Cognex: Compelling Entry Point Ahead Of Earnings Announcement

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About: Cognex Corporation (CGNX)
by: Richard Cheever, CFA
Summary

Cognex will report Q4 financial results this Thursday after market close. Financial estimates for the company have been trending lower, driven largely about concerns about slowing end-market demand.

Even though the shares price has recovered from a December selloff, the current share price represents a compelling entry point for long-term, growth-oriented investors.

The company provides exposure to the machine vision technology industry, which is poised to grow along with accelerating adoption of artificial intelligence in factory automation applications.

Management has a history of exceeding guidance, which could lead to a positive earnings surprise.

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Thesis

Cognex Corporation (CGNX) is a leader in the machine vision technology industry providing vision systems, software and inspection systems used in manufacturing automation applications. The shares provide exposure to disruptive technology in artificial intelligence (AI) and robotics industries. The company has been generating top-line growth in the high-teens over the past five years, but concerns of growth deceleration have led to downward revisions to estimates, creating a compelling entry point for patient, risk-tolerant investors, in my view.

Earnings Call Preview

Preparing for the earnings conference call next week, there are a few things to pay attention to. First, what's the tone of questioning from analysts? Financial projections for the company have been trending lower. On the previous earnings call there was a healthy degree of skepticism about the prospects for top-line growth and disappointment would add downside risk to the valuation range outlined below. Second, are they seeing accelerating AI customer adoption? Much has been made about the slowing smartphone replacement lifecycle, resulting in slowing growth in the consumer electronics segment, so identifying the next sales growth engine is important. Finally, are they seeing signs of capital spending pullback from their end markets due to a slowing global economy?

Q4 revenue guidance is for a range of $180M to $190M. Management has a solid track record of surpassing revenue targets having exceeded the high end of guidance in nine out of the past 11 quarters and they have not missed revenue guidance over that time. At the end of Q3, Cognex had more than $13 million of Unbilled Revenue sitting on the balance sheet, an increase of more than $10 million from the prior quarter. During the call, management mentioned that some AI customers that had previously been conducting trials had moved forward deploying systems. If those system implementations were pending completion, this could help explain the large unbilled revenue accrual. Fourth quarter revenue last year was just under $183 million, so even with zero organic top-line growth and a reversal of that accrual, the company would easily eclipse the high end of revenue guidance. The average analyst revenue estimate is right down the middle at $185M, so there's ample opportunity for Cognex to post a positive revenue surprise this week, in my view.

Management does not issue EPS guidance. The Wall Street average estimate is for EPS of $0.22. This number is readily achievable as well. Consider the following:

Assume revenue at the guidance mid point $185.0M
Gross margin based on the "mid-70s %" guidance $138.8M
Operating expense guidance is "sequentially assume flat," so ($95.5M)
So assume operating income of roughly: $43.3M
Assuming investment income the same as last quarter: + $3.9M
Pre-tax income: $47.2M
Less income tax, based on 16% guidance ($7.6M)
Net meInco $39.6M
EPS based on diluted share count from Q3 $0.22

This "back of the envelope" income statement gets to the consensus estimate without making any bold assumptions beyond management guidance. Cognex has an existing $53M from its current share buyback authorization and authorized an additional $200M last year, and any reduction in the share count would be a catalyst to beat Wall Street estimates. And don't forget the unbilled revenue previously discussed. Just because a company hasn't recognized revenue from pending sales doesn't mean they haven't incurred the expenses, so when they do recognize this revenue, it should be at a high margin, which could flow through to a positive earnings surprise.

Valuation

Rather than identify a single price target for the shares, I prefer to think about a range of values. Over the next year, the shares offer a compelling return opportunity relative to the downside risk, in my view, based on current financial projections. The table below outlines various price targets based EPS, sales and operating income estimates. Multiples used for the base-case valuation estimates are derived from the three-year average and the downside-case multiples are based on levels from late-December lows.

The price target using a PE-multiple approach is straightforward. Since I’m using the 12-month forward PE multiple, I'm using the 2020 EPS estimate to determine a one-year price target. At 36.4 times earnings, the base-case price target would be $58 per share. Using the 25.0 multiple, I get a valuation estimate of $40.

To derive a price target based on sales I also need to assume a year-end share count. For the purposes of calculating sales and operating income per share, I’m assuming a 2019 diluted average share count of 175.3 million shares. The 2019 sales estimate of $879 million would generate just more than $5 per share of sales. At 11.5 times and 7.8 times sales per share, the price targets would come out to $58 and $39 per share, respectively. Finally, starting with the estimate for operating income of $312 million and applying the EV/EBIT multiples of 28.8x and 21.1x come to enterprise values of roughly $9.0 billion and $6.6 billion, respectively. Adding back cash and investments of $800M would equate to a total market value of $9.8B and $7.4B, or $56 and $42 per shares, respectively.

Multiple

Estimate

Consensus

Base Case

Valuation Estimate

Downside Case

Valuation Estimate

PE NTM

EPS 2020

$1.59

36.4x

$58

25.0x

$40

PS TTM

Sales2019

$879M

11.5x

$58

7.8x

$39

EV/EBITNTM

EBIT2020

$312M

28.8x

$56

21.1x

$42

Source: Factset, author assumptions

Triangulating the valuation estimates for my base-case scenario comes out to a little over $57 per share in the next 12 months, or about a 19% gain from today. Assuming current estimates remain stable, while using the downside-case multiples, the blended price target comes in just above $40 per share, representing a potential 16% decline.

The risk to this valuation methodology is continued downward revisions to revenue and earnings forecasts and/or deterioration in the valuation multiples that investors are willing to pay for Cognex shares. Even the multiples used here for the downside case are admittedly relatively rich if the company can no longer achieve the level of top-line growth it has delivered in the past. Upside to the base-case scenario could come from renewed conviction in the company’s ability to deliver revenue growth, leading to valuation multiple expansion.

Conclusion

Cognex will release Q4 financials after the close on Thursday. The company is poised to post better-than-expected results, in my view. For growth-oriented investors looking for a way to participate in the AI revolution, Cognex is worth considering adding to your portfolio. There are some fundamental considerations that need to be addressed on the upcoming conference call. Given current consensus estimates, I envision high-teens upside potential for share price appreciation, balanced with mid-teens downside risk.

Disclosure: I am/we are long CGNX. 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.