The David and Goliath of GPS

There are pros and cons to small-cap investing. One advantage is that undiscovered, underpriced small companies have lots of room to grow and can potentially reward investors with outsized returns. After all, that's the reason Fool co-founder Tom Gardner's Motley Fool Hidden Gems small-cap newsletter is beating the S&P 500 by an average of 20 percentage points.

A downside to hunting for investments among small caps is that these firms often face industry behemoths firing on all cylinders. When that's the case, investors might be wise to head elsewhere -- as I believe they would be in the case of $130 million Lowrance Electronics (Nasdaq: LEIX  ) , which is simply facing too much excellence in $7 billion Garmin (Nasdaq: GRMN  ) . The question, however, remains: Is it worth paying up to own Garmin?

Breadth of business
If you need to pinpoint your exact location -- on land, sea, or air -- Garmin has a Global Positioning System (GPS) device to meet your needs. The two co-founders, Chairman Emeritus Gary Burrell and Chairman and current CEO Dr. Min Kao (Gar-Min -- get it?), remain the two largest shareholders.

Garmin's diverse lineup of GPS products for consumer and aviation markets is far broader than that of Lowrance. Consumer applications are offered for marine, automotive, and recreational markets, as well as original equipment manufacturers (OEMs), and are distributed through more than 3,000 dealers. The aviation segment provides in-flight navigation and communication avionics to OEMs such as Cessna, Piper, Raytheon (NYSE: RTN  ) , and Diamond, as well as the aircraft aftermarket. Lowrance's offerings are narrower; its strongest presence is in Sonar and GPS-based fish finders, although it has had some well-received products in the aviation and aftermarket automobile navigation markets.

Much was made about Lowrance floating a secondary offering a year ago to help fund new research and development ventures. However, compared with its larger competitor, those R&D outlays are mere drops in the bucket. Garmin spends almost double the percentage of revenue on R&D, and nearly 10 times more in actual dollars:

Garmin Lowrance
2003 R&D Spending (% of Revenue) $43.7 (7.6%) $4.2 (4.7%)
2004 R&D Spending (% of Revenue) $61.6 (8.1%) $5.3 (4.7%)
TTM* R&D Spending (% of Revenue) $67.4 (7.7%) $6.3 (4.3%)
*Trailing 12 months; dollar figures in millions

According to analysts at Frost & Sullivan, "[GPS] product development and product runs are becoming shorter in duration ... [putting] more pressure on R&D and manufacturing." This trend aligns beautifully with Garmin's competitive advantage of in-house engineering and manufacturing. Because of lower costs and its ability to re-engineer or launch new products quickly, Garmin is unafraid to cannibalize itself -- as evidence, look no further than the company's steady (some might say aggressive) stream of new products. Moreover, the company boasts that it is "run by engineers," and with 208 patents (and 168 pending), it is the industry pacesetter.

Quality of management
Perhaps I'm currently too sensitive in light of the recent proxy fight taking place in the Quality Systems (Nasdaq: QSII  ) boardroom, but it's refreshing to see management aligned with shareholders (as it is at Garmin), rather than trying to pick pockets through generous option packages.

At Garmin, CEO Kao owns 22.5% of the stock; ex-Chairman Burrell owns 14.8%. Kao's brother owns an additional 6%. This substantial insider ownership has more than kept dilution in check, with fewer shares on the market today compared with the company's 2000 IPO.

In addition to the recent secondary offering, options granted by Lowrance diluted shareholders 4.3% in fiscal year 2005. With that in mind -- and considering the competitive threats posed by not only Garmin but also Trimble (Nasdaq: TRMB  ) , TomTom, and Magellan -- I would've preferred that Lowrance cut its generous dividend payment to fund R&D rather than resort to the secondary offering. I'm also not pleased by the fact that CEO Darrell Lowrance's personal stake has dwindled from 50% to less than 15%.

Financials and growth
Lowrance is putting up the good fight. The company has turned in some impressive numbers for its most recently completed fiscal year. Yet Garmin -- a company with 28 times Lowrance's earnings -- is accelerating past Lowrance. Take a look:

Garmin Lowrance
TTM sales growth 33.4% 30.8%
TTM earnings growth 40.3% 7.5%
TTM owner earnings growth 51.8% (2.2%)


Garmin's balance sheet is embarrassingly solid: $634.7 million in cash and equivalents and not a dime of debt. Cash growth continues even after the 0.8% annual dividend, opportunistic share buybacks, and cash paid for acquisitions and its new engineering and customer support facility.

Comparing a few operating metrics on an apples-to-apples basis, it becomes clear that Garmin outpaces Lowrance in virtually every category:

Garmin 2003 Garmin 2004 Garmin TTM Lowrance 2004 Lowrance 2005
Net income $183.9* $225.7* $263.4* $8.6 $9.4
Cash flow from operations $175.4 $241.7 $230.9 $6.9 ($8.6)
Net cash $495.8 $572.1 $634.7 $1.4 $3.8
Debt 0 0 0 $7.9 $7.7
Cash conversion cycle (days) 145.7 165.9 172.2 137.6 169.4
Gross margin 57.7% 53.9% 54.6% 42.3% 37.5%
Net margin 32.1% 29.6% 30.2% 7.8% 6.4%
*Adjusted for currency effects; dollar figures in millions

The concern for both companies -- although Lowrance should be generally worried -- is that the cash conversion cycle has lengthened while both companies build out inventory to feed new gadget demand. Although Lowrance exhibits Tom Gardner's favored trait of positive inventory divergence, not enough cash is getting to the bottom line.

The Foolish bottom line
Here's the problem: Industry leader Garmin trades for 27 times earnings and sports an enterprise value/owner earnings ratio of 23. It's not cheap. There is, however, some potential hope for the patient investor.

Mr. Market has a tendency to discount Garmin's well-run business, niche domination, and strong annual sales, earnings, and cash growth on a seemingly annual basis. It happened after the first quarter of 2004, when consumer margins seemingly slipped. It happened again after the first quarter of 2005, when consumer growth was lower than expected and inventories inflated beyond sales growth. Both times, investors were presented with buying opportunities 50% off the highs of the previous quarter. I suspect that investors will again be presented with a future opportunity and should save their powder until that time comes. As for Lowrance, I don't think it will be the next small cap that pays off big.

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Fool contributorJim Gilliesowns shares of Garmin and is long $45 Jan. 2007 Garmin calls and short $35 Jan. 2006 Garmin puts. He would love to buy a Garmin StreetPilot, but Jim doesn't believe in keeping anything in his car that is worth more than the actual car. Lowrance Electronics has appeared as a Hidden Gems Tiny Gem. Quality Systems is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.


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