By The Valuentum Team
Garmin (NASDAQ:GRMN) offers navigation products for a variety of end markets through its five operating segments (listed with percentage of total first quarter 2016 revenue contributed): Auto (31%), Fitness (23%), Aviation (17%), Outdoor (16%), and Marine (13%). Garmin's fitness segment has been a strong performer as of late thanks to strong demand for its products with Garmin Elevate™ wrist heart rate technology, but it will continue to face intense competition from established players such as Apple (NASDAQ:AAPL) and FitBit (NYSE:FIT).
Weakness in Garmin's Auto segment, its largest in terms of revenue generated, is expected to continue for the remainder of 2016, mostly due to ongoing contractions in the personal navigation device market (PND). The proliferation of GPS-enabled smartphones has played a role in the reduction of demand for the firm's products in this area, but its market share remains solid. Revenue in the Auto segment is expected to decline ~15% in the full year 2016.
Such weakness in Garmin's Auto segment may be a blessing in disguise for its long-term outlook, however. The decline in the segment's demand has forced the firm to look to its higher-margin businesses for growth. In the first quarter of 2016, for example, operating margins in the Auto segment came in at 9%, compared to 29% in its Outdoor and Aviation segments and 12% in its Marine and Fitness segments. While Auto segment revenue is expected to decline materially in 2016, the Outdoor, Fitness, and Marine segments are each expected to grow revenue 10% and Aviation segment revenue is expected to advance 5% in 2016.
We're big fans of Garmin's balance sheet health (more than $2.3 billion in cash and marketable securities and no debt as of the end of the first quarter of 2016) and free cash flow generation. These qualities lead us to believe the company's dividend is safe and help it register a Dividend Cushion ratio of 1.8. Garmin's ~5% dividend yield is attractive, but we can't ignore the competitive risks of its businesses and falling demand in its largest segment. Garmin currently registers a 6 on the Valuentum Buying Index.
Garmin's Investment Considerations
• Garmin provides navigation products, many of which are enabled by GPS technology. Revenue growth in its automotive/mobile segment (about 40% of business) has slowed, but the firm boasts strong global market share, with North America exceeding 70% and Europe in the low-to-mid 30% range. The company was founded in 1990 and is based in Switzerland.
• For the full-year 2016, Garmin is expecting revenue to be approximately $2.82 billion and earnings per share to be ~$2.25. The firm is expecting to see an improvement in its Americas region and growth from its APAC region in the year.
• The company's outdoor, fitness, aviation and marine divisions (collectively over 60% of business) are growing nicely. Its fitness division is growing the fastest thanks to market expansion in the rapidly-growing activity monitor category. Garmin continues to innovate and is committed to being a leader for athletes and novices.
• The global economic environment and intensified competitive landscape have challenged Garmin's ability to continue its strong financial performance of 2014. However, the firm plans to introduce compelling new products in 2016, which should buoy results.
• Gross margins on the firm's automotive/mobile products have declined and could further decline due to price reductions in the competitive market for navigation solutions. We're watching profitability in its largest segment very closely.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Garmin's 3-year historical return on invested capital (without goodwill) is 44.3%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Garmin's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.8 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Garmin's free cash flow margin has averaged about 14.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Garmin, cash flow from operations decreased about 55% from levels registered two years ago, while capital expenditures expanded about 48% over the same time period.
In the first three months of fiscal 2016, Garmin reported cash flow from operations of ~$129 million and capital expenditures of ~$14 million, resulting in free cash flow of ~$115 million, representing an ~80% increase from the first quarter of fiscal 2015.
This is the most important portion of our analysis. Below we outline our fair value assumptions as well as derive a fair value estimate for shares.
We think Garmin is worth $41 per share with a fair value range of $33-$49. Shares are currently trading at ~$40, fairly close to our fair value estimate. This indicates that we feel there is a similar amount of upside potential and downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
We're expecting revenue to be relatively flat in coming years for Garmin as declines in demand in its largest operating segment are expected to be ongoing. Solid performance from its remaining segments will buoy results, and resilience in the Auto segment could surprise to the upside. We're also anticipating a reduction in earnings per share in the near term as margin pressures persist.
Our model reflects a compound annual revenue growth rate of 1.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.3%. Our model reflects a 5-year projected average operating margin of 26.7%, which is above Garmin's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Garmin, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $41 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Garmin. We think the firm is attractive below $33 per share (the green line), but quite expensive above $49 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Garmin's fair value at this point in time to be about $41 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Garmin's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $49 per share in Year 3 represents our existing fair value per share of $41 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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