Machine vision company Cognex Corporation (NASDAQ:CGNX) is one of the most compelling growth stocks in the industrial sector. It's also one of the most expensive, trading at 28 times forecast earnings for 2014. That's a heady mix that ensures that investors will closely follow its upcoming third-quarter earnings report. Let's see what those investors might expect.
Cognex: the numbers
Cognex investors will remember the company's fourth-quarter results from February, when the company beat earnings estimates and promptly fell more than 8%, only to rise 7% the next day. While it's always interesting to follow such events, long-term investors will want to look at its earnings in the context of the development of the business.
Before delving into a qualitative discussion, here is what Cognex's management forecasted for the third quarter at the time of the second-quarter earnings call.
- Revenue between $165 million and $170 million, representing a more than 50% increase from last year's third quarter -- a figure boosted by a $60 million order from one customer.
- Gross margin in the mid-70% range.
- Operating expenses expected to increase 25% on a sequential basis, and then to decline 12% sequentially in the fourth quarter.
- Effective tax rate of 19%.
The increase in operating expenses is due to expenses that got shifted into the third quarter from the second, the servicing of a major contract won in April, and an increase in investments to generate future growth.
Focus on factory automation
A quick look at its end-market mix reveals how Cognex generates revenue.
Customers of the Surface Inspection Systems Division, or SISD, are manufacturers that use continuous processes and need machine vision to detect any surface defects. The semiconductors and electronics end market, meanwhile, consists of capital equipment manufacturers that incorporate Cognex's products into their equipment and then sell their machinery to customers that manufacture semiconductors or printed circuit boards. As an indication of how Cognex's end markets have changed over the years, semiconductor equipment manufacturers made up 61% of revenue in 2000, and that figure was down to just 7% in 2013.
The real key to the company's growth prospects lies with its factory automation revenue. These customers make up a broad network, with Cognex particularly strong in the automotive industry, which tends to be an early adopter of automation technology, and in food and beverages. However, one of its key growth opportunities is to expand factory automation sales to new industry verticals such as pharmaceuticals and medical -- something to look out for in the results.
Cognex's factory automation prospects
Essentially, the stock has doubled in the past two years, because the company has managed to expand its total addressable market, or TAM, while exceeding expectations with its revenue and earnings generation. Again, the key to expanding its TAM is the factory automation end-market, specifically its product ID solutions.
Cognex's management no longer discloses the share of factory automation revenue that comes from product ID as opposed to non-product ID. However, on last year's third-quarter earnings call, CEO Richard Willett disclosed that "ID products revenue was at $25.5 million," representing around 35% of total factory automation revenue. Fast-forward to the last Cognex earnings call, and when asked about the ID product marketplace, Willett said, "It's a $900 million market that's probably growing in the mid-single digits, and we are expecting to [achieve] 30% growth."
Furthermore, within that $900 million market figure, management sees the logistics market as being a $250 million market. To put these figures into perspective, Cognex's total company revenue was $354 million in 2013, with around $280 million from factory automation -- plenty of room for growth.
Digging into the details of ID products revenue, if you use Willett's 30% growth number for ID products, then total ID product revenue is likely to be around $33.1 million in the third quarter. It's tricky to guess at a more precise number, because of the distorting effects of the revenue from the large $60 million order to be delivered in the quarter. Cognex is unable to disclose details on the contract or the customer.
In addition, Fools should note that the original expectation for the large order was for revenue of $40 million in the third quarter -- only to be increased to $60 million -- with Willett stating on the previous earnings call: "We don't believe this is a one-time deal. Rather, it's the beginning of a long-term relationship with the potential for substantial revenue in future years."
What to look out for with Cognex's earnings
I've outlined the numbers to monitor. As for qualitative assessments, the key is ID product contracts and revenue growth. Cognex investors will want to know how the company is expanding into its TAM. As the company has already demonstrated this year, it has the capability to sign large deals and then increase the deal value as part of a relationship. Therefore, Fools should look out for any color on the potential for future deals there.
Moreover, Cognex is working with potential logistics customers with a view to signing orders. Any update on progress there would be useful, as would news on how Cognex is diversifying into new industry verticals.
All told, Cognex is always going to be a cyclical company -- factories don't like making capital equipment purchases in a slowdown -- and any sign of a slowdown in manufacturing conditions will hurt the stock. The company's secular growth drivers -- those not dependent on the economy -- are strong, but so is its current valuation. Cognex needs to deliver on the numbers -- and, more importantly, on the deal outlook.