Groans for Garmin

So what gives, investors? Were you not listening to Garmin (Nasdaq: GRMN  ) last month? CFO Kevin Rauckman said plain as day that:

  • Q1 sales would come in between $615 million and $738 million. Actual number: $664 million.
  • Garmin hoped to maintain market share in the U.S., and gain market share in Nokia's (NYSE: NOK  ) and TomTom's fortress, Europe. When earnings came out, Garmin confirmed that "PND [portable navigation device] market share in North America remains relatively stable, while European market share is increasing, a benefit of our European distributor acquisitions." (Incidentally, Garmin announced yesterday that it is buying its distributors in Austria and Portugal in furtherance of this strategy.)
  • Garmin will re-enter the cell phone/PND market with its Nuvifone in Q3, taking on smartphone competitors Motorola (NYSE: MOT  ) , Research In Motion (Nasdaq: RIMM  ) , and Apple (Nasdaq: AAPL  ) in the process. Update: Garmin says it is in talks with "a number of wireless carriers" about offering the Nuvifone to their customers. (Rumor has it that AT&T (NYSE: T  ) is on the short list. But Garmin also has an existing relationship with Sprint Nextel (NYSE: S  ) .)

So why did investors sell off the stock post-earnings? Sure, revenue came in lighter than Wall Street expected. Yes, profits were off a bit. But basically, Garmin delivered precisely what it had promised us in early April.

More is less
Then again, while Garmin delivered on its promises, it also delivered quite a bit that it didn't promise ... and that no one asked for. While sales grew 35% year over year (in a pleasant counterpoint to TomTom's predicted decline), the profits earned on those sales didn't fare so well.

But please, don't blame gross margins. For all that we've been warned time and again that gross margins in the GPS space will decline, Garmin got through Q1 with just a 10-basis point dip, to 48.2%. For the most part, gross margins either held steady or expanded in each of Garmin's four business segments: automotive, aviation, outdoor, and marine.

The real shocker was not what happened to the gross margins, but what happened at the operating level. Garmin shed another 200 basis points there, as both selling, general, and administrative costs, and research and development expenses, roared ahead 48%. Automotive, aviation, outdoor -- they all took their hits, with only Garmin's smallest division, marine, escaping unscathed. By the time all the damage was done, Garmin's total operating margin had fallen to 26%.

Now, toss onto these rising expenses an increase in Garmin's tax rate (taxes grew nearly twice as fast as revenue) and unfavorable currency exchange movements, and Garmin ended the quarter with earnings up a meager 5%, at $0.67 per share.

Cash is not king
A Fool could hope that this was just a case of GAAP earnings misrepresenting the company's true cash profitability. Sadly, that hope would be misguided. Free cash flow rose a bare 5% in Q1, to $165.8 million. Which brings us to the final groan voiced over Garmin's earnings news: working capital.

When a company's sales grow 35%, ideally, you want to see such line items as accounts receivable and inventories either fall or rise more slowly than sales growth. Garmin accomplished none of these things. To the contrary, accounts receivable leapt 54% year over year, while inventories grew 139%. Worse still, from a positive inventory divergence point of view, was the kind of inventories that have piled up. Raw materials increased about 140% year over year, but finished goods increased 160%.

When a company grows raw materials rapidly, this can be interpreted (rightly or wrongly) as an indication that management is getting ready to fill an anticipated surge in demand. In contrast, when finished products are bursting warehouses to the seams, you have to wonder why they're sitting there at all, and not being rushed out the doors into the eager hands of consumers. Thus, the fact that not only are inventories piling up faster than sales, but that finished goods are growing faster than raw materials, is a good indicator of potentially weak sales performance down the road.

Foolish takeaway
I hate to end an article on a low note, so as bad as much of the above sounds, let me point out once again how exceedingly cheap this stock appears, its many "issues" notwithstanding. Garmin shares currently change hands for a mere 11 times trailing earnings, yet analysts are projecting 17% annual growth for the company over the next five years. Even if they're a tad optimistic on that point, it seems to me that today's price offers a margin of safety wide enough to cushion an awful lot of wishful thinking.


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