Automation enabler Cognex (CGNX) has continued its rally from the March panic lows, as investors warm to the idea that the COVID-19 recession won’t linger on as long as feared and that short-cycle end-markets like autos will recover strongly. Add in the strong growth potential of automation in the logistics/warehouse market and the perception of Cognex as a play on onshoring/reshoring, and the shares have continued to perform well, though the spread relative to the overall industrial sector over the last three months hasn’t been as wide as you might imagine.
My issue with Cognex remains the valuation and the strength of the recovery already priced into the shares. I have no problem with a low-to-mid teens long-term revenue growth rate and long-term FCF margins in the 30%s, but even those assumptions aren’t enough to drive a particularly attractive fair value here. While I realize Cognex is a well-liked name with key automation-enabling technology (and a space that’s somewhat hard to invest in), and I likewise realize that exceptional companies aren’t bound by normal valuation rules, I’m just not eager to pay this much of a premium even if it is for an exceptional industrial growth idea.
Better-Than-Feared Results For The Second Quarter
In many respects, Cognex’s second quarter results were pretty typical for what we’ve seen from the industrials so far. Revenue came in at a mid-teens decline instead of the nearly 25% decline that the Street feared, and margins held up better than expected. Likewise, consistent with other industrial/multi-industrial reports (including reports from 3M (MMM), ABB (ABB), Honeywell (HON), and KION (OTCPK:KIGRY)), Cognex pointed to profound weakness in the auto sector in the second quarter, improving demand in consumer electronics, healthy capex investments in biopharma, and strong ongoing interest in automation in the logistics/warehouse chain.
Revenue declined 15% in the quarter but that was still good for an 18% versus expectations. Sales to the auto sector, once close to a third of the business, declined 40% this quarter to just over 20% of total sales. Revenue from consumer electronics customers was also down year-over-year, but improved sequentially, while life sciences-derived revenue was up and logistics grew nicely.
Margins were mixed. Gross margin declined almost four points and came in weaker than expected, but Cognex did a much better job than expected in cutting operating costs, leading to a better than 100% beat at the operating income line (on a non-GAAP basis that excludes SOE).
Mixed Trends Still The Dominant Theme
While I went into this quarter expecting pretty dire numbers for companies that supply auto capital equipment, I also expected that business to pick up in the second half and exit 2020 in decent shape. Cognex’s view isn’t quite that positive, as it seems like they’re expecting a recovery more in 2021.
In the consumer electronics business, Cognex is expecting a big improvement in business in the third quarter, consistent with the investment cycle for Apple (AAPL) suppliers, and that led management to guide to a third quarter number that was 18% above the prior sell-side estimate at the midpoint. What happens in the fourth quarter was left pretty vague, with management only really saying that they expect the third quarter to be the strongest of the year.
Logistics is more of an unknown at this point, albeit an unknown going in a very positive direction. Honeywell reported better than 300% order growth for its Intelligrated business, while KION reported around 100% order growth. These aren’t like-for-like comparables, particularly as Intelligrated does a lot of system design, integration, and installation work, and Cognex is still much more leveraged to hardware, but I think the point stands that major retailers and logistics providers continue to invest in automation to reduce costs and improve fulfilment efficiency.
Beyond these major markets, there’s less to go on. “General industrial” automation is a bigger market for Cognex than it gets credit for from many analysts and investors, but management pointed to a weak environment for “core factory automation”. Indeed, orders for automation have been weak across the board so far, but most of the automation hardware players have remained relatively bullish on the prospect for rebounding demand late in 2020 and into 2021, and I would expect the same for Cognex.
Can Onshoring/Reshoring Drive Meaningful Business?
With tariffs, trade wars, and suddenly-vulnerable supply lines, the notion of onshoring/reshoring manufacturing has gotten a lot of attention. Given the higher labor costs, it has been widely assumed that companies looking to bring manufacturing back to their home countries (usually assumed to be the U.S., but also Europe to some extent) would have to make much greater use of automation, and that has been cited as a key potential driver for companies like Cognex and Rockwell (ROK). Indeed, Rockwell and Stanley Black & Decker (SWK) have discussed a project in which Stanley Black & Decker is looking to use automation to shift from around 45% domestic manufacturing to over 60%.
While I’m not denying that some onshoring/reshoring will occur, I think the trade has run ahead of what is likely to be the reality. I definitely see some manufacturing being relocated, particularly in areas like active pharmaceutical ingredients, components used in the defense supply chain, and in semiconductors. I don’t see much happening in autos, though, and I likewise don’t see much changing in consumer goods or consumer electronics – smartphone assembly, for instance, is already pretty meaningfully automated and it’s hard to see how that can be economical to reshore.
So, relative to Cognex’s existing business mix (and how I already see it evolving given the growth in areas like logistics/warehouse), I see a modest potential pick-up from biopharma and maybe some from semis but not a major shift that meaningfully alters the long-term revenue opportunity. To me, the bigger opportunity remains the expansion of machine vision as an enabling technology for more automated processes (including robots/cobots).
The Outlook
The biggest change I’m making to my model is a shift of revenue between 2020 and 2021 as I see a better 2020 and a somewhat less impressive rebound in 2021. My long-term outlook really hasn’t changed, though, and I still expect Cognex to generate low-to-mid teens revenue growth on an annualized basis. I likewise still expect Cognex to drive FCF margins toward the mid-30%s as it scales up and benefits from a greater software mix.
The Bottom Line
Prospective returns now look to be in the mid-single-digit range, which isn’t so out of line with quality industrials now. Unfortunately, I think the industrial rebound/relief rally has gone a little too far, and I don’t see a lot of names that jump out as attractive. On the other hand, I do still also believe that Cognex is a major player in key automation-enabling technologies, and I believe machine vision and product ID are both major secular growth opportunities in the industrial space. Quality names should trade for premiums, and maybe some readers are comfortable paying today’s price for Cognex, but I’d prefer to wait for an entry point with a better expected long-term return.
Disclosure:I am/we are long ABB, MMM.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.
