Description

Garmin Ltd. is a mid/large cap, liquid technology stock that has been a reliable cash cow over the years, and after a recent earnings miss it has become very cheap today, with a 10.5% EBIT/TEV yield.

Jumpy investors are skittish about the stock’s prospects for several reasons. The main objection to investing in Garmin is that cheap, or free GPS-enabled handhelds phones and mapping apps, are decimating their core business of automotive GPS products and encroaching in other areas. For instance, on the automotive side, Google maps, Waze, Apple maps, Scout and many other apps are freely available on Apple and Android, and everyone has a smartphone. Why would you even consider buying a pricey automotive GPS unit from Garmin? Garmin’s automotive business, which accounts for its main product lines and almost half its business is falling at double digit rates. Additionally, the strength of the U.S. dollar will create stiff currency headwinds for international sales in 2015. Furthermore, Garmin is now pushing into one of the most competitive markets on the planet – the smartwatch market – where some of the most well-capitalized companies in history, including Apple and Google, are beginning to compete. In short, you would be insane to want to invest in this company.

Although this is why the stock is cheap, hopefully, there are some contrarians who are still reading. If so, there is more to the story, and some nuances worth considering.

For those unfamiliar with the company, Garmin designs, manufactures and markets a variety of GPS navigation products across five segments. The company is built around GPS technology, which offers resolution is to within about 3 meters, and serves as a key differentiator in many categories. The global parent company is in Switzerland and it employs over 11,000, with approximately half of those in Taiwan.

We’ll take each segment in turn, review some financial data, and then step back to consider the big picture. 

Auto/Mobile – 43.2% of Revenues

Let’s get right to the heart of the short case. In a recent earnings call, the company announced that Auto/mobile revenues for Q414 declined by 11% versus Q413, and gave pessimistic guidance for Auto for 2015, saying they anticipated a 15% decline in Auto revenues for 2015. Yikes!

While Garmin has an approximately 45% market share globally (and 86% in the U.S.) in the Auto market, Garmin’s flagship auto-based, GPS-enabled personal navigation device (PND), “nuvi,” is being eaten alive by the ubiquitous smartphone.  Before getting into the details, we wanted to share some general observations.

There are good reasons to prefer a PND or GPS unit for your car. Maybe your cell phone carrier offers poor reception/coverage in certain areas, or you don’t want to crush your data plan. Maybe you like a larger hi-res screen, or easier inputting/voice commands, and natural language direction (e.g., “keep straight past the post office and turn right at the stop light.”). Maybe you like aspects of Garmin’s personalized local search information. There are myriad differentiating features you can read about on various consumer web sites.

Whether or not you buy into the long run franchise value associated with these features, there are unquestionably still people out there who still prefer a PND, and it’s not obvious that Garmin cannot continue to find creative ways to stem market share erosion, and defend against falling profits.

Certainly Garmin is doing a good job of blunting the impact of this erosion, by diversifying away from nuvi’s shrinking market. In 2014, 2013, and 2012, nuvi accounted for 43%, 34%, 27%, respectively, of consolidated revenues. And so while nuvi is clearly being pressured by Google maps and smartphones, the reduced influence of nuvi on Garmin’s financials is reflected in automotive segment revenues, which declined only 4.8% from 2013 to 2014 (athough 2014 included some deferred revenue benefits, which will go away in 2015).

In Auto, Garmin has built on its position in the consumer market and PNDs to penetrate the OEM market by integrating into cars with in-dash technology at the manufacturer level, which is growing business. Garmin has software and infotainment offerings through Mercedes Benz, Suzuki, Toyota, Chrysler, Volkswagen, Harley-Davidson, and others. The company recently announced a partnership with Honda on the Civic and CRV. While Garmin is not knocking the cover off the ball here, they have a chance to offset anticipated losses in PNDs, creating more balance in this segment.

At the profitability level, although automotive revenues are in decline, automotive gross margins increased modestly over this period, and operating income increased by 14.4%, due to aggressive cost cutting, reduced cooperative advertising, and redeployment of R&D spend towards higher growth segments. Thus, despite significant anticipated 2015 headwinds, including additional PND declines and a reduced contribution of amortization of deferred revenues, Garmin has some tools in its arsenal to combat erosion of profits in the segment. Say you take the company’s guidance at face value and believe Auto revenues will decline by 15% (which includes the effect of lower amortization of deferred revenues). Does it follow that operating profit will necessarily decline for 2015? It’s by no means a slam dunk.

It’s also worth keeping in the mind that the consolidated revenue mix is also shifting, with Auto/Mobile accounting for 43% of revenues in 2014, down from 55.0% in 2012. Meanwhile, the company’s non-Auto segments provided 68% of operating income in Q414. So the problems in this segment are becoming a bit easier to manage in the context of Garmin’s overall business.

Fitness – 19.8% of Revenues

Now that the bad news is out of the way, we can consider the good news. And there’s some very good news here.

Leveraging an expanding exercise-loving demographic, Garmin has moved aggressively into the Fitness space, with wearable/portable offerings in the “vivo” family of products for active lifestyle and recreation markets, including for running, cycling, swimming, triathlons, etc. These tech-crazed users love the route and performance granularity you can get with GPS technology. The products include various activity tracking features, including speed, distance, pace, heart monitoring, etc., and users can upload and analyze data to their heart’s content. The Garmin Connect platform (with > a billion logged miles), where customers track and analyze personal workout data, has gotten good traction in the fitness community. And more apps are coming: Garmin launched Connect IQ, an open source platform which opens up APIs to developers for apps for various products.

Garmin has been spending aggressively on advertising for this segment, more than doubling its ad spend during 2014 versus 2013. But this move appears to have paid off. The company grew fitness segment revenues at 60% in FY14, including 70% growth for Q414 versus Q413, and has achieved a fitness market share in the mid-teens for activity trackers. Despite the higher advertising expense, operating income for the segment was up 59% in 2014. The company has indicated Fitness segment revenues will grow on the order of 25% in 2015. High gross margins are driving operating income for Fitness, which for Q414 exceeded operating profits for the Auto segment, and this will likely be the case for 2015, making Fitness the most profitable – and fastest growing – segment of the company. That’s a good sign.

Fitness/Smartwatch Competition

One thing that’s important when considering the Fitness, and to a lesser extent the Outdoor (discussed below) segments is that this is where Garmin will begin to compete on wearables, and more specifically watches, with the likes of Apple, Samsung, Motorola, Sony, Google/Android and a host of formidable smaller competitors such as TomTom, who has said they intend to double their GPS watch business in 2015, Pebble, and Fitbit Surge.

Yet here the industry tailwinds are strong. BI intelligence estimates the wearables market will compound at 35% for the next five years, the lion’s share of which will be smartwatches. Hence the interest from the big players.

As with any hot new consumer product category, there are practically limitless smartwatch variations available. While there are many market categories of the coming first generation of smartwatches, including social, communication, travel, and many others, Garmin is tightly focused on their chosen markets. This should pay dividends in the near-term.

But what about longer-term? One industry dynamic that is important to understand is what a smartwatch is today, and how smartwatches and the market will evolve over the next few years.

On the one hand, you have the hardware, the actual watch/wearable products, including activity trackers, and on the other hand you have the software apps, which apply to specific categories. Google has helpfully defined app categories this way: Featured, Health & Fitness, Travel & Local, Social, Tools, Communication, Productivity, and More Apps. That’s a lot of categories, but by now you have a sense where Garmin fits in them.

If you Google “smartwatch” you’ll see that the lines rapidly begin to blur between smartwatches, fitness activity trackers, and these other various nichey market categories. Some are generalized products with flexibility to load any app you want, some are geared for very specific uses, and some are a blend.

The “smartest” watches will be those that most resemble smart phones, with their own operating system and a suite of apps that allow total customization of the watch. But there are tradeoffs, in terms of price, weight, battery life, durability, and so forth, especially in these early smartwatches. These matter for many of Garmin’s customers.

Garmin has made headway on making its products fairly “smart,” in that they are well-designed for specific uses, and are more feature-rich and simply better than the alternatives, in certain categories. They have good specialized software and a watch that’s designed for specific uses. This specialization will enable them to stay competitive for now with the Apples of the world, who control an operating system, and thus whose watches will get smart fast and be “universal,” i.e., able to do pretty much everything. Today, however, these universal watches can’t compete with a dedicated Garmin sportswatch in, say, running, cycling and golf.

Conversely, Garmin watches will never be universal in the sense that some coming watches will be. Garmin will never have its own operating system. Garmin’s products will never integrate with many apps that will work well on Apple or Android products. But maybe all that is ok, if you buy a watch for a specific purpose. You’re not going to buy a Garmin if you’re a casual user and want to use your watch to text your friends and share podcasts. Instead, Garmin is for people who want a watch for Fitness and are serious about it. We saw a lot of complaints from fitness buffs about running with a thick or clunky watch, battery life issues, and the lack of data/detail from Apple and Android, whose watches don’t stack up in these areas.

Along these lines, another important thing to consider when evaluating Garmin versus Apple or Android watches, at least in these categories, is that Garmin offers a built-in GPS, while Apple does not intend to, at least for now. Some Android smartwatches offer GPS, although it’s unclear how well these compare. Regardless, battery life is a significant issue for many users, especially outdoorsy, athletic, or long distance types, and a dedicated GPS generally offers substantially better battery life. Meanwhile, some Apple watches need to be recharged every day.

Thus, much of Garmin’s future growth in the watch/wearable category may hinge on the extent to which Apple, Google and others integrate their watches into an operating system, control the platform and ecosystem, deploy the killer apps and then go on to offer specialized, directly competitive products that offer better value than Garmin based on price, flexibility of use, weight, durability, water resistance, battery life, and the like. A universal watch cannot compete along every dimension. There are a lot of attributes to consider, and users are finicky. There may come a day when Apple will eat Garmin’s lunch in Fitness, but today is not that day. Furthermore, watches have always had a stylistic element to them, to a degree that is not true for phones. Sure, Apple and Android dominate the smartphone market, but does that mean we should similarly expect to see everyone wearing watches from just a few manufacturers ten years from now? We’re not convinced.

Outdoor – 14.9% of Revenues

The Outdoor segment is focused on more niche-like categories, such as hiking, geocaching, climbing, riding, paddling, skiing, etc., which extends to areas like golf and sporting dog-training. Garmin Outdoor products have a higher degree of customization, such as barometer, altimeter, compass, and even golf swing temp training features. Here Garmin has even pushed into GoPro’s turf, with some sports and action camera products.

While not as fast-growing as Fitness (Outdoor revenues grew at 2.4% and 4.0% in 2013 and 2014), this segment is fairly stable, with high gross margins, in the 60%+ range, although Outdoor operating income declined slightly in 2014 from 2013, due to a higher ad spend, which didn’t get the same traction as with Fitness.

Aviation – 13.4% of Revenues

Aviation offers products to a variety of aircraft, from light-sport planes to business jets and helicopters. In addition to GPS navigation, Garmin offers VHF transmitters, instrumentation systems, and other avionics equipment providing details on attitude, weather, terrain, traffic, and engine information.

Garmin’s competitive advantage in the segment stems from its expertise in the highly specialized aviation market, where the high degree of specialization required creates barriers to entry due to numerous technology, manufacturing and distribution challenges for potential competitors. Garmin has OEM relationships in Aviation as well, including with Augusta Westland, Bombardier, Bell Helicopter, Cessna and others. While Aviation doesn’t have the same growth rate as Fitness, it is arguably a market in which Garmin can more easily defend share.

This segment shows the strongest segment revenue growth after Fitness, growing 16.4% and 13.7% in 2013 and 2014, respectively. Gross margins in Aviation are the strongest of all segments, at in excess of 70%, and have grown in each of the past 3 years. This segment, despite an increased ad spend with dealers, experienced an increase in operating income of 22% in 2014, so Garmin’s advertising efforts appear to have been effective. The company has guided to 10% revenue growth in Aviation for 2015.

Marine – 8.6% of Revenues

The Marine segment relates to recreational boating, including nifty products such as radar, depth sounders, fishfinders, autopilot, compass and other instrumentation and communication equipment, and includes handhelds and wrist-worn devices. Garmin has some OEM relationships relating to plotters, sonar, radar and other features, which could also support the segment. Customers include Ranger Tugs, Cutwater Boats, Bayliner and others.

Although it is the smallest segment within Garmin, Marine has been another strong contributor. Revenues grew at 11.4% in 2014, including a solid 18% in Q414 versus Q413, and operating income grew at 42% in 2014, although the small size of the segment, at 11% of 2014 operating income, limited the contribution to earnings. The company has guided to 10% growth in revenues in the segment for 2015.

Economic Moat

We argue that Garmin today shows numerous financial signs that it has sustainable competitive advantages that have allowed it to maintain extraordinary profits for an extended period. That is, it has all the characteristics of a firm with a solid economic moat. Before reviewing the evidence for Garmin’s moat, we’ll talk about the structural characteristics of its moat.

Brand

Garmin has a highly recognizable brand in many of its markets. Garmin’s products are known for their quality and reliability, and it enjoys high brand awareness in many functional categories. People rely on the Garmin name for specialized, high quality products, for everything from running to aviation.

People have a good relationship with the company, and it drives good associations. The brand drives customer satisfaction and retention. Drivers have used Garmin GPS systems for many years, and now in Fitness, Garmin has suite of successful products and Garmin Connect is bringing together many fitness users under the Garmin name. The company provides free customer support for a year after products are purchased.

Being the market leader in many categories allows Garmin to earn returns above those for industry competitors.

Manufacturing

Garmin owns and occupies > 1 million square feet of facilities in Taiwan, where the company manufactures most of its high volume products. It has vertically integrated manufacturing, with close collaboration between design/engineering and manufacturing processes, which provides advantages relating to product cost, quality and time to market. The company’s size also confers manufacturing scale advantages. For instance, Garmin integrated manufacturing allows individual processes to exchange information, so that products with lower sales volume can piggy-back on the R&D and scale economies of higher volume products.

Its facilities in the US, Taiwan, and the UK are certified to the ISO 9001 international quality standard. Auto and Aviation also boast difficult-to-achieve certifications, which create barriers to market entry, and contributes to the company’s economic moat.

Garmin has bargaining power across a deep bench of suppliers for a range of materials and components, such as flash memory, RAM, chipsets, LCDs, etc. This enables the company to keep costs low, thus ensuring higher margins at certain price points versus competitors who cannot source as efficiently, or with as much market clout.

Garmin’s multiple shared facilities, where manufacturing and distribution are integrated, also enhance time to market.

Distribution

Garmin operates distribution centers in the US, UK, Australia, Taiwan, and also distributes its products (excepting those from Aviation) through a network of 4,000 independent dealers around the world. It has strong presence among well-established consumer retailers, including Amazon, Best Buy, Costco, Wal-Mart, etc. Its scale and reach provide Garmin with distribution economies. Customer concentration doesn’t seem to be a big issue, as no customer represents > 10% of revenues, and with the top 10 accounting for approximately a quarter of revenues.

Garmin’s distribution network provides various advertising synergies. Garmin engages in cooperative advertising with many of its dealers, allowing broader advertising exposure through multiple outlets, as well as more targeted messaging in specialty markets. This is important since a significant portion of its cost structure relates to advertising expense.

Garmin imports/exports from/to and manages supply chain security in more than 20 countries – a network that would be difficult for competitors to recreate, which contributes to its moat. The company claims 99.9% of orders audited were correct.

Garmin’s extensive distribution network provides the company’s products with consistent availability, and rapid time to market.

Patents

Garmin has a sizeable patent portfolio, with over 880 patents and 610 trademark registrations. This intellectual property provides Garmin some quasi-monopolistic opportunities for certain products, providing competitive advantages and additional pricing power.

Currency Exposure

A word on currencies. The Taiwan dollar is the main currency associated with Garmin’s manufacturing costs, and when the U.S. dollar strengthens against the Taiwan dollar Garmin benefits through lower effective manufacturing costs. Although in 2014, these currency benefits offset the losses versus the Euro and the British Pound, if 2015 spreads between the Taiwan dollar and Euro/British pound change, the effect could be different.

Returns on Capital / Assets, long-term FCF

Over time, Garmin’s management have proved to be smart allocators of capital, as the company has generated investment cash flows that have far exceeded the cost of capital used to finance its assets, and over the past 8 years, has earned returns nothing short of spectacular. This is due to Garmin’s various competitive advantages discussed above. Since 2007, Garmin has earned geometric average returns on assets of 15.7%, and on capital of 21.2%.

Garmin has earned high returns on its investments not only versus its direct competitors, but also when compared with the broader stock market. In comparing Garmin’s returns to those found in our investable universe (stocks > $1.8 billion), we find that Garmin falls in the 96th and 94th percentiles, for ROA and ROC, respectively. That is long-term success.

A note on 2014 net income. We use net income in the numerator for ROA and ROC, and in so in 2014, while Garmin generated a ROA of 7.8%, and ROC of 10.7%, both below long-run averages, 2014 net income was impacted due to a one-time tax expense of $308 million, associated with an intercompany restructuring that moved business units out of Taiwan, allowing more efficient repatriation of earnings. Normalizing for this tax expense by backing it out, we get ROA of 14.3%, and ROC of 19.7% for 2014, which are both in line with 8-year ROA CAGRs of 15.7% and 21.2%, respectively.

Additionally, over the past 8 years the company has generated $5.5 billion of free cash flow, representing 117% of its total assets. This is an astonishing ratio, placing Garmin in the 98th percentile of our investable stock universe (> $1.8 billion market cap). It is impossible to argue that the company has not been a free cash flow machine over recent history.

Margins

Gross margins have been on a tear, growing from 46% in 2007 to 56% in 2014, for an 8-year CAGR of of 2.8%. This rate of increase is better than approximately 85% of our broader market (again, of stocks > $1.8 billion market cap). And this trend appears to be intact in the recent past. Consider gross margin increases over the past 3 years:

2012  53.0%

2013  53.5%

2014  55.9%

Clearly, in the aggregate, Garmin has demonstrated consistent pricing power and cost control over time, even recently, notwithstanding the auto headwinds.

Financial Strength / Operating Momentum

Garmin is showing numerous signs of financial strength operational momentum.

As discussed, Garmin earned (adjusted) ROA and ROC of 14.3%, and 19.7% in 2014. Free Cash Flow increased in 2014 versus 2013. The company had positive earnings and free cash flow, with free cash flow exceeding earnings, indicating the Garmin is not using accruals, which would be a red flag for us. As discussed above, gross margins are improving. Asset turnover increased, indicating increased productivity, and more efficient use of assets.

In 2014, the company was a net repurchase of equity. Garmin’s CEO reported that the company returned over 100% of 2014 free cash flow to shareholders, and Garmin has announced a new $300 million share buyback program. Garmin is also raising the dividend – the quarterly dividend will increase to $0.51, which works out to > 4% yield versus the current stock price. Also, the company has no long-term debt, and huge cash/marketable securities position, which today stands at $2.7 billion.

We think this is a shareholder-friendly company in a financially strong position.

Summary

So Garmin, at least historically, is showing many signs of being a very high quality business, and today it is unquestionably cheap. Its EBIT/EV yield of 10.5% falls roughly in the cheapest 5% of all stocks that we feel are sufficiently liquid to invest in (those above $1.8 billion).

A skeptic would say that auto GPS/PDNs were the source of Garmin’s competitive advantage, and since that market is in decline, Garmin is therefore no longer a high quality company and will no longer continue to enjoy the investment returns and margin strength it did in the past.

It strikes us that the company is priced today as if its moat is more or less gone.  In short, this stock is priced for a death sentence for auto, a face-plant for fitness and flat for the other businesses. The market is saying, “it’s over, they are done, you can safely ignore all that operating history.” They can no longer price, or generate returns, or grow or stabilize margins, and Apple will kill them.

These kinds of anticipated downside scenarios have not materialized historically, and have arguably not done so even recently. While you might not know it from looking at Wall Street’s knee-jerk, selloff reaction, Garmin’s Q414 revenues were up by 5.7%, versus Q413, and FY14 revenues were up 9.1% over FY13. Operating income was up 20.0% in 2014 versus 2013. Units shipped were up by 9% in 2014 versus 2013. Are these results consistent with those of a company in crisis, justifying relegating them to the bottom 5% of the market for valuation? We’re not so sure.

From a behavioral finance standpoint, the market’s response to Garmin’s recent earnings strikes us as a classic overreaction, where analysts are over-focused on Auto, unduly pessimistic on Fitness, Aviation and Marine, and armed with a few highly-available and publicized bad news items, are extrapolating to the downside. Sometimes this dynamic creates opportunities for value investors.

The company’s strategic focus has been to manage away from reliance on Auto and towards Fitness, and we think that is taking place and is realistic. The question is. can strong growth in Fitness, and decent growth in Aviation and Marine offset the declines in Auto, or perhaps even drive overall growth? There are signs this could be the case.

Garmin possess a solid economic moat based on its strong brand, expertise and IP in technology, and integrated manufacturing and distribution economies, and this has been demonstrated over time through its superior long-run returns on assets and capital, and margin strength, and by its financial strength today. We think these attributes will continue to provide the company with pricing power and additional sustainable margins and high returns in the future. If this is the case, it is a bargain today, and we think this price represents a reasonable entry point for investors.

Catalyst

- Garmin offsets declines in nuvi and Auto/PDN, manages around Auto operating profit

- Fitness has another year like 2014, defends market share against new smartwatches

- Continued performance of Aviation/Marine

- Additional cost controls, disciplined ad spend in Outdoor

- Taiwan currency