HON - Cognex Languishing Through A Painful Reset Of A Major Growth Market

Summary

• Cognex has been hammered by a sharp decline in its logistics business, as Amazon has shifted from "investment" to "digestion" with its distribution capex.
• Logistics revenue will likely see another double-digit drop in 2023, and Cognex's other two major markets - autos and consumer electronics - seem unlikely to fill the void.
• The long-term arguments for automation haven't changed, and Cognex is using AI to enable more affordable and workable solutions for smaller customers with advanced inspection needs.
• If long-term revenue growth of 10% and 30%-plus long-term FCF margins are still valid assumptions, Cognex shares look undervalued, but near-term valuation is more challenging and sentiment is a big headwind.

It would have been difficult to be more wrong about Cognex ( CGNX ) than my call back in April that, despite challenges in the logistics market (warehouse automation), this machine vision company would still manage double-digit growth in 2022. In fact, Cognex is likely looking at not only a revenue decline in 2022, but quite possibly a decline in 2023 as well given weaker macro trends. With weaker end-market demand (and a fire at a manufacturing partner), Cognex is on pace for far less in terms of profitability and cash flow than I’d expected, and it may not be “business as usual” until 2024/2025.

Down about a third since my last ill-fated update , Cognex has been a notable laggard in an otherwise flattish market for other automation names like Datalogic ( DLGCF ), Fanuc ( FANUY ), Keyence ( KYCCF ), Rockwell ( ROK ), and Yaskawa ( YASKY ), though KION ( KIGRY ), another logistics-driven name, has been even weaker. While I do see long-term value in the name here, it’ll be difficult for sentiment to turn with logistics revenue likely down 20%-plus again in 2023, particularly if other end-markets weaken more than seems to be baked into sell-side expectations.

Logistics In Hibernation After A Feeding Frenzy

Cognex has been laid low in large part by a sharp decline in logistics/warehouse automation spending in 2022, and more specifically a sharp decline in new investments at Amazon ( AMZN ). Cognex (and the logistics/warehouse automation space in general) got a major boost from Amazon going on a spending binge to build out and automate distribution facilities around the country, but that customer is now in a prolonged “digestion phase”. Likewise with many smaller customers that accelerated their investments during the pandemic but are now pulling back.

For what little comfort it offers, Cognex isn’t the only company to see this sharp decline in the logistics market. Honeywell ( HON ) has been reporting double-digit declines (-28% in Q1, -25% in Q2, -15% in Q3) in its Warehouse / Workflow subgroup due to weaker demand for the Intelligrated business, and Kion has seen a 24% decline in orders in its Supply Chain Solutions business, with a 56% decline in the third quarter alone, though revenue has held up better this year. Keyence, meanwhile, has fared better given lower reliance on higher-spec systems and less overall leverage to this space.

Estimates for the penetration of automation in the logistics/warehouse space are all over the place, but most estimates seem to cluster in the teens now. That suggests to me that logistics is still an attractive market over the long term, and to that end Cognex management believes the market is still poised to grow more than 20% a year (and they believe they’ll outgrow the market, with 30% growth).

There are still multiple drivers for logistics automation. Warehouse work can be exacting and exhausting, and that’s usually a combination that lends itself well to automation. What’s more, e-commerce continues to grow and while companies may not return completely to the standards of their pre-pandemic just-in-time inventory systems, the reality is that overall volumes are going to continue to increase from here, with customers (both retail and commercial) putting a high value on accuracy and delivery times.

Still, while the long-term future for warehouse automation may be fine, the near-term is definitely not. Amazon likely won’t need another major investment push for at least a few years, and unlike auto and consumer electronic companies that need to update/re-tool their facilities with new product launches, warehouses won’t see that same recurring need to refresh their capabilities. I believe Cognex could well see another major year-over-year decline in 2023 (before a rebound and longer-term growth), and that will weigh on results.

Neither Auto Nor Consumer Electronics Seem Poised To Ride To The Rescue

Making an already-challenging situation worse, Cognex isn’t likely to get much help from its other two major markets (autos and consumer electronics) in 2023.

Cognex management did guide to double-digit growth for consumer electronics in the fourth quarter, but that appears driven by large orders that aren’t likely to recur. In the meantime, pretty much every chip and components company with exposure to the consumer space is talking about a significant slowdown in demand for consumer electronics. I believe this is largely the consequence of demand pulled forward by the pandemic, but it still makes for a difficult environment over the next 12 months or so.

The auto market, too, doesn’t seem to have much on offer for 2023. Auto OEMs struggled all throughout 2022 to produce at capacity due to shortages in semiconductors, and while that situation is resolving, demand is likely to soften in 2023 on a tougher macro environment. At the same time, multiple auto OEMs have modestly pushed out launch schedules for new electric models. While I do think that management’s projection of double-digit growth in the market is credible, it won’t grow at that rate in 2023.

The Outlook

There’s little that management can do about the downturn it is seeing in the logistics market and likely softer demand conditions in other markets in 2023. What it can do, though, it is doing. The recent acquisition of Sirius Advanced Cybernetics looks like a smart tuck-in deal for its core machine vision portfolio (advanced lighting/illumination). I also like the company’s increased focus on AI-enabled edge learning, a technology that will enable affordable/workable higher-end offerings for smaller customers; many smaller companies still rely on human labor for inspection work because complex vision systems are too expensive and complicated to implement.

I’ve slashed my revenue expectations for 2022 and 2023, with my 2023 number going below $1B, but I do believe Cognex will see a meaningful rebound in 2024 and 2025 and several years of double-digit growth thereafter, ultimately driving around 10% long-term growth from FY’21 levels. To whatever extent it matters, it’s not just Cognex that believes in the double-digit potential of these growth markets; Honeywell and others have echoed similar long-term growth expectations on the other side of this “reset” period.

Looking at margins, I do still expect high-20%’s operating margins in FY’23, with 30%-plus margins in 2024 and beyond. Likewise, I think the company will get back to high-20%’s free cash flow margins in 2025 and beyond, with long-term margins in the low-to-mid-30%’s. That, then, should drive low double-digit annualized FCF growth.

Cognex still looks expensive by shorter-term valuation approaches (P/E, EV/EBITDA), which I think is as expected given the weaker near-term growth outlook. If my longer-term projections are reasonable (10% revenue growth, 10%+ FCF growth), though, I do think the shares are undervalued today and priced for a double-digit annualized long-term return.

The Bottom Line

The risks with a Cognex investment today are straightforward in some respects – logistics / warehouse automation could be even weaker than expected in 2023 and the long-term industry adoption/growth rate may not be what industry players expect. Likewise, 2023 could be an even worse year than expected for auto and consumer electronics capex, and overall adoption of automation and automation-enabling technologies may not live up to expectations. Last and not least, it’s not easy to expect outperformance from a company that is likely to see revenue contraction (and possibly margin contraction) over the next year.

I don’t ignore those risks, but I think this is a case where the near-term and long-term opportunity sets are diverging. Cognex may well be a lackluster name through at least part of 2023, but I do believe in the technology and the value proposition of machine vision within automation. Readers with a better feel for anticipating shifts in sentiment (market/stock timing, in other words) may want to hold off, but I find the name pretty interesting at today’s price even with the ongoing risks to the 2023/2024 outlook.

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