Business Breakdowns
· Brett Larson, Matt Reustle
[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. [00:00:00] S0: My takeaway from that would be that the market might be suggesting that there's some more meaningful compression on the margin profile of the business. We're certainly seeing it beaten up through this cycle. But is there any reason to believe that margin compression or the margin recovery won't be as strong as the cycle does recover?
· Matt Reustle, Brett Larson
[00:00:00] S0: My takeaway from that would be that the market might be suggesting that there's some more meaningful compression on the margin profile of the business. We're certainly seeing it beaten up through this cycle. But is there any reason to believe that margin compression or the margin recovery won't be as strong as the cycle does recover? [00:00:00] S1: I think that's certainly a discussion. Historically, we have seen margins decline in magnitude with cycles and they've always recovered back to 30%. We just saw even in the last quarter where some growth returned to the business and they grew more in the double digits organically and you can see the leverage that fell through in the quarter. There's signs like that that we're watching. That's certainly a debate on the name is what normalized margins will look like. [00:00:00] S0: Always the debate on anything in this space. So I can appreciate that. What are the other risks you would point to? I think we've probably outlined a lot of fairly obvious risks, but what really stands out to you?
· Brett Larson
[00:00:00] S1: There's a couple that are top of mind. The first one is obviously just the cyclicality. Early is the same thing as wrong. Basically every incremental investor in Cognex the last year or two is probably feeling very early right now with regards to that one. Frankly, it's just a matter of if the cycle will turn or if we're sitting here a year from now and still feeling early, hopefully still temporarily. The other one is China, which we briefly mentioned. So it's 18% of sales in 2024. Two thirds of that is to western multinationals and a good chunk of that, probably half of that or more is Apple Foxconn. For those customers, it seems unlikely they're going to put HiPe Robotics in their factories for obvious reasons. For the remainder, call it the other mid to high single digits percent of overall Cognex sales that are domestic Chinese manufacturers. I think on a five to ten year basis it's probably going to be uphill battle to grow those customers. At least that's a well understood risk as well that people talk about. The last one would just be the tech transition. Ultimately, I think the tech transition opens a great window of opportunity for Cognex and there's reasons to believe they're early and ahead in terms of applying machine learning to machine vision. But with any tech transition it opens the window for disruption as well. So that's the third risk out there that's on my mind.
· Matt Reustle, Brett Larson
[00:00:00] S0: Yeah, it's an interesting cyclical name because when I think of the majority of cyclicals, they will trade in terms of the slowdown or the growth within a range. It is not this S curve type growth. When you do have major pickups and to the extent that they do have new S curves emerge, which from the very, very, very high level view, I would imagine that they exist out there and it'll just be a matter of how Cognex aligns. It's an interesting one with a slightly different tilt on cyclicality than a normal business. [00:00:00] S1: What's also interesting is the cyclicals, whether it be analog semis or semi caps or metals and mining, they'll trade peak multiple on trough earnings and the like. And you look historically at Cognex's multiple and it's basically trended up when sales are growing and down when sales are declining. It's kind of really interesting. I don't know exactly why that is, but that's the reality. [00:00:00] S0: The peak on peak phenomenon is one that can be painful on the way down. So it's interesting to watch. This has been very informative. Filled in a lot of blanks that I had in terms of the research that I did and there were many. What would you point to as the key lessons that take away from Cognex and apply elsewhere?
· Matt Reustle, Brett Larson
[00:00:00] S0: The peak on peak phenomenon is one that can be painful on the way down. So it's interesting to watch. This has been very informative. Filled in a lot of blanks that I had in terms of the research that I did and there were many. What would you point to as the key lessons that take away from Cognex and apply elsewhere? [00:00:00] S1: It's funny, I was thinking about all the episodes I've listened to a business breakdowns and I feel like it's got to be the number one answer is culture. I'd be curious if that's accurate, but I think it's clearly culture for Cognex too. And I think what's interesting about it more than just having a unique culture is how they've maintained it through the founder departing so specifically, like I mentioned, the ministers of culture that they have the job of maintaining it secondarily. Just that long overlap of the founding CEO with the new CEO as the new CEO took over the reins and just ensuring that it lasted through the transition. I think those were unique and I hadn't really seen that before elsewhere. [00:00:00] S0: It's definitely one of the more common answers often related to businesses that have had these very long term durations of success. So it's interesting and very hard to measure, which probably makes it even more valuable to study. So very fascinating business. Thank you again for sharing the knowledge Brett. It was a pleasure. [00:00:00] S1: It was a lot of fun. Thanks for having me back on.