Garmin shows signs of beginning to crack and represents a timely short opportunity and recent channel checks have shown increasing deterioration in their core markets. I believe the stock is worth ~$29/share which represents ~20% downside from current levels.

Thesis overview:

While the market has long been aware of the challenge posed to Garmin by the proliferation of smartphones equipped with GPS functionality, the Company has been able to rely on other legs of their business for growth. I believe those other legs have become increasingly feeble and the timing is right for a short position. It is important to note the Company lacks any proprietary mapping software or technology. They are simply a consumer electronics manufacturer.

Business Overview:

• Auto/mobile Personal Navigation Device (“PND”) segment makes handheld navigation devices and accounts for ~49% of revenue and 40% of Gross Profit
• Outdoor segment makes GPS devices for hiking, hunting and other outdoor activities and accounts for 17% of revenue and 20% of GP
• Fitness Segment makes sport watches and bike monitors and accounts for 13% of revenue and 15% of GP
• Aviation segment makes GPS devices for aircraft and accounts for 13% of revenue and 17% of GP
• Marine makes GPS devices for boats and accounts for 8% of revenue and 8% of GP

Key Thesis points:

• PND segment is in terminal decline. Market is aware that this isn’t a growth segment, but isn’t aware of the magnitude of the decline.  GOOG’s introduction of free turn by turn voice direction in Google Maps in late ’12 and AAPL maps around the same time was a game changer. Mobile devices can now offer all the functionality of GRMN’s PND’s, whereas before, they had been limited to mapping. The importance of directions, as opposed to just mapping, is underappreciated by the market.
  • Excluding deferrals, PND sales are tracking down mid-high teens. This segment is simply falling apart.
• Market has been looking to outdoor and fitness as growth segments but these segments have been facing increased competition. For example, Nike and Motorola have recently introduced fitness electronics with GPS functionality. The overall market for these products is expected to expand, but the Company will not be able to continue making 60+% GMs in the space as competition increases.
  • Importantly, as a CE manufacturer with minimal proprietary technology, OP margins +40% are going to provide unsustainable. I believe these will come down to figure in the high 20’s as competition increases. So revenue increases will be offset by margin compression. This will not be the growth segment the market anticipates.
  • Additionally, top-line growth for these segments has slowed from low DD to closer to flat over the past few quarters. Q113 was the Company’s first quarter without any material revenue growth in the segment. This is an important marker.
• They do have a good niche in aviation, but this is a small portion of their business and can’t support valuation levels.
• Accounting issues (none of which are improper) are misleading.
  • GRMN allocates a meaningful portion of opex (~1/3) to it’s segments based on % of revenue contribution. Since PND is the largest revenue contributor, this has the effect of depressing PND margins and increasing margins in the smaller segments. This causes the market to look at “growth” segments like outdoor/fitness and admire the higher margins, but the reality is the margins aren’t as high as they would seem.
    • Overhead allocation based on revenue leads to intuitively unlikely margin results like the most mature segment (PND) sporting the lowest margins while the growth segments which require more aggressive advertising and investment, having the best margins.
    • An accounting change in Q311 reduced the amount of PND ASP’s attributed to lifetime map bundles which has the effect of increasing revenue on a YoY basis, although this effect has already begun to annualize.
    • Because of recognition of revenue deferrals for lifetime mapping bundles, the Company has historically experienced CF in excess of income. This is now reversing which is flattering EPS numbers, but will eventually lead to a mismatch bw EPS and CF. While precipitous CF declines are not imminent and the Company has a solid balance sheet, I believe this will be the final, and most powerful, leg of the short thesis.   
      • In Q113 YoY FCF declined from $116MM to $48MM, in Q412 FCF was $163MM v $212MM in Q411 and FY12 FCF was $646MM v $782MM in FY11.
      • CF declines will limit financial flexibility and lower the chances of meaningful dividend boosts.
    • While not a meaningful factor in the analysis, we have also seen other signs of low quality earnings like warranty reserves tracking  below expenditures for the past several quarters and EPS driven by tax rates and FX changes.

Segment Overview:

Valuation:

As PND continues to decline and outdoor/fitness experience margin compression, EPS will contract. I value the Company at 8x my forward EPS of $2 and net out cash of ~$13/share to arrive at $29 price target.

Risks to thesis:

• Solid balance sheet with 5% dividend will support stock price. They also have a $300MM repurchase authorization but have slowed down the repurchase pace as CF has been pressured.
• Fitness/outdoor segment may prove more resilient than I anticipate.
• Market focus on EPS allows the Company to benefit from tailwind of deferred revenue recognition for several more quarters.