241
Loss on extinguishment of debt		2,256			1,100
Impairment of assets held for sale		850			—
Inventory obsolescence provision		1,151			978
Deferred income taxes		(6	)		(1,044	)
Loss on disposal of assets		240			160
Change in assets and liabilities:
Accounts receivable		1,448			1,864
Inventories		(8,463	)		2,173
Other assets		(592	)		351
Accounts payable		4,531			(2,844	)
Accrued interest payable		4,747			3,068
Accrued compensation and benefits		(874	)		885
Other current liabilities		(4,025	)		(4,604	)
Other noncurrent liabilities		2,154			917
Income taxes payable		(1,992	)		(101	)
Net cash provided by discontinued operating activities		—			3,633

Net cash provided by operating activities		4,259			9,417
Investing Activities
Proceeds from sale of businesses		2,000			45,722
Purchases of property, plant, and equipment, net		(16,178	)		(5,752	)

Net cash provided by (used in) investing activities		(14,178	)		39,970
Financing Activities
Debt payments — long term		(37,667	)		(84,802	)
Debt proceeds — long term		48,000			35,000
Costs associated with debt		(1,633	)		(1,749	)
Premium on early retirement of debt		(1,080	)		—
Common stock transactions		(150	)		(350	)

Net cash provided by (used in) financing activities		7,470			(51,901	)
Effect of exchange rate changes on cash		(16	)		(43	)

Net change in cash and cash equivalents		(2,465	)		(2,557	)
Cash and cash equivalents at beginning of period		11,227			23,879

Cash and cash equivalents at end of period	$	8,762		$	21,322

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In Thousands)

September 30, 2004 and 2003

(unaudited)

1. Basis of Recapitalization and Presentation

The unaudited consolidated financial statements include the accounts of Knowles Electronics Holdings, Inc. and its subsidiaries (Company). All material intercompany accounts, transaction and profits are eliminated in consolidation.

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 results for the period ended September 30, 2004 do not necessarily indicate the results that may be expected for the full year ending December 31, 2004. For further information, refer to the Company’s consolidated financial statements and notes thereto included in the Company’s Form 10-K dated for the year ended December 31, 2003.

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.

The Recapitalization was 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.

2. Discontinued Operations

The Company’s consolidated financial statements and related footnote disclosures reflect the Synchro-Start and Infrared (Ruwido) businesses as discontinued operations, net of applicable income taxes, for all periods presented in accordance with SFAS No. 144 — Accounting for the Impairment or Disposal of Long-Lived Assets. As such, discontinued operations includes the January 2003 thru May 2003 operating results of the Synchro-Start business, the sale of which was completed May 30, 2003. Discontinued operations also includes the January 2003 thru July 2003 operating results of the Infrared business, the sale of which was completed July 29, 2003.

The Synchro-Start division was part of the Company’s Automotive Components reporting segment. The Infrared business was part of the Company’s Acoustic and Infrared Technology reporting segment. The Company has subsequently modified its segment reporting, see Footnote 7. Segment Information.

Operating results of the discontinued business for the three and nine months ended September 30, 2003, respectively, are as follows:


	Three months ended			Nine months ended
	September 30,			September 30,
	2003			2003
Sales	$	1,207		$	26,513

Income from discontinued operations	$	(462	)	$	1,102
Income tax expense		—			(169	)

Income from discontinued operations, net of tax	$	(462	)	$	933

Gain on disposal of Synchro-Start division	$	1,121		$	36,294
Income tax expense		—			(1,000	)

Gain on disposal of Synchro-Start division, net of tax	$	1,121		$	35,294

Loss on disposal of Infrared division	$	432		$	(8,402	)
Income tax benefit		—			—

Loss on disposal of Infrared division, net of tax	$	432		$	(8,402	)

The Company sold Synchro-Start for $49.7 million May 30, 2003. The Company retained pension liabilities of $3.5 million associated with the pension plan covering U.S. employees. As of December 2003, the Company recorded a pre-tax gain on the sale of Synchro-Start of $36.3 million. The tax on the gain was $0.7 million which reflects an alternative minimum tax created by the transaction. The benefit of the carryforward of the alternative minimum tax credit has not been recognized due to the uncertainty of the realization of this benefit. The tax on the gain was limited to the alternative minimum tax due to the utilization of net operating loss carryforwards that had previously not been benefited.

The Company sold the Infrared business for $0.1 million on July 29, 2003 and the buyer retained debt of $4.0 million. As of December 2003, the Company recorded a pre-tax loss on the sale of $8.6 million. No tax benefit from the loss was recorded because the loss is netted against the gain on the Synchro-Start sale and the tax on that net gain is offset by the utilization of net operating loss carryforwards that had previously not been benefited.

3. Accumulated Other Comprehensive Income (Loss)

For the nine months ended September 30, 2004 and 2003, total comprehensive income (loss) amounted to ($4,084) and $26,394, respectively. For the three months ended September 30, 2004 and 2003, total comprehensive loss amounted to ($1,809) and ($90), respectively. The difference between net income (loss) and comprehensive income (loss) is related to the Company’s foreign currency translation.

4. New Accounting Standards

In May 2003, the FASB issued SFAS No 150 — Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 requires certain obligations including mandatorily redeemable preferred stock to be reflected as liabilities in the balance sheet. Additionally, dividends paid or accrued on mandatorily redeemable preferred stock will be presented as interest expense in the income statement. We adopted the provisions of SFAS 150 on January 1, 2004. Since the Company’s preferred stock contains provisions whereby the preferred stock and accumulated dividends may be converted to common stock, the preferred stock and its dividends continue to be reflected as such. There was no material impact on our financial position or results of operations as a result of the adoption of SFAS 150.

5. Inventory

Inventories are as follows:


	September 30,			December 31,
	2004			2003
Raw materials	$	13,134		$	9,211
Work in process		1,779			1,341
Finished goods		15,439			10,969

		30,352			21,521
Less allowances for :
Obsolescence and net realizable value		(5,667	)		(4,148	)

	$	24,685		$	17,373

6. Notes Payable

As part of the Recapitalization transaction, the Company entered into a Credit Agreement dated June 28, 1999 and amended and restated as of July 21, 1999, and further amended and otherwise modified from time to time, most recently as of April 14, 2004, with certain lenders (“Credit Agreement”).

Knowles Electronics Holdings, Inc. obtained a Seventh Amendment to Credit Agreement and Second Amendment to Security Agreement as of April 14, 2004, amending the (i) Credit Agreement and (ii) the Security Agreement dated as of June 30, 1999 (as amended, restated, supplemented or otherwise modified from time to time), among Knowles Electronics Holdings, Inc., its U.S. subsidiaries and JPMorgan Chase Bank (successor to The Chase Manhattan Bank) as Administrative Agent (the “Seventh Amendment”). The Seventh Amendment, which became effective April 14, 2004, provides for Tranche D Term Loans due June 2007 in a principal amount of $48 million, the repayment in full of Tranche C Term Loans with part of the proceeds of Tranche D Term Loans and an amendment to the Credit Agreement’s interest coverage ratio and leverage ratio requirements, among other changes. Pursuant to the Seventh Amendment, the Company has repaid the outstanding principal balance under the Tranche C Term Loans, (which had an 18.5% interest rate) together with accrued interest thereon, together totaling approximately $36.0 million. The Company also paid a related prepayment penalty of $1.1 million and certain other fees to the lenders in connection with the Seventh Amendment.

The Credit Agreement as amended consists of approximately $155 million, which provides for revolving loans of $15 million (“Revolving Credit Facility”) through June 30, 2006 (unless the Tranche B Facility is paid in full prior to such date in which case the Revolving Credit Facility will cease to exist and any amounts outstanding thereunder shall become due and payable), a Tranche B Facility of $92 million (“Tranche B Facility”), which matures on June 29, 2007, and a Tranche D Facility of $48 million (“Tranche D Facility”), which matures on June 29, 2007. The Revolving Credit Facility bears interest, at the Company’s option, at either: (1) one-, two-, three-, or six-month LIBOR plus 4.0%, 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 3%. The Tranche B Facility bears interest, at the Company’s option, at either: (1) one-, two-, three-, or six-month LIBOR plus 5.00%, or (2) Alternate Base Rate plus an initial margin of 4.00%. The Tranche D Term Loans bear currently payable interest, at the Company’s option, at either: (1) one-, two-, three-, or six-month LIBOR plus 7.25%, or (2) the greatest of the prime rate, a base certificate of deposit rate plus 1.0% or the federal funds effective rate plus 0.50%, in each case plus an initial margin of 6.25%. At September 30, 2004, the weighted average interest rate was 6.1875% for the Tranche B Facility and 8.625% for the Tranche D Facility.

In September 2004, the Company repaid $2.0 million of the Tranche B Facility with $2.0 million of proceeds received from escrow that resulted from the sale of the Synchro-Start business in 2003.

The balance under the Tranche B, C and D Facilities, the 13 1/8% Senior Subordinated Notes (“13 1/8% Notes”), and the 10% Senior Subordinated Notes (“10% Notes”) is as follows:


	September 30,		December 31,
	2004		2003
Term B Facility	$	89,600	$	91,600
Term C Facility		—		35,668
Term D Facility		48,000		—
13 1/8% Senior Subordinated Notes, net of discount		151,119		150,912
10% Senior Subordinated Notes		10,000		10,000

Total long-term notes payable	$	298,719	$	288,180

As of September 30, 2004, there was no amount outstanding under the Revolving Credit Facility. The Company subsequently borrowed $9.0 million against the Revolving Credit Facility in October 2004.

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 Credit Agreement requires that the Company comply with certain covenants and restrictions, including specific financial ratios that must be maintained. As of September 30, 2004, the Company is in compliance with these covenants. If future actual results are lower than planned 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 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., Knowles Electronics Sales Corp. formerly known as Emkay Innovative Products, Inc. and Knowles Manufacturing Ltd. The following tables present summarized balance sheet information of the Company as of September 30, 2004 and December 31, 2003, summarized income statements for the three and nine months ended September 30, 2004 and 2003, and summarized cash flow information for the nine months ended September 30, 2004 and 2003. 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, 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, 2004 and December 31, 2003, summarized income statement for the three and nine months ended September 30, 2004 and 2003, and summarized cash flow information for the nine months ended September 30, 2004 and 2003 is as follows:


	September 30, 2004
	Parent			Guarantors			Non-Guarantors		Eliminations			Consolidated
Cash	$	18		$	5,139		$	3,605	$	—		$	8,762
Accounts receivable		—			30,681			60,597		(69,598	)		21,680
Inventories		—			6,193			18,492		—			24,685
Other current assets		—			2,070			3,220		—			5,290
Net property, plant and equipment		—			21,610			29,954		—			51,564
Assets held for sale, net of impairment		—			3,263			—		—			3,263
Investment in and advances to subsidiaries		101,346			376,126			1,148		(478,620	)		—
Deferred finance costs, net		6,370			—			—		—			6,370
Other non-current assets		—			1,122			351		—			1,473

Total assets	$	107,734		$	446,204		$	117,367	$	(548,218	)	$	123,087

Accounts payable	$	—		$	29,063		$	55,535	$	(68,795	)	$	15,803
Accrued restructuring costs		—			1,165			—		—			1,165
Advances from parent		228,165			87,280			342		(315,787	)		—
Other current liabilities		9,615			11,169			3,755		(803	)		23,736
Deferred income taxes		—			(7	)		969		—			962
Noncurrent liabilities		—			10,940			3,971		—			14,911
Notes payable		298,719			—			—		—			298,719
Preferred stock		305,393			—			—		—			305,393
Stockholders’ equity (deficit)		(734,158	)		306,594			52,795		(162,833	)		(537,602	)

Total liabilities and stockholders’ equity (deficit)	$	107,734		$	446,204		$	117,367	$	(548,218	)	$	123,087


	December 31, 2003
	Parent			Guarantors		Non-Guarantors		Eliminations			Consolidated
Cash	$	866		$	5,627	$	4,734	$	—		$	11,227
Accounts receivable		—			29,333		60,541		(66,746	)		23,128
Inventories		—			6,047		11,326		—			17,373
Other current assets		—			1,169		3,854		—			5,023
Net property, plant and equipment		—			25,609		19,896		—			45,505
Investment in and advances to subsidiaries		101,347			358,574		2,443		(462,364	)		—
Deferred finance costs, net		7,168			—		—		—			7,168
Other non-current assets		—			2,969		180		—			3,149

Total assets	$	109,381		$	429,328	$	102,974	$	(529,110	)	$	112,573

Accounts payable	$	—		$	32,642	$	45,376	$	(66,746	)	$	11,272
Accrued restructuring costs		—			1,490		—		—			1,490
Advances from parent		217,164			90,385		350		(307,899	)		—
Other current liabilities		4,875			15,761		5,244		—			25,880
Deferred income taxes		—			—		968		—			968
Noncurrent liabilities		—			9,043		3,714		—			12,757
Notes payable		288,180			—		—		—			288,180
Preferred stock		284,401			—		—		—			284,401
Stockholders’ equity (deficit)		(685,239	)		280,007		47,322		(154,465	)		(512,375	)

Total liabilities and stockholders’ equity (deficit)	$	109,381		$	429,328	$	102,974	$	(529,110	)	$	112,573


	Three Months Ended September 30, 2004
	Parent			Guarantors		Non-Guarantors			Eliminations			Consolidated
Net sales	$	—		$	42,663	$	56,959		$	(53,111	)	$	46,511
Cost of sales		—			23,358		56,535			(52,784	)		27,109

Gross margin		—			19,305		424			(327	)		19,402
Selling, research and administrative expenses		—			8,872		2,383			(327	)		10,928
Restructuring activities		—			1,445		875			—			2,320

Operating income		—			8,988		(2,834	)		—			6,154
Other income (expense):
Interest income		—			5		26			(15	)		16
Interest expense		(8,313	)		124		(2	)		15			(8,176	)
Dividend income		—			—		—			—			—

Income (loss) from continuing operations before income taxes		(8,313	)		9,117		(2,810	)		—			(2,006	)
Income taxes		—			—		(203	)		—			(203	)

Net income (loss)	$	(8,313	)	$	9,117	$	(2,607	)	$	—		$	(1,803	)


	Three Months Ended September 30, 2004
	Parent			Guarantors			Non-Guarantors			Eliminations			Consolidated
Net sales	$	—		$	31,686		$	38,641		$	(35,667	)	$	34,660
Cost of sales		—			20,300			32,660			(35,477	)		17,483

Gross margin		—			11,386			5,981			(190	)		17,177
Selling, research and administrative expenses		—			7,570			1,735			(164	)		9,141

Operating income		—			3,816			4,246			(26	)		8,036
Other income (expense):
Interest income		—			28			3			(8	)		23
Interest expense		(8,673	)		(1	)		(60	)		65			(8,669	)
Dividend income		—			1,346			—			(1,346	)		—

Income (loss) from continuing operations before income taxes		(8,673	)		5,189			4,189			(1,315	)		(610	)
Income taxes		—			36			531			—			567

Income (loss) from continuing operations after income taxes		(8,673	)		5,153			3,658			(1,315	)		(1,177	)
Income (loss) from discontinued operations after income taxes		—			1,402			(386	)		75			1,091

Net income (loss)	$	(8,673	)	$	6,555		$	3,272		$	(1,240	)	$	(86	)


	Nine Months Ended September 30, 2004
	Parent			Guarantors		Non-guarantors			Eliminations			Consolidated
Net sales	$	—		$	122,724	$	152,197		$	(138,308	)	$	136,613
Cost of sales		—			70,649		143,017			(137,512	)		76,154

Gross margin		—			52,075		9,180			(796	)		60,459
Selling, research and administrative expenses		—			27,510		6,509			(796	)		33,223
Impairment of assets held for sale					—		850			—			850
Restructuring activities		—			1,375		875			—			2,250

Operating income		—			22,340		1,796			—			24,136
Other income (expense):
Interest income		—			17		242			(212	)		47
Interest expense		(25,522	)		335		(5	)		212			(24,980	)
Loss on extinguishment of debt		(2,256	)		—		—			—			(2,256	)

Income (loss) before taxes		(27,778	)		22,692		2,033			—			(3,053	)
Income taxes		—			—		1,015			—			1,015

Net income (loss)	$	(27,778	)	$	22,692	$	1,018		$	—		$	(4,068	)


	Nine Months Ended September 30, 2003
	Parent			Guarantors			Non-guarantors			Eliminations			Consolidated
Net sales	$	—		$	100,166		$	118,723		$	107,819	)	$	111,070
Cost of sales		—			59,472			103,230			(107,345	)		55,357

Gross margin		—			40,694			15,493			(474	)		55,713
Selling, research and administrative expenses		—			24,600			5,115			(455	)		29,260

Operating income		—			16,094			10,378			(19	)		26,453
Other income (expense):
Interest income		—			118			12			(67	)		63
Interest expense		(26,654	)		(370	)		(67	)		567			(26,524	)
Loss on extinguishment of debt		(1,100	)		—			—			—			(1,100	)
Dividend income		—			36,577			—			(36,577	)		—

Income (loss) from continuing operations before income taxes		(27,754	)		52,419			10,323			(36,096	)		(1,108	)
Income taxes		—			676			1,178			—			1,854

Income (loss) from continuing operations after income taxes		(27,754	)		51,743			9,145			(36,096	)		(2,962	)
Income from discontinued operations after income taxes		—			27,641			559			(375	)		27,825

Net income (loss)	$	(27,754	)	$	79,384		$	9,704		$	(36,471	)	$	24,863


	Nine Months Ended September 30, 2004
							Non-
	Parent			Guarantors			guarantors			Eliminations			Consolidated
Net cash provided by (used in) operating activities	$	(19,319	)	$	25,269		$	(1,691	)	$	—		$	4,259
Proceeds from sale of businesses		—			2,000			—			—			2,000
Equity contributions into subsidiaries		—			(3,802	)		—			3,802			—
Purchases of property, plant and equipment, net		—			(11,673	)		(4,505	)		—			(16,178	)

Net cash provided by (used in) investing activities		—			(13,475	)		(4,505	)		3,802			(14,178	)
Debt payments - long term		(37,667	)		—			—			—			(37,667	)
Debt proceeds - long term		48,000			—			—			—			48,000
Costs associated with debt		(1,633	)		—			—			—			(1,633	)
Premium on early retirement of debt		(1,080	)		—			—			—			(1,080	)
Common stock transactions		(150	)		—			—			—			(150	)
Intercompany loans		11,001			(12,282	)		1,281			—			—
Equity contributions into subsidiaries		—			—			3,802			(3,802	)		—

Net cash provided by (used in) financing activities		18,471			(12,282	)		5,083			(3,802	)		7,470
Effect of exchange rate changes on cash		—			—			(16	)		—			(16	)

Net change in cash and cash equivalents		(848	)		(488	)		(1,129	)		—			(2,465	)
Cash and cash equivalents at beginning of period		866			5,627			4,734			—			11,227

Cash and cash equivalents at end of period	$	18		$	5,139		$	3,605		$	—		$	8,762


	Nine Months Ended September 30, 2003
							Non-
	Parent			Guarantors			guarantors			Eliminations			Consolidated
Net cash provided by (used in) operating activities	$	(22,343	)	$	32,272		$	11,222		$	(15,367	)	$	5,784
Net cash provided by discontinued activities		—			1,610			2,023			—			3,633

Net cash provided by (used in) operating activities		(22,343	)		33,882			13,245			(15,367	)		9,417
Proceeds from sale of businesses		—			45,722			—			—			45,722
Equity contributions into subsidiaries		—			(4,185	)		—			4,185			—
Purchases of property, plant and equipment, net		—			(4,866	)		(886	)		—			(5,752	)

Net cash provided by (used in) investing activities		—			36,671			(886	)		4,185			39,970
Debt payments - long term		(84,559	)		—			(243	)		—			(84,802	)
Debt proceeds - long term		35,000			—			—			—			35,000
Costs associated with debt		(1,749	)		—			—			—			(1,749	)
Common stock transactions		(350	)		—			—			—			(350	)
Intercompany loans		72,962			(70,074	)		(2,888	)		—			—
Intercompany dividends		—			—			(15,367	)		15,367			—
Equity contributions into subsidiaries		—			—			4,185			(4,185	)		—

Net cash provided by (used in) financing activities		21,304			(70,074	)		(14,313	)		11,182			(51,901	)
Effect of exchange rate changes on cash		—			—			(43	)		—			(43	)

Net change in cash and cash equivalents		(1,039	)		479			(1,997	)		—			(2,557	)
Cash and cash equivalents at beginning of period		9,614			7,578			6,687			—			23,879

Cash and cash equivalents at end of period	$	8,575		$	8,057		$	4,690		$	—		$	21,322

7. Segment Information

The Company’s continuing business consists of one operating segment known as Microacoustics. In the third quarter of 2003 after the sale of the Synchro-Start and Infrared operations, the Company reviewed its segment reporting under SFAS No. 131 — Disclosure about Segments of an Enterprise and Related Information, and concluded that the operating results of the Company should be reported as a single operating segment. Previously, the Company reported three operating segments: hearing aid components, acoustic technology, and automotive components. The Synchro-Start division was sold May 30, 2003, and was the primary part of the Company’s Automotive Components reporting segment. The Infrared business was part of the Company’s Acoustic and Infrared Technology reporting segment. (see Footnote 2. Discontinued Operations.)

The Microacoustic operating segment utilizes the Company’s acoustic technologies to design, manufacture, and market transducers and other components for hearing aids, mobile communications and computer telephony integration telematics (voice controlled wireless services delivered to an automobile environment).

The Company uses consolidated financial information to assess performance and make resource allocation decisions.

8. Restructuring Expenses

November 2003 Elgin, Illinois Restructure

The Company announced the closure of its Elgin, Illinois facility in November of 2003, which it completed in September of 2004. Operations were shifted to facilities in China, Malaysia and Itasca, Illinois, with 46 positions at the Elgin facility being eliminated. The Company recorded employee severance and outplacement expenses of $1,479 as of December 31, 2003. The following table presents the restructure costs and payments for the period.


				Accrued
	Restructure			Restructure
	Expense			Liability
Balance December 31, 2003	$	—		$	1,479
Facility consolidation costs		2,340			2,340
Facility consolidation payments		—			(2,340	)
Employee severance and outplacement payments		—			(224	)
Adjustment due to reduced expected terminations		(90	)		(90	)

Balance September 30, 2004	$	2,250		$	1,165

9. Commitments and Contingencies

Synchro-Start Divestiture Indemnifications In connection with sale of the Synchro-Start business, the Company has agreed to indemnify certain tax obligations arising out of tax audits or administrative or court proceedings relating to tax returns for any periods ending on or prior to the closing date of the sale. The Company has also agreed to indemnify certain liabilities, losses or claims arising from presale operations, limited such that the Company is not liable for total claims under $0.3 million, is fully liable for claims totaling between $0.3 and $7.5 million, is 50% liable for total claims between $7.5 million and $12.5 million and is not liable for total claims exceeding $12.5 million. Proceeds from the Synchro-Start sale included $2.5 million in escrow for potential indemnification obligations, of which the Company received $2.0 million in September 2004. The Company considers it unlikely that a claim would be made of such magnitude that it would have a material impact on the Company’s financial position.

The foregoing summary of the indemnities made by the Company in connection with the sale of the Synchro-Start business is qualified in its entirety by reference to the Stock Purchase Agreement Between and among Woodward Governor

Company and Knowles Intermediate Holding, Inc. and Knowles Electronics Holdings, Inc. dated May 20, 2003 incorporated by reference to Exhibit 10.25 to Form 8-K filed with the Securities and Exchange Commission June 16, 2003.

Ruwido (Infrared) Divestiture Indemnifications In connection with the sale of the Ruwido business, the Company has agreed to indemnify certain liabilities, losses or claims up to a total of $0.1 million. The Company believes that any claim would not have a material impact on the Company’s financial position.

The foregoing summary of the indemnities made by the Company in connection with the sale of the Ruwido business is qualified in its entirety by reference to the Share Deal agreed by and between Knowles Intermediate Holding, Inc. and FM Electronics-Holding GmbH and WEHA Holding GmbH dated July 29, 2003 incorporated by reference to Exhibit 10.27, a copy of which was attached as an exhibit to the Form 10-Q for the period ended June 30, 2003.

Other Commitments and Contingencies The Company is involved in various lawsuits, claims, investigations and proceedings including patent and commercial matters that are in the ordinary course of business. The Company cannot at this time estimate with any certainty the impact of such matters on its financial position.

Product Warranties The Company provides an accrual for estimated future warranty costs at the time products are sold and periodically adjusts the accrual to reflect actual experience. The warranty on products sold generally extends from one to three years.

Changes in the Company’s accrual for warranty during the period are as follows:


	2004
Balance December 31, 2003	$	2,282
Settlements made during the period		(1,073	)
Provision for warranty liability on sales		663
Adjustments in estimates for pre-existing warranties		(752	)

Balance September 30, 2004	$	1,120

10. Retirement Plans

Components of net periodic benefit cost for the three months ended September 30 are as follows:


	U.S. Plans						Foreign Plans
	2004			2003			2004			2003
Components of net periodic benefit cost:
Service cost	$	330		$	394		$	92		$	69
Interest cost		973			958			235			176
Expected return on plan assets		(1,156	)		(1,107	)		(222	)		(167	)
Amortization of prior service cost		15			22			1			—
Amortization of transitional asset		—			—			4			3
Recognized actuarial (gain) or loss		—			—			115			94
Expected contributions from employees		—			—			(6	)		(12	)

Net periodic benefit cost	$	162		$	267		$	219		$	163

FAS 88 curtailment cost		31			—			—			—

Total expense	$	193		$	267		$	219		$	163

Components of net periodic benefit cost for the nine months ended September 30 are as follows:


	U.S. Plans						Foreign Plans
	2004			2003			2004			2003
Components of net periodic benefit cost:
Service cost	$	1,019		$	1,378		$	239		$	167
Interest cost		2,908			2,873			614			429
Expected return on plan assets		(3,306	)		(3,323	)		(581	)		(406	)
Amortization of prior service cost		58			84			—			—
Amortization of transitional asset		—			—			10			7
Recognized actuarial (gain) or loss		—			—			316			228
Expected contributions from employees		—			—			(32	)		(29	)

Net periodic benefit cost	$	679		$	1,012		$	566		$	396

FAS 88 curtailment cost		31			—			—			—

Total expense	$	710		$	1,012		$	566		$	396

In 2004 the Company made contributions of $366 to its U.S. defined benefit plan.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

In 2003, the Company completed a program to divest its non-core businesses and to focus on its core microacoustic 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. The financial statements for the period ended June 30, 2003 have been prepared with Ruwido and Synchro-Start accounted for as discontinued operations under Generally Accepted Accounting Principles (GAAP). (See Note 2 – Discontinued Operations).

Quarter Ended September 30, 2004 Compared to Quarter Ended September 30, 2003

The table below shows the principal line items from our consolidated income statements for the three months ending September 30.


	Three Months Ended						$		%
	September 30,						Increase/ (decrease)		Increase/ (decrease)
$000s	2004			2003			from prior year		from prior year
Net sales	$	46,511		$	34,660		$	11,851		34.2	%
Cost of sales		27,109			17,482			9,627		55.1	%

Gross margin	$	19,402		$	17,178		$	2,224		12.9	%
Gross margin %		41.7	%		49.6	%
Research and development		2,906			2,539			367		14.5	%
Selling and marketing		2,940			2,260			680		30.1	%
General and administrative		5,082			4,343			739		17.0	%
Restructuring activities		2,320			—			2,320


	Three Months Ended						$			%
	September 30,						Increase/ (decrease)			Increase/ (decrease)
$000s	2004			2003			from prior year			from prior year
Total operating expenses	$	13,248		$	9,142		$	4,106			44.9	%

Operating income from continuing operations	$	6,154		$	8,036		$	(1,882	)		-23.4	%
Interest expense, net		(8,160	)		(8,646	)		486			-5.6	%

Loss from continuing operations before tax	$	(2,006	)	$	(610	)	$	(1,396	)		228.9	%
Income tax (benefit)		(203	)		567			(770	)		-135.8	%

Loss from continuing operations after tax	$	(1,803	)	$	(1,177	)	$	(626	)		53.2	%
Income from discontinued operations after tax		—			1,091			(1,091	)		-100.0	%

Net loss	$	(1,803	)	$	(86	)	$	(1,717	)		1996.5	%

EBITDA from continuing operations	$	7,862		$	9,508		$	(1,646	)		-17.3	%

EBITDA is defined as earnings before interest, loss on extinguishment of debt, taxes, depreciation and amortization and 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.


	Three Months Ended
	September 30,				Increase/ (decrease)			Increase/ (decrease)
$000s	2004		2003		from prior year			from prior year
Operating income from continuing operations	$	6,154	$	8,036	$	(1,882	)		-23.4	%
Depreciation and amortization		1,708		1,472		236			-16.0	%

EBITDA from continuing operations	$	7,862	$	9,508	$	(1,646	)		-17.3	%

Note — For purposes of calculating the Company’s performance under its Credit Agreement, restructuring costs of $2,320 in the three months ending September 30, 2004 are excluded from EBITDA.

Sales increased $11.9 million or 34.2% in the third quarter 2004 compared to the same quarter of 2003. The increase in sales is due to increased demand for transducers and hearing aid assemblies, as well as increasing sales of the company’s silicon microphone (“Sisonic”), which was introduced in the summer of 2003.

Cost of sales as a percent of sales increased by 7.9 percentage points in the third quarter of 2004 compared to the same period the prior year. The increase is primarily associated with the production ramp up costs of Sisonic in both the U.S. and Asia.

Research and development expenses in the third quarter of 2004 were 14.5% higher than in the same period in the prior year, primarily due to higher spending on Sisonic. Sales and marketing expenses increased 30.1% primarily due to costs associated with higher sales levels and customer support costs. General and administrative expenses increased by 17.0% due to higher employee related costs and information system support costs. Restructuring expenses of $2.3 million were recorded in the third quarter of 2004 related to the severance, costs to consolidate facilities and relocate employees associated with the closure of our Elgin, Illinois facility and the transfer of activities to our China, Malaysia and Itasca, Illinois locations. The Elgin facility closed in September 2004. Total operating expenses increased by $4.1 million, or 44.9%.

Operating income from continuing operations in the third quarter of 2004 decreased by $1.9 million or 23.4% from the third quarter of 2003 due to the increased costs associated with increasing Sisonic production, the higher operating expenses, only partially offset by additional margin from increased sales.

In connection with our June 1999 recapitalization, we currently have significant senior debt and senior subordinated debt. Net interest expense decreased by $0.5 million in the third quarter of 2004 compared to the third quarter of 2003 primarily due to the Tranche C refinancing, which replaced $36 million of 18.5% Tranche C debt with $48 million of Tranche D debt, which has a variable interest rate, currently priced at an 8.3% interest rate.

The third quarter of 2003 included $1.1 million income from discontinued operations, primarily an adjustment to the gain on the sale of Synchro-Start.

Income tax was $0.3 million of benefit in the third quarter of 2004 compared to $0.6 million of expense in the third quarter of 2003. We are providing tax consistent with the expected taxes in foreign locations.

We reported a net loss of $1.8 million for the third quarter of 2004 compared to a net loss of $0.1 million in the same period in the prior year, primarily due to restructuring costs and other higher operating expenses that were partially offset by the margin on increased sales in 2004 and the prior year included a gain on sale of discontinued operations.

EBITDA from continuing operations decreased by $1.6 million or 17.3 % in the third quarter of 2004 primarily due to restructuring costs and other higher operating expenses, only partially offset by additional margin from increased sales.

Nine months ended September 30. 2004 Compared to the Nine Months Ended September 30, 2003

The table below shows the principal line items from our consolidated income statements for the nine months ending September 30.


	Nine Months Ended						$			%
	September 30,						Increase/ (decrease)			Increase/ (decrease)
$000s	2004			2003			from prior year			from prior year
Net sales	$	136,613		$	111,070		$	25,543			23.0	%
Cost of sales		76,154			55,357			20,797			37.6	%

Gross margin	$	60,459		$	55,713		$	4,746			8.5	%
Gross margin %		44.3	%		50.2	%
Research and development		8,485			7,708			777			10.1	%
Selling and marketing		8,270			6,682			1,588			23.8	%
General and administrative		16,468			14,870			1,598			10.7	%
Impairment of assets held for sale		850			—			850
Restructuring activities		2,250			—			2,250

Total operating expenses	$	36,323		$	29,260		$	7,063			24.1	%

Operating income from continuing operations	$	24,136		$	26,453		$	(2,317	)		-8.8	%
Interest expense, net		(24,933	)		(26,461	)		1,528			-5.8	%
Loss on extinguishment of debt		(2,256	)		(1,100	)		(1,156	)		105.1	%

Loss from continuing operations before tax	$	(3,053	)	$	(1,108	)	$	(1,945	)		175.5	%
Income tax		1,015			1,854			(839	)		-45.3	%

Loss from continuing operations after tax	$	(4,068	)	$	(2,962	)	$	(1,106	)		37.3	%
Income from discontinued operations after tax		—			27,825			(27,825	)		-100.0	%


	Nine Months Ended					$			%
	September 30,					Increase/ (decrease)			Increase/ (decrease)
$000s	2004			2003		from prior year			from prior year
Net income (loss)	$	(4,068	)	$	24,863	$	(28,931	)		-116.4	%

EBITDA from continuing operations	$	29,902		$	32,069	$	(2,167	)		-6.8	%


	Nine Months Ended				$			%
	September 30,				Increase/ (decrease)			Increase/ (decrease)
$000s	2004		2003		from prior year			from prior year
Operating income from continuing operations	$	24,136	$	26,453	$	(2,317	)		-8.8	%
Depreciation and amortization		5,766		5,616		150			2.7	%

EBITDA from continuing operations	$	29,902	$	32,069	$	(2,167	)		-6.8	%

Note — For purposes of calculating the Company’s performance under its Credit Agreement, restructuring costs of $2,250 in the nine months ending September 30, 2004 are excluded from EBITDA.

Sales increased $25.5 million or 23.0% in the first nine months 2004 compared to the same period of 2003. The increase in sales is due to increased demand for transducers and related hearing aid assemblies, as well as increasing sales of the company’s silicon microphone (“Sisonic”), which was introduced in the summer of 2003.

Cost of sales as a percent of sales increased 5.9 percentage points in the first nine months of 2004 compared to the same period the prior year. The increase in costs is due to the production ramp up costs of Sisonic in both the U.S. and China.

Research and development expenses in the first nine months of 2004 increased by 10.1% compared to 2003 due to higher personnel costs and increased project expenses. Sales and marketing expenses increased 23.8% in the first nine months of 2004 due to primarily due to costs associated with higher sales levels and customer support costs. General and administrative expenses increased by 10.7% primarily due to higher employee related costs and information system support costs.

A charge of $0.9 million for the impairment of assets held for sale was recorded in the third quarter of 2004 representing the revaluation of our Elgin, Illinois facility to fair market value. $2.3 million of restructuring costs in the third quarter are related to the severance, moving and training costs associated with the closure of our Elgin, Illinois facility and the transfer of activities to our China, Malaysia and Itasca, Illinois locations. The Elgin facility closed in September 2004.

Operating income from continuing operations in the first nine months of 2004 decreased by $2.3 million compared to the same period in 2003 due to the increased costs associated with increasing Sisonic production, the restructuring costs, the impairment of assets held for sale and other higher operating expenses, only partially offset by additional margin from increased sales.

The April 2004 refinancing of the Tranche C portion of our Credit Agreement resulted in a $2.3 million loss on extinguishment of debt. This amount reflected the write-off of previously deferred charges associated with the origination of the Tranche C debt as well as a prepayment penalty paid to the Tranche C lenders. The March 2003 refinancing of the Tranche A portion of our Credit Agreement resulted in a $1.1 million loss on extinguishment of debt, reflecting the write-off of previously deferred financing fees.

In connection with our June 1999 recapitalization, we currently have significant senior debt and senior subordinated debt. Net interest expense decreased by $1.5 million in the first nine months of 2004 compared to the same period in 2003 primarily due to more favorable interest rates associated with the refinancing of the Tranche C debt.

The first nine months of 2003 included $27.8 million income from discontinued operations, primarily made up of the gain on the sale of Synchro-Start net of the loss on the sale of Ruwido.

Income tax expense was $1.0 million in the first nine months of 2004 compared to an expense of $1.9 million in the first nine months of 2003. We are providing tax consistent with the expected taxes in foreign locations.

We reported a net loss of $4.1 million for the first nine months of 2004, primarily due to the $2.3 million restructuring costs, $2.2 million of loss on the extinguishment of debt and $0.9 million impairment of assets held for sale. We reported net income of $24.9 million for the same period in 2003, primarily due to the $27.8 million in income from discontinued operations, net of taxes.

EBITDA from continuing operations decreased by $2.2 million in the first nine months of 2004 compared to the year earlier period due to the increased operating expenses and restructuring costs partially offset by the margin on increased sales.

Liquidity and Capital Resources

We have historically used available funds for capital expenditures and working capital management. These funds have been obtained from operating activities and from lines of credit. We also will have substantial interest expense of approximately $32 to $36 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.

In association with its recapitalization on June 30, 1999, the Company borrowed $200 million under a Credit Agreement in two facilities, a Tranche A Facility of $50 million and a Tranche B Facility of $150 million. On June 30, 1999, the Company also borrowed $153.2 million under a senior subordinated note agreement. The Company borrowed an additional $10 million in Senior Subordinated Debt in August 2002, as required under the Amendment and Waiver to the Credit Agreement dated May 10, 2002. On March 25, 2003, the Company entered into the Fifth Amendment of the Credit Agreement which refinanced $31.7 million of the Credit Agreement, replacing the balance of the original Tranche A Facility with a Tranche C Facility and revising certain terms and conditions of the Credit Agreement. In the first quarter of 2003, the Company repaid $7.7 million of principal on the Tranche B Facility as required under the Excess Cash provision of the Credit Agreement. In May 2003 the Company obtained Amendment Number Nine and Waiver that approved the sale of Synchro-Start and Ruwido under certain conditions. The Company completed the sale of the Synchro Start division May 30, 2003 and prepaid $42 million of Tranche B Facility loans. Additional prepayments of $2.3 and $2.0 million related to the Synchro Start sale were made in November 2003 and September 2004 respectively. The Company completed the sale of Ruwido in July 2003 and prepaid $1 million of the Tranche B loans in July 2003.

On April 14, 2004 the Company obtained a Seventh Amendment to its Credit Agreement which replaced the $36 million Tranche C Facility with a $48 million Tranche D Facility at reduced interest rates and more favorable terms. The Tranche D loans bear interest at the Company’s option of a LIBOR rate plus 7.25% or the U.S. prime rate plus 6.25%. On the date of the refinancing, the applicable rate of the Tranche D loan was 8.35% compared to the rate of 18.5% in the Tranche C loan. The Company paid a related prepayment penalty of $1.1 million to the Tranche C debtholders.

Under the amended terms of the Credit Agreement, the Company must maintain certain financial ratios. The two primary ratios the Company must maintain are the leverage ratio, which is total net debt divided by EBITDA, as defined by the Credit Agreement, 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.

For purposes of calculating the required ratios, under the amended terms of the Credit Agreement, EBITDA excludes up to $7.5 million in cash charges related to the nonrecurring costs of restructuring overhead in the three year period 2003 through 2005. These restructuring costs are related to the Company’s announced closure of its Elgin facility and other activities to reduce overhead costs. To date, cash charges of $3.9 million have been incurred relating to this restructuring.

The required ratios as amended in the Seventh Amendment for future year-ends are as follows:


			Required
	Required		Interest
	Leverage		Coverage
	Ratio		Ratio
December 31, 2004		6.50		1.25
December 31, 2005		6.00		1.35
December 31, 2006		5.50		1.45

We expect to be able to comply with the required covenants. However, our ability to meet these covenants is highly dependent upon market and competitive conditions. If future results are lower than planned, 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.

The Credit Agreement as amended provides total credit of $152.6 million, including a $15 million in Revolving Credit facility that was not utilized as of September 30, 2004. The following table summarizes the Company’s actual credit amounts outstanding as of September 30, 2004:


	Total credit
	outstanding
	as of
	September
($000s)	30, 2004
Revolving Credit Facility	$	—
Tranche B Facility		89.6
Tranche D Facility		48.0

Total Credit Agreement	$	137.6

13 1/8% Senior Subordinated Notes due 2009		151.1
10% Senior Subordinated Notes due 2009		10.0

Total Long Term Notes Payable	$	298.7

As of September 30, 2004, there was no amount outstanding under the Revolving Credit Facility. The Company subsequently borrowed $9.0 million against the Revolving Credit Facility in October 2004.

Interest rates on the Revolving Credit Facility are 4 percentage points above the London Inter Bank Offered Rate (LIBOR). Interest on the Tranche B Facility bears interest (at the Company’s option) at either: LIBOR plus 5.0% or U.S. Prime Rate plus 4.0%. The Tranche D facility bears interest, at the Company’s option at either LIBOR plus 7.25% or Prime Rate plus 6.25%. (See Note 6 – Notes Payable)

The principal on the Revolving Credit Facility and the Tranche B Facility is due in four principal payments from June 30, 2006 to June 29, 2007. The Tranche D Facility is payable in full on June 29, 2007.

Net cash provided by operating activities from operating activities was $4.3 million in the first nine months of 2004 compared to $9.4 million from operating activities in the first nine months of 2003. The decrease of $5.2 million is primarily due to an increase in inventories and the absence of cash flow from discontinued operations in the current year, partially offset by an increase in accounts payable. The net loss from continuing operations was $4.1 million in the nine months of 2004 compared to a net loss of $3.0 million in 2003. The impairment of assets held for sale of $0.9 million was a non-cash

writedown in the first nine months of 2004. The loss on extinguishment of debt of $2.2 million in the nine months of 2004 was the non-cash write-off of costs associated with the Tranche C debt, which was repaid in 2004. Inventory increased by $8.5 million in 2004 compared to a decrease in inventory of $2.2 million in 2003, to support higher sales levels and Sisonic ramp up. Accounts payable increased $4.5 million in the first nine months of 2004 compared to a decrease of $2.8 million in the same period in 2003, due to increased inventory purchases and capital investments. Net cash provided by discontinued operating activities (SSPI and Ruwido) added $3.6 million to the prior year.

Net cash used in investing activities was $14.2 million in the first nine months of 2004 compared to net cash provided by investing activities of $40.0 million in the first nine months of 2003. Proceeds from the sale of business were $2.0 million in the first nine months of 2004 as escrow amounts relating to the sale of SSPI were received. Net purchases of property, plant and equipment for new product introductions and expansion of Asian production facilities was $16.2 million in the first nine months of 2004. In the nine months ending September 30, 2003, cash used for purchases of property, plant and equipment of $5.8 million was offset by the $45.7 million provided by the sale of SSPI and Ruwido.

Net cash from financing activities was $7.5 million in the first nine months of 2004 compared to a use of $51.9 million in the first half of 2003. The activity in 2004 reflects the refinancing of debt in April 2004, which resulted in the payment of Tranche C debt of $35.7 million and the borrowing of $48.0 million of Tranche D debt at a more favorable interest rate. In addition, the $2 million of proceeds associated with the escrow from the sale of SSPI that was received in the first nine months of 2004 were used to repay the Tranche B loan. Associated with this April 2004 refinancing was the payment of $1.6 million in financing fees related to the Tranche D loan and a prepayment penalty of $1.1 million on the Tranche C debt. The net cash used from financing activities in the nine months ended September 30, 2003 reflects the payment of debt related to the sale of SSPI and Ruwido of $42.0 million, and transactions associated with the refinancing of the Tranche A facility, including the completion of the borrowing of the Tranche C Facility of $35.0 million and the payment of the $33.5 million of Tranche A Facility. In addition, the nine months ended September 2003 included the payment of $7.7 million of principal of Tranche B Facility associated with an excess cash calculation as of December 2002.

The change in net cash in the first nine months of 2004 was a decrease in cash of $2.5 million, as cash used in investing activities of $14.2 million was only partially offset by $4.2 in cash provided by operating activities and cash provided by investing activities of $7.5 million. In the nine months of 2003, net cash decreased by $2.6 million, as the sale of SSPI and Ruwido was cash neutral (net cash proceeds were used to reduce debt), and cash used for purchases of plant, property and equipment was $5.8 million and bank debt was reduced by $7.7 million due to the excess cash calculation, only partially offset by cash provided from operations of $9.4 million.

We expect capital expenditures of $19 to $22 million in 2004, funded by operating activities and lines of credit. We expect our major capital expenditures in 2004 will primarily be to support increased capacity, especially for the Sisonic product line and new product introductions. The amount and timing of actual capital expenditures may be different than our current expectations.

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; 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; implementation of new software systems; 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

We are exposed to foreign currency exchange rate risks. Our revenues are primarily denominated in the U.S. dollar. During the first nine months of 2004, approximately 93% of our revenue was denominated in U.S. dollars, approximately 4% was denominated in Japanese Yen and the balance denominated in other foreign currencies. None of the revenue that is earned in foreign currencies is hedged. Some of our expenses are denominated in the local currencies of the United Kingdom, China, Japan, Malaysia and Taiwan, none of which are hedged. A number of the currencies in which are expenses are denominated are closely tied to the U.S. Dollar. 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. In addition to revenue and expenses, we have certain contractual obligations that are expressed in a foreign currency. These obligations are hedged in order to limit the Company’s liability.

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 1 percentage point in the interest rate of the loans under the Credit Agreement would change our annual interest expense by $1.4 million. We have $151 million outstanding in 13 1/8% notes due in 2009. The estimated fair value of the notes as of September 30, 2004 is 105% of their face value or $161 million based on current market prices. The fair value of the Tranche B loan, Tranche D loan and 10% Notes are estimated to be $90, $48 and $10 million respectively.

Item 4. Controls and Procedures

As of the end of the period covered by this report, September 30, 2004, 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-15(e) and 15d-15(e) 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 was no change in the Company’s internal controls over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. Other Information

Item 6. Exhibits and Reports on Form 8-K

Exhibits

31.A Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002

31.B Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002

Reports on Form 8-K

None


	Page
PART I — Financial Information
Item 1 Financial Statements Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003		2
Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003		3
Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003		4
Notes to the Consolidated Financial Statements		5
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
Item 3 Qualitative and Quantitative Disclosures about Market Risk		24
Item 4 Controls and Procedures		24
PART II — Other Information
Item 1 Legal Proceedings — None
Item 2 Changes in Securities and Use of Proceeds — None
Item 3 Defaults Upon Senior Securities — None
Item 4 Submission of Matters to a Vote of Security Holders — None
Item 5 Other Information — None
Item 6 Exhibits and Report on Form 8-K — None
Signatures
Certifications
Certification
Certification


		KNOWLES ELECTRONICS HOLDINGS, INC.

		By		/s/ JAMES H. MOYLE

				James H. Moyle,
				Executive Vice President & CFO,
				(As duly authorized officer and as the principal financial and accounting officer)

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		31.A Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002

		31.B Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002