SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


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

		For the quarterly period ended September 30, 2003

or

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

		For the transition period from to

Commission file number 333-40076

Knowles Electronics Holdings, Inc.

(Exact name of registrant as specified in its charter)


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

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

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

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

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

TABLE OF CONTENTS


Part I — Financial Information
		Consolidated Statements of Operations
		Consolidated Balance Sheets
		Consolidated Statements of Cash Flows
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Qualitative and Quantitative Disclosures about Market Risk
	Item 4. Controls and Procedures
Part II. Other Information
	Item 6. Exhibits and Reports on Form 8-K
	Exhibits
SIGNATURES
EX-31.1 Certification Pursuant to Section 302
EX-31.2 Certification Pursuant to Section 302

TABLE OF CONTENTS


		Page

PART I —	Financial Information
Item 1	Financial Statements Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2002		3
	Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002		4
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002		5
	Notes to the Consolidated Financial Statements		6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 3	Qualitative and Quantitative Disclosures about Market Risk		27
Item 4	Controls and Procedures		27
PART II —	Other Information
Item 1	Legal Proceedings — None
Item 2	Changes in Securities and Use of Proceeds — None
Item 3	Defaults Upon Senior Securities — None
Item 4	Submission of Matters to a Vote of Security Holders — None
Item 5	Other Information — None
Item 6	Exhibits and Report on Form 8-K		28
	Signatures		29
	Certifications

Part I — Financial Information

Knowles Electronics Holdings, Inc.

Consolidated Statements of Operations
Unaudited


			Three months ended September 30,						Nine months ended September 30,
			2003			2002			2003			2002

			(in thousands)						(in thousands)
Net sales			$	34,660		$	39,708		$	111,070		$	123,415
Cost of sales				17,482			21,619			55,357			66,557

Gross margin				17,178			18,089			55,713			56,858
Research and development expenses				2,539			2,461			7,708			8,868
Selling and marketing expenses				2,260			2,136			6,682			7,252
General and administrative expenses				4,343			4,554			14,870			16,351
Impairment of Ruf division assets held for sale				—			4,175			—			12,858
Restructuring expenses				—			955			—			1,556

Operating income				8,036			3,808			26,453			9,973
Other income (expense):
	Interest income			23			25			63			35
	Interest expense			(8,669	)		(8,739	)		(27,624	)		(26,372	)

Loss from continuing operations before income taxes				(610	)		(4,906	)		(1,108	)		(16,364	)
Income tax (benefit)				567			(2,133	)		1,854			(2,703	)

Loss from continuing operations after income taxes				(1,177	)		(2,773	)		(2,962	)		(13,661	)
Income (loss) from discontinued operations after income taxes:
	Gain (loss) on sale of Infrared division			432			—			(8,402	)		—
	Gain on sale of Synchro-Start division			1,121			—			35,294			—
	Income (loss) from discontinued operations			(462	)		1,402			933			4,059

		Income from discontinued operations after income taxes		1,091			1,402			27,825			4,059

Net income (loss)			$	(86	)	$	(1,371	)	$	24,863		$	(9,602	)

Knowles Electronics Holdings, Inc.

Consolidated Balance Sheets
(unaudited)


					Restated
		September 30,			December 31
		2003			2002

Assets
Current Assets:
	Cash and cash equivalents	$	21,322		$	23,879
	Accounts receivable, net		19,220			21,084
	Inventories, net		16,469			19,620
	Prepaid expenses and other		5,076			5,076
	Assets of discontinued operations		—			33,490

Total current assets			62,087			103,149
Property, plant and equipment, at cost:
Land			2,787			2,787
Building and improvements			18,710			18,215
Machinery and equipment			47,398			44,740
Furniture and fixtures			23,889			23,421
Construction in progress			5,302			4,674

	Subtotal		98,086			93,837
Accumulated depreciation			(59,751	)		(55,073	)

	Net		38,335			38,764
Other assets, net			3,336			1,187
Deferred finance costs, net			7,297			8,058

Total assets		$	111,055		$	151,158

Liabilities and stockholders’ equity (deficit)
Current liabilities:
	Accounts payable	$	8,017		$	10,861
	Accrued compensation and employee benefits		5,487			4,602
	Accrued interest payable		10,149			7,253
	Accrued warranty and rebates		4,361			8,344
	Accrued restructuring costs		182			1,197
	Other liabilities		2,837			3,388
	Income taxes		6,732			6,833
	Deferred income taxes		497			541
	Current portion of notes payable		2,300			11,996
	Liabilities of discontinued operations		—			13,153

Total current liabilities			40,562			68,168
Accrued pension liability			13,781			12,566
Other noncurrent liabilities			104			—
Notes payable			287,766			327,626
Preferred stock mandatorily redeemable in 2019 including accumulating dividends			277,630			258,547
Stockholders’ equity (deficit):
	Common stock		—			—
	Capital in excess of par value		16,488			16,838
	Accumulated deficit		(519,972	)		(525,752	)
	Accumulated other comprehensive loss		(5,304	)		(6,835	)

Total stockholders’ equity (deficit)			(508,788	)		(515,749	)

Total liabilities and stockholders’ equity (deficit)		$	111,055		$	151,158

Knowles Electronics Holdings, Inc.

Consolidated Statements of Cash Flows

(unaudited)


			Nine months ended September 30,
			2003			2002

			(in thousands)
Operating Activities
Net loss from continuing operations			$	(2,962	)	$	(13,661	)
Adjustments to reconcile net loss from continuing operations to net cash provided by operating activities:
	Depreciation and amortization			5,617			7,418
	Impairment of assets held for sale			—			12,858
	Restructuring costs			—			1,556
	Amortization of deferred financing fees and debt discount			2,341			1,812
	Inventory obsolescence provision			978			1,627
	Deferred income taxes			(1,044	)		(1,883	)
	Stock compensation expense			—			200
	Loss on disposal of fixed assets			160			—
	Change in assets and liabilities:
		Accounts receivable		1,864			6,481
		Inventories		2,173			6,039
		Other assets		351			671
		Accounts payable		(2,844	)		(4,886	)
		Accrued restructuring costs		(1,015	)		(2,551	)
		Accrued interest payable		3,068			4,832
		Accrued compensation and benefits		885			20
		Other current liabilities		(4,604	)		(61	)
		Other noncurrent liabilities		917			706
		Income taxes payable		(101	)		(3,569	)
Net cash provided by discontinued operating activities				3,633			6,987

Net cash provided by operating activities				9,417			24,596
Investing Activities
Proceeds from sales of businesses				45,722			—
Purchases of property, plant, and equipment, net				(5,752	)		(7,105	)

Net cash provided by (used in) investing activities				39,970			(7,105	)
Financing Activities
Debt payments — long term				(84,802	)		(6,750	)
Debt proceeds — long term				35,000			10,000
Debt payments — short term, net				—			(1,534	)
Costs associated with debt				(1,749	)		(541	)
Repurchase of common stock				(350	)		(400	)

Net cash provided by (used in) financing activities				(51,901	)		775
Effect of exchange rate changes on cash				(43	)		(476	)

Net change in cash and cash equivalents				(2,557	)		17,790
Cash and cash equivalents at beginning of period				23,879			2,130

Cash and cash equivalents at end of period			$	21,322		$	19,920

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In Thousands)

September 30, 2003 and 2002

(unaudited)

1. Basis of Recapitalization and Presentation

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

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of our management, all adjustments, consisting of normal recurring accruals, necessary for a fair presentation have been included. Certain prior year amounts have been reclassified to conform to current year presentation. The results for the period ended September 30, 2003 do not necessarily indicate the results that may be expected for the full year ending December 31, 2003. For further information, refer to the Company’s consolidated financial statements and notes thereto included in the Company’s Form 10-K dated for the year ended December 31, 2002.

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

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

2. Discontinued Operations

The Company’s consolidated financial statements and related footnote disclosures reflect the Synchro-Start and Infrared (Ruwido) businesses as discontinued operations, net of applicable income taxes, for all periods presented in accordance with SFAS No. 144 — Accounting for the Impairment or Disposal of Long-Lived Assets. As such, discontinued operations includes the January 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 7. Segments and Geographical Information.

Operating results of the discontinued business for the three and nine months ended September 30, 2003 and 2002, respectively, are as follows:


	Three months ended						Nine months ended
	September 30,						September 30,
	2003			2002			2003			2002

Sales	$	1,207		$	11,888		$	26,513		$	37,420

Income (loss) from discontinued operations	$	(462	)	$	1,489		$	1,102		$	4,423
Income tax expense		—			(87	)		(169	)		(364	)

Income (loss) from discontinued operations, net of tax	$	(462	)	$	1,402		$	933		$	4,059

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

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

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

Gain (loss) on disposal of Infrared division, net of tax	$	432		$	—		$	(8,402	)	$	—

The major classes of assets and liabilities for the discontinued operations at December 31, 2002 were as follows:


	December 31,
	2002

Current assets	$	23,942
Net property, plant and equipment		8,309
Miscellaneous other assets		1,239

Assets of discontinued operations	$	33,490

Accounts payable and other current liabilities	$	11,871
Notes payable		1,282

Liabilities of discontinued assets	$	13,153

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 $1.0 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 $100 on July 29, 2003 and the buyer assumed debt of $4.0 million. The Company recorded a pre-tax loss on the sale of $8.4 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 periods presented in this document.

3. Accumulated Other Comprehensive Income

For the nine months ended September 30, 2003 and 2002, total comprehensive income (loss) amounted to $26,394 and ($7,273), respectively. For the three months ended September 30, 2003 and 2002, total comprehensive income (loss) amounted to ($90) and ($1,391), respectively. The difference between net income (loss) and comprehensive income (loss) is related primarily to the Company’s foreign currency translation.

4. New Accounting Standards

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations,” which is effective for fiscal years beginning after June 15, 2002. The Statement requires legal obligations associated with the retirement of long-lived assets to be recognized at their fair value at the time that the obligations are incurred. Upon initial recognition of a liability, that cost should be capitalized as part of the related long-lived asset and allocated to expense over the useful life of the asset. We adopted SFAS No. 143 as of January 1, 2003, and there was no material impact on our financial position or results of operations.

In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Cost Associated with Exit or Disposal Activities,” which changes the timing of the recognition of restructuring charges. Liabilities for restructuring costs will be required to be recognized when the liability is incurred rather than when we commit to the plan. SFAS No. 146 is effective for restructuring activity initiated after December 31, 2002. The adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. We adopted the provisions of FIN No. 45 on January 1, 2003 for all new or amended guarantees subsequent to that date. The adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

In May 2003, the FASB issued SFAS No 150 — Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 requires certain obligations including mandatorily redeemable preferred stock to be reflected as liabilities in the balance sheet. Additionally, dividends paid or accrued on mandatorily redeemable preferred stock will be presented as interest expense in the income statement. The Company will adopt the provisions of SFAS 150 on January 1, 2004.

5. Inventory

Inventories are as follows:


		September 30,		December 31,
		2003		2002

Raw material & components		$	9,029	$	10,269
Work in process			1,753		1,074
Finished goods			10,319		13,367

			21,101		24,710
Less allowances for:
	Obsolescence and net realizable value		4,632		5,090

		$	16,469	$	19,620

6. Notes Payable

As part of the Recapitalization transaction, the Company entered into a Senior Credit Agreement dated June 28, 1999 and amended and restated as of July 21, 1999, and further amended as of December 23, 1999, April 10, 2000, December 12, 2001, May 10, 2002, March 25, 2003 and May 28, 2003 with certain lenders (“Senior Credit Agreement”). The Company obtained a Limited Waiver and Amendment dated as of March 25, 2003 under which the remaining balance of the Term A Facility was repaid and replaced by a $35,000 Term C Facility due June 29, 2007 with a fixed interest rate of 18.50%. The Limited Waiver and Amendment waives the required interest coverage ratio and leverage ratio from the effective date of the Amendment through June 29, 2003 and amends these ratios for the remainder of the Credit Agreement. The Limited Waiver and Amendment also increased the Term B Facility interest rate and the Revolving Credit Facility interest rate by 0.5 percentage points, modified the Term B Facility installment payments, and reduced the Revolving Credit Facility to $15,000.

The Senior Credit Agreement as amended consists of approximately $195,000 (effective March 31, 2003), which provides for revolving loans of $15,000 (Revolving Credit Facility) through June 30, 2006 (unless the Term B Facility is paid in full prior to such date in which case the Revolving Credit Facility will cease to exist and any amounts outstanding thereunder shall become due and payable), a Term B Facility of $145,000 (Term B Facility), which matures on June 29, 2007, and a Term C Facility of $35,000 (Term C Facility), which matures on June 29, 2007. The Revolving Credit facility bears interest, at the Company’s option, at either: (1) one-, two-, three-, or six-month LIBOR plus 4.0%, or (2) the greater of the prime rate, a base certificate of deposit rate plus 1.00%, or the federal funds effective rate plus 0.50% (the Alternate Base Rate), in each case plus an initial margin of 3%. The Term 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 Term C Facility bears interest at a fixed rate of 18.5% of which 13% is payable in cash, and the remainder, at the Company’s option, payable in cash or increased principal. The percentage rate that is payable in cash increases 1.0 percentage point on March 31 of each year. At September 30, 2003, the weighted average interest rate was 6.25% for the Term B Facility and 18.5% for the Term C Facility.

The Company obtained Amendment Number Six and Waiver, dated as of May 28, 2003, which approved the sale of the Synchro-Start division and Ruwido (infrared) division under certain conditions. The Synchro-Start division sale required minimum net proceeds from the sale of $42 million to be used to prepay Term B Facility loans, provided that $10 million of the principal repayment out of the net proceeds from the transaction would be applied to the subsequent scheduled repayments, and any payments in respect of excess cash flow, and the remaining net proceeds would reduce the remaining scheduled Term B repayments ratably. The sale of the Ruwido division would require a prepayment of not less than $1 million made up of the sum of the net proceeds received on the date of consummation plus the amount of any optional prepayments. The Amendment Number Six and Waiver also amended the definition of consolidated EBITDA to exclude up to $7.5 million of cash restructuring charges taken in 2003, 2004 and 2005 in connection with restructuring of overhead costs. The Company completed the sale of the Synchro-Start division May 30, 2003 and prepaid $42 million of Term B facility loans. An additional prepayment of $2.3 million was made in November 2003

based on the final purchase price adjustment related to the Synchro-Start sale. The Company completed the sale of the Ruwido division July 29, 2003 and made the required $1 million principal prepayment.

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


	September 30,		December 31,
	2003		2002

Term A facility	$	—	$	33,461
Term B facility		93,900		144,998
Term C Facility		35,172		—
13 1/8% Senior Subordinated Notes, net of discount		150,994		151,163
10% Senior Subordinated Notes		10,000		10,000

		290,066		339,622
Less: Current portion		2,300		11,996

Total long-term notes payable	$	287,766	$	327,626

Included in the liabilities of discontinued operations is the long-term debt of Ruwido, our Austrian subsidiary as follows:


	September 30,		December 31,
	2003		2002

Austrian subsidiary long-term debt due September 2006	$	—	$	1,145
Austrian subsidiary long-term debt due June 2006		—		593

		—		1,738
Less: Current portion		—		456

Total long-term notes payable	$	—	$	1,282

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

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

The Company’s Senior Credit Agreement requires that the Company comply with certain covenants and restrictions, including specific financial ratios that must be maintained. As of September 30, 2003, the Company is in compliance with these covenants. If future actual results are lower than planned the Company may be unable to comply with the debt covenants or make required debt service payments. Such inability could have a material adverse impact on the Company’s financial condition, results of operations or liquidity. There are no assurances that the Company could favorably resolve such a situation.

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

The 13 1/8% Notes and 10% Notes (collectively “Subordinated Notes”) are unconditionally guaranteed, on a joint and several basis, by the following wholly owned U.S. subsidiaries of the Company: Knowles

Electronics LLC, Knowles Intermediate Holding, Inc., Emkay Innovative Products, Inc. and Knowles Manufacturing Ltd. The following tables present summarized balance sheet information of the Company as of September 30, 2003 and December 31, 2002, summarized income statements for the three and nine months ended September 30, 2003 and 2002, and summarized cash flow information for the nine months ended September 30, 2003 and 2002. The column labeled “Parent Company” represents the holding company for each of the Company’s direct subsidiaries, which are guarantors of the Subordinated Notes, all of which are wholly owned by the parent company; and the column labeled “Non-guarantors” represents wholly owned subsidiaries of the Guarantors, which are not guarantors of the Subordinated Notes. Pursuant to a contribution agreement effective August 30, 1999, Knowles Electronics, Inc., recognized in prior periods as the parent company, contributed substantially all of its operating assets and liabilities (other than the capital stock of Knowles Intermediate Holding, Inc. and certain foreign subsidiaries and Knowles Electronics, Inc.’s liabilities under the Senior Credit Agreement and Subordinated Notes) to Knowles Electronics, LLC, a newly created Delaware limited liability company. As a result of this reorganization, Knowles Electronics, Inc., which changed its name to Knowles Electronics Holdings, Inc., is now a holding company that does not conduct any significant operations. The Company believes that separate financial statements and other disclosures regarding the Guarantors, except as otherwise required under Regulation S-X, are not material to investors.

Summarized balance sheet information as of September 30, 2003 and December 31, 2002, summarized income statement for the three and nine months ended September 30, 2003 and 2002, and summarized cash flow information for the nine months ended September 30, 2003 and 2002 is as follows:


	September 30, 2003

	Parent			Guarantors		Non-Guarantors		Eliminations			Consolidated

Cash	$	8,575		$	8,057	$	4,690	$	—		$	21,322
Accounts receivable		—			28,615		70,205		(79,600	)		19,220
Inventories		—			5,566		10,903		—			16,469
Assets of discontinued operations		—			—		—		—			—
Other current assets		—			1,364		3,712		—			5,076
Net property, plant and equipment		—			18,942		19,393		—			38,335
Assets held for sale, net of impairment		—			—		—		—			—
Investment in and advances to subsidiaries		101,347			344,039		2,913		(448,299	)		—
Deferred finance costs, net		7,297			—		—		—			7,297
Deferred income taxes		—			—		—		—			—
Other non-current assets		—			3,146		190		—			3,336

Total assets	$	117,219		$	409,729	$	112,006	$	(527,899	)	$	111,055

Accounts payable	$	—		$	38,468	$	49,149	$	(79,600	)	$	8,017
Accrued restructuring costs		—			67		115		—			182
Advances from parent		210,255			83,309		2,535		(296,099	)		—
Liabilities of discontinued operations		—			—		—		—			—
Other current liabilities		9,259			15,309		5,495		—			30,063
Short-term debt		2,300			—		—		—			2,300
Noncurrent liabilities		—			11,218		2,667		—			13,885
Notes payable		287,766			—		—		—			287,766
Preferred stock		277,630			—		—		—			277,630
Stockholders’ equity (deficit)		(669,991	)		261,358		52,045		(152,200	)		(508,788	)

Total liabilities and stockholders’ equity (deficit)	$	117,219		$	409,729	$	112,006	$	(527,899	)	$	111,055


	December 31, 2002

	Parent			Guarantors		Non-Guarantors		Eliminations			Consolidated

Cash	$	9,614		$	7,578	$	6,687	$	—		$	23,879
Accounts receivable		—			28,511		51,479		(58,906	)		21,084
Inventories		—			8,120		11,500		—			19,620
Assets of discontinued operations		—			11,583		29,932		(8,025	)		33,490
Other current assets		—			2,204		2,872		—			5,076
Net property, plant and equipment		—			19,377		19,387		—			38,764
Investment in and advances to subsidiaries		101,347			216,763		425		(318,535	)		—
Deferred finance costs, net		8,058			—		—		—			8,058
Other non-current assets		—			996		191		—			1,187

Total assets	$	119,019		$	295,132	$	122,473	$	(385,466	)	$	151,158

Accounts payable	$	—		$	33,187	$	29,506	$	(51,832	)	$	10,861
Accrued restructuring costs		—			1,045		152		—			1,197
Advances from parent		137,293			16,026		2,650		155,969			—
Liabilities of discontinued operations		—			10,176		19,727		(16,750	)		13,153
Other current liabilities		6,361			18,505		6,942		(847	)		30,961
Short-term debt		11,996			—		—		—			11,996
Noncurrent liabilities		—			10,101		2,465		—			12,566
Notes payable		327,626			—		—		—			327,626
Preferred stock		258,547			—		—		—			258,547
Stockholders’ equity (deficit)		(622,804	)		206,092		61,031		(160,068	)		(515,749	)

Total liabilities and stockholders’ equity (deficit)	$	119,019		$	295,132	$	122,473	$	(385,466	)	$	151,158


		Three Months Ended September 30, 2003

		Parent		Guarantors			Non-guarantors			Eliminations			Consolidated

Net Sales		$	—	$	31,686		$	38,641		$	(35,667	)	$	34,660
Cost of sales			—		20,300			32,660			(35,478	)		17,482

Gross margin			—		11,386			5,981			(189	)		17,178
Selling, research and administrative expenses			—		7,570			1,735			(163	)		9,142
Loss on sale of business			—		—			—			—			—
Restructuring activity			—		—			—			—			—

Operating income			—		3,816			4,246			(26	)		8,036
Other income (expense):
	Interest income		—		28			3			(8	)		23
	Interest expense		—		(8,674	)		(60	)		65			(8,669	)
	Dividend income		—		1,346			—			(1,346	)		—

Income (loss) from continuing operations before income taxes			—		(3,484	)		4,189			(1,315	)		(610	)
Income taxes			—		36			531			—			567

Income (loss) from continuing operations after income taxes			—		(3,520	)		3,658			(1,315	)		(1,177	)
Income from discontinued operations after income taxes			—		1,402			(386	)		75			1,091

Net income (loss)		$	—	$	(2,118	)	$	3,272		$	(1,240	)	$	(86	)


		Three Months Ended September 30, 2002

		Parent			Guarantors			Non-guarantors			Eliminations			Consolidated

Net Sales		$	—		$	31,537		$	39,165		$	(30,994	)	$	39,708
Cost of sales			—			18,491			33,943			(30,815	)		21,619

Gross margin			—			13,046			5,222			(179	)		18,089
Selling, research and administrative expenses			—			6,255			3,079			(183	)		9,151
Impairment of assets held for sale			—			—			4,175			—			4,175
Restructuring activity			—			(227	)		1,182			—			955

Operating income			—			7,018			(3,214	)		4			3,808
Other income (expense):
	Interest income		—			1,354			141			(1,470	)		25
	Interest expense		(8,732	)		(426	)		(380	)		799			(8,739	)
	Dividend income		—			577			—			(577	)		—

Income (loss) from continuing operations before income taxes			(8,732	)		8,523			(3,453	)		(1,244	)		(4,906	)
Income taxes			—			(1,828	)		(305	)		—			(2,133	)

Income (loss) from continuing operations after income taxes			(8,732	)		10,351			(3,148	)		(1,244	)		(2,773	)
Income from discontinued operations after income taxes			—			169			566			667			1,402

Net income (loss)		$	(8,732	)	$	10,520		$	(2,582	)	$	(577	)	$	(1,371	)


		Nine Months Ended September 30, 2003

		Parent			Guarantors			Non-guarantors			Eliminations			Consolidated

Net Sales		$	—		$	100,166		$	118,723		$	(107,819	)	$	111,070
Cost of sales			—			59,472			103,230			(107,345	)		55,357

Gross margin			—			40,694			15,493			(474	)		55,713
Selling, research and administrative expenses			—			24,600			5,115			(455	)		29,260
Loss on sale of business			—			—			—			—			—
Restructuring activity			—			—			—			—			—

Operating income			—			16,094			10,378			(19	)		26,453
Other income (expense):
	Interest income		—			118			12			(67	)		63
	Interest expense		(19,081	)		(9,043	)		(67	)		567			(27,624	)
	Dividend income		—			36,577			—			(36,577	)		—

Income (loss) from continuing operations before income taxes			(19,081	)		43,746			10,323			(36,096	)		(1,108	)
Income taxes			—			676			1,178			—			1,854

Income (loss) from continuing operations after income taxes			(19,081	)		43,070			9,145			(36,096	)		(2,962	)
Income from discontinued operations after income taxes			—			27,641			559			(375	)		27,825

Net income (loss)		$	(19,081	)	$	70,711		$	9,704		$	(36,471	)	$	24,863


		Nine Months Ended September 30, 2002

		Parent			Guarantors			Non-guarantors			Eliminations			Consolidated

Net Sales		$	—		$	85,774		$	122,319		$	(84,678	)	$	123,415
Cost of sales			—			51,818			98,984			(84,245	)		66,557

Gross margin			—			33,956			23,335			(433	)		56,858
Selling, research and administrative expenses			—			23,781			9,142			(452	)		32,471
Impairment of assets held for sale			—			—			12,858			—			12,858
Restructuring activity			—			374			1,182			—			1,556

Operating income			—			9,801			153			19			9,973
Other income (expense):
	Interest income		—			1,694			383			(2,042	)		35
	Interest expense		(26,363	)		(1,162	)		(881	)		2,034			(26,372	)
	Dividend income		—			11,879			—			(11,879	)		—

Income (loss) from continuing operations before income taxes			(26,363	)		22,212			(345	)		(11,868	)		(16,364	)
Income taxes			—			(6,403	)		3,700			—			(2,703	)

Income (loss) from continuing operations after income taxes			(26,363	)		28,615			(4,045	)		(11,868	)		(13,661	)
Income from discontinued operations after income taxes			—			2,264			1,795			—			4,059

Net income (loss)		$	(26,363	)	$	30,879		$	(2,250	)	$	(11,868	)	$	(9,602	)


	Nine Months Ended September 30, 2003

	Parent			Guarantors			Non-guarantors			Eliminations			Consolidated

Net cash provided by (used in) operating activities	$	(22,343	)	$	32,272		$	11,222		$	(15,367	)		5,784
Net cash provided by discontinued activities		—			1,610			2,023			—			3,633

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

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

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

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

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


	Nine Months Ended September 30, 2002

	Parent			Guarantors			Non-guarantors			Eliminations			Consolidated

Net cash provided by (used in) operating activities	$	(19,741	)	$	43,410		$	5,819		$	(11,879	)	$	17,609
Net cash provided by discontinued activities		—			4,113			2,874			—			6,987

Net cash provided by (used in) operating activities		(19,741	)		47,523			8,693			(11,879	)		24,596
Proceeds from sales of property		—			—			—			—			—
Equity contributions into subsidiaries		—			(1,290	)		(265	)		1,555			—
Purchases of property , plant and equipment, net		—			(3,605	)		(3,500	)		—			(7,105	)

Net cash provided by (used in) investing activities		—			(4,895	)		(3,765	)		1,555			(7,105	)
Debt payments — long term		(6,750	)		—			—			—			(6,750	)
Debt proceeds — long term		10,000			—			—			—			10,000
Debt proceeds (payments) — short term, net		(2,000	)		—			466			—			(1,534	)
Common stock transactions		(400	)		—			—			—			(400	)
Intercompany loans		29,896			(31,067	)		1,171			—			—
Costs associated with debt		(541	)		—			—			—			(541	)
Intercompany dividends		—			(5,651	)		(6,228	)		11,879			—
Equity contributions into subsidiaries		—			—			1,555			(1,555	)		—

Net cash provided by (used in) financing activities		30,205			(36,718	)		(3,036	)		10,324			775
Effect of exchange rate changes on cash		—			—			(476	)		—			(476	)

Net change in cash and cash equivalents		10,464			5,910			1,416			—			17,790
Cash and cash equivalents at beginning of period		5			98			2,027			—			2,130

Cash and cash equivalents at end of period	$	10,469		$	6,008		$	3,443		$	—		$	19,920

7. Segments and Geographical Information

The Company’s continuing business consists of one operating segment known as Microacoustics. Previously, the Company reported three operating segments: hearing aid components, acoustic technology, and automotive components. The Synchro-Start division was sold May 30, 2003, and was part of the Company’s Automotive Components reporting segment prior to its reclassification to discontinued operations. The 2002 amounts for Automotive Components represent the Ruf business, which was sold in November 2002. The Infrared business, which was sold in July 2003, was part of the Company’s Acoustic and Infrared Technology reporting segment. (see footnote 2. Discontinued Operations.) As a result of these transactions and managements decision to focus on its core Microacoustic business, segment information for the prior year has been restated to combine the Acoustic and Infrared Technology and Hearing Aid Components segments into the Microacoustic segment.

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

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


				Ruf
		Microacoustics		Electronics			Total

Three months ended September 30, 2003
	Revenues from external customers	$	34,660	$	—		$	34,660
	Operating income		8,036		—			8,036
Three months ended September 30, 2002
	Revenues from external customers	$	35,342	$	4,366		$	39,708
	Operating income (loss)		8,158		(4,350	)		3,808
Nine months ended September 30, 2003
	Revenues from external customers	$	111,070	$	—		$	111,070
	Operating income		26,453		—			26,453
Nine months ended September 30, 2002
	Revenues from external customers	$	110,801	$	12,614		$	123,415
	Operating income (loss)		23,769		(13,796	)		9,973

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


		Three Month Ended						Nine Month Ended
		September 30,						September 30,

		2003			2002			2003			2002

Total operating income for reportable segments		$	8,036		$	3,808		$	26,453		$	9,973
Other expenses			(8,646	)		(8,714	)		(27,561	)		(26,337	)

Income (loss) from continuing operations before income taxes		$	(610	)	$	(4,906	)	$	(1,108	)	$	(16,364	)

Geographical Information (revenues based on billing location of product shipped)
	United States	$	19,672		$	19,072		$	63,084		$	60,042
	United Kingdom		11,379			13,020			36,169			39,076
	Germany		—			4,323			—			12,343
	Other geographical areas		3,609			3,293			11,817			11,954

		$	34,660		$	39,708		$	111,070		$	123,415

8. Restructuring Expenses

The Company announced a major restructuring in March 2000 under which the Company consolidated its worldwide manufacturing operations by ending production at five manufacturing facilities and either outsourced component production or moved final assembly to lower cost locations in Malaysia, China and Hungary. The following table presents the restructure costs and payments for the period.


		Nine Months Ended September 30, 2003

				Accrued
		Restructuring		Restructuring
		Expense		Costs

Beginning Balance		$	—	$	1,197
Employee severance and outplacement payments			—		(1,015	)

	Ending Balance	$	—	$	182

The majority of the remaining liability balance is expected to be paid out in 2003.

9. Commitments and Contingencies

Synchro-Start Divestiture Indemnifications In connection with sale of the Synchro-Start business, the Company has agreed to indemnify certain tax obligations arising out of tax audits or administrative or court proceedings relating to tax returns for any periods ending on or prior to the closing date of the sale. The Company has also agreed to indemnify certain liabilities, losses or claims arising from presale operations, limited such that the Company is not liable for total claims under $250, is fully liable for claims totaling between $250 and $7.5 million, is 50% liable for total claims between $7.5 million and $12.5 million and is not liable for total claims exceeding $12.5 million. Proceeds from the Synchro-Start sale include $2.5 million in escrow for potential indemnification obligations. The Company considers it unlikely that a claim would be made of such magnitude that it would have a material impact on the Company’s financial position.

The foregoing summary of the indemnities made by the Company in connection with the sale of the Synchro-Start business is qualified in its entirety by reference to the Stock Purchase Agreement Between and among Woodward Governor Company and Knowles Intermediate Holding, Inc. and Knowles Electronics Holdings, Inc. dated May 20, 2003 incorporated by reference to Exhibit 10.25 to Form 8-K filed with the Securities and Exchange Commission June 16, 2003.

Ruwido (Infrared) Divestiture Indemnifications In connection with the sale of the Ruwido business, the Company has agreed to indemnify certain liabilities, losses or claims up to a total of $100. The Company believes that any claim would not have a material impact on the Company’s financial position.

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

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

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

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


	Nine months ended
	September 30, 2003

Balance, December 31, 2002	$	4,438
Settlements made during the period		(1,256	)
Provision for warranty liability for 2003 sales		1,206
Adjustments in estimates for pre-existing warranties		(1,331	)

Balance, September 30, 2003	$	3,057

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

Overview

The Company has been actively engaged during the last twelve months in a program to divest its non-core businesses and to focus on its core microacoustics business. On July 29, 2003 the Company completed the sale of its Ruwido Austria GmbH subsidiary, whose operations made up the Infrared division, to FM Electronic Holdings. On May 30, 2003 the Company completed the sale of its Synchro-Start division to Woodward Governor Company. In November 2002 the Company sold Ruf Electronics, a manufacturer of automotive sensors and controls. The financial statements for the period ended September 30, 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 and cash flows for all periods presented. The assets and liabilities of the discontinued operations have been summarized as current and netted together for presentation on the December 31, 2002 balance sheet. Ruf is not accounted for as a discontinued operation under GAAP, but is included in continuing operations in the period up to its sale in November 2002. With the sale of these three business units, the Company has focused its product offerings in one business segment — Microacoustics.

The following table shows our net sales and net sales growth for the third quarter and first nine months of 2003 and 2002 compared to the same periods of their respective prior years:


	Third Quarter							First Nine Months

$ in thousands					Percent							Percent
					Change							Change
	2003		2002		2003 vs 2002			2003		2002		2003 vs 2002

Microacoustics	$	34,660	$	35,342		-1.9	%	$	111,070	$	110,801		0.2	%
Ruf Electronics		—		4,366		-100.0	%		—		12,614		-100.0	%

Total	$	34,660	$	39,708		-12.7	%	$	111,070	$	123,415		-10.0	%

Overall, sales were down by thirteen percent in the third quarter of 2003 compared to the same period last year. The decrease was primarily a result of the sale of Ruf business in November 2002. Microacoustics revenues dropped by 1.9% in the third quarter, primarily due to an unfavorable mix of customers and products.

Sales for the first nine months of 2003 declined ten percent compared to the first nine months of 2002 as a results of the sale of the Ruf business.

Consolidated Results of Operations

The following table shows the principal line items from our consolidated statements of operations, as a percentage of our net sales, for the three months and nine months ended September 30, 2003 and 2002.


	Three Months						Nine Months
	Ended September 30,						Ended September 30,

	2003			2002			2003			2002

Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		50.4	%		54.4	%		49.8	%		53.9	%
Research and development		7.3	%		6.2	%		6.9	%		7.2	%
Selling and marketing		6.5	%		5.4	%		6.0	%		5.9	%
General and administrative		12.5	%		11.5	%		13.4	%		13.2	%
Impairment of Ruf division assets held for sale		0.0	%		10.5	%		0.0	%		10.4	%
Restructuring expenses		0.0	%		2.4	%		0.0	%		1.3	%

Operating Income (loss)		23.3	%		9.6	%		23.9	%		8.1	%
Loss from continuing operations after income taxes		-3.4	%		-7.0	%		-2.7	%		-11.1	%
EBITDA from continuing operations		27.3	%		14.9	%		28.9	%		14.1	%

“EBITDA” is defined as earnings before interest, taxes, depreciation, amortization, and miscellaneous income/expense. EBITDA should not be construed as an alternative to operating income, or net income, as determined in accordance with GAAP, as an indicator of our operating performance, or as an alternative to cash flows generated by operating, investing and financing activities. EBITDA is presented solely as a supplemental disclosure because we believe that it is a widely used measure of operating performance and our debt agreements contain financial covenants tied to EBITDA. Because EBITDA is not calculated under GAAP, it may not be comparable to similarly titled measures reported by other companies.

The following is a reconciliation of EBITDA from continuing operations to loss from continuing operations after income taxes as a percentage of net revenue:


	Three Months						Nine Months
	Ended September 30,						Ended September 30,

	2003			2002			2003			2002

Loss from continuing operations after income taxes		-3.4	%		-7.0	%		-2.7	%		-11.1	%
Less interest income		0.1	%		0.1	%		0.1	%		0.0	%
Plus interest expense		25.0	%		22.0	%		24.9	%		21.4	%
Plus income tax expense (less income tax benefit)		1.6	%		-5.4	%		1.7	%		-2.2	%
Plus depreciation		4.2	%		5.4	%		5.1	%		6.0	%

EBITDA from continuing operations		27.3	%		14.9	%		28.9	%		14.1	%

Operating income as a percentage of net sales was 23.3% for the quarter ended September 30, 2003 compared to 9.6% in the quarter ended September 30, 2002. Included in the year earlier period was an asset impairment charge related to Ruf of 10.5% of sales and restructuring charges of 2.4% of sales. Cost of sales as a percentage of revenue improved by 4.0 percentage points due to the sale of the low-margin Ruf business, and reduced manufacturing and product costs. Research and development, sales and marketing and general and administrative costs all increased as a percent of revenue in the third quarter ended September 30, 2003 compared to the prior year due to exceptionally low spending in the third quarter of the prior year. Operating income for the three months ended September 30, 2003 increased by 13.7 percentage points from the year earlier period, due to the impairment and restructuring provisions in 2002 and the reduced cost of sales percentage in 2003.

EBITDA was 27.3% in the quarter ended September 30, 2003 compared to 14.9% in the quarter ended September 30, 2002. The increase in EBITDA was caused by the impairment of assets related to the sale of Ruf and restructuring activity that was included in the prior year.

Operating income as a percentage of net sales was 23.9% for the nine months ended September 30, 2003 compared to 8.1% for the nine months ended September 30, 2002. Included in the year earlier results was an asset impairment charge related to Ruf of 10.4% of sales and restructuring expenses of 1.3% of sales. Cost of sales as a percentage of revenue improved by 4.1 percentage points for the nine months compared to the year earlier period due to the sale of the low margin Ruf business and reductions in manufacturing and product cost.

EBITDA was 28.9 % in the nine months ended September 30, 2003 compared to 14.1% for the nine months ended September 30, 2002. The increase in EBITDA was caused by the impairment of assets related to the sale of Ruf and restructuring activity that was included in the prior year figure and the improved cost of sales percentage in the current year.

Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
Results from Operations


	Three Months Ended September 30,

(dollars in millions)							Increase
							(decrease)
	2003			2002			in amount

Net sales	$	34.7		$	39.7		$	(5.0	)
Cost of sales		17.5			21.6			(4.1	)

Gross margin		17.2			18.1			(0.9	)
Gross margin percent of net sales		49.6	%		45.6	%
Research and development expenses		2.5			2.5			—
Selling and marketing expenses		2.3			2.1			0.2
General and administrative expenses		4.3			4.6			(0.3	)

Operating expenses		9.1			9.2			(0.1	)
Impairment of Ruf division assets held for sale		—			4.2			(4.2	)
Restructuring expenses		—			1.0			(1.0	)

Operating income		8.1			3.7			4.4
Operating income percent of net sales		23.3	%		9.3	%
Other income (expense):
Interest income		—			—			—
Interest expense		(8.7	)		(8.7	)		—

Loss from continuing operations before income taxes		(0.6	)		(5.0	)		4.4
Income tax (benefit)		0.6			(2.1	)		2.7

Loss from continuing operations after income taxes		(1.2	)		(2.9	)		1.7

Income from discontinued operations after income taxes		1.1			1.5			(0.4	)

Net loss	$	(0.1	)	$	(1.4	)	$	1.3

Consolidated sales decreased $5.0 million or 12.6 percent in the third quarter 2003 compared to the same quarter of 2002. The decrease was primarily a result of the sale of Ruf business in November 2002. Microacoustics revenues dropped by 1.9% in the third quarter, primarily due to an unfavorable mix of customers and products.

Consolidated cost of sales improved by 4.0 percentage points as a percent of sales in the third quarter 2003 compared to the same period the prior year. The change in cost of sales as a percentage of revenue was primarily caused by the sale of Ruf Electronics, and a reduction in manufacturing costs and expenses, including improved quality and a lower provision for obsolete inventory.

Operating expenses decreased $0.1 million in the third quarter of 2003 compared to the same quarter of 2002, with an increase of $0.2 million in sales and marketing expenses offset by a decline of $0.3 million in general and administrative expenses.

Operating income increased by $4.4 million in the third quarter of 2003 compared to the same period in the prior year, due to the inclusion in the prior year of a $4.2 million impairment of the Ruf assets held for sale and $1.0 million of restructuring expenses.

In connection with our September 1999 recapitalization, we currently have significant senior debt and senior subordinated debt. As a result, net interest expense was $8.7 million the third quarter of this year compared to $8.7 million the same quarter last year. Interest expense was unchanged inspite of the March 2003 recapitalization that resulted in a $35 million of Term C facility that replaced the Term A facility, at significantly higher interest rates, due to the $43 million reduction in the Term B facility from the proceeds of the Synchro-Start sale.

In the three-month period ended September 30, 2003 we recorded an income tax expense of $0.6 million, compared to a benefit of $2.1 million in the third quarter last year. The expense in the current year represents the estimated provision required for foreign taxes.

Net income from discontinued operations in the third quarter ended September 30, 2003 of $1.1 million includes a gain realized on the sale of the Synchro-Start business of $1.1 million, a gain on the sale of the Infrared business of $0.4 million, and the net loss of $0.4 million earned by the Infrared business during the Third quarter of 2003. The net income from discontinued operations in 2002 of $1.5 million represents the profit from operating the Synchro Start business partly offset by the loss from the Infrared business in the third quarter of the prior year.

We reported a net loss of $0.1 million in the third quarter of 2003 compared to a net loss of $1.4 million the third quarter of the prior year. The $1.3 million improvement in net income from the prior year is primarily due to impairment charges in the prior year of Ruf assets of $4.2 million, partly offset by the increase in tax expense in the third quarter of 2003 of $2.7 million.

Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002


		Nine Months Ended September 30,

(dollars in millions)								Increase
								(decrease)
		2003			2002			in amount

Net sales		$	111.1		$	123.4		$	(12.3	)
Cost of sales			55.4			66.6			(11.2	)

Gross margin			55.7			56.8			(1.1	)
Gross margin percent of net sales			50.1	%		46.0	%
Research and development expenses			7.7			8.9			(1.2	)
Selling and marketing expenses			6.7			7.2			(0.5	)
General and administrative expenses			14.9			16.4			(1.5	)

	Operating expenses		29.3			32.5			(3.2	)
Impairment of Ruf division assets held for sale			—			12.8			(12.8	)
Restructuring expenses			—			1.5			(1.5	)

Operating income (loss)			26.4			10.0			16.4
Operating income percent of net sales			23.8	%		8.1	%
Other income (expense):
Interest income			—			—			—
Interest expense			(27.6	)		(26.4	)		(1.2	)

Income (loss) from continuing operations before income taxes			(1.2	)		(16.4	)		15.2
Income tax (benefit)			1.8			(2.7	)		4.5

Income (loss) from continuing operations after income taxes			(3.0	)		(13.7	)		10.7

Income from discontinued operations after income taxes			27.9			4.1			23.8

Net income (loss)		$	24.9		$	(9.6	)	$	34.5

Consolidated sales declined $12.3 million or 10 percent the first nine months 2003 compared to the same period of 2002 due to the sale of the Ruf Electronics business in November, 2002.

Gross margin as a percent of sales increased by 4.1 percentage points in the nine months ended September 30, 2003 due to the sale of Ruf Electronics in November 2002, and improved quality and reduced manufacturing costs.

Operating expenses decreased in the first nine months of 2003 compared to the first nine months of 2003 by $3.2 million due to the sale of Ruf Electronics.

Operating income increased in the first nine months of 2003 compared to the first nine months of 2002 by $16.4 million due to the inclusion of the operating loss incurred by Ruf in the 2002 results in addition to the Ruf impairment, restructuring expenses, and reduced manufacturing expenses in continuing operations in 2003.

Restructuring expenses of $1.5 million in the prior year did not recur in the current period. Also in the prior year period was the impairment of assets held for sale of $12.8 million related to Ruf.

In connection with our June 1999 recapitalization, we currently have significant senior debt and senior subordinated debt. As a result, interest expense was $27.6 million the first nine months this year compared to $26.4 million the same period last year. The increase in interest expense is due primarily to a write-off of prepaid fees in association with the Limited Waiver and Amendment of March 2003 and the higher interest rate on the $35 million in Term C facility that replaced the Term A facility as part of the Limited Waiver and Amendment, partly offset by the $43 million reduction in the Term B facility from the proceeds of the Synchro-Start sale.

For the nine months ended September 30, 2003 income taxes were an expense of $1.8 million compared to a $2.7 benefit for the same period in 2002. The expense in the current year represents a provision for expected foreign taxes.

Net income from discontinued operations in the first nine months of 2003 of $27.9 million includes the gain realized on the sale of the Synchro Start business of $35.3 million, the $8.4 million charge associated with the sale of the Infrared business, the net profit of $1.9 million earned by the Synchro-Start business in the period from January 1, 2003 to the date of sale of May 30, 2003, and the net loss of $0.9 million recorded by the Infrared business during the first three quarters of 2003. The net income from discontinued operations in 2002 of $4.1 million represents the profit from operating the Synchro-Start business and the loss from operating the Infrared business in the first nine months of the prior year.

We reported a net profit of $24.9 million in the first nine months of this year compared to a net loss of $9.6 million for the same period last year. The increase of $34.5 million in net income is primarily due to the gain in 2003 on the sale of the Synchro Start business of $35.3 million, and the impairment of Ruf division assets in the prior year of $12.9 million partially offset by the $8.4 million loss in 2003 on the sale of Infrared and the $4.5 million increase in provision for income taxes.

Liquidity and Capital Resources

We have historically used available funds for capital expenditures, inventory, accounts receivable, interest and principal repayment. 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 Credit Agreement in two facilities, a Term A Facility of $50 million and a Term 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.

The Company obtained a Limited Waiver and Amendment dated March 25, 2003 to the Credit Agreement. This amendment refinanced $31.7 million of the Credit Agreement, replacing the balance of the original Term A Facility with a $35 million Term C Facility and revised certain terms and conditions of the Credit Agreement. Under this Amendment, the Company received agreement from its lenders to waive compliance with the terms of certain ratios of EBITDA through June 29, 2003 and to revise the terms of such ratios thereafter. 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.

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


			Required
	Required		Interest
	Leverage		Coverage
	Ratio		Ratio

December 31, 2003		6.5		1.35
December 31, 2004		6.0		1.45
December 31, 2005		5.5		1.55
December 31, 2006		5.0		1.65

We were in compliance with the required covenants as of September 30, 2003 and we expect to be able to comply with the required covenants in future periods. 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 Limited Waiver and Amendment substantially revises the term of the Credit Agreement. The interest rates were increased from 3.5 to 4 points above LIBOR for the Revolving Credit Facility. The interest rates for the Term B Facility were increased to 5 points above LIBOR. The refinancing provides for an interest rate on the Term C Facility that totals 18.5%, a portion of which is payable in cash on a monthly basis. The portion of interest that must be paid in cash on a monthly basis for the Term C Facility is 13% for the year ending March 2004, with the cash portion of interest increasing to 14% in the year ending March 2005 and by 1% per year thereafter. The remainder of the interest on the Term C Facility shall, at the option of the Company, be paid in cash or accrue and be added monthly to the outstanding principal balance of the C Facility and paid at maturity, scheduled for June, 2007. The Amendment also provided that interest on all revolving credit loans and loans under the Term B Facility be paid monthly.

The Limited Waiver and Amendment dated March 25, 2003 reduced the Revolving Credit Facility to $15 million and increased the quarterly amortization of the Term B Facility to approximately $750,000 per quarter beginning June 30, 2003 through June 30, 2006, with the balance paid in four quarterly principal payments from September 30, 2006 to June 29, 2007. Subsequent to the Limited Waiver of March 25, Amendment Number 6 was approved on May 28, 2003 which applied $10 million of the proceeds from the sale of Synchro Start to the nearest scheduled principal repayments, and to any prepayments required in respect to Excess Cash Flow. No principal payments are expected on the Term B facility in the next twelve months.

The Amendment dated March 25, 2003 also provides that 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 Term C Facility is payable in full on June 29, 2007.

The Company was required to obtain approval of its lenders under its Credit Agreement in order to complete the sale of Synchro-Start in May 2003. The resulting Amendment Number Six and Waiver provided that $42 million of the proceeds from the sale be used as a principal repayment of the Term B facility and that $10 million of the principal repayment be applied to the subsequent scheduled repayments and any payments in respect of excess cash flow. Amendment Number Six also provided for the greater of $1 million or the proceeds from the sale of the Infrared business to be paid to reduce the Term B Facility upon the sale of the Infrared business. This principal payment was made on July 30, 2003. In addition, Amendment Number Six provided for up to $7.5 million in future restructuring expenses to be added back to EBITDA for purposes of calculating compliance with the required leverage and interest coverage ratios.

Net cash provided by operating activities was $9.4 million in the first nine months of 2003 compared to $24.6 million generation of cash by operating activities in the first nine months of 2002. Net income from continuing operations was a net loss of $3.0 million in the first nine months of this year compared to a net loss of $13.7 million the same period last year. Non-cash charges for depreciation were $5.6 million in the

first nine months compared to $7.4 million last year. The decrease in depreciation was primarily due to the sale of Ruf in November 2002. The net loss from continuing operations in the nine months ended September 30, 2003 included non-cash charges related to the impairment of assets held for sale of $12.9 million and restructuring costs of $1.6 million. Non-cash charges related to the amortization of deferred finance fees were $2.3 million in the first nine months of 2003, which was an increase of $0.5 million over prior year due to the write-off of fees associated with the Term A Facility, which has been repaid. Accounts receivable decreased by $1.9 million in the first nine months of 2003 compared to a decrease of $6.5 million in 2002. Inventories declined in the first nine months of 2003 by $2.2 million and decreased in the prior year by $6.0 million. Accounts payable decreased $2.8 million in the first nine months of the current year and $4.9 million in the prior year. Accrued interest payable increased by $3.1 million in the current year compared to an increase of $4.8 million in the prior year. Other current liabilities declined by $4.6 million in the first nine months of the current year compared to a decline of $0.1 million in the prior year, primarily due to a decrease in the accrual for warranty and rebates. Net cash provided by discontinued operating activities provided $3.6 million in the current year compared to $7.0 million in the prior year, due to the sale of the SSPI business in May, 2003.

Net cash provided by investing activities was $40.0 million in the first nine months of this year compared to a use of $7.1 million in the first nine months of last year. The proceeds from the sale of Synchro-Start in the current year were $45.7 million. The purchase of property, plant and equipment was $5.8 million in the first nine months of 2003 compared to $7.0 million in the first nine months of 2002.

Net cash from financing activities was a use of $51.9 million in the first nine months of 2003 compared to a source of $0.8 million in the first nine months of 2002. The activity in 2003 includes the payment of $43 million in Term B principal associated with the sale of Synchro-Start, payment of $33.5 million of Term A Facility associated with the Limited Waiver and Amendment of March, 2003 and a $7.7 million payment of principal of Term B facility associated with an excess cash calculation as of December, 2002. Debt proceeds for the nine months of 2003 of $35 million are a result of the borrowing under the Term C facility as part of the Refinancing of March 2003. Financing activities in the first nine months of 2003 also included $1.7 million of expenses associated with issuing debt. Financing activities in 2002 were driven by the issuance of additional Notes Payable of $10 million, partially offset by reductions in long-term debt of $6.8 million, and a reduction in short-term debt of $1.5 million.

Because the net cash used in financing activities was only partially offset by the net cash provided by investing and operating activities, cash decreased in the first nine months of 2003 by $2.6 million. In the first nine months of 2002, the cash balance increased due to additional borrowings. Our cash balance as of September 30, 2003 was $21.3 million, compared to $19.9 million at September 30 last year.

We expect capital expenditures of $12 to $14 million in 2003. Our major capital expenditures in 2003 will be to support new product introductions for our new Sisonic silicon microphone and for other production equipment. The amount and timing of actual capital expenditures may be different than our current expectations.

Forward-Looking Statements

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

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

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

Item 3. Qualitative and Quantitative Disclosures about Market Risk

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

We do not hedge our foreign currency exchange rate exposure. Therefore, we are exposed to foreign currency exchange rate risks. Our revenues are primarily denominated in the U.S. dollar. During the third quarter of 2003, in excess of 90% of our revenue was denominated in U.S. dollars, with balance denominated in other foreign currencies including the Japanese Yen and the British pound. Our expenses are principally denominated in the same currencies, in which we have sales, allowing us to essentially hedge through offsetting revenue and expense exposures. As a result, during the third quarter of 2003, our operating income and margins were not significantly affected by changes in exchange rates. Some of our expenses are denominated in the local currencies of China, Malaysia, the United Kingdom, Japan and Taiwan, some of which are closely tied to the U.S. dollar. Our primary exposure longer term is the relation of the U.S. dollar and major Asian currencies.

We do not invest in speculative or derivative financial instruments. We have significant amounts of debt that are subject to interest rate fluctuation risk. The Term B Facility loans outstanding under the Credit Agreement have variable interest rates and, therefore, adjust to market conditions. An increase or a decrease of 1 percentage point in the interest rate of the loans under Term B Facility of the Credit Agreement would change our annual interest expense by $0.9 million. The Term C Facility loan outstanding under the Credit Agreement has a fixed interest rate. We have estimated the fair value of the Term C facility loan as of September 30, 2003 to have a market value equal to 100% of par. The Senior Subordinated notes have fixed rates of interest. We have estimated the fair value of the Notes as of September 30, 2003 to have a market value equal to 94% of par or $144 million as of September 30, 2003.

Item 4. Controls and Procedures

As of the end of the period covered by this report, September 30, 2003, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There was no change in the Company’s internal controls over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. Other Information

Item 6. Exhibits and Reports on Form 8-K

Exhibits


31.1		Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002

31.2		Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002

Reports on Form 8-K

A report on Form 8-K was submitted August 14, 2003 by Knowles Electronics Holdings, Inc. furnishing information pursuant to Item 2 with respect to the sale of its Infrared division and pursuant to Item 7 pro-forma financial statements with respect to that sale.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, to be signed on its behalf by the undersigned thereunto duly authorized.


		KNOWLES ELECTRONICS HOLDINGS, INC

		By		/s/ JAMES H. MOYLE

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

Date: November 12, 2003

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

KNOWLES ELECTRONICS HOLDINGS INC 10-Q