A Short Trip for Garmin?

by: Paul Zimbardo

Garmin Ltd. (NASDAQ:GRMN) is a company that specializes in global positioning systems (“GPS”) technology, specifically stand-alone GPS receivers for automobiles. In fact, Garmin is so synonymous with GPS technology that Garmin is the first result on Google (NASDAQ:GOOG) when searching for “GPS”.

After appreciating from the single digits in 2002 to reaching its all-time high of 125.68 in late October 2007, Garmin stockholders have watched Garmin’s share price plummet to 14.40 before stabiliFive Year Stock Performancezing in the low twenties. In 2009, Garmin is down 45.0% whereas the S&P500 is down “only” 26.6%. This previous high-flier has certainly fallen out of favor on Wall Street but was this just a case of heightened expectations crashing down as the economy weakened, or were there fundamental problems behind the decline? Also, were there any signals that could have alerted investors that Garmin’s stock price in October 2007 was unjustified?

I will analyze the current events in the industry, examine the fundamentals of the company with a focus on the financial statements, and finally assess the valuation of the company for a potential long-term investment. So buckle up, and we will be arriving at our destination shortly. Next stop: an informed investment decision.

In the start-up phase of the industry, Garmin had only two major competitors TomTom (OTCPK:TMOAF) and MiTAC International (creator of the Magellon brand). Growth prospects were abundant and virtually all companies were able to achieve success. Unfortunately for Garmin, this industry quickly attracted competitors with deep pockets. Today, technology heavyweights including Apple (NASDAQ:AAPL) and Research in Motion (RIMM) offer smartphones with navigation abilities that rival the capabilities of dedicated GPS devices. For example, turn-by-turn GPS navigation applications exist for both platforms.

Factoring in the knowledge that GPS units are priced similar to the increasingly popular smartphones, the GPS companies are facing a serious threat. There is no masking the fact that Garmin has seen its core business come under increasing pressure from smartphones: the pressure is quickly reaching critical mass as smartphone adoption increases. There is little doubt that Garmin will pursue strategies to profit from this shift in consumer preferences but it may be too little, too late. TomToms response was to announce a turn-by-turn GPS navigation kit for the iPhone last month.

On the other hand, Garmin is still pursuing the oft-delayed Garmin Nuvifone (a product similar to the iPhone) but with a MSRP of $499.99, does anyone really think that Garmin can demand such a premium over Apple's iPhone? Garmin has a strong brandname, but its not that strong. GPS technology is quickly becoming a commodity and it is clear that Garmin is straying far from its core competencies if it attempts to enter the smartphone market (especially during such a weak economy).

A cleverly titled article written last week in the New York Times discusses the GPS unit versus smartphone debate quite well.

“High-end phones like the BlackBerry from Research in Motion and the new Palm Pre increasingly come equipped with features common in portable navigational devices, like spacious touch-sensitive screens, intuitive menu designs and improved audio capabilities.

'The smartphone has made a lot of progress in the last year,' said Dominique Bonte, director of navigation research with ABI Research. 'It gets very close to what people expect from the experience of the personal navigational device.'”

Turning to Garmin’s financials, at first glance the income statement indicates strong year-over-year growth in sales as revenues have more than tripled from 2005 to 2008. Upon further investigation, the deterioration in margins is quite alarming. Both margins have declined by ten percent in the examined period. This signals increasing pricing pressures and explains the growth in sales. As the company shifts more towards selling software rather than hardware, the margins should improve but the damage has been done.

TTM 2008 2007 2006 2005
Gross Margin 46.3% 46.7% 48.0% 52.2% 56.3%
Profit Margin 19.4% 21.0% 26.9% 29.0% 30.3%

The release of the Nuvifone should certainly improve margins if it is released at that price point. The last line item worth noting on the income statement is that research & development expenses are keeping pace with sales over the period. The true question is with R&D at only $200M in 2008, can the company possibly keep pace with the aforementioned tech powerhouses? For comparison, Apple spent more than five times as much on R&D in 2008 and Research in Motion spent three times as much in the same year.

iPhone Timeline
iPhone Version Date
Version 1.0 June 29, 2007
3G July 11, 2008
3GS June 19, 2009

To put the argument that Garmin's misfortunes are due solely to Apple's iPhone to rest, one merely needs to compare the margin data with a timeline of Apple's iPhone. Garmin's margins have been declining, since before the first iPhone was even announced. It was not until the iPhone 3G was released in mid-2008 that decent navigation capabilities came to the iPhone and it was not until the 3GS that true turn-by-turn capabilities were possible. With the 3GS on the market for only three weeks and the simultaneous 3G price cut, it would appear that the worst is yet to come for Garmin's margins.

Fortunately Garmin has a very strong balance sheet. Liquidity is excellent, highlighted by a current ratio of 6.0 and a quick ratio of 4.5. However, long-term assets, specifically PP&E have been declining as capital expenditures are not increasing significantly. I will discuss the significance of this in more detail in the free-cash-flow analysis below but for now just take note that this is not a good sign for a growing company. On the other side of the balance sheet you see a company with no long-term debt. In fact, Garmin has three times more current assets than total liabilities ($1.8B versus $.5B), an impressive characteristic that I cannot remember witnessing in any other stock that I follow.

Garmin is currently yielding 3.2%, much higher than average for a growing technology company. Typically these high-growth companies reinvest earnings in operations so in this scenario, I consider Garmin’s high yield to be a red flag when the industry average is .4%. The dividend certainly appears to be safe with a payout ratio of 25 and strong free cash flows; however, I cannot fathom the dividend continuing to grow at anywhere near its historical growth rate (five-year dividend growth rate is over 30%).

(millions) 2008 2007 2006 2005
FCF $675.4 $393.6 $229.3 $218.4

By paying out such a high dividend and using excess cash to repurchase shares, management appears to be signaling that the “supergrowth” days are over for Garmin. Rather than investing in R&D and expanding the potential market, Garmin is choosing to return value to shareholders. Ordinarily this is commendable but this will inevitably lead to a drop in analysts’ estimates; however, I temper this by noting that the PE is already a minuscule 7.5. On the other hand, GRMN is trading at a relatively expensive price-to-book greater than 2.0. Therefore, let the buyer beware.

In closing, there is no denying that Garmin is an efficient company that is focusing on increasing shareholder value. This is confirmed by the insiders and five percent owners holding a 44% stake in the company. I hope to give potential investors pause when trying to classify this as a classic growth or dividend play. This concern may be coming to fruition with the short percent of float at 13.3% as of June 10th. With its hybrid status and lack of a clear classification, I am afraid that Garmin will be shunned by both groups of investors and ultimately succumb to the intense competition from its peers.

Sources: Motley Fool, New York Times, Wikipedia, and Yahoo Finance

Disclosures: I am long AAPL, GOOG, and RIMM.