Business Breakdowns
· Brett Larson
[00:00:00] S1: Longer term they target 15% top line and constant currency and 40% incrementals. And then they layer on capital allocation from there, starting with revenue. So in the 10 year period ending either 2020, 2021, 2022, so just before this down cycle and adjusted for divestitures that they did, they've grown about 13% excluding M&A and then mid teens in constant currency. So they've been right there. I think actually the right long term bogey and what most people have in mind, understanding we're at a cyclical place, so a few years above this, but is more like low double digit top line. Longer term is how most people think about it. But again, we're at the end of a very long down cycle and there's this new customer base that's being added to Cognex that hopefully should drive some revenue at least in the nearer term that's above that on margins. Similarly, they're depressed cyclically right now and also they have the headwind from the emerging customer initiative investment, salesforce investment, and they actually expect the emerging customer initiative to be operating margin accretive. It already is gross margin accretive, but operating margins last year were 13% and that's down from a peak above 30%. And there's a couple hundred basis points of the emerging customer initiative headwind in there. But longer term they target regaining 30% level. As the leverage returns to the business, they get back to growing and then obviously the salesforce investment flips from a headwind to a tailwind to margins.
· Matt Reustle, Brett Larson
[00:00:00] S0: That swing is pretty meaningful between the 40% incrementals, 30% target, 13% last year. I know we're in a down cycle right now, but when you go back over time, is that the types of swings that you tend to see? [00:00:00] S1: Not to that magnitude. I think part of it is that they've invested very heavily in this current strategy, which makes it deeper than it otherwise would have been. For example, back in 2019, which was prior to this down cycle, the last time that they had a down cycle, margins went from 27% down to 20%. The depth and duration of this downturn along with investing through it, is what makes the operating margins what they are. And the target again is to regain the 30% level and then grow incrementally 40% from there. [00:00:00] S0: In terms of the cycle are there signposts that either you monitor, the industry monitors, the management team monitors to suggest that there's inflections. And I know there's several end markets here, so it's going to vary. But what could you point to just in terms of the timing of that and what you typically look for?
· Matt Reustle, Brett Larson
[00:00:00] S0: In terms of the cycle are there signposts that either you monitor, the industry monitors, the management team monitors to suggest that there's inflections. And I know there's several end markets here, so it's going to vary. But what could you point to just in terms of the timing of that and what you typically look for? [00:00:00] S1: For logistics specifically, that market's returned to growth now. So that's their largest end market. It grew quickly last year, should probably grow quickly again this year. Similarly semiconductor, you watch the semi cap companies, so the company selling equipment to TSMC and the like, that's primarily who they're selling to. And again the outlook there is relatively positive right now. Consumer electronics like we mentioned, we're kind of at a steady place as we're waiting to see if there is going to be like a next consumer electronics type of CapEx cycle that's needed. And that could be new features or new form factors tied to LLMs or AR and VR or whatever it might be. But that's usually what drives the growth there. There's nothing tangible on the horizon right now for that. And then automotive, we found a place of stabilization now or we're closer to that than the down cycle. But just watching the automotive OEMs and their CapEx is the signpost that you watch for that one. And then lastly PMI is the catch all for the rest of the business is just general industrial activity, industrial sentiment and the like is what drives CapEx for those types of customers.
· Matt Reustle, Brett Larson
[00:00:00] S0: Would you classify their performance as somewhat of a leading indicator on cycles? I'm just trying to visualize you have the CapEx announcements which will ultimately drive the business for Cognex. But it does feel like they're still at the front end of the actual cycle where you will eventually see that come on board and whatever they're producing be released. Is that a fair way to categorize it relative to just general macro trends? [00:00:00] S1: I think you've captured it right there. Given their short cycle and then especially with something like consumer electronics, that business will inflect before we even know what it is they're spending on just the nature of that. So it's pretty interesting in that regard. [00:00:00] S0: Definitely, very, very interesting. You see that a little bit in the transports, but this is a completely different play on something similar. Going back to the business you mentioned cyclicality, you mentioned a little bit about investing through through the cycle, just on the balance sheet, capital allocation more broadly. How would you categorize them in terms of capital allocators and risk of managing the balance sheet versus conservatism?
· Matt Reustle, Brett Larson
[00:00:00] S0: Definitely, very, very interesting. You see that a little bit in the transports, but this is a completely different play on something similar. Going back to the business you mentioned cyclicality, you mentioned a little bit about investing through through the cycle, just on the balance sheet, capital allocation more broadly. How would you categorize them in terms of capital allocators and risk of managing the balance sheet versus conservatism? [00:00:00] S1: First, on free cash flow generation for them, they've generally converted 100% of net income to free cash flow over time. So they produce good free cash flow when they've returned over 100% of that to shareholders. So a third dividend and two thirds share repurchases. They do do the occasional M and A and that's primarily to this point at least been more those IP acquihire type of deals. So VD and SUALAB and then they have a fortress balance sheet I would say. So they have net cash on the balance sheet. Cash and investments actually right now is 10% of the market cap. They've always run net cash on the balance sheet. [00:00:00] S0: When you piece it all together, cyclical business, they wouldn't argue that. How do you go about approaching valuation when you can see sharp changes in cycles, different dynamics like that, how do you approach it?
· Matt Reustle, Brett Larson
[00:00:00] S0: When you piece it all together, cyclical business, they wouldn't argue that. How do you go about approaching valuation when you can see sharp changes in cycles, different dynamics like that, how do you approach it? [00:00:00] S1: I think there's two ways that I approach valuation on this one. So the first one is we look at what's implied in terms of the future free cash flow growth to justify the current valuation. So we do that by assigning an exit free cash flow yield out in the future and then have our internal hurdle rate which is at least 10%. Then we place that within just the range of outcomes for the business to assess the attractiveness. And at present we think frankly that Cognex needs to compound free cash flow at more of like a low double digits rate over the long term. That's below the long term model and also coming from a place that's at the low point of a cyclical down cycle with a lot of hopefully margin recovery ahead. So that's the bull case. The other way we look at it is the historic multiples. And just given the margin dynamics we specifically are looking at, EV to net next 12 months sales is the relevant one for us. Currently it's within reach of its 10 year low at 5 and a half times next 12 months sales. It traded as high as 16 times sales during ZIRP, which is like most things, just hilarious in hindsight. But otherwise a more normal range. It's been more like 6 to 10 times sales is where it's traded.