Friday, February 15, 2013

Cognex is a Play on Increased Automation

Machine vision company Cognex (NASDAQ: CGNX) reported better than expected results and the market rewarded the company with an initial markup. I could stop the commentary right here but I think investors should look deeper into these numbers because there are a lot of things going on here. In summary I think the slowdown in the consumer electronics industry in 2012 has hit Cognex disproportionately hard, and if you consider that is about to turn up then the company is well worth a closer look.

Cognex’s Mixed Q4

For the sake of brevity I am not going to introduce the company to readers but sufficed to say there is a good primer article on CGNX linked here. Revenues and earnings declined in the quarter and superficially the company appears stuck in a downtrend as earnings fell for the full year to $1.56 from $1.63 last year. Before delving into further details, a quick look at the revenue split by marketplace in 2012.

Breaking out revenues by marketplace shows that Factory Automation revenues actually grew 4% for the year and 1% in the quarter. Surface Inspection revenues grew 5% for the full year and 22% on the quarter, but don’t get too excited because revenues tend to be very lumpy in this division. The real story of 2012 is that Semiconductor and Electronics Capital Equipment sales declined 24% for the year and 20% for Q4.  Note that this market made up 12% of revenues last year but only 9% in 2012.

Similarly the weakness in the Factory Automation numbers came from the consumer electronics industry which is highly correlated to the semiconductor industry anyway. Moreover, Cognex’s relative exposure is not doing it any favors either. Japan is a key geographic region; its Factory Automation revenues declined 17% in the quarter, and for Asia overall it was a 21% decline.

Consumer Electronics Trough?

Much of what Cognex reported on consumer electronics could have been predicted by looking at Semiconductor Industry Association reports (SIA) and you will find a graph of changes in 2012 in the link. In order to demonstrate the geographic relevance and highlight the tentative signs of a trough being passed I’ve tabulated some numbers from it.

Clearly Cognex’s Japanese exposure has hurt it and much of its current sales to China are related to consumer electronics. Management stated that around 11% of its Factory Automation revenues came from China in 2012. Going forward, the challenge is to diversify its end markets for factory automation, particularly within China. For example it has opportunities to do so within automotive, food and beverages.

Regarding semiconductors I view the latest industry numbers as a positive, and Intel (NASDAQ: INTC) forecast that its gross margins would be flat next quarter. I discussed these issues in an article linked here. The best indicator of a bottoming out process in consumer electronics is what happens with Intel’s gross margins and its inventory to sales ratio. As such, Intel reported a significant reduction in inventory in the last quarter, and the gross margins appear to be stabilizing. Coupled with the SIA numbers, this tentatively implies a trough in the industry.

Other Key Revenue Drivers for Cognex

ID products represent a significant area of expansion for CGNX and it expects 20%+ growth in 2013. ID product revenues were $19.7 million or 24% of total revenues in the quarter so this growth is relevant. In addition, there are hopes that CGNX can expand take-up and utilization of its ID products within the logistics industry. The ID and associated RFID industry does tend to have lumpy orders as evidenced by Roper Industries (NYSE: ROP) divisional numbers, which can be looked at here. RFID development takes time because customers tend to want to try the system, analyze the efficacy and then roll it out incrementally. It’s a similar process for CGNX’s ID solutions so it’s understandable if the logistics companies take their time over adoption. Although, with Roper it can expand margins via increased software sales.

Automotive is a key vertical for CGNX and the management declared itself to be cautiously optimistic over conditions in North America amidst predicting mid to high single digit growth. Looking at what Alcoa (NYSE: AA) reported recently, the strength in automotive production will come from China in 2013 so CGNX will hope to expand sales in this market too. Furthermore, while Alcoa sees European revenues to be down 1-4%, it is a story of bifurcation between a weaker Southern Europe and a stronger Northern Europe and Central Europe. Recall that the German automakers all have some production plants in Central and Eastern Europe.

Is Cognex a Stock to Buy?

The bullish case for CGNX is that a trough has been passed in the semiconductor and consumer electronics industry and that global manufacturing will hold up in 2013. It sees CGNX expanding ID product sales as intended and the potential for increased end market diversification within its Factory Automation sales.

The bear case contains the usual worries over global growth and concern over CGNX’s exposure to highly cyclical industries.

I happen to be weighted more on the bullish side here. For example, China is under-automated by international standards and the potential to expand end markets is a real one. It is hard to predict what the semiconductor industry will do but I think the evidence is building for at least some stability in 2013. Analysts have CGNX on forward earnings of $1.73 and I would pencil in an assumption of $2 in free cash flow. Assuming the stock should trade on a forward rate of say 5% of enterprise value gives a target of around $47. I would be looking for entry point around $40 for this stock.

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