Cognex Muddling Through Some Temporary Macro Challenges

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About: Cognex Corporation (CGNX), Includes: AAPL, ABB, DLGCF, HON.W, KUKKF, KYCCF
by: Stephen Simpson, CFA
Summary

Shrinking demand from smartphone OEMs and softer trends in autos are pushing Cognex's revenue growth momentarily below the long-term trend line, but growth should recover in 2020.

Logistics is quickly maturing as a major opportunity; the sector is under-penetrated in terms of automation technology and Cognex has opportunities to add customers and grow share-of-wallet as warehouses automate.

Cognex shares aren't such a clear-cut opportunity after a 20% move since early December, but still a credible hold given the long-term potential.

I flagged Cognex (CGNX) back in early December as offering rare upside for a high-growth industrial, and though the shares had further to fall before bottoming on Christmas Eve, they’re still up about 20% since that early December article – outperforming its closest peer Keyence (OTCPK:KYCCF) and industrial stocks in general.

It’s a harder call to make now, though I still really like the machine vision space and continue to believe that Cognex has attractive addressable long-term growth opportunities in logistics, autos, and factory automation. I don’t believe my expectations of low double-digit revenue growth and mid-teens FCF growth over the next decade are conservative and I’m worried that there could still be another round of disappointment in consumer electronics and autos, though a negotiated trade agreement with China could brighten that outlook. I’d definitely look at Cognex again were it to pull back to mid-$40’s, but here it looks more like an attractive hold.

Looking Back At Earnings

Cognex’s mid-February fourth quarter earnings report was a little better than expected, but that has to be seen in the context of estimate cuts going into the quarter on growing fears of slowing demand in the electronics and auto sectors that make up about 60% of the company’s revenue base.

Revenue rose 6%, with 18% growth excluding the consumer electronics business and over 50% growth in the logistics business (now around 15% of total revenue). Back-of-the-envelope math, then, suggests that the consumer electronics business was down more than 20%, consistent with the reports of numerous suppliers into the Chinese smartphone assembly market like Fanuc (OTCPK:FANUY). Even so, revenue came in about 4% better than expected.

Gross margin declined three points from the prior year. While operating income fell 11% from the prior year, operating margin was still about a point better than expected despite a roughly 150bp shortfall in gross margin relative to sell-side expectations.

An Iffy 2019 On Several Fronts

Nobody expects Cognex to have a banner year in 2019, and there’s still a lot of uncertainty as to just how challenging the company’s end-markets will get.

Management cited a “tentative” auto sector, and other providers of automation technology into the auto space have offered a wide range of takes on the market – from meaningful signs of slowing spending to “some signs of a slowdown” to relative strong demand for ABB (ABB). With that, I think the reality is that this is a market that various considerably by customer mix, as auto OEMs with greater near-term commitments to hybrid and EV launches still seem to be committing to meaningful equipment capex. Specific to Cognex, I would expect low-to-mid single-digit revenue growth from this market in 2019 before a reacceleration in 2020/2021.

We should know a lot more about the consumer electronics market outlook when Cognex reports its first quarter results in early May, as capital budgets from the major customers will be clearer and there will be more data points from other equipment providers. While Apple’s (AAPL) double-digit decline in capex will certainly hurt, Apple is shrinking as a percentage of revenue (to around 15% from 20%) and there are still some share/share-of-wallet opportunities in the market such that I think this business could still grow for Cognex in 2019, but it’s likely to be weighted to the second half.

Logistics Is A Big Opportunity… But Not The Only One

I talked about a significant and underrated opportunity for Cognex in logistics back in December, and Cognex management itself has recently started talking more directly about this opportunity and its potential to be a major contributor to revenue growth. Sales to the logistics end market have been growing better than 50% a year for two years now, and as automation companies like Honeywell (HON), ABB, and KUKA (OTCPK:KUKAY) have highlighted in the recent past, the logistics end-market remains dramatically under-penetrated in terms of automation.

Specific to Cognex, the vast majority of the opportunity today is in fairly basic barcode readers, a meaningful opportunity for Cognex, Keyence, Datalogic (OTC:DLGCF), and others, but one that I expect to grow to include more 3D vision and dimensioning capabilities over the next five to 10 years.

Logistics is likely to be the hottest near-term growth opportunity for Cognex, but it’s certainly not the only growth opportunity. A wide range of end-markets are embracing automation in their manufacturing and logistics operations, and that includes pharmaceuticals, food/beverage, medical devices, consumer products, and “general manufacturing”. In many cases, these industries are using only the most bare-bones machine vision tools (or none at all), creating some significant opportunities for Cognex.

I also believe the auto opportunity remains attractive longer term. Auto OEMs continue to adopt more and more automation to offset labor costs, and new tasks like EV battery assembly will require more (and more sophisticated) machine vision tools. I’m not so excited about the longer-term opportunities offered by phones; yes, there are still some share-of-wallet opportunities and still some tasks done manually that could be automated with machine vision, but I don’t expect phones/electronics to be a major growth driver.

The Outlook

Although I’ve modestly lowered my expectations for 2019 and 2020 (by about 2% to 3%), it has everything to do with macro weakness in auto and smartphone OEM spending, and nothing to do specifically with Cognex. I do believe the move to hybrids and EVs will stimulate healthy demand in the auto sector in a few years, and I likewise believe that there are attractive opportunities in sight for logistics, healthcare, and food/beverage, as well as some arguably under-appreciated opportunities in areas like aerospace.

2019 will likely be the second straight year of below-trend revenue growth for Cognex, but I believe that will correct in 2020 and I expect double-digit revenue growth over the next 10 years on a CAGR basis. I likewise expect Cognex to leverage this growth into better operating leverage and better asset turnover, driving further improvement in FCF margins and mid-teens FCF growth.

The Bottom Line

Where I previously thought Cognex was priced to deliver double-digit annualized returns to shareholders on the basis of discounted cash flow, that anticipated return has dropped into the high single digits. Accordingly, I’m not as excited about buying the shares today, but I would definitely reconsider if the shares were to slip back toward the mid-$40’s.

Disclosure: I am/we are long ABB. 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.