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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.
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