Sunday, November 11, 2012

Cognex Research Analysis Part I

Cognex (NASDAQ: CGNX) is one of those stocks that you really want to like. Its long term growth prospects are very good and its management always ‘tell it like it is’ regarding the company’s prospects. Throw in the humor with its highly entertaining results presentations and it’s hard not to feel engaged by this company. I strongly recommend looking at its annual reports in order to see how investing information can be fun and factual at the same time.

Now I know you are expecting the ‘but’ bit right now and you wouldn’t be wrong. The simple fact is that any company that makes capital machinery is going to be tied to investment cycles in manufacturing and to the industries it serves. Moreover globalization has resulted in the almost seamless ability of manufacturers and OEMs to shift production to different countries or suppliers. This means a company like Cognex is dependent on its customers production patterns. That said this is an attractive long term story and investors willing to take a long term view may find a great investment here.

Who is Cognex and what is the Long Term Story?

Cognex is the global leader in seeing machines. In other words vision systems that monitor production processes at automated manufacturers. As production becomes increasingly robotized and items get ever smaller, the need for quick and accurate quality control and monitoring is getting more important and Cognex provides the solution.  Good ole human eyesight simply cannot compete with its vision machines.

In addition technological advances with Cognex’s product range mean that it can offer its products to a wider range of industries and in the future this will help reduce the cyclical nature of its earnings. Things like surface inspection solutions for the packaging industry would help but, for now, Factory Automation and Semiconductors remain the key end markets.

And with 85% of its revenues in highly cyclical industries, it’s not hard to see why earnings and revenues have proved so cyclical over the last few years.

Cognex got hit badly in the last recession but the long term trend is positive. Due to its fixed cost base when end demand falls there is little Cognex can do to keep margins and cash flow up. However, the company’s free cash flow generation is improving and if you average out the last seven years the company converts 18.6% of revenue into free cash flow. Furthermore the compound annual growth rate (CAGR) of revenues in this period works out to around 6.8%.

It’s not difficult to play around with these numbers in a DCF calculation and conclude that Cognex is attractively priced right now, but I don’t think investing is that simple.

Cognex’s Near Tern Challenges

I have a few near to mid-term concerns here.

First, on a geographical basis Cognex has challenges. The world and his wife know that European manufacturing is going through a tough time, but investors shoudn’t forget that the BRICs are slowing too. Listening to FedEx (NYSE: FDX) the other day, it is clear that global trade is slowing more than global GDP.  FedEx discussed this as being partly due to Governments policies affecting export industries but also due to a slowdown in European/US consumption trends causing Asian exports to slow. Given that Asia’s strength is in export led manufacturing this is a significant issue for FedEx and it is also a problem for Cognex. Cognex has positioned itself as the leading machine vision company in China and if its customers slow investment it too will suffer.

Second, on an industry specific basis the end market mix does not look favorable. Cognex has heavy exposure to the semiconductor, solar and consumer electronics industries and they are weak right now.  Applied Materials (NASDAQ: AMAT) is a good company to look at because it has exposure to semiconductors and solar cell capital spending cycles. Its recent results and outlook were not good.  The semiconductor industry is suffering from weaker than expected end demand and the solar industry has overcapacity compounded with a growing reluctance amongst Governments to subsidize it. Applied Materials forecast net sales to decline by 25-40% in Q4 and its operating margins continued their decline.

With regards to general factory automation I think Danaher Corp (NYSE: DHR) is a useful bellwether. Across its line of business the weakest recently has been Industrial Technology (the area most relevant to Cognex). In its last quarter Danaher argued that its second half might play out weaker than expected. Everyone , from telco to luxury goods, is hoping for a rebound in growth from China but everyone seems to be reporting that it hasn’t happened yet and Danaher is no exception. Danaher discussed taking cost actions in order to protect margins should current trends continue.

Where Next for Cognex?

To be fair Cognex did express a significant amount of caution in its guidance for the rest of the year. However, my opinion is that the risk over China is skewed more towards the downside. I think that plays out negatively for Cognex.

On the other hand, its long term drivers are excellent and provided you can put up with the potential for near term disappointment this looks like the kind of small cap that many investors will look back at in 10 years time and wonder ‘why the hell didn’t I buy it back then?’

If you think the global economy will rebound and China with it then the stock looks like a very good value. For those of us who are a bit more cautious this is a great stock for the watch list.