HPQ - Logitech Should Be Bottoming Out But The Market Already Agrees

Summary

• Logitech's December quarter was exceptionally weak, and it's unclear that channel inventory is improving yet.
• The downturn in PC-related hardware has been brutal, and now video conferencing is falling off as well; the good news is that Logitech appears to be gaining share in both.
• Demand will recover in time and Logitech has attractive opportunities in the enterprise VC market, but the market already anticipates a recovery and I don't see a compelling risk/reward today.

The problem with assuming that a struggling company has hit a floor is that there could be a basement or two still waiting below. That’s been the case for Logitech ( LOGI ) bulls for a little while now, as optimistic sell-side analysts looking to make early turnaround calls have underestimated the severity of the correction in gaming and video conferencing demand. But perhaps with a weak December quarter and yet another cut to guidance, the bottom is finally in sight.

There are definitely reasons to like Logitech and try to anticipate a rebound. Logitech has built a good brand, and while margins are not exceptional, they’re good for the industry (including a gross margin edge of over 10 points versus many comps) and the company generates good cash flows and returns on assets and capital. With the shares already up more than 30% from the recent trough, though, I don’t see quite enough upside now to take the risk of mistiming the eventual rebound.

Logitech Warned That The Quarter Was Bad … And It Was

Logitech warned the Street of weaker fiscal third quarter results a couple of weeks ago, and indeed the December quarter results were poor. Some analysts had interpreted the lack of downward revision after the second quarter (where revenue missed by operating profits beat) as a sign of the bottom, but there has been at least one more leg down.

Revenue fell 22% year over year (or 17% in constant currency), missing Street expectations by about 9%. Weakness was broad-based, from a 14% decline in Pointing Devices, to a 22% decline in Keyboards and a 33% decline in Audio/Wearables. Gaming revenue was down more than 16%, while Video Collaboration was down 21%, and this appeared to be the biggest deviation from Street expectations, as Logitech saw a sharp downturn in enterprise demand for video conferencing cameras and ancillary products.

Gross margin declined 270bp yoy and 70bp qoq to 37.9%, missing by 90bp. Though component availability has started to improve, the company saw a 300bp headwind from promotional activity. Operating income declined 32% yoy to $204M, missing by 12%, while margin contracted 240bp yoy to 16.1% (though improving 250bp qoq) and missed by 70bp.

This was the worst December quarter for Logitech in over a decade, and management’s guidance implies that March revenue will be down 26% to 34% (against a -20% comp), with operating margins somewhere around 5% to 12% - exceptionally weak results by historical standards.

Is The End In Sight?

Not to be deterred, I’ve seen more bullish sell-side analysts proclaiming that the end of the steep correction cycle is now in sight (once again…), and they have pointed to metrics like sell-through to suggest that conditions are improving.

Sell-through declined 12%, and that was indeed better than the reported revenue decline this quarter, as well as the 22% decline in sell-in. Here’s the problem – my understanding is that sell-through is reported gross of promotions, while sell-in is reported net of promotions. Factoring in the promotional headwinds, it would seem that Logitech may have actually built channel inventory this quarter – not by a lot, but still moving in the wrong direction. I’d likewise note that inventory days increased by 14 yoy (though improving 22 qoq) to 93 days.

I’d also note that results are still well ahead of pre-pandemic levels. Assuming that Logitech hits current targets for this fiscal year, revenue will be up about 60% from the last pre-pandemic year. A lot of demand has been pulled forward by the pandemic (work/play from home, increased enterprise investment in video conferencing, et al) and that can still impact results.

On a more encouraging note, I would observe that IDC reported a 28% decline in PC sales in the fourth quarter. That’s the worst result in over 20 years, but Logitech did outperform that baseline, and moreover the company has been outperforming peers like Corsair ( CRSR ) and Turtle Beach ( HEAR ) in recent quarters, leading me to believe that the company has been gaining share in gaming. It’s harder to say about the video conferencing business, but it does seem as though the company has been gaining some share on Cisco ( CSCO ) and HP ’s (HPQ) Poly, though we’ll see if those companies see a similar sharp drop when they next report.

Opportunities To Do Better

I do think we’re close to the end of this hardware down-cycle. That’s not the same thing as expecting a sharp rebound, though, and I think overall enterprise spending on PCs and peripherals will remain weak in 2023. I’ve seen suggestions that enterprises will look to use upgraded peripherals as a way of easing and incentivizing employees back into the office, and maybe that’s true, but I don’t think it will be enough to offset a weak macro environment.

I’m more bullish about the gaming side, and NVIDIA ( NVDA ) had generally positive things to say recently about excess inventory working its way out of the sales channel in gaming.

I also see opportunities in video conferencing. While there is going to be a “digestion” period for corporate spending on video conferencing, Logitech has benefited from improving ASPs tied to companies spending on better cameras, auxiliary products (like video whiteboards), and more software-enabled hardware. Further retrofitting/upgrading could drive meaningful value growth for Logitech (a tricked-out VC package can sell for 3x-5x or more versus bare bones offerings), and I do think Logitech can gain more share from new adoption, particularly as Huawei is a non-option now for many buyers.

Hopefully management’s upcoming Analyst day (in early March, I believe) will be an opportunity for Logitech to put a stake in the ground and mark a rebound in business. I’d also expect to see a lot of discussion of newer software-enabled products (including products addressing AR/VR opportunities both in gaming and in enterprise/industrial settings) and possibly refreshed revenue and margin guidance for the longer term.

The Outlook

My revenue estimates work out to a long-term revenue growth rate of around 4% to 5%, but that includes the steep decline in this current fiscal year. From where I project the bottom (the next fiscal year), I’m expecting longer-term growth closer to 6%, and that could prove conservative if Logitech can gain more share in enterprise VC and leverage emerging opportunities like AR/VR.

I think it will take a few years to regain high-teens margins; I see 17%-plus EBITDA margins in two years, as well as operating margins above 12%. Over the longer term, I expect FCF margins in the 12% to 13% range, supporting 6%-plus long-term core FCF growth from the trough.

Between discounted long-term free cash flows and EV/EBITDA I get a near-term fair value in the low $60’s, but I do see the potential for high single-digit to low double-digit long-term annualized returns from here.

The Bottom Line

In the low $50’s (or below) I may very well be willing to take a risky bet that the end of the downturn is in sight for Logitech. At today’s price, I think the market is already pricing in that rebound, and I think that elevates the risk if Logitech reports another couple of miss-and-lower quarters. I do think this is a name with good leverage to an eventual hardware rebound, but at this price I don’t see enough reward to take on the risk of getting the timing wrong.

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