The Short Case On Garmin

| About: Garmin Ltd. (GRMN)

Garmin (NASDAQ:GRMN) shares are extremely overvalued at 23 times the Street’s 2007 EPS estimates, and should begin to decline as we move closer to the 2006 holiday season. Not only are analysts using unrealistic gross and operating margin assumptions for 2007 and beyond as year/year revenue growth decelerates due to ASP declines, most are valuing the company’s hardware-only model inline with companies with significant intellectual property and recurring revenues, such as Research in Motion (RIMM).

Garmin is undeniably benefiting from a surge in demand for portable navigation devices [PNDs]. Revenue is forecast by analysts to grow 65% to $1.5 billion in 2006 with EPS expected to surge 50% from 2005 levels to $3.65 a share. While this growth is impressive, and seemingly calls for a lofty valuation given industry forecasts for continued 100% plus unit growth, the company will soon face an influx of competition from lower cost producers. In turn, the company’s device only model will succumb to significant pricing pressure, thus leading to EPS growth shortfalls and valuation multiple contraction. Shares have 50% potential downside from a recent price of $50.60.

Drivers of Recent Growth:

1. Resilient average selling prices [ASPs]. (See Table 2 below)
2. Strong consumer spending trends.
3. Relative price difference expansion between in-dash and PND option.
4. Lumpy but strong growth in aviation market [22% of 2005 revenue].
5. Market share gains due to rapid roll-out of multiple PND devices [40 in 2005].

Risks to Model:

1. Device only companies fail; it’s just a matter of when, not if.
2. Garmin relies heavily on new product introductions for shelf space gains.
3. Commoditization driven by new market entrants poses a major threat to ASPs.
4. Double counting in auto and PND markets will lead to downside surprise in industry unit growth.

Demand for Garmin products has increased rapidly as the company rolled out new products at a rapid clip and early adopters were willing to pay up to get the latest technology gadget. Total Garmin PND units grew from 735,000 in 2004 to 1,159,000 in 2005, or 58%. For 2006, analysts are forecasting similarly strong results with ASPs expected to be roughly flat from 2005 levels at $374. Total units are expected to rise 133% to 2,699,000 for the year. Garmin maintains an estimated 50% share of the U.S. retail market, a feat the company likely attributes to its strong brand recognition, quality hardware, and constant innovation with new form factors rolling out an average of 3 times per month.

Garmin’s strong operating results should not come as a surprise. The company is following the life cycle of most consumer electronic companies; rapid early growth with stable to slightly falling ASPs. However, like most consumer electronics categories, the PND market will soon face an influx of competition looking to get a piece of a rapidly growing pie. Competition will accelerate ASP declines in 2007 and beyond, which in turn will drive gross and operating margins down towards other consumer electronics company.

As Table 1 below clearly shows, Garmin has seen a meaningful surge in demand for its PND devices while ASP’s have held fairly constant. From virtually zero sell-in in 2004, the company has seen its units grow to nearly 800,000 per quarter.

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Table 1: Garmin PND Unit and ASP Trends
Table 1 Garmin PND Unit and ASP Trends

Table 2 shows a similar trend in demand and ASP results from Palm (PALM), which has seen a similar surge in demand for its Treo smartphones.

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Table 2: Palm Unit/ASP Trends
Table 2 Palm Unit-ASP Trends

A play-by-play of recent Palm events could be a good blue-print for the fate of Garmin. After the Street recognized that Palm’s Treo smart phone, introduced in 2004, would save the former high-flying PDA maker from bankruptcy, shares rallied from the single digits to the mid-$20 level. While adoption of the Treo 600, Palm’s first smartphone, was gathering steam, the company lost some credibility with the Street as channel inventories swelled from strong sell-in and investors questioned if the company was stuffing the channel in order to make numbers at the cost of future quarter results.

Palm continued to roll-out new products and brought in a new CFO, and shares rebound in late 2005 as the Treo 650 was the hands down winner in the smartphone arena with strong traction at Cingular and other U.S. carriers. In the first quarter of 2006, the company stepped away from its loved Palm operating system and offered a Windows Mobile smartphone with 3G capabilities dubbed the Treo 700w. Volumes surged, and the smartphone market as a whole was at an inflection point with strong consumer demand for 3G services forcing carriers to add smartphone options to their shelves.

Competitors saw the success of Palm and quickly began introducing new products at lower price points. Palm management was quick to dismiss new entrants as second tier players that could not garner the same consumer support as its products regardless of ASPs. However, carriers were quick to adopt new products because it brought consumers into the store and led to an increase in high-margin, high ASP data subscription plans. Not surprisingly, the laws of business took over and Palm was offering company sponsored $100 rebates on its smartphones with Verizon by September and withdrew its full year guidance. The company cited competition from lower priced products as the main culprit.

Palm’s history matters because the company, in many important ways, is identical to Garmin. Neither Palm nor Garmin manufacture their own products. While Palm has its own operating system, current and future unit growth has and will be been driven by the adoption of Windows OS, so neither company owns the software in its machines. Neither company has any significant recurring revenue to speak of. And both are dependant on the introduction of new products in order to maintain ASPs and shelf space. Both require semiconductor products and software from third-party vendors that often have slower price declines than Garmin or Palm’s price declines.

Despite the surge in units and relatively tame declines in ASP’s, Palm’s share price has been volatile.

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Palm 3-yr chart
Palm Stock Prices

Garmin has relied heavily on new product introductions in order to maintain market and mind share with consumers. According to the company’s 10-K annual report for 2005, Garmin introduced 40 new products in 2005. A quick look at’s top selling product list reveals that there are multiple Garmin devices in the top-40 of all electronics. However, I believe the company will struggle to innovate at a similar pace while still creating a meaningful differentiation relative to past products and competitors. R&D as a percentage of sales has remained relatively fixed, as seen in the table below. The company significantly under-invests in R&D relative to Palm, a trend that may change should the company’s motivation to innovate shift from product creation to market share defense.

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Table 3: R&D Spending as % of Revenue
Table 3 R&D Spending as % of Revenue

As more PND devices come onto the market in 2006 and beyond, consumers will be forced to ask whether or not Garmin products deserve a premium price relative to substitutes. In the early goings, consumers will likely stick with Garmin as the PND market is still a niche market and users will have more product knowledge and focus on device usability over price. However, as Palm found out, when attempting to penetrate the mass consumer market, consumers will quickly adopt the trendiest, least expensive device regardless of functionality. Palm’s channel visibility quickly disappeared and sales lead times lengthened as soon as Motorola unveiled its Q smartphone at a much lower price point. While the product was inferior, unit sales quickly eclipsed Palm unit sales.

Competition will come from multiple companies. In addition to Magellan and TomTom, the company will see an influx of ODM’s, such as HTC, which have significant manufacturing advantages and time to market advantages. GPS chip company SiRF (SIRF) mentioned HTC on its recent earnings conference call and HTC recently announced that It will use SiRFstarIII in GPS enabled smartphones. Aside from HTC and other, more established companies, the market is dismissing the cell-phone handset manufacturers as potential market share takers in the GPS space. Verizon already offers a GPS service for its subscribers, and Nokia is working on a new GPS device that is expected to use SiRF technology for GPS capabilities.

Garmin lists its competitors to be:

Garmin believes that its principal competitors for portable automotive products are TomTom NV, Thales Navigation, Inc. [“Thales”], Alpine Electronics, Inc., Lowrance Electronics Inc. [‘‘Lowrance’], Cobra Electronics Corporation [“Cobra”], Navman NZ Ltd., a subsidiary of Brunswick Corporation, [“Navman”], Mitac International Corp. [“Mitac”], Navigon AG [“Navigon”] and Sony Corporation. Garmin believes that its principal competitors for handheld recreational product lines are Thales and Lowrance. For marine chartplotter products, Garmin believes that its principal competitors are Raymarine Ltd. [“Raymarine”], Furuno Electronic Company [“Furuno”], Navman, the Standard Vertex Division of Yaesu Co. Ltd. [“Standard”], Simrad and the Northstar Technologies unit of Brunswick Corporation. For Garmin’s fishfinder/depth sounder product lines, Garmin believes that its principal competitors are Lowrance, Raymarine, the Humminbird division of Johnson Outdoors, Inc., Navman, Simrad and Furuno. For Garmin’s general aviation product lines, Garmin considers its principal competitors to be Lowrance, for portable GPS units, and Honeywell, Inc., Avidyne Corporation, L-3 Avionics Systems, Meggitt PLC, Rockwell Collins, Inc., Universal Avionics Systems Corporation, Chelton Flight Systems and Free Flight Systems for panel-mount GPS and display units. For Garmin’s Family Radio Service and General Mobile Radio Service product line, Garmin believes that its principal competitors are Motorola, Inc. [“Motorola”], Cobra and Audiovox Corporation. For Garmin’s personal digital assistant product line, Garmin considers its principal competitors to be Palm, Inc., Mitac, Navman, Medion AG, Navigon, Hewlett-Packard Company, Acer Corporation, Dell Computer Corporation and Toshiba Corporation.

Garmin targets both the consumer market and the aviation market. Table 4 shows a breakdown of sales and gross margins in each segment.

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Table 4: Segment Revenue and Margin Breakdown
Table 4 Segment Revenue and Margin Breakdown

As the table shows, PND’s have grown dramatically as a percentage of revenue for Garmin, which has weighed on the company’s blended gross margin. Even so, the outsized top-line growth has led to substantial earnings increases. However, a simultaneous slow down in unit growth and ASP’s in 2007 will lead to severe corporate margin contraction as Garmin clearly dependent on strong top line growth in order to offset lower segment margin contribution. Competition, high device prices relative to alternatives such as cell phones, and a potential slow down in consumer spending and saturation of the early adopter PND market all point to larger than expected margin contraction.

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Table 5: Valuation Comparison
Table 5 Valuation Comparison

Garmin continues to garner a premium valuation despite the potential for the company to follow a similar cycle of prosperity and despair as Palm. The company’s 30%-plus operating model will come under pressure in 2007 and beyond for the reason outlined above. At the same time, EPS growth could potentially halt to the mid-teens as a result of decelerating unit shipments and declining ASPs. Also, there are no recurring revenue streams at Garmin as there are at Research in Motion, and the company is dependent on component and semiconductor makers such as Dell in order to offer faster, easier to use, products.

Garmin is on the cusp of having to manage, for the first time, the working capital of a high growth business. This poses several near-term risks including the potential to over ship into the channel as retailers order more products and procuring more raw materials and inventory than necessary to meet end-market demand. This will be a drain on cash flow for the foreseeable future, and the company’s ability to manage inventory will be key as rapid ASP erosion will lead to inventory devaluation at a rapid pace.

Disclosure: Author has no position in GRMN