SECURITIES AND EXCHANGE COMMISSION

Form 10-K

(Mark One)

Commission file number 333-40076

Knowles Electronics Holdings, Inc.

Registrant’s telephone number, including area code:
630-250-5100

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

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

Title of Each Class
None

     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
Year Ended December 31, 2004

CONTENTS

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PART I

Item 1. Business

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 2004 results from continuing operations reflect revenue, operating income and EBITDA, of $186.0 million, $34 million and $42 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 and was accepted as an important new component from a number of major cellphone manufacturers in 2004, 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 above 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.

Competitive Strengths

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

	Leading International Market Position and Strong Customer Base

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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 above 75%. We protect our leading market share by maintaining strong relationships with all of the key manufacturers that require high quality transducers including

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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.

	Technological Expertise

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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 commercially manufacture a MEMS-based surface mount silicon microphone.

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To enhance our technological expertise, we emphasize research and development investment. Our 2004 research and development expenditures were $11.1 million, or 6.0% 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.

	International Low Cost Manufacturing Capability

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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 the closure of our Elgin, Illinois facility, which was completed in September 2004. The majority of manufacturing activity was transferred from Elgin to our locations in China and Malaysia, which were expanded to accommodate the additional volume. Certain high value operations were 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.

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:

	Capitalize on Growth Opportunities in the Hearing Aid Market

     Our worldwide share of the hearing aid transducer market is above 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

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	•	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.

	Develop non-hearing aid Markets for transducers

     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.

	Penetrate High Volume Markets with SiSonic(TM) Silicon Microphone

     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.

	Leverage Core Acoustic Expertise to Develop Additional Innovative Products for Markets with High Growth Potential

     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.

     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.

	Strengthen Customer Relationships

     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.

	Maintain Low Cost and High Quality Manufacturing Leadership

     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. With the completion of our restructuring efforts in 2004, nearly all of our manufacturing activity is located in China and Malaysia, which allows us to benefit from both their lower cost labor markets, and proximity to emerging product markets.

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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.

Research and Development

     Our 2004 research and development expenditures were $11.1 million, or 6.0% of net sales. We have a team of 107 scientists, engineers and technicians located primarily in Itasca, Illinois, Taiwan and Suzhou, China. 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 and China. Custom acoustic assembly and microphone product development are conducted in Taiwan. In 2004, 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(R). 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 2004 allowed us to continue to transition 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.

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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. Prior to the closure of our Elgin, Illinois facility at the end of 2004, we expanded our operations with additional facilities in our Penang, Malaysia and Suzhou, China locations. These new facilities added approximately 55,000 square feet of assembly capacity and 25,000 square feet of metal fabrication capacity.

     In November 2003 we announced the closure of our Elgin, Illinois facility that was closed in September 2004. Certain high value manufacturing operations were 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 were 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 80% utilized. Our transducer manufacturing facilities are ISO 9001:2000 certified. Our manufacturing processes are comprised of both automated and manual assembly operations. Capacity can be increased as demand increases.

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 23 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 31 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; pro-audio manufacturers; and manufacturers of micro-acoustic devices. In 2004, we had three customers that each represented more than ten percent of our consolidated sales. As a group, these three customers represented 47 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 above 75% in 2004. Our principal competitor is SonionMicrotronic, which we believe had a significant portion of the remaining market share in 2004. 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.

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Patents, Copyrights and Trademarks

     Intellectual property is a valuable and important asset to the Company. As a matter of practice, we follow a 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. We currently have approximately 170 patents issued in 15 countries around the world. In addition, we have more than 80 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 approximately 140 trademarks registrations and pending applications for registration in 25 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.

     There can be no assurance that our patents and other intellectual property rights will protect us from competition or be of commercial benefit. 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 2,921 employees as of December 31, 2004. Of these, approximately 70% were direct production employees and 30% were staff. Geographically, 249 of our employees are based in North America, 27 in Europe and 2,645 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

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performance capabilities of any hearing aid. Without high performance transducers, the processing capabilities of hearing devices are ineffective.

     The overall market for hearing aids continued to grow in 2004, continuing the improvement seen in the second half of 2003. The United States is currently the world’s largest market for hearing aids. Hearing aid sales increased approximately 4% in the U.S in 2004, with a strong increase in the first half of the year followed by a more moderate growth in the second half, according to the Hearing Industries Association, an industry trade group. 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.

     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.

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International penetration. - According to industry studies, approximately 10% of the population could benefit from hearing aids. In developed countries, 20% of the people who could benefit from hearing aids own them. In developing countries, the percentage of hearing aid ownership is far lower. 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 600 million mobile phones sold in 2004, 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.

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High End Consumer Electronics

     We manufacture the largest offering of balanced 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.) and greater consumer demand for high fidelity mobile applications.

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.

Item 2. Properties

PROPERTIES

Item 3. Legal Matters

     The Company has no material pending or threatened litigation.

Item 4. Submission of Matters to a Vote of Security Holders

     Not applicable.

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PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

     Not applicable.

Item 6. Selected Consolidated Financial Data

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See accompanying notes.

(8)

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, 2000, 2001, 2002 and 2004 by approximately $14.4, $2.2 $19.2 and $1.9 million, respectively. In 2003, the Company’s earnings exceeded fixed charges by $1.2 million.

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(9)

The results for 2000 have been restated to correct an error in the balance of Other Comprehensive Income resulting from the conversion to a new consolidation system in 2000. The error incorrectly recorded a translation loss as an adjustment to equity rather than an adjustment to the income statement and was primarily related to the U.K. entity. The correction increased cost of sales in 2000 by $1,578. Appropriate balance sheet accounts have also been restated. See Consolidated Financial Statement Footnote 2.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of 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.

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 2002 and 2003 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 periods through 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 through 2003. 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 2004, the Company increased its debt by replacing the $35 million of C Facility debt with $48 million of D Facility debt, at significantly lower interest rates. As of December 2004, the Company had $9 million of short-term debt and notes payable of $299 million. On December 20, 2004 the Company entered into a new unsecured credit agreement with Xerion Partners II Master Fund Limited (Xerion) and other lenders for additional borrowings for up to $10 million. No borrowing was outstanding under this agreement as of December 31, 2004. 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, 2004 and expects to be in compliance through December 31, 2005. For more detail, see the Liquidity and Capital resources section below.

     Our 2004 revenue, operating income and EBITDA were $185.5 million, $34.1 million and $42.4 million, respectively. Our 2003 EBITDA (defined in Item 6. Selected Consolidated Financial Data, Footnote 7) was $44.4 million.

     Sales increased by $31.5 million in the twelve months ending December 31, 2004 because of increases in the sale of transducers in both the hearing aid and non hearing aid applications, including increases in the sale of the Sisonic microphone, and increases in the sale of electromechanical components to the hearing aid industry. Gross margin rates declined by 5.2 percentage points in 2004 primarily due to the costs of establishing production of the Sisonic microphone. Operating expenses increased by $4.7 million primarily due to the increased research and development and sales and marketing expenses associated with Sisonic. The Company reported restructuring expenses of $5.3 million in 2004 and $1.5 million in 2003, primarily costs related to the closure of our Elgin, Illinois facility. Operating income decreased by $2.9 million in 2004, due to the increased restructuring expenses. The Company reported a $2.3 million loss on the extinguishment of debt in 2004, due to expenses related to the extinguishment of the C Facility debt. The Company’s key performance indicator is EBITDA, which decreased by $2.0 million in 2004 due to the increased restructuring expenses. For more detail, see the Consolidated Results from Operations, below.

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	Key Line Items in the Income statement

     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 significantly in the worldwide market for hearing aids in the second half of 2003 and the first half of 2004.

     Net sales for microacoustic devices 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 refined this innovative product and developed manufacturing methods that allowed us to ship the Silicon Microphone into markets such as cell phones in commercial quantities. In 2004, we moved production of the Silicon Microphone to China, and successfully produced and shipped more than 25 million microphones, primarily for cellphone applications.

     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 63% of our depreciation expense in 2004 and 57% of depreciation expense in 2003 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 Meadows, Illinois facilities and ceased production at our manufacturing facilities in the United Kingdom and Taiwan. During 2004, we transferred most of the manufacturing activity from our Elgin, Illinois facility to our locations in China and Malaysia. The Elgin facility was closed at the end of September 2004.

     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.

     We have replaced certain management information systems, requiring expenditures of approximately $11 million from 2000 through 2003. All locations now are integrated into the Company’s ERP system.

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     Other income (expense). Other income (expense) consists of interest income, interest expense and loss on extinguishment of debt. Due to our recapitalization, interest expense was $33.8 million in 2004, $34.7 million in 2003 and $33.9 million in 2002. We recorded a loss on extinguishment of debt in 2004 of $2.3 million, including a write-off of deferred finance charges and prepayment penalty, and in 2003 of $1.1 million to write-off deferred finance charges.

     Income taxes. Effective June 30, 1999, Knowles became a C corporation and subsequently, has been subject to federal income taxes. 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. In 2004, the taxes were an expense of $2.9 million, primarily due to the taxes on profitable foreign operations.

     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.

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 the consolidated results are shown with and without the Ruf business, which was sold in November 2002.

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Key Changes in 2004

     Sales increased by $31.5 million in 2004 compared to the year earlier due to increases in sale of transducers for hearing aid and pro-audio applications, increased sales of the silicon microphone and increased sales of electromechanical devices to the hearing aid market.

     Gross margins as a percentage of revenue in 2004 decreased by 5.2 percentage points due to the start-up and production costs associated with the silicon microphone.

     Restructuring expenses of $5.3 million in 2004 and $1.5 million in 2003 were expenses related to the Company’s transfer of manufacturing from its Elgin Illinois facility to facilities in China and Malaysia. The Elgin facility was closed at the end of September, 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 decreased by $2.9 million in 2004, due to the increased restructuring expenses and increased marketing expenses associated with the silicon microphone, partially offset by a higher gross margin.

     Interest expense decreased by $0.9 million in 2004, primarily due to lower interest rates partially offset by increased borrowing levels.

     The Company recorded a loss on extinguishment of debt of $2.3 million in 2004 related to prepayment fees and the write-off of deferred charges associated with the C Facility debt, as the $35 million in C Facility debt was replaced with $48 million in D Facility debt at more favorable interest rates.

     Income from continuing operations before tax decreased by $3.1 million, due to the loss on the extinguishment of debt and the increased restructuring expenses.

     EBITDA deceased from $44.4 million in 2003 to $42.4 in 2004 primarily due to the increased restructuring expenses.

     For more detail on results of operations, see the section below, “Year Ended December 31, 2004 Compared to Year Ended December 31, 2003”.

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Operating income was 18.4% in 2004 compared to 24.0% in 2003 and 21.7% in 2002 excluding Ruf. EBITDA was 22.9% in 2004 compared to 28.8% in 2003 and 27.2% in 2002 excluding Ruf.

     The decline in profitability as a percentage of sales in 2004 was due to the startup costs and manufacturing costs associated with the silicon microphone and the increased restructuring expenses. The increase in 2003 over the prior year was due to 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, 2004 Compared to Year Ended December 31, 2003

     Consolidated net sales increased by 20.5% in 2004 compared to 2003 due to the increase in sales of transducers to the hearing aid industry, the increase in sales of transducers to non-hearing aid manufacturers, the increase in sales of the silicon microphone. and the increase in sales of Deltek brand electromechanical components.

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

     Consolidated cost of sales as a percentage of net sales increased by 5.2 percentage points due to the startup and manufacturing costs associated with the silicon microphone.

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     The following table sets forth net income for the twelve months ending 2004 compared to the year earlier period:

     Research and development spending increased by $0.9 million or 8.8% due to increased spending on product development, including the Ferrofluid receiver, the Pantograph receiver, the Business Class Microphone, the Silicon Microphone and the expanded offering of Deltek electromechanical controls. Sales and marketing expenses increased by $2.8 million or 30.4% primarily due to expanded sales support of the Silicon Microphone worldwide and higher sales in all product lines. General and administrative expenses increased by $1.0 million or 4.9%, primarily due to increased costs related to the Itasca headquarters.

     Operating income of $34.1 million in the twelve months ending December, 2004 decreased by $2.9 million from the prior year, due to the $3.8 million increase in restructuring expenses partially offset by increased gross margins from increased sales.

     Restructuring expenses of $5.3 million in 2004 and $1.5 million in 2003 were costs related to the Company’s transfer of production from of its Elgin, Illinois manufacturing facility in 2004 to its facilities in Malaysia and China.

     Interest expenses of $33.7 million in 2004 and $35.8 million in 2003 reflect the debt incurred by the Company in association with its recapitalization in 1999. See Liquidity and Capital Resources below.

     Loss from continuing operations before tax was a $1.9 million in 2004 compared to income of $1.2 million in 2003. The decline of $3.1 million is due to the increase in restructuring expense and the $2.3 million loss on extinguishment of debt partially offset by a higher gross margin.

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     The key measurement used by management to gauge the profitability of the business is EBITDA, which decreased from $44.4 million in 2003 to $42.4 million in 2004. The decrease of $2.0 million was caused by the increased restructuring expenses.

     The tax provision in 2004 reflects taxes on profitable foreign operations. In 2003 the taxes on profitable foreign operations was partly offset by a reduction in the valuation allowance against the net U.S. deferred tax income tax asset.

     The company sold Syncho-Start in May 2003 for $49.7 million. The Company retained pension liabilities of $3.5 million associated with the SSPI pension plan covering U.S. employees. The Company recorded a gain of $35.6 million on the sale of Synchro-Start, which is net of $0.7 million of tax expense on the gain. The Company sold the Infrared business for $0.1 million in July 2003 with the buyer assuming $4.0 million of debt. The Company recorded an $8.6 million loss on the sale.

     Income from discontinued operations, after tax of $0.9 million in 2003 reflects the after-tax results of the Synchro-Start and the Ruwido businesses in 2003 prior to their sale.

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

     Consolidated net sales decreased by 6.2% in 2003 compared to 2002, due to the November 2002 sale of Ruf Electronics. Excluding the sales of Ruf in 2002, sales increased by 2.7 % in 2003 over 2002. The increase was caused by an increase in sales of transducers to the hearing aid industry and to security and medical applications, increased sales of the Silicon Microphone and increased sales of Deltek brand electromechanical components.

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

     Consolidated cost of sales as a percentage of net sales decreased by 4.5 percentage points, with approximately half of the decrease due to the sale of the low-margin Ruf business. The remaining decrease was primarily due to improved manufacturing efficiencies, including lower production costs, improved inventory controls and reduced costs of warranty.

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     The following table sets forth income from continuing operations for the twelve months ending 2003 compared to the year earlier period:

Research and development spending (excluding Ruf) increased by $0.2 million or 2% due to increased spending on product development, including the Ferrofluid receiver, the Pantograph receiver, and the Silicon Microphone. Sales and marketing expenses excluding Ruf increased by $0.7 million or 8.2% primarily due to expanded sales support of the Silicon Microphone worldwide. General and administrative expenses excluding Ruf increased by $1.2 million or 6.2%, primarily due to increased employee and employee benefit costs, including relocation, pension, medical and other benefit expenses.

     Operating income of $37.0 million in the twelve months ending December, 2003 increased by $22.4 million, with $16.7 million of the increase due to the loss in 2002 on the sale of Ruf and the balance due to improved profitability in ongoing operations due to increased sales and improved gross margin rates. The Company announced the sale of Ruf in November 2002. Although the proceeds from the sale were not significant, the sale allowed the Company to exit from a non-core business, which was not profitable. The net loss from the sale of Ruf in 2002 was $16.7 million.

     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.

     Interest expenses of $35.8 million in 2003 reflect the debt incurred by the Company in association with its recapitalization in 1999. See Liquidity and Capital Resources below. Compared to 2002, interest expense increased by $2.0 million, primarily due to the refinancing of the $31.7 million of the A Facility portion of the bank debt, which was replaced with $35 million of C Facility debt. The C Facility debt is at a fixed rate of 18.5% compared to a lower rate of LIBOR plus 5% for the A Facility debt.

     Income from continuing operations before tax was $1.2 million in 2003, an improvement of $20.4 million compared to the loss of $19.2 million in 2002. The improvement was due to the 2002 loss on the sale of Ruf of $16.7 million, the avoidance of the 2002 operating loss from Ruf of $1.3 million and of improved operating results that were only partially offset by increased interest expense of $2.0 million.

     The key measurement used by management to gauge the profitability of the business is EBITDA, which increased from $40.8 million in 2002 to $44.4 million in 2003. The increase of $3.6 million was caused by increased sales and improved gross margin rates, only partially offset by increased operating expenses.

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     Key statistics related to income taxes and gains/losses from discontinued operations are as follows:

     The tax provision in 2003 reflects taxes of foreign operations partly offset by a reduction in the valuation allowance against the net U.S. deferred tax income tax asset. In 2002, the Company provided for $11.7 million of taxes despite a pre-tax loss primarily due to providing a valuation allowance against the net U.S. deferred income tax assets.

     The Company sold Synchro-Start in May 2003 for $49.7 million. The Company retained pension liabilities of $3.5 million associated with the SSPI pension plan covering U.S. employees. The Company recorded a gain of $35.6 million on the sale of Synchro-Start, which is net of $0.7 million of tax expense on the gain. The Company sold the Infrared business for $0.1 million in July 2003 with the buyer assuming $4.0 million of debt. The Company recorded an $8.6 million loss on the sale.

     Income from discontinued operations, after tax of $0.9 million in 2003 reflects the after-tax results of the Synchro-Start and the Ruwido businesses in 2003 prior to their sale. The income from discontinued operations was significantly lower than the prior year due to the partial year nature of the results, a decrease in margin rates and an increase in operating expenses.

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Seasonality and Quarterly Results of Operations

     Our sales have been subject to a small degree of seasonality in the past several years. The fourth quarter has been our strongest quarter primarily due to stronger customer demand. In addition to the normal seasonality trends, the fourth quarter of 2003 was especially strong due to improved conditions in the hearing aid market and an increase in shipments of the Silicon Microphone. The sales of Silicon Microphones continued to increase in each quarter during 2004.

     The following table sets forth selected financial information by fiscal quarter.

SELECTED FINANCIAL INFORMATION BY QUARTER — UNAUDITED

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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. In the future, we will continue to have these needs. We also will have substantial interest expense of approximately $33 to $38 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 bank credit agreement in two facilities, an A Facility of $50 million and a 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. In the first quarter of 2003, the Company repaid $7.7 million of principal on the B facility as required under the Excess Cash provision of the Credit Agreement. On March 25, 2003, the Company entered into the Fifth Amendment of the Credit Agreement, which resulted in the Company repaying the balance of the A facility ($31.7 million), replacing the original A Facility with a $35 million C Facility and revising certain terms and conditions of the Credit Agreement. In May 2003 the Company obtained Amendment Number Six 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 B Facility loans. An additional prepayment of $2.3 million related to the Synchro-Start sale was made in November 2003. The Company completed the sale of Ruwido in July and prepaid $1 million of B Facility loans in July 2003.

In April, 2004 the Company entered into the Seventh Amendment of the Credit Agreement, which resulted in the Company repaying the $35 million in C Facility loans and replacing these C Facility loans with $48 million in D Facility loans at substantially lower interest rates.

     In December, 2004 the Company entered into a new unsecured credit agreement for up to $10 million in additional financing with Xerion Partners. No amount was outstanding under this agreement as of December 31, 2004.

     As of December 31, 2004 the Company’s outstanding borrowing and repayment dates were as follows:

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     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, 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 ratio, under the amended terms of the Credit Agreement, EBITDA excludes up to $7.5 million in cash charges related to the costs of restructuring overhead in the three year period 2003 through 2005. These restructuring costs will be related to the Company’s announced closure of its Elgin facility and the increase in capabilities in our Asian manufacturing facilities. These restructuring costs were $5.3 million in 2004 and $1.2 million in 2003.

     The required ratios as amended for future years ends are as follows:

     We expect to be able to comply with the required covenants through December 31, 2005. 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 totals $153 million of credit as of December 31, 2004. Included is a $15 million Revolving Credit Facility through June 30, 2006, a B Facility of $89.6 million which matures on June 29, 2007 and a D Facility of $48 million 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 .50 (the Alternate Base Rate) in each case plus an initial margin of 3%. The 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 D Facility bears interest at a rate of LIBOR plus 7.25%. At December 31, 2004, the weighted average interest rate was 7.2% for the B facility and 9.5% for the D facility.

     The Credit Agreement as amended reduced the Revolving Credit Facility to $15 million. The Sixth Amendment and Waiver and the subsequent sale of Synchro-Start and Ruwido substantially revised the terms of the amortization of the Credit Agreement. The principal is due and payable in four quarterly principal payments from September 30, 2006 to June 29, 2007. Under the amended Credit Agreement, in the event the B Facility is fully prepaid prior to June 30, 2006 the Revolving Credit Facility will cease to be available to the Company and any amounts outstanding thereunder shall thereupon become due and payable. The D Facility is payable in full on June 29, 2007.

     The Seventh Amendment replaced the $35 million C facility with $48 million of borrowing at substantially lower interest rates. The Fifth and Sixth Amendments modified the Credit Agreement that was substantially amended on May 10, 2002. On that date, the Company received agreement from the lenders to revise the terms and conditions of the Credit Agreement. At the end of the first quarter of 2002, the Company was not in compliance with the terms of the Credit Agreement, particularly the required leverage and interest coverage ratios. As a result, the Company did not make the interest payment on its senior subordinated notes scheduled for April 15, 2002. After the Company obtained the Fourth Amendment and Waiver to the Credit Agreement on May 10, 2002 (the “Fourth Amendment”), on May 14, 2002 the Company made the interest payment on our senior subordinated notes. The Fourth Amendment waived our non-compliance with the required interest coverage ratio for the period ended March 31, 2002 and the leverage ratio for the period January 1, 2002 through March 31, 2002, and amended these required ratios for subsequent periods through the first quarter of 2003. In addition the Fourth Amendment required the Company to receive additional funding of at least $10 million by September 3, 2002, which was required to pay down the outstanding balance on the revolving credit facility to $8.25 million. As a result of this agreement, the Company entered into a Senior Subordinated Debt agreement with an affiliate of Doughty Hanson on August 28, 2002 for $10 million in financing, under terms pari passu to the Senior Subordinated Debt Agreement of 1999. The proceeds were used to provide funding for working capital and reduced the balance under the revolving credit agreement to zero.

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     In December, 2004 the Company entered into a new unsecured credit agreement with Xerion Partners for up to $10 million in borrowing. No amount was outstanding as of December 31, 2004.

Cash Flows 2004 vs 2003

     Cash balances increased by $5.7 million in 2004, as $6.9 million in cash provided by operating activities and $16.0 million in cash provided by financing activities were more than the $19.1 million used in purchases of property, plant and equipment. The Company also received $2.0 million out of escrow from the sale of the Synchro - Start business.

     Net cash provided by operating activities was $6.9 million in 2004 compared to $11.1 million in 2003. The decrease was primarily due to increased investment in inventory partially offset by higher accounts payable.

     Net cash used in investing activities in 2004 was $17.1 million, primarily representing the $19.1 million of capital expenditures required to increase production capacity necessary to serve the traditional transducer market as well as grow our production capacity for the Silicon Microphone. Net cash provided by investing activities in 2003 of $30.5 million was due to the $45.2 million in cash generated by the sales of Synchro-Start and Ruwido offset by $14.8 million in capital equipment purchases.

     Net cash provided by financing activities in 2004 of $16.0 million represents the increase in borrowing during the year. The $48.0 million D Facility replaced the C Facility of $35.0 million plus related deferred fees and expenses. In addition, $9 million in borrowing was made on the Revolving Facility in December, 2004. Net cash used in financing activities in 2003 was $54.2 million which primarily represents the $9.5 million payment of principal on the bank debt related to the Excess Cash provision of the Credit Agreement; the $31.7 million payment of the A Facility portion of the bank debt; and $45.3 million in payments on the bank debt related to the sale of SSPI and Ruwido partially offset by the additional borrowing of $35 million of C Facility debt.

Cash Flows 2003 vs 2002

     Cash balances decreased by $12.7 million in 2003, as the Company used the $11.1 million of cash provided by operations and the $45.2 million in proceeds from the sale of SSPI and Ruwido to pay down debt and to fund capital expenditures.

     Net cash provided by operating activities was $11.1 million in 2003 compared to $29.7 million in 2002. Net cash provided by operating activities in 2002 was higher than in 2003 despite lower income from continuing operations. The 2002 loss included two significant non-cash write-offs — the $16.6 million non-cash loss on the sale of Ruf and the $6.7 million non-cash loss from adjustments in deferred tax valuations. The decrease in cash flow reflects cash generated by reductions in working capital in 2002 that were not repeated in 2003 — a reduction in accounts receivable of $6.9 million and a reduction of inventory of $9.4 million.

     Net cash provided by investing activities in 2003 of $30.5 million represents the $45.2 million in cash generated by the sales of Synchro-Start and Ruwido offset by $14.8 million in capital equipment purchases. The primary capital expenditures in 2003 were for new product tooling and production equipment, particularly the equipment required for the new Silicon Microphone. Net cash used in investing activities of $4.9 million in 2002 was primarily the purchases of new tooling and production equipment, partially offset by the proceeds from sale of the Taiwan building for $3.6 million.

     Net cash used in financing activities in 2003 was $54.2 million which primarily represents the $9.5 million payment of principal on the bank debt related to the Excess Cash provision of the Credit Agreement; the $31.7 million payment of the A Facility portion of the bank debt; and $45.3 million in payments on the bank debt related to the sale of SSPI and Ruwido partially offset by the additional borrowing of $35 million of C Facility debt. Debt payments on the long-term portion of the Company’s Credit Agreement totaled $10.5 million in 2002, with an additional $2.0 million in payments used to reduce the Company’s short-term debt. The Company issued $10 million of 10% Senior Subordinated Notes dated August 28, 2002.

The Recapitalization

     On June 30, 1999, Key Acquisition, L.L.C. (“Key Acquisition”), all of whose membership interests are held by limited partnerships for which Doughty Hanson & Co. Limited or its affiliates (collectively, “Doughty Hanson”) act as general partner, acquired control of Knowles Electronics, Inc. in a recapitalization transaction (“Recapitalization”). On June 29, 1999, Knowles’ equipment financing business, which included certain parcels of real estate, were distributed to our preexisting stockholders, in redemption of 10% of the stock owned by those stockholders. As part of the June 30, 1999 recapitalization, we repurchased from our

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preexisting stockholders for $505.5 million 90% of our common stock remaining outstanding after the previous day’s redemption, and our preexisting stockholders exchanged their remaining common stock for shares of the newly authorized common stock and preferred stock. In addition, upon closing of the Recapitalization, certain of our senior officers purchased shares of newly authorized common stock issued by Knowles. Upon the closing of the recapitalization, Key Acquisition owned approximately 82.3% of our newly authorized common stock and approximately 88.9% of our newly authorized preferred stock, certain of our preexisting stockholders owned approximately 10.3% of our common stock and approximately 11.1% of our preferred stock, and certain of our senior officers owned approximately 7.4% of our common stock.

     Ownership of Knowles. Interests in Key Acquisition, which owns approximately 83.6% of our common stock and 88.9% of our preferred stock are held by the limited partnerships. The general partner of these limited partnerships is Doughty Hanson & Co. Limited.

     Holding Company Reorganization. Subsequent to the Recapitalization, we reorganized Knowles Electronics, Inc. as a holding company. Pursuant to a contribution agreement on August 30, 1999 Knowles Electronics, Inc. contributed substantially all of its assets and liabilities (other than the capital stock of Knowles Intermediate Holding Company, Inc. and certain foreign subsidiaries and Knowles Electronics, Inc.’s liabilities under the Credit Agreement and Subordinated Bridge Notes) to Knowles Electronics, LLC, a newly created Delaware limited liability company. As a result of this reorganization, Knowles Electronics, Inc. is now a holding company that does not conduct any significant operations. Subsequent to the transaction, Knowles Electronics, Inc. changed its name to Knowles Electronics Holdings, Inc.

The Credit Agreement

     We entered into the Credit Agreement, dated as of June 28, 1999 and amended and restated as of July 21, 1999, and amended most recently April 14, 2004 with the Lenders named therein, JP Morgan Chase Bank (as successor to The Chase Manhattan Bank), as Administrative Agent and Swingline Lender, Morgan Stanley Senior Funding, Inc., as Syndication Agent, and Chase Securities Inc., as Lead Arranger and Book Manager. The Credit Agreement, as amended, consists of (i) a $89.6 million term loan facility (“B Facility”) due in scheduled principal payments that begin September 30, 2006 and are completed as of June 29, 2007, (ii) a $48 million term loan facility (“D Facility”) due June 29, 2007 and (iii) a $15 revolving credit facility due June 30, 2006 (the “Revolving Facility”). Under the terms of the Credit Agreement, and in order to provide financing for the Recapitalization, the A Facility (which was subsequently replaced with C Facility in March, 2003) and then the D Facility in April 2004) and B Facility were fully drawn on June 30, 1999, the closing date of the Recapitalization. The Revolving Facility is available for working capital and general corporate purposes. $9 million in borrowing was outstanding under The Revolving Facility as of December 31, 2004.

     In March 2003 we repaid $9.5 million of aggregate principal of the A and B Facilities in accordance with the excess cash provision of the amended Credit Agreement. In June 2003 we repaid $42 million in principal of the B Facility in accordance with Amendment No. 6 and the sale of Syncho-Start. An additional prepayment of $2.3 million related to the Synchro-Start sale was made in November 2003. A payment of $1 million related to the sale of Ruwido was made in July 2003. In April, 2004 the C Facility was replaced with a $48 million D Facility at substantially lower interest rates.

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Repayment Dates

     According to the revised terms of the Amended Credit Agreement, and taking into account the effect of the three prepayments in 2003, the B Facility will amortize in four quarterly amounts commencing on September 30, 2006. The D Facility is due and payable upon maturity on June 29, 2007.

     The Revolving Facility is available as revolving credit advances or letters of credit. Pursuant to the Revised Credit Agreement, this facility has no scheduled reduction in availability, unless the B Facility is fully repaid prior to June 30, 2006, in which case the Revolving Facility will cease to be available to the Company and any amounts outstanding thereunder shall thereupon become due and payable. If such earlier maturity does not occur, final repayment is due on all amounts outstanding under this facility on June 30, 2006. The Credit Agreement provides for certain limitations governing advances under the Revolving Facility, in particular limits on the amount of letters of credit and swingline loans outstanding at any one time.

Prepayment

     In addition to the scheduled repayment dates described above, in certain circumstances the Credit Agreement requires us to make mandatory prepayments of outstanding amounts under the B Facility and D Facility, when we or our subsidiaries receive proceeds of certain material dispositions and insurance claims or issue certain indebtedness or when we have a positive adjusted cash flow in the prior year. We may voluntarily prepay the B Facility in whole or in part without premium or penalty.

Interest Rate and Fees

     Amounts outstanding under the Revolving Facility will bear interest, at our option, at either (1) one-, two-, three- or six-month LIBOR plus an initial interest margin of 4.0% (as amended most recently April 14, 2004) 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% (“Alternate Base Rate”), in each case plus an initial margin of 3%. Amounts outstanding under B Facility will bear interest, at our option, at either (1) one-, two-, three- or six-month LIBOR plus an initial interest margin of 5.0% (as amended most recently April 14, 2004) or (2) the Alternate Base Rate plus an initial margin of 4%. The interest margin may be reduced for advances under the Revolving Facility if we, on a consolidated basis, meet certain specified leverage ratio targets during a period consisting of the prior four consecutive fiscal quarters. Amounts outstanding under the D Facility bear interest at one, two, three or six month LIBOR plus 6.25%.

     We will pay a commitment fee on the undrawn portion of the Revolving Facility at a rate of 0.380% to 0.50% per annum, depending upon our leverage ratio. In addition, the Amended Credit Agreement provides for additional interest to accrue to the B Facility at the rate of approximately $420,000 per year (subject to a reduction in the event of a prepayment of the B Facility), to be paid at the maturity of the facility (or in certain instances, at an earlier date). The requirement for the additional interest terminated with the prepayment of $42 million resulting from the sale of the Synchro-Start division. In addition, we will pay certain agency and other fees.

     On December 20, 2004 the company entered into a new unsecured $10 million credit agreement with Xerion Partners. Except in certain circumstances, loans under the new unsecured agreement bear interest at the one, two, three or six month LIBOR rate plus 7.75%. No borrowing was outstanding under this loan agreement as of December, 31, 2004.

Guarantee and Security

     Our obligations under the Credit Agreement are guaranteed by our U.S. subsidiaries. As security for our obligations under the Credit Agreement, we have pledged all of the shares of our U.S. subsidiaries and 65% of the shares of our non-U.S. subsidiaries and have granted the lenders a security interest in substantially all of our assets and the assets of our U.S. subsidiaries.

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Covenants

     The Amended Credit Agreement contains a number of covenants requiring us to achieve or maintain specified consolidated financial ratios, including certain interest expense coverage ratios and certain leverage ratios, which have been described above. The Amended Credit Agreement also contains general covenants which restrict the incurrence of debt and liens, the payment of dividends, the incurrence of additional debt, the disposition of assets, the incurrence of capital expenditures above certain levels or the making of other investments, not to make any acquisitions of another company or business and certain other activities and transactions.

Senior Subordinated Debt

13	1/8% Senior Subordinated Notes due 2009

     We issued Notes under an Indenture, dated October 1, 1999, among us, the Subsidiary Guarantors and the Bank of New York, as Trustee (the “Trustee”). The Notes are general unsecured obligations of the Company, rank subordinate to all Senior Indebtedness of the Company and pari passu or senior to all other Indebtedness of the Company, and are unconditionally guaranteed on a general unsecured senior subordinated basis by all of the Company’s existing and future domestic Restricted Subsidiaries and any other Restricted Subsidiaries of the Company that guarantee the Company’s indebtedness under the Credit Agreement.

Principal, Maturity and Interest

     The Company issued $153,200,000 aggregate principal amount of Notes on October 1, 1999 in denominations of $1,000 and integral multiples of $1,000. The Notes will mature on October 15, 2009. The Notes will not be entitled to the benefit of any mandatory sinking fund.

     Subject to the covenants described below under “Covenants” and applicable law, the Company may issue additional Notes under the Indenture. The Notes offered hereby and any additional Notes subsequently issued will be treated as a single class for all purposes under the Indenture.

     Interest on the Notes will accrue at the rate of 13 1/8% per annum and will be payable semi-annually in arrears on each April 15 and October 15 (each, an “Interest Payment Date”), commencing on April 15, 2000. Payments will be made to the persons who are registered Holders at the close of business on April 1 and October 1, respectively (each, a “Regular Record Date”), immediately preceding the applicable interest payment date. The Company did not make the interest payment on our senior subordinated notes scheduled for April 15, 2002. We subsequently obtained an Amendment and Waiver dated as of May 10, 2002 to our Credit Agreement and made the interest payment on our senior subordinated notes that was scheduled for April 15, 2002 on May 14, 2002.

Guarantees

     Payment of the principal of, premium, if any, and interest on the Notes will be guaranteed, jointly and severally, on an unsecured senior subordinated basis by certain Subsidiaries of the Company (the “Subsidiary Guarantors”), each of which has guaranteed Indebtedness of the Company incurred under the Credit Agreement. All current and future Restricted Subsidiaries of the Company other than Foreign Subsidiaries will be “Subsidiary Guarantors.” In addition, if any Restricted Subsidiary which is a Foreign Subsidiary becomes a guarantor of Indebtedness of the Company incurred under the Credit Agreement, the Company will cause such Restricted Subsidiary to guarantee the Company’s obligations under the Notes. Foreign Subsidiaries of the Company, which have substantial assets, liabilities, net sales and income, will not initially guarantee the Notes, and the Company does not anticipate that any Foreign Subsidiary will at any time become a Subsidiary Guarantor.

     The Note Guarantee of any Subsidiary Guarantor may be released in certain circumstances.

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   Covenants

     The Senior Subordinated Note Agreement also contains general covenants, which restrict Limitation on Indebtedness, Limitation on Senior Subordinated Indebtedness, Limitation on Restricted Payments, Limitation on Dividend and Other Payment Restrictions Affecting Restricted Subsidiaries, and Limitation on Liens. The Senior Subordinate Note Agreement also contains the following covered in detail below.

     Limitation on Asset Sales

     The Company will not, and will not permit any Restricted Subsidiary to, consummate any Asset Sale, unless: (i) the consideration received by the Company or such Restricted Subsidiary is at least equal to the fair market value of the assets sold or disposed of; and (ii) at least 75% of the consideration received consists of: (A) Replacement Assets; or (B) cash or Temporary Cash Investments, provided that the amount of: (a) any liabilities of the Company or any such Restricted Subsidiary that are assumed by the transferee of any such assets, provided that the Company or such Restricted Subsidiary is irrevocably and unconditionally released in writing from all such liabilities, or (b) any notes or other obligations received by the Company or any such Restricted Subsidiary from such transferee that are converted within 120 days by the Company or such Restricted Subsidiary into, shall be deemed to be cash for the purposes of determining the percentage of cash or Temporary Cash Investments received by the Company or such Restricted Subsidiary.

     Repurchase of Notes upon a Change of Control

     The Company must commence, within 30 days of the occurrence of a Change of Control, and consummate an Offer to Purchase for all Notes then outstanding, at a purchase price equal to 101% of the principal amount thereof, plus accrued interest (if any) to the Payment Date.

     There can be no assurance that the Company will have sufficient funds available at the time of any Change of Control to make any debt payment (including repurchases of Notes) required by the foregoing covenant (as well as any covenant that may be contained in other securities of the Company which might be outstanding at the time). The above covenant requiring the Company to repurchase the Notes will, unless consents are obtained, require the Company to repay all indebtedness then outstanding which by its terms would prohibit such Note repurchase, either prior to or concurrently with such Note repurchase.

   10% Senior Subordinated Notes due 2009

     We issued a Note under a Note Purchase Agreement dated August 28, 2002, among us, the Subsidiary Guarantors and Key Acquisition LLC. The Note is a general unsecured obligation of the Company, ranks subordinate to all Senior Indebtedness of the Company and pari passu to the 13 1/8% Senior Subordinated Notes due 2009.

   Principal, Maturity and Interest

     The Company issued a $10,000,000 Note on August 28, 2002 that will mature on October 15, 2009 and not be entitled to the benefit of any mandatory sinking fund.

     Interest on the Note will accrue at the rate of 10% per annum and will be payable semi-annually in arrears on each April 15 and October 15 (each, an “Interest Payment Date”), commencing on April 15, 2003. Payments will be made to the persons who are registered Holders of such Note either in cash or at the option of the Company, by issuance of an additional Note registered in the name of such Holders, bearing interest from the relevant Interest Payment Date at a rate of 10%, and having a face value equal to the amount of the Interest Payment applicable to such Note.

   Guarantees

     Payment of the principal of, premium, if any, and interest on the Notes will be guaranteed, jointly and severally, on an unsecured senior subordinated basis by certain Subsidiaries of the Company (the “Subsidiary Guarantors”), each of which has guaranteed Indebtedness of the Company incurred under the Credit Agreement. All current and future Restricted Subsidiaries of the Company other than Foreign Subsidiaries will be “Subsidiary Guarantors.” In addition, if any Restricted Subsidiary which is a Foreign Subsidiary becomes a guarantor of Indebtedness of the Company incurred under the Credit Agreement, the Company will cause such Restricted Subsidiary to guarantee the Company’s obligations under the Notes. Foreign Subsidiaries of the Company, which have

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substantial assets, liabilities, net sales and income, will not initially guarantee the Notes, and the Company does not anticipate that any Foreign Subsidiary will at any time become a Subsidiary Guarantor.

     The Note Guarantee of any Subsidiary Guarantor may be released in certain circumstances.

     Covenants

     The Senior Subordinated Note Agreement also contains general covenants, which restrict Limitation on Indebtedness, Limitation on Restricted Payments, Limitation on Dividend and Other Payment Restrictions Affecting Restricted Subsidiaries, Limitation on the Issuance of Capital Stock of Restricted Subsidiaries, Limitation on Issuances of Guarantees by Restricted Subsidiaries, Limitation on Transactions with Stockholders and Affiliates, Limitation on Senior Subordinated Indebtedness and Limitation on Liens. The Senior Subordinate Note Agreement also contains the following covered in detail below.

     Limitation on Asset Sales

     The Company will not, and will not permit any Restricted Subsidiary to, consummate any Asset Sale, unless: (i) the consideration received by the Company or such Restricted Subsidiary is at least equal to the fair market value of the assets sold or disposed of; and (ii) at least 75% of the consideration received consists of: (A) Replacement Assets; or (B) cash or Temporary Cash Investments, provided that the amount of: (a) any liabilities of the Company or any such Restricted Subsidiary that are assumed by the transferee of any such assets, provided that the Company or such Restricted Subsidiary is irrevocably and unconditionally released in writing from all such liabilities, or (b) any notes or other obligations received by the Company or any such Restricted Subsidiary from such transferee that are converted within 120 days by the Company or such Restricted Subsidiary into, shall be deemed to be cash for the purposes of determining the percentage of cash or Temporary Cash Investments received by the Company or such Restricted Subsidiary.

     Repurchase of Notes upon a Change of Control

     The Company must commence, within 30 days of the occurrence of a Change of Control, and consummate an Offer to Purchase for all Notes then outstanding, at a purchase price equal to 101% of the principal amount thereof, plus accrued interest (if any) to the Payment Date.

     There can be no assurance that the Company will have sufficient funds available at the time of any Change of Control to make any debt payment (including repurchases of Notes) required by the foregoing covenant (as well as any covenant that may be contained in other securities of the Company which might be outstanding at the time). The above covenant requiring the Company to repurchase the Notes will, unless consents are obtained, require the Company to repay all indebtedness then outstanding which by its terms would prohibit such Note repurchase, either prior to or concurrently with such Note repurchase.

Credit Agreement dated as of December 20, 2004

     We entered into a Credit Agreement, dated as of December 20, 2004 with Xerion Partners II Master Fund Limited as lender and other lenders party hereto from time to time. The Credit Agreement provides for the granting of loans at the Company’s request up to $10 million and in the case of the initial borrowing, not less than $8.5 million. The commitment to provide loans terminates January 31, 2005. Any borrowings mature June 29, 2007. Except in certain limited specified cases, the loans bear interest at a one-, two-, three-, or six-month adjusted LIBOR plus 7.75%.

Subsequent Events

     The Company borrowed $9.0 million under the Xerion Credit Agreement dated as of December 20, 2004 in January, 2005.

     The Company obtained an Amendment No. 8 and Waiver dated as of March 10, 2005, to the Credit Agreement dated as of June 28, 1999. The Amendment, among other things, permits us to incur an additional $10 million of unsecured indebtedness and increases for each period beginning December 31, 2004 through maturity of the loans, the maximum allowable leverage ratio applicable to us under the Credit Agreement’s leverage ratio covenant.

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     Pursuant to the terms of the Xerion Credit Agreement dated as of December 20, 2004 that Agreement is deemed to be amended by the Amendment No. 8 to the same extent.

     The Company obtained Amendment One to the Xerion Credit Agreement March 29, 2005 which increased the credit facility by $10 million. The Company borrowed $10 million under the Xerion Credit Agreement in March 2005. See Exhibit 10.33 filed with this Form 10-K.

Critical Accounting Policies

     The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions. We believe that of our significant accounting policies (see Note 1 to the consolidated financial statements), the following may involve a higher degree of judgment and complexity.

   Bad Debt

     We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

   Excess and Obsolete Inventory

     Significant management judgment is required to determine the reserve for obsolete or excess inventory. Inventory on hand may exceed future demand either because the product is outdated, or obsolete, or because the amount on hand is more than can be used to meet future need. We currently make a 50% provision for all inventory that has had no activity for 18 months and a 100% provision for all inventory that had no activity for more than 36 months as well as any additional specifically identified inventory to be excess. We also provide for the total value of inventories that we determine to be obsolete based on criteria such as customer demand and changing technologies. At December 31, 2004, our inventory reserves were $5.3 million, or 15% of our $34.7 million gross inventories.

     We value our inventories at lower of cost or market. Cost is determined by the first-in, first-out (FIFO) method.

   Warranties

     Products sold are generally covered by a warranty for periods ranging from one to three years. We accrue a warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service warranty obligations is based on historical claims experience and expectation of future conditions. To the extent we experience increased (or decreased) warranty claim activity or increased (or decreased) costs associated with servicing those claims, our warranty accrual will increase (or decrease) resulting in decreased (or increased) gross profit.

   Pension Benefits

     The Company’s pension benefit costs and obligations are dependent on the various actuarial assumptions used in calculating such amounts. These assumptions relate to discount rates, salary growth, long-term return on plan assets and other factors. The Company bases the discount rate assumptions on current investment yields on AA-rated long-term corporate bonds. The salary growth assumptions reflect the Company’s actual experience and near-term outlook. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment. The Company’s key assumptions are described in further detail in Consolidated Financial Statement Note 8.

   Deferred Tax Assets

     We account for deferred income taxes based upon differences between the financial reporting and income tax bases of our assets and liabilities. The measurement of deferred tax assets is adjusted by a valuation allowance, if necessary, to recognize the extent to which, more likely than not, the future tax benefits will be recognized.

   New Accounting Pronouncements

     In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No 150 — Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 requires certain obligations including mandatorily

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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.

     In November 2004, the FASB issued SFAS No. 151, “Inventory Costs - an amendment of ARB No. 43 Chapter 4.” SFAS No. 151 more clearly defines when excessive idle facility expense, freight, handling costs, and spoilage are to be current-period charges. In addition, SFAS No. 151 requires the allocation of fixed production overhead to the cost of conversion to be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has reviewed the provisions of this standard, and does not expect SFAS No. 151 to have a material impact on the financial statements.

     In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R supercedes APB No. 25, SFAS No. 123, as amended by SFAS No. 148, and related interpretations. Under FAS No. 123R, compensation cost is measured at the grant date based on the estimated fair value of the award and is required to be recognized as compensation expense over the vesting period. The Company plans to adopt SFAS No. 123R in the third quarter of 2005. The Company has reviewed the provisions of this standard, and its adoption is not expected to have a material effect on the Company’s Consolidated Financial Statements.

     Management does not anticipate the adoption of any other new accounting pronouncement will have a material effect on our results of operations or on the financial position of the company.

   Restatement of Financial Statements

     The Company is restating its prior years’ financial statements because an error was discovered that affects cost of sales and other comprehensive income and certain disclosures previously reported in our financial statements. The results for 2000 have been restated to correct an error in the balance of other comprehensive income resulting from the conversion to a new consolidation system in 2000. The error incorrectly recorded a translation loss as an adjustment to equity rather than an adjustment to the income statement and was primarily related to the U.K. entity. The correction increased cost of sales in 2000 by $1,578 and decreased net income by the same amount. Appropriate balance sheet accounts have also been restated.

   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 thru May operating results of the Synchro-Start business, the sale of which was completed May 30, 2003, and the gain on the Synchro-Start sale. Discontinued operations also includes the January thru July operating results of the Infrared business, the sale of which was completed July 29, 2003, and the loss on the sale. The assets and liabilities of these businesses have been summarized as current on a gross basis and reclassified for presentation on the December 31, 2002 balance sheet.

     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 3 — Segments and Geographical Information.

     Summarized selected financial information for the discontinued operations is as follows:

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     The Company sold Synchro-Start for $49.7 million. The Company retained pension liabilities of $3.5 million associated with the pension plan covering U.S. employees. 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. 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.

     In November 2002, the Company sold its Ruf division, which was part of the Company’s Automotive Components reporting segment. In accordance with APB No. 30 Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, the Ruf business did not qualify as a discontinued operation and therefore, its results of operations and cash flows are included in the Company’s results of continuing operations and cash flows for all 2002 and 2001 periods presented in this document.

Forward Looking Statements

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

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

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

Item 7a. Quantitative and Qualitative Disclosures about Market Risk

     We do not hedge our foreign currency exchange rate exposure. Therefore, we are exposed to foreign currency exchange rate risks. Our revenues are primarily denominated in the U.S. dollar. During 2004, approximately 91% of our revenue was denominated in U.S. dollars compared to 93% in 2003. In 2004 and 2003, approximately 7% and 4%, respectively, of our revenue was denominated in Japanese Yen, and the balance were denominated in other foreign currencies. Some of our expenses are denominated in the local currencies of the United Kingdom, China, Japan, Malaysia and Taiwan,

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a number of which 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. If the China Renminbi were to appreciate 10% against the U.S. Dollar, the Company estimates its Renminbi denominated costs would increase approximately $2.6 million. Similarly, a 10% appreciation of the Malaysia Ringgit would increase Ringgit denominated costs approximately $2.3 million.

     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 B and D Facilities of the Credit Agreement have variable interest rates, and therefore, adjust to market conditions. An increase of 1 percentage point in the interest rate of the loans under the Credit Agreement would increase annual interest expense by approximately $1.4 million. The amount outstanding under the 13 1/8% Senior Subordinated Notes accrues interest at a fixed rate of 13.125%. We have estimated the fair value of the notes as of December 31, 2004 to be 104% of their face value or $159 million based on current market prices. We also have $10 million outstanding under 10% Senior Subordinated Notes.

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Item 8

KNOWLES ELECTRONICS HOLDINGS, INC.

CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2004, 2003 and 2002

CONTENTS

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Knowles Electronics Holdings, Inc.

We have audited the accompanying consolidated balance sheets of Knowles Electronics Holdings, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Knowles Electronics Holdings, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

	/s/ Ernst & Young LLP

Chicago, Illinois
February 25, 2005

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KNOWLES ELECTRONICS HOLDINGS, INC.

CONSOLIDATED BALANCE SHEETS