Cognex Corporation (CGNX) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Brian Gesuale, senior analyst covering the industrial tech space for Raymond James. Thank you for joining us after lunch here today. I'm delighted to have Cognex here to present their story with the company's Chief Financial Officer, Paul Todgham, here to take us through it. This is one of my favorite ideas, perpetual double-digit grower, lots of embedded technology around machine vision, deep learning, artificial intelligence and others. They're certainly entering 2022 with most of their end markets in pretty healthy shape and it's one that we think can be a perpetual double-digit top line grower and has the bones of gross margins in the mid-70s. So with that, Paul is going to take us through some slides and some introductory points, then we're going to engage in some Q&A.

Awesome. Thanks, Brian. All right. Yes. Hi, everyone. It's a pleasure to be here in Florida, coming down from Boston for a couple of days. Thanks to the Raymond James team for hosting us. And yes, I'm just hitting my 2-year anniversary at Cognex this week, in fact. The last 2 years have been a pretty wild ride for all of us. I joined Cognex having moved from the Bay Area, though, not physically relocated, the week that Tom Hanks got COVID and the NBA shutdown. So it was a pretty memorable starting week. For me, personally, it's been a rewarding experience to work with a talented and dedicated group of people to help navigate Cognex through a turbulent macroeconomic environment. I believe we're an even stronger company today as -- with great growth prospects, supported by industry-leading technology and an excellent culture. Just the usual disclaimer. Keep in mind that any forward-looking statements I make today are based upon information that we believe to be true as of today, and please refer to our SEC filings for risk factors around the statements. Okay. So what is machine vision? Cognex is the leader in industrial machine vision, which is an exciting technology that gives equipment the ability to see. Machine vision operates very much like human vision. Your eyes, like a camera, capture data and your brain, like vision software, make sense of what is seen. You don't think about that a lot in humans. It happens pretty easily, but it can be very challenging in manufacturing. Getting the answer with high accuracy, speed, repeatability and reliability in the real environment requires a lot of technology, optics knowledge and application experience. We've been at it for 41 years now and have learned a lot in that time, but we still believe we're in the early innings. Cognex applies its technologies to different applications, difficult applications performed on high-speed production lines in manufacturing and in logistics. It's something we do better than anyone else. Our products provide these applications in these areas that we use the acronym GIGI, G-I-G-E, to explain what we do, and that's Guidance, Identification, Gauging and Inspection. So for instance, Cognex machine vision might guide a robot putting a printed circuit board into a smartphone or a windshield onto a car. In identification, we read unique barcodes and alphanumeric characters to ensure the right process is performed on the right item and the right sequence in production. And then we measure or gauge critical features and inspect for cosmetic defects on parts such as automotive brake pads. Machine vision is a great market. It's growing quickly. It's difficult to do and there's a lot of advancement going on all the time. There are hundreds of millions of humans working in manufacturing around the world and tens of millions of them are inspecting with their eyes to perform basic tasks that are often done better and more cost effectively by machines. Driving the adoption of machine vision linked to robotics and advanced automation is the need for quality and productivity improvements, a desire for faster throughput, and products that are becoming too small to make by human hand or view by human eye. And in a world increasingly focused on sustainability, Cognex helps leading manufacturers produce higher-quality products and with significantly less waste or scrap of metal, plastics and other scarce materials. COVID-19 has accelerated this trend. The potential to boost productivity by freeing workers from manual, dangerous and repetitive tasks have become even more important. And in turn, vision technology frees them to use their brain to do something more creative and valuable. So this is how we think about our available market. We think about our served market as about $4.2 billion, and this is a narrow conservative view of the applications that can be addressed today by Cognex products. It excludes potential opportunities that may develop over time and those segments we choose not to target. We calculate our own market estimate because there's no reliable third-party data available. We then segment the market in several ways by products, by application, by industry or end customer. And this data is due for a refresh. This is published in 2019, and we expect we'll publish a new one around our Analyst Day this September. Cognex is a growth technology company focused solely on machine vision. Our high revenue growth, high operating margin business model is supported by strong gross margins and a great, highly differentiated software-based products. In 2021, we surpassed $1 billion of annual revenue for the first time in our history, while also setting new annual records for net income and EPS from continuing operations. We've sold more systems and have a better-recognized brand than any other company in our industry. We believe Cognex has 2 high-level competitive advantages that are easy to explain, but difficult to replicate. The first is our technology leadership. Our ability to deliver strong top line growth over the long term comes from our investment in engineering. In 2021, we invested 13% of revenue in RD&E or about $135 million. We believe we invest more in machine vision than any of our competitors. We're a high intellectual property business with more than 1,000 patents issued or pending. The sophistication of our software and our application experience creates significant barriers to entry. Our second competitive advantage is our culture, and it reinforces the first. Our success is underpinned by a strong corporate culture, as demonstrated by our motto, Work Hard, Play Hard and Move Fast. We strive to create an environment where people, particularly engineers, love to come and do their best work. We also believe it's important to have fun together as a team and not take ourselves too seriously. When Cognoids, as we call ourselves, see the CFO, CEO and other executives, making fun of ourselves, it promotes informal communication, lack of hierarchy, a sense of comradery, and an engaged committed employee population. That's us dressed up at last year's Halloween party, which is our biggest celebration. My 4 kids at home were both confused and delighted when Dad came home dressed as a smurf. I want to talk briefly about 2 important growth drivers for Cognex. First is logistics, which represents a greater than $1 billion market opportunity for Cognex. Logistics is a great market globally in the early stages of adopting machine vision and advanced automation. Most of our business today is barcode reading and e-commerce fulfillment, where the need to ship items to individual customers faster than ever is driving massive changes in technological innovation and automation. Logistics was our fastest-growing major end market in 2021 and was our largest end market for the first time. Revenue grew by approximately 65% year-on-year and represented about 30% or $300 million of annual revenue. We're benefiting from a broadening set of companies investing in automation to enable higher throughput and cost reduction. The second area I want to point out is deep learning. Cognex is the leader in applying this new technology to industrial machine vision. It's an area where we've invested in heavily, both inorganically and organically. Unlike traditional rule-based machine vision, deep learning is trained by example. It's particularly valuable in inspection when looking for defects, like scratches and chips on surfaces that may be harder to define. More and more, we're seeing deep learning and our traditional machine vision algorithms run side by side for a powerful application solution. And as we look at the opportunities ahead, we believe we're just scratching the surface, pun intended, of what we can accomplish. So Cognex is a growth company. Our stretch goal for revenue growth is 20% over the long term, but as history demonstrates, the revenue growth isn't linear. There are distortions over time that can result in breakout years with huge growth like we experienced in 2017 and 2021, and then years with more moderate growth. From a business perspective, our sales activity broadened in 2021 after fairly narrow growth in 2020, and it was a much stronger year than we expected. Annual revenue grew by 28% year-on-year due to growth in many markets led by logistics. As we move into 2022, demand continues to be good, broadly speaking. Companies are leaning into investments for machine vision and logistics automation, EV manufacturing, deep learning and life sciences. In summary, Cognex is an interesting -- industry leader in the exciting field of industrial machine vision. We have an experienced management team that understands the industry, a great brand built from years of technological leadership and strong partnership with our customers and a great business model that generates high-quality revenue growth with tremendous fall-through to the bottom line. Thank you very much.

Well, thank you, Paul. And join me up here, and we can start on some Q&A. If you have some questions from the audience, please feel free to raise your hand.

That was a great overview. I want to double-click maybe on some of the verticals, logistics being your biggest one and one I get a lot of questions about. Results have been stellar in that business for the last few years now, as you support e-commerce and just-in-time delivery. How do you think about penetration rates, whether that's with customers as part of the overall market or even with your technology as you kind of think across those vectors?

Yes. I mean, I think, certainly, with our largest customers, we're pretty well penetrated today, but still seeing great growth opportunities, particularly as our largest customers maybe move from a domestic focus to increasing investment internationally, and as they move from a focus more on barcode reading to kind of broader vision applications like 3D dimensioning or inspection for damaged packages or particular labels on items. And then the part of the business that's growing fastest in logistics really is kind of the longer tail, which is really a broad base of customers, think about folks who are trying to catch up with kind of the industry leader in delivering products same day or 1-day or 2-day delivery and like companies like the company I joined. I left Levi Strauss & Company trying to catch up or at least be in the game with distribution times and so on. We're really well penetrated in terms of we know who those customers are, and we are -- we've got great relationships, but they're in very early days of adopting Cognex technology or adopting machine vision technology broadly, particularly as many of those companies are making that transition from both mostly brick-and-mortar or a ship-to-store to a ship-to-individual-consumer, which requires significantly more automation, significantly more technology and obviously great opportunities for Cognex machine vision.

That's great. I want to move on to one of your other big verticals, the automotive space. Would you talk about it maybe across 3 different areas, maybe with so many new models coming online, the impact of electric vehicles on -- and your role in the battery manufacturing process and really how you think about Cognex's long-term ability to grow above market rate of auto production?

Sure. Yes, I'll start with the last part. So we generally view automotive as a business for us that we hope in the long term is growing about 10% a year. So kind of -- we believe it's positive growth, but -- and that would be above-market growth, I would think, for automotive. But dilutive to our overall growth rate if we're targeting kind of a 20% rate and our history would suggest more of a sort of a mid-teens growth profile. I think that the 2 other factors you've mentioned kind of the growth of EV, which is then spurning more new models to be coming on the market is leading to a period where I think we're going to see quite a bit faster growth than that. And there's questions about how long can that last? How long is the duration? And to me, without committing to anything in 2022, it feels to me like at least 3, 4 years, if you think about just this year, amount of manufacturing and capacity expansion for electric vehicles today. So we grew automotive a little above 30% last year, coming off of 2 down years, down 10% and down 20% in 2019 and 2020. So we're kind of back to where we were, but that was driven by -- EV was a big driver of that, just large battery manufacturers, particularly in Asia, but now broadening to Europe and the Americas as well. As well as just a rebound in -- among the OEMs and among the Tier 1 suppliers just ramping up for new models as rate suggests.

Yes. Right. We're excited about that opportunity for you. Maybe look at kind of the third of the big 3 consumer electronics. If we look back over time at the different cycles we had, we had a 2017 peak, a couple of down years, a rebound in 2020, '21 was off just a little bit. How do we think about where we're at in the cycle, where customers are in penetration and really just how we should think about that vertical for you as we move forward?

Sure. Yes. So we tend to think about consumer electronics as kind of there's -- the device we all like can't live without, which is sort of the phone, and then there's sort of everything else, which collectively -- they're by and large, keep it simple, roughly equal in size kind of this phone versus everything else. The phone business does tend to follow an annual cadence. We tend to be able to share visibility into that in our Q1 results earnings call, end of April, early May or so, because we typically are getting kind of orders from the contract manufacturers and so on, and seeing is this a big year for new production of new form factors, new technology being integrated? 2017 was a really big year with the rise of OLED screens. 2020 was a pretty big year with the incorporation of 5G, which has been kind of long promise but more aggressively implemented in 2020. So form factor certainly drives a lot of what's going on there. And then I would say just your -- is it a big production cycle? Is it sort of relatively bullish or is it relatively modest? That will also affect things. We do think within phone, though, there's a driver for us, which is we mentioned kind of 35 million visual inspectors as sort of their job is to basically look at something. And are there scratches, are there defects and so on. We have technology that we are still very much in pilot phase that we think can do that better than a good million number of inspectors. So we could drive years of growth when we get that piloted and traction and invested for a few years, even without major changes in the cycle. So generally, I would think phone is reasonably mature, but you never know what kind of technology will come up with next and then we have some stuff that doesn't require major technological changes, just our customers would rather spend on CapEx than on OpEx if the return is there. On the non-phone space, it really -- there's no -- it's harder to say what the trend is or is it a cycle. In 2020, the work-from-home dynamic with COVID really kind of caught us out of the blue. I mean, I told you this over lunch yesterday. I had -- we had 1 set of headsets in the Todgham household, and I have 4 kids, and we now have 6. We bought them all in 2020. And I don't have 12 in 2021, we have the ones we need, right? So that certainly has a microcosm of kind of the growth we were seeing, the tablet growth, laptop growth and so on. What's next? Is it VR/AR, possibly. Certainly, we've got some investments there? Is it something we haven't seen yet, I'm not sure?

Okay. Fantastic. This period seems to be, for me, the most broadest set of end market strength for the company. So I look at some of these smaller end markets for you as a percentage of revenue, they seem to have some pretty healthy dynamics. Can you talk about maybe the outlooks in life sciences? Certainly, semi capacity is going up. Food and beverage supply chain issues are pretty popular or unpopular depending on how you're looking at it. Can you just tell us everything you're seeing? Because it seems like just about every end market that you're in, is moving favorably.

Yes. Yes. We saw really broad-based strength across those markets in 2021, and we're optimistic that, that momentum will continue in 2022. So you're right. So we have these 3 large end markets that we tend to talk about in isolation, logistics being the biggest at 30%, automotive at 20%, consumer electronics at 20%, and then sort of everything else makes up 30%, which includes consumer products, think about like P&G or Unilever type stuff, food and beverage, semi, medical-related device, kind of -- yes, all things medical and health, which might be about 10% of that 30% of which life sciences is one piece of that, along with pharma and med devices. So the smallest of those is probably life sciences, but it's one that we really like the play we're making and the growth we're seeing there. This is basically small vision systems that go into machines being built by other companies. So a public example that we've used is Brainlab, a company based in Germany, which does patient positioning technology and Cognex vision supports that. So you're going into an MRI or so that making sure you're in the right spot. We tend to measure that success of that business by design wins. How many machines can we get embedded in and once you're embedded in the machine, that machine gets FDA approval or the appropriate regulatory approval. You might see 7 years of really steady product. So although there's very little that's predictable of our revenue stream as a CapEx provider, that's a pretty predictable revenue stream. Across -- certainly across food and beverage, you're seeing a lot of interesting stuff like meatpacking plants, who had a terrible COVID. How can we reduce the number of people there? How can we add technology? Our deep learning technology, there was a question in our last earnings call that caught me off guard at the very end about protein and the protein market, which I hadn't thought about and you guys have all just had lunch, but we do chicken deboning for a major chicken manufacturer. And it's a great technology for deep learning inspection because no one -- as much as they try to make every chicken look alike. No one chicken breast is identical. But being able to spot sort of defects and sizes and figure out exactly how to get this chicken off the bone in the way that maximize the amount of protein available, is a great opportunity. Within pharma, within consumer package, just the rise of traceability of supply chains, certainly, within the COVID world, being able to track the product from start to finish. That means more scanning of barcodes, more tracking of that system through the supply chain means more vision components for us. So yes, I would agree, broad-based strength and then there's some sort of near-term macroeconomic and supply chain-driven trepidation would be the only counter, I would say to that.

Maybe we can talk a little bit about some of the supply chain challenges that you've navigated through both last year and that are ongoing. Maybe just talk about the magnitude, duration and how you view them in general?

Yes. Yes. So you guys are listening to lots of different companies. I'm hoping supply chain is coming up pretty frequently in those...

You're not alone.

In those conversations. Yes, I mean it's been the most challenging supply chain environment that I think most of us have faced in our careers. And it really started with semiconductors and integrated circuits, lead times pushed out really dramatically. Pricing went up and that ability of the core suppliers to fulfill in a reasonable time frame is compromised. For us, the biggest impact really was just that challenging to fulfill our customers. If you look at our gross margins, and we have pretty good pricing in the market, we were a little less worried about do we need to -- it's going to be more expensive to get stuff to customers. We're already flying virtually every product to customers. So some companies are going from having to do -- shipping to airfreight. We're just going from airfreight to a little more expensive airfreight. We're willing to absorb price increases of the sort of the magnitude we're seeing in semis and other stuff, and we'll pass that on to our customers, who recognize the value of our technology. What's most challenging really has been the scarcity. And so, we've had to engage extensively in what's called the broker market. But basically, there might be a chip that's sole sourced in to create certain products that the manufacturer who maybe is now pricing at a significant premium, what they priced it 12 months ago, even with us taking that higher price, still can't get it to us in time, and we don't want to make our customers wait or have to delay a broader production process. So we might pay anywhere from 5x to 100x what it costs for that one $4 chip or whatnot. So that's the biggest piece right now of what's kind of taken us from being at 75% margins to 70% margins, which we delivered in Q3 and better than that kind of 72% in Q4. So the bad news is we're basically giving money to middlemen, which is just sucks to do. It's like paying scalpers to go to a concert. The good news is no one runs a business that way long term, and it's very easy to turn that off. And we're getting the guarantees and the delivery, we're seeing this from our core suppliers that they're able to produce it in time. So we're not so focused on. We've got a price for that particular phenomenon. It's more like we're doing that to please our customers. And when that goes away, I feel like there's a pretty clear path back to our strong gross margin. And already with lead times, I would say, with about 90% of our product portfolio as of kind of end of Feb, we're back to pretty much normal delivery times. We've got about 10%, we're monitoring closely. And I would say maybe 6 months ago or 4 months ago, it might have been closer to the reverse. It might have been kind of like 20% to 30% had regular lead times and 70% or 80% was compromised.

I want to pull a little bit more on that gross margin threat. I think you've made some investments, particularly in logistics markets and maybe into some others that have maybe come at the expense of gross margins temporarily. Can you kind of think about or help us understand the magnitude and the duration of these investments in and when we might see those investments kind of bear fruit?

Yes. Yes. So logistics, we've been saying for a while that logistics gross margins are improving, but dilutive to our overall company margins. And we don't give transparency on that in the near term for competitive reasons and so on. But if you would think sort of 3, 4, 5 years ago, logistics margins might have been around 60% gross margin for a company that's 75% on average. And we've narrowed that gap significantly in the last few years. Last year, we -- our margins didn't improve significantly in logistics, primarily because of one strategic investment, which we called out with a high potential customer that had a strong service component. So the main reason logistics margins are dilutive for us is less because we sell the products for less and more that -- to implement some of these products in the logistics fulfillment center requires a high service component and we're co-investing along with our customers, while we're simultaneously building up the partner infrastructure, so that once it becomes sort of more productized, more routine, you've got the playbook, somebody else can go do that, and we might collect a small royalty for training them and for introducing them to the customer. There are plenty of suppliers out there or logistic service providers, who would be happy to accept 30%, 40% service margins. When we would prefer not to. We'd be happy to give that away and collect a small royalty. So that's really kind of that path is how do we get that service component productized, standardized and then offloaded to partners. We're making pretty good progress along that front. The investment we made last year really was kind of a pretty herculean effort where we were adding new tunnels to a production process where you basically have a limited amount of downtime because when you're building a new greenfield distribution center, you got as much time as you need within reason to get it going and test it up and running. When you're taking a line offline and then putting a new one in, you might have 10 hours, 12 hours. So getting it done a little slower than that is not an option. So we overinvest in resources to do that.

That makes a lot of sense. Can we maybe tie this whole profit thing full circle here. How are you thinking about incremental margins as some of the revenue comes back at different revenue growth rates?

Yes. I mean, I think in year, our flow though when we outperform is very, very high. I tend to think of it as like 65%, let's say, on average because we got about 70%, 75% gross margins and not a whole lot of cost after that. We might have to fund our company bonus if we're having a good year, and we have to pay our salespeople commissions. And that's pretty much it. So when we outperform, if we sort of set internal targets to grow at a certain rate, call it the low teens or something like that, and we outperform that, the flow-through is very, very high. I think on kind of an ongoing basis, it's probably more in the sort of 40-ish percent range, let's say, as we run the business with about 30% operating income margins. And we're going to get leverage as we grow, but we still are also investing a lot back into more sales headcount. We still -- probably the biggest reason we lose opportunities in sales today is because we just aren't there. And our biggest competitor Keyence has a salesforce that's significantly larger than ours, which means they're penetrating in certain markets more often than we are. So we always love to add salespeople, but we do that in a very disciplined way tied to sales capacity. We've been investing in our systems. We have a new sales force CRM system we implemented over the last year. We greenlit that at the same time we were trimming our headcount just to be ready for a rebound knowing that, that was a longer-term investment. So yes, I think kind of in that range is probably appropriate. And hopefully, you guys are all satisfied with that.

That sounds great. Maybe last one before we head to the breakout room. Balance sheet is loaded. I think just last week, you re-upped the stock -- the share buyback card, reloaded that. Can you talk about share buyback, capital deployment overall and maybe any type of appetite for M&A and how it would fit in with your culture and the types of deals you're looking at?

Yes. No, I think if we think about our capital allocation priorities, the #1 priority would be organic business growth, but we fully fund that and obviously still generate significant excess cash. So beyond that, M&A would be #1. But we're aggressively looking at opportunities, but we're also very choosy. So -- this is a -- this might be the longest gap we've had before doing a deal from buying Sualab in October of 2019 to where we are now integrating Sualab based in Korea, when no one is able to travel to Asia over sort of a 12-month period or 18 months was pretty challenging. So COVID wasn't necessarily the best environment to be looking at deals. But we feel like we're past that, and we're looking at a lot, and we're certainly as much as our stock being down is a bit of a bummer to some folks trying to cash in on options. It does make the market a little more attractive for M&A, which is good. I would say stock buybacks would be the next most. I mean, our dividend is about $10 million or $11 million a quarter, pretty modest. It's a nice level of discipline and so on, but as a growth technology company, I don't think we necessarily excite anyone with a dividend yield of 30 basis points or 40 basis points. But stock buyback for sure. I mean, our stated goal is to offset dilution from our equity programs, and we've done that for all new equity issued since 2013. We're a few million shares ahead in buying back that dilution, but we look for opportunities to be a little bit more opportunistic than that. And certainly, late Q4 and early Q1 have been those opportunities. We issued a whole lot of equity at $90 to our team last year -- just over a year ago. We bought back a lot of that at an average price of below $80. So we think that's a pretty good deal for our shareholders. And eventually, we believe those options will be in the money and people will be paying us that money for those shares. So Q4 was our biggest market for -- our biggest quarter for share buybacks with $113 million that we executed. But when we re-upped our share buyback last week and got $500 million authorized, which was 2.5x the largest authorization we've had previous to that point, we mentioned that we've exhausted our previous acquisition. So we've already authorized -- we've already spent $117 million in the quarter to date, given pretty favorable conditions. So we're never going to boost our share price by the volume we buy. Our market cap is too high for that, and it's not our style. We're a growth technology company, but we are looking for opportunities to be -- to invest in ourselves when the conditions warrant itself and when we're confident enough in our free cash flow generation that we're not diluting our ability to do transformative M&A in the future.

That sounds great. We're going to end it there. Paul, thank you so much for coming. We're going to go down to the breakout room downstairs for more Q&A. Thanks everyone.

Thanks, Brian.