Garmin: Dividend Is Safe In 2023
- Garmin has enough resources to cover its dividends.
- The company increased its inventory costs, eroding operating cash flows.
- The company has a fabulous set of assets, making it a great acquisition target.
Garmin (NYSE:GRMN) hopes that consumer spending on discretionary items will stabilize in 2023. Some negative factors that pressured revenue and profits, such as the strong dollar and increased inventory costs, will fade in 2023. The company has enough cash to cover its dividends for the foreseeable future. Investors may consider the stock when it drops below $90.
Shrinking revenue across segments, but aviation is a bright spot
In Q4 2022, the company saw its revenue decreases by 6% y/y (Exhibit 1). The strong dollar hurt revenue to the tune of $228 million. According to Clifton Pemble, the CEO, if not for the strength of the U.S. dollar, the company's revenue would have increased by 2% in the fourth quarter. The company's aviation segment was bright, with revenue rising by 27% y/y. The company pointed to its strength in both aftermarket and OEM categories which drove revenue growth.
The company also announced that L3Harris Technologies had chosen its G3000 tandem integrated flight deck as part of a U.S. Special Operations Command Armed Overwatch Program Contract. For 2022, the company saw its Aviation segment revenue grow by 11% y/y. The Aviation segment should continue its strong performance as global travel rebounds and the business jet market remains strong.
The company's Outdoor segment offers adventure watches, outdoor handhelds, golf devices, and mobile apps. The Outdoor segment was also substantial during the year, growing 17% y/y; its growth is tailing off in Q4, with revenue rising 3% y/y. This segment may suffer further revenue losses as consumers cut back on their discretionary spending.
In Q3, the company's Aviation and Outdoor segments were substantial, while its fitness segment was a significant laggard (Exhibit 2). Q1 and Q2 saw similar declines in the company's Fitness segment. The company blamed the normalization of demand from the frantic pace of sales during the pandemic and the strong dollar for the revenue decline in 2022. Besides those factors, it is challenging for Garmin to compete against Apple in the fitness segment. Apple has the brand recognition, global reach, and marketing budget to overshadow competitors.
Gross and operating margins should stabilize in the second half of 2023
The company saw excellent annual gross margins above 59% in 2018, 2019, and 2020, compared to its average of 57.1% during the past decade (Exhibit 3). The company's annual gross margin in 2022 was 57.7%, closer to its average over the past decade. Quarterly data shows revenue drop by mid-single-digit in three out of the four quarters. The gross margins held up well in 2022. The company ended 2022 with a quarterly gross margin of 57% in Q4, compared to its average quarterly gross margin of 58.3% since June 2020 (Exhibit 4). The operating margin eroded significantly to 20.4% in Q4 2022 compared to its quarterly average of 23.6% since June 2020.
Substantial increase in inventory costs in 2021 and 2022
The company's inventory carrying costs have increased dramatically over the past year, which should continue to pressure margins. The company saw a massive increase in its inventory of 61% y/y in 2021 and another 23% y/y increase in 2022 (Exhibit 5). The company carried 269 days' sales worth of inventory, while its average over the past decade was 163, with a standard deviation of 48.
Most companies have indeed seen a massive increase in inventory during this period of high inflation, but Garmin's increase in inventory costs is a notch above everyone else (Exhibit 6). Its inventory is so high that it stands two standard deviations above the mean (average), a practically unheard-of number. This increased inventory will take a while to work through and negatively impact margins for the next few quarters. The good news is that the company's inventory costs should not see a spike in the coming quarters and provide a tailwind as the company sells its products.
Although inflation is fading, consumers face headwinds from a slowing economy and higher borrowing costs, pressuring discretionary spending. Consumers have also shifted their spending from goods to services as the U.S. population emerged from the pandemic. The job market has held up thus far, but any spike in the unemployment rates could further pressure discretionary spending. With every passing day of 2023, it is just a matter of when the U.S. economy will enter a recession. These trends spell bad news for Garmin, with discretionary spending under immense pressure in the first half of 2023. The combination of high inventory costs and decreased demand could push Garmin's margins lower in the coming quarters. After an epic rally, the dollar's strength has faded in the last four months, and inflation is coming down across sectors (Exhibit 7). These trends can help cushion some of Garmin's revenue and margin declines.
Operating Cash Flow & Free Cash Flow
The declining revenues and increased inventory costs have reduced cash flows in 2021 and 2022. The change in inventory of $476 million in 2021 and 363 million in 2022 were the most significant factors for a steep decline in operating cash flows. The annual operating cash flow margin dropped from 27.1% in 2020 to 20.3% in 2021 and 16.2% in 2022 (Exhibit 8). Over time, the company can increase its operating cash flow margins to nearly 20% but may find it difficult to reach the 27% margin it achieved in 2020. After spending money on CapEx and dividends, the company had a negative free cash flow of $135 million.
Dividends may not be at risk in 2023
Given the negative cash generated by Garmin's operations, the company's dividend may not be at risk in 2023. The company is focused on selling the inventory it has built up over the past couple of years, so as those products sell, it should generate cash for its operations. The company may also lower its CapEx spending in 2023 and thus save money to pay the dividends. The company also has $1.4 billion in cash and marketable securities, which could be used to pay dividends. The company paid $679.09 million in total dividends in 2022 (Exhibit 9).
But the dividend's safety depends on the consumer and their spending on discretionary products. If the consumer continues spending and Garmin's sales stabilize, the company can protect its dividend without cutting spending or using cash reserves to pay its dividends. But, all bets would be off if sales decline continues at a mid-single-digit pace in 2023. The company's management understands the importance of protecting its dividend, so it would have to be in a desperate cash flow situation to cut its dividend; Garmin has yet to arrive at such a situation.
The company pays a dividend of $2.92 per share, amounting to a yield of 3% at the stock price of $96.02. Although the company has grown its dividend by an average of 7.4% over the past five years, investors cannot expect further dividend hikes for the foreseeable future. The company does not carry debt, so it does not have to worry about interest payments or pay back its debt.
Reasonable valuation, especially if sales stabilize
The company trades at a forward GAAP PE of 19x, only a slight discount to its five-year average of 22x. The stock is trading at a premium to its sector with a median PE of 14x. A discounted cash flow model estimates the per-share equity value of $135, compared to the current $96 (Exhibit 10). This model assumes a 1% revenue growth rate until 2027 and 4% after that. Given the current interest rates, we used a 7% discount rate, which may be an optimistic assumption. We have used a free cash flow margin of 16.7%, the average over the past decade. The company has a good return on invested capital of 15.8% (source: Seeking Alpha).
Investors may consider buying the stock if it drops below $90 due to market volatility. But, it may be best to wait for the company's Q1 earnings and hear the commentary from the management. Another strategy is to buy some if the stock drops below $90 and add to one's holdings based on the first quarter earnings commentary.
Garmin is a good acquisition target
The company could make a good acquisition target for a larger, well-funded consumer products company. Garmin has introduced healthcare products such as its blood pressure monitor. But, healthcare products take much capital to develop and time to bring to the market. A well-funded acquirer will have the R&D and CapEx resources to spend on a product that could take years to pay off financially. Apple (AAPL), a potential acquirer, comes to mind, but it favors a build versus a "buy" culture. Apple rarely makes acquisitions to bolster its product line. Besides, Apple already has a highly successful watch and may not want to produce multiple different lines of watches, which would undercut the profitability of its Apple Watch.
Samsung or Google (GOOGL) could be potential acquirers of the company. Both have a massive balance sheet and resources to pull off a $22 billion acquisition (current market capitalization plus a 20% premium). Garmin would allow any acquirer to enter multiple new markets quickly, and the data gathered from the Garmin devices would be a boon for any company. But, Google could face antitrust concerns on an acquisition that would give it so much control over a vast data trove. If the valuation drops, the company may become an enticing target for a private equity firm looking for valuable assets which can be turned around and sold a few years later.
Garmin faces revenue headwinds from a weakening consumer and demand normalization in its fitness segment. The company's inventory costs have peaked, bolstering the cash flows in 2023 as it sells its inventory. The dollar has weakened considerably, and inflation is fading. These two factors should help prevent further erosion of sales and margins. The company has enough cash and resources to continue paying its dividend in 2023. Investors can consider the stock if the market volatility falls below $90. At $84, the stock would yield nearly 3.5%.
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