Description

Buy Cognex, CGNX.  While CGNX is not the cheapest looking stock on the surface, it is one of the highest quality, open ended growth stories that we are aware of trading towards the lower end of its historical valuation ranges.   Increasingly hawkish trade rhetoric and disappointingly slow growth in 2018, after unsustainably high growth in 2017, driven by consumer electronic product cycles, have created a compelling opportunity to buy the stock.

CGNX is a leader in machine vision products that enable industrial automation, by capturing and analyzing visual information, so that tasks can be automated. It has been adopted by industries that need to automate the manufacture and tracking of items where quality control, inspection and line speed are important, and also in applications where human vision is inadequate.  The general tasks that machine vision performs are: guidance, identification, inspection, and gauging. Guidance: determines the exact physical location and orientation of an object. Identification: identifies an object by analyzing its physical appearance or by reading a serial number or symbol. Inspection: inspecting for flaws and/or defects. Gauging: determines the dimensions of an object.

CGNX is trading at $44 and there are 172 million shares outstanding, for a market cap of $7.5 billion.  It has $755 million of cash and investments with no debt, for an enterprise value of $6.8 billion.

Consumer electronics is 40% of CGNX revenues, automotive is 25%, logistics 10%, food and beverage 5%, consumer goods 5%, semiconductor capital equipment is 4%, and other is the remaining 11%.  Vision systems are 45% of revenues v ID systems at 55%. Roughly half of sales are direct to end customers or machine builders (ie robotics and automation OEMS that incroporate CGNX products into their equipment.  And the other half come from ~400 distributors and systems integrators. Geographically, Europe is 43% of sales, the US is 24%, China is 14%, Japan is 5%, and other is the remaining 14%.

This opportunity is available because Apple’s supply chain ramped up spending throughout 2017 in order to prepare for the launch of the iPhone X.  Apple revenue with CGNX grew 60% in 2017. Following this spending binge, 2018 has been a year of digestion for Apple and it is estimated that Apple revenue will fall 40% this year.  As a result, in 1Q18 CGNX reported revenue growth of 22%, which was at the low end of its guidance range and below consensus estimates. It guided revenues to be roughly flat through 3Q18.  Investors were disappointed and the stock had been trading at record valuation, so stock performance has been understandably poor since then, as revenue growth for 2018 will come in around 5%, after the impressive 47% growth last year.  Management has maintained a long term view with respect to investing in the business also, so it has continued to increase spending on R&D and growing salesforce, despite some of the end market and customer specific cyclicality, which has caused further margin pressure due to fixed cost under-absorption issues.  When management reported 2Q18, the stock responded positively as guidance implied that the 2017 consumer electronic spending boom would be lapped in 3Q18 and there would be no more shoes to drop. Not only does the worst appear to be behind it in consumer electronics, but a number of emerging growth areas have continued to perform strongly, which has gone somewhat unnoticed beneath the surface of the top line slowdown.  Barring any macro surprises growth should reaccelerate in 4Q18.

However, as trade tensions have mounted this year, more concerns arose that there could be significant disruption to CGNX’s business if the situation escalated.  Trade policy is difficult to predict and beyond the scope of this report, but surely if things deteriorated there could be pauses in supply chain capex that would negatively impact CGNX as customers take a wait and see approach.  On its 2Q18 call, management stated that they have not seen any impact of OEMs rearranging global manufacturing footprint, as of yet. IPG Photonics, however, lowered guidance in early October, partially as a result of the uncertainty surrounding the trade dispute, which is impacting purchasing patterns.  CGNX sold off sharply on the news and it bears watching. Further escalation could certainly impact CGNX’s customers purchasing plans, as well, and keep sentiment negative on the stock in the short term. Longer term the strong secular trends that CGNX is benefitting from should make this a compelling time to buy the stock.

Despite the passing storm clouds, and the potential of more storm clouds on the horizon, CGNX remains a very high quality business.  It has historically reported gross margins of ~75% and operating margins of ~30%, while committing to meaningful investment in R&D of ~13% of sales.  Its capital requirements are relatively low at~ 4% of sales. CGNX has also consistently generated FCF in excess of net income over time. Due to a number of secular tailwinds its end markets are expected to grow high single digits over the long term.  CGNX is growing appreciably faster than end markets as it takes market share, which is generally in the ~25% range depending on the market, it has exposure to some of the faster growing segments, and it enters new adjacent verticals and products. Management has a stretch goal of 20% growth.

Its products are indispensable to manufacturers that need to automate to remain competitive by cutting costs, improving productivity and increasing throughput.  While ASP’s are $3,000-4,000, this is relatively low compared to overall costs of manufacturing facilities, and also in comparison to the cost savings, efficiency gains, and improvements to line speeds.

CGNX has considerable IP with 571 patents and over 400 more pending, creating large barriers to entry.  The markets it operates in are fairly competitive, but operate as rational oligopolies. Customer relationships tend to be enduring, while CGNX can command premium pricing.  Finally, CGNX has ample opportunities to reinvest at similar or better rates of return than its current business through internal development and tuck-in acquisitions, and in its currently addressed markets and adjacent verticals.

In general, the robust long-term growth outlook is supported by the inexorable advance of automation, and the need for improved quality and productivity.  More specifically, machine vision growth is driven by customer innovation, optimizing capacity utilization, increasing demand for quality control, improving manufacturing yields, reducing defects, reducing material costs, accelerating line speeds, improving tracking and traceability, etc.  Further, customers are also facing wage inflation pressures and shortages of skilled labor, which could translate into increased demand for automation.

CGNX benefits from strong secular growth within its core end markets.  Machine vision demand in consumer electronics is being driven by miniaturization and increasing complexity.   Even though consumer electronics is CGNX’s largest end market, it is still early in the adoption of machine vision.  CGNX exposure to OLED will contribute to it growing faster than the overall market after lapping this digestion period.  In automotive, in addition to taking share, the transition to electric vehicles and hybrids is driving machine vision demand, as are quickening design cycles.   Auto is currently growing over 20% for CGNX, but management feels 10% growth is more realistic over the longer term.

Newer verticals and products have even stronger growth rates, which could persist for many years.  Logistics and 3D vision both have the potential to add several points to organic growth in the coming years.  Logistics is expected to be 13-15% of 2018 revenues and is growing 50% per annum. The secular drivers here are increasing ecommerce volume and increasing automation at logistics providers and retailers.  There is also a transition away from laser barcode readers to machine vision, which CGNX is a major beneficiary of, because it dramatically improves throughput. And machine vision market share is still low compared to laser barcode readers.  Thus far, machine vision growth within logistics has been primarily US based, but eventually it should spread internationally, reinforcing this secular trend. Currently, machine vision in logistics has also only been concentrated in ID systems, but at some point it seems likely that 3D vision will also be implemented (ie for “picking” applications), so this could add another leg to growth.

3D vision is an exciting emerging growth product line for CGNX, which is also growing at approximately 50%, off of a base of $45-50 million.  This growth rate is roughly double the overall 3D vision market. Aside from the impressive growth rates, the emerging opportunities are often higher priced and higher margin.  For instance, with 3D vision ASP’s are ~$10,000 v 2D at $3,500 because of the much larger amount of data that is captured and requires analysis.

CGNX was founded in 1981 by Dr. Robert Shillman, who is still Chairman.  He appears to be a good steward of our capital and personally owns 7.7 millions shares, or 4.4% of shares outstanding.  Robert Willet has been CEO since 2008. Previously, he was the VP of Business Development and Innovation for Danaher’s Product Identification business group.

The capital allocation track record seems solid.  CGNX regularly engages in M&A to bolster its product portfolio and engineering talent.  It has acquired seven companies in the last three years for a total of $51 million, which have been in the fields of 3D vision, sensors and hardware, mobile barcode verifiers/scanners. In 2015 it sold its Surface Inspection division for $165 million because it was no longer deemed strategic, in order to free up resources for higher growth and higher quality opportunities.  With the pullback of the stock this year, management repurchased $121 million of shares in the first half of the year. $450 million has been spent on buybacks since 2013, which has more or less offset stock comp dilution.

At first blush, CGNX might not seem like a traditional value investment, given the relatively high multiples.  However, the growth rates and its competitive advantage period seem likely to persist for an exceedingly long time, given the trends in the end markets, quality of the franchise, and lack of competition.  CGNX has historically traded at 30x forward earnings and 19x forward EBITDA. In 2020, revenues will be approximately $1.15 billion, with EBITDA around $415 million and EPS of ~$2, so it is trading around 16.5x EV/EBITDA and 22x P/E.  Furthermore, sentiment on the stock is fairly negative at the moment due to the slowing growth rate and margin compression, as well as the macro concerns, but this should prove short-term in nature. Once growth reaccelerates, while expenses flatten out, CGNX should experience good operating leverage and incremental returns on invested capital will improve, and so should the sentiment on the stock.

Over the long-term, the main risk to CGNX will be the competition that 75% gross margins invites and eventually technological disruption could create price competition, although at present this is not a major concern.  In the shorter term, customer concentration is a real issue. 2018 has been a year of resetting expectations for the stock. Apple was a 21% customer in 2017 and while it will be down dramatically in 2018, it will remain a material part of the business and CGNX will remain exposed to customer innovation cycles and product launches.  As far as, Apple and this iPhone cycle is concerned, the worst appears behind us, which is creating a buying opportunity. Perhaps more concerning in the near term, is the fact that despite the strong secular growth rates, CGNX is still very much an economically cyclical company with so much of its business tied to automotive, consumer electronics, and industrials in general.  This cyclicality does not present the risk of permanent impairment of capital, but could result in periods of underperformance. Other considerations: about ¾ of sales are international and ~40% of contracts are non-USD, so FX fluctuations can be material. Furthermore, design cycles can be fairly short, resulting in limited visibility.

Catalyst

Reacceleration of growth