Cognex Corporation (CGNX) Earnings Call Transcript & Summary

[Audio Gap] and I'm Brian Gesuale, senior analyst covering the industrial technology space for Raymond James. Welcome this morning. Delighted to have Cognex here to present their story. Obviously, a leader in automation, lots of big themes playing here from China reopening to reshoring to just general automation trends. We have the company's Chief Financial Officer, Paul Todgham here to take us through the story. What we're going to do is, a brief presentation from Paul, and then we're going to open it up to Q&A. I'll lead some of those. But if you have some questions, raise your hand, and I'll try to get to them. Paul?

Excellent. Thanks, Brian. Cool. It's a pleasure to be here today. And yes, this -- I'll talk for maybe 6 or 7 minutes and then turn it over to Q&A. Just provide an overview before diving into your questions. Please keep in mind that any forward-looking statements I may make, are based upon information that we believe to be true, as of today. You should refer to our SEC filings for our risk factors around these statements. So, I'll start things off with just a high-level overview of Cognex. We are a high intellectual property growth technology company, and the technology leader in industrial machine vision, which gives equipment the ability to see. We've been around for more than 40 years. And in 2022, we generated over $1 billion of revenue, reported a 72% gross margin, nearly 25% GAAP operating margin and about 27% non-GAAP operating margin. So, what do we mean by machine vision, for folks who are newer to the story? It's a technology that operates much like human vision. Your eye like a camera, captures data in your brain, like vision software algorithms, make sense of what is seen. While this happens easily in humans, it can be very challenging in manufacturing. Replicating vision with the 99.99% accuracy required in manufacturing takes a lot of technology and know-how, which Cognex has spent over 40 years developing. We focus on machine vision for difficult applications performed on high-speed production lines in manufacturing and logistics. It's something we do better than anyone else. For example, Cognex machine vision might guide robots for tasks such as placing a computer chip on a circuit board. We identify unique barcodes and alphanumeric characters to ensure traceability, and we precisely measure or gauge critical features and inspect for cosmetic defects on parts, such as smartphones or automotive brake pads. Machine vision is a great market. It's growing quickly. It's difficult to do and there's a lot of technological advancement going on in it. Labor shortages and the rising cost of labor are driving companies to invest in automation. Machine vision is one of the most important and difficult technologies required to make that happen. Machine vision also helps manufacturers produce higher-quality products, and with significantly less waste or scrap of metals, plastics and other scarce materials. At our Analyst Day last September, we introduced an updated view of our served market. This estimate is $6.5 billion, growing at about 13% annually. We expect to outperform market growth due to the strength of our technology and customer relationships and our market focus. Now our served market is a narrow, relatively conservative view of the applications that can be addressed today by Cognex products, rather than a comprehensive TAM. It excludes potential opportunities that may develop over time and those segments we choose not to target. I'll talk briefly about the largest 3 sectors in our served market from left to right. First is automotive, where machine vision is used in almost every step of vehicle manufacturing. Historically, our automotive revenue has grown by about 10%, compounded annually over the long term. We're optimistic that the multiyear investment in EV battery manufacturing equipment that's currently underway will increase that rate in the medium term. Next is electronics. Electronic companies have big plans for technologies and new uses for smartphones that will be difficult to manufacture on a massive scale. We expect to be the partner of choice, as companies bring their devices to market. And third is logistics, which we believe will continue to be an important growth driver for us. It's emerged as the largest, and we expect it will remain the fastest-growing sector in our served market. After growing our logistics business at about 50% compounded annually over the past 5 years ending in 2021, we shrank 25% in 2022 because leading e-commerce players have taken a post-pandemic time-out to absorb excess capacity. However, our differentiated technology and opportunities we see in logistics give us confidence we can continue to be a share gainer and grow that part of our revenue by up to 30% over the long term. Now Cognex is a growth company. As our history demonstrates, revenue growth isn't linear. There are distortions over time, and this can result in breakout years with huge growth, and other years, where growth is much lower or negative. Following a substantial growth year in 2021, led by logistics, our revenue declined slightly in 2022, due primarily to slower spending by a few large customers in logistics and a headwind from FX. We mentioned recently on our fourth quarter earnings call that we also started to see broader softness towards the end of 2022, and beginning of this year. While many of our customers are being cautious with their capital spend in this uncertain environment, we remain just as confident and optimistic in our long-term growth drivers. Over the long term, our target is to achieve revenue growth of 15% compounded annually, a gross margin in the mid-70% range and an operating margin of 30% or greater. I just want to wrap, by giving you a glimpse into Cognex' unique culture. It's something, we probably talk about more than many companies you might meet with. The success of Cognex is underpinned by a strong corporate culture, as is 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 think our 2 strongest competitive advantages are our technology leadership and our culture, and the 2 reinforce each other. When Cognoids, as we call ourselves, see the CEO or CFO or other leaders, poking find it ourselves, it promotes informal communication, lack of hierarchy, a sense of comradery, and an engaged committed employee population. That's us in the middle top middle, dressed up at last year's Halloween party is the Willy Wonka cast. Most importantly, we persevere to deliver excellence in a demanding technical field and move fast, whether in responding to a crisis, we're aggressively going after a new growth opportunity. It's an exciting place to work, and we hope for those with a long-term growth mindset and exciting investment opportunity. Thank you.

Thanks, Paul. I'm going to stand, so if anyone has some questions just raise your hand. And I'll try to get to you throughout the program. Paul, maybe we just start with your biggest end market. This is the singular most received question I get, logistics. Can you talk about what's happened there? I think, you went into it, a little bit. Maybe talk about the importance of kind of new builds or incremental square footage, versus technology insertion into existing facilities. And what you're looking for to get signals that, that business is beginning to recover?

Sure. Yes. Yes, we were here, a year ago. And we just come in off 65% growth for logistics, 28% growth for the whole company, this year coming off of 2022 where we shrank 3%, up 1% in constant currency with logistics down 25%. It is certainly a different story. What's happened is essentially there's been a pause in new capacity expansion for generally large e-commerce providers. We have one that's listed in our 10-K, went from 17% of revenue in 2021 to 11%, in 2022. So that's a pretty significant decline, obviously, driving the majority of that 25% decline we saw in logistics last year. And that really reflects a -- yes, a pause on new capacity expansion for that customer, and then others who have done the same. So there's kind of -- our logistics business is primarily made up of 3 different types of revenue. There's new capacity expansion, productivity improvement projects. So, we develop technology that improves one part of the process in a fulfillment center, a distribution center, might get piloted in one place and then rolled out across the entire network. And then kind of a replacement cycle and just replacement of spares and so on. And really, that first piece has been the biggest for our largest customers, followed by that productivity improvement. We haven't have a meaningful replacement cycle yet because our technology is still fairly new and holding up pretty well. So yes, we're seeing that pause right now. For many other customers who didn't kind of take off immediately during the pandemic. Many of them put their investments actually on hold in 2020 and 2021, and we're seeing those kind of come back to life. So we think that piece is holding up pretty well. And again, excluding just a small handful of customers in e-commerce, the rest of the business did grow last year, maybe not as fast as we'd like, but still growing.

Can you maybe talk, maybe about some of those? The big customers, it sounds like they've been on pause because they were early to invest, some of the other late investors into e-commerce activities, are really building out that capability. How long is that tail of those customers kind of spending?

Yes. I mean, we serve about 30,000 customers overall in our business. And logistics is about 20% of our business, last year. So, I don't think we've enumerated our logistics customers, but you can make a fair sort of extrapolation from there. We do have some very large businesses in what we would call kind of our base business. They may not be as big for us as an 11% customer, but very large. We described one of them in our last earnings call, which is a Fortune 50 retailer, that's again, more of an omnichannel retailer, big physical presence, growing their online business, investing aggressively in automation. Yes, I think it's a pretty broad portfolio. I mean -- I think the big macro trend in logistics is more and more stuff being sold online to consumers directly. That has significant implications for the machine vision content you require. It just takes a lot more barcode reading, a lot more cameras to ship millions of packages every day to people in stores, then tens of thousands of boxes to -- sorry, to people at their homes than tens of thousands going to stores. So that's a general trend. That trend spiked, obviously, during the pandemic, and is now still upward but basically absorbing. Beyond that, other levers of growth, U.S. e-commerce is probably the most automated of all parts of logistics. So the most use of our technology and other technologies. You still see a lot of people moving stuff on conveyors with handheld scanners or whatnot. Other parts of the U.S., brick-and-mortar retail and then more broadly in Europe and Asia. So, as labor continues to be scarce and wage rates continue to grow, particularly in Asia, we're seeing more appetite for automation there. Most of our business today is still barcode reading in logistics, but we have some great vision applications, which is really what we do across our broader portfolio, and more equal measure. Doing things like helping you figure out, as a pack -- as a box is going down, where to find that clear spot to put a label that doesn't cover up a hazmat symbol or some other symbol that you can't cover or previously put down barcode. Helping dimension, helping spot defects or damage on boxes, things like that, helping to prevent its maintenance in fact -- in a distribution center. So we see levels of growth along that dimension as well.

Terrific. Maybe we pivot over to the auto vertical. One of your biggest markets, 20% of sales roughly. Can you talk about the dynamics between increasing auto production this year, how that impacts your business? And then think about the 2 vectors of kind of your traditional auto business, and then this EV business, which has started to rapidly grow over the last couple of years?

Sure. yes. We spent a bunch of time internally trying to figure out the best way to characterize the EV investment, we're seeing. And how to talk about it. And I think our thinking and our description have sort of evolved over time. But initially, we were sort of saying, "Just let's just flag anything that is tied to EV as an EV business." And it ends up being pretty tricky for our sales force because a lot of our business is with Tier 1 suppliers across sort of a wide range of areas like cars, car seats, obviously, the traditional ICE Powertrain, EV battery also with the brand owners as well. So these days, we're now saying we're focusing a little more exclusively on EV battery, as sort of a market that's really easy to define, really well understood, quite concentrated. 90%-plus of the production is in Asia, sort of 6 major players and whatnot. That's about 10% to 20% of our business today, Brian, we've sort of quantified, but growing very, very fast. And, what we're seeing there is still a lot of investment in Asia, but increasingly more JVs and plants broken ground and so on in the Americas and in Europe. We're not really seeing a meaningful revenue from that yet. I think we're still sort of in the let's win let's win the spec, let's get spec-ed into the new factories as they're being built. It's been a little bit slower than we might have expected. Just some of that's been based on government regulations and so on. But that's sort of probably the fastest-growing, most exciting part of the business. We recently acquired a small German company that has some computational lighting that helps us better do inspection on battery cells for that industry, in particular. Beyond that, we've got exposure to the powertrain, the -- again, the wheels, all parts of an automotive. But we do believe that, that pace of investment in EV is going to far outstrip the decline in kind of traditional ICE Powertrain in the near term to medium term. Just the amount of new capacity that's being brought online is more than offsetting the fact that it's -- you're having a tough go of it if you're making traditional ICE Powertrain parts. And we've obviously been serving those people for a while, but we expect we'll pick up more than we lose.

I'm wondering, if you can talk a little bit about the technology development trends in machine vision. What would be required to unlock new applications, by way of perhaps feature size resolution or the speed of things moving through past the cameras, 2D going to 3D, AI, ML, other technology trends that might help you untap -- unlock new markets applications?

Yes, I'll do my best. I'm an economist. So I might blend this a little bit, but thankfully, I don't have any of our engineers here to correct me. But first of all, there's a lot of innovation across all the different things you mentioned. I mean, I think at the core of our market, there still is just kind of continuous improvement of faster, smaller with a wider read rate. Like what was new to me coming to this business 3 years ago, that I hadn't expected is just how much people are still making those trade-offs today. Like you would think, if my smartphone has 20 megapixel camera, why is it everything 20 megapixels and color? And yet we do the vast majority of our business, if we can, at the sort of 2 megapixel, 5 megapixel, black and white because why -- any introduction of incremental variables, just requires more technology or more expense or slows you down, and we want to be doing stuff, as fast as possible. So there's still, I would say, just a lot of innovation just in kind of what I would have considered sort of core stuff, right? Like that you think kind of from a consumer point of view, no one worries about how many megapixels your camera is anymore or whatnot. But, we still worry about how small a device with what chip count that we can power and so on that we can do to unlock opportunities. Beyond that, I think the biggest and most exciting growth opportunity over the last 5 years has been with deep learning and innovation there. So prior to, say, 8 years ago-or-so, all of our technology was rule-based vision, which is algorithms that if then and various statements that based on what inputs it's receiving, telling the algorithm that spit out a certain outcome. Whereas, deep learning, conceptually, is just trying to get computers to think more like humans do, via neural network and pretrained models, and so on. Where, based on training by example rather than training by rules, they can do things that otherwise machine vision couldn't do very well. The example I'd like to give is like spotting something weird going on with the wall, like if I'm looking at that wall over there, I can see a few like things going down/like there's some discoloration over there. The human picked that up super easily. To train a machine to say, "Hey, that panel of that wall needs inspection, the other 12 panels look fine," is actually really, really difficult, especially if I don't know what we're trying to spot. Is it a discoloration, is it a scratch, is it a squash bug or something like that. But by showing a company model and of images you can train it well, and spot defects that way. So first, it was just the ability to do that, and that required really high computational processing GPUs and generally hundreds or thousands of images. And then more recently, in the last 2 or 3 years, we've launched this edge learning. Our first product came to market last year, the In-Sight 2800, where you can do sort of simpler inspections on about 5 to 10 or 15 images or classifications. So it's basically not all of the power of the most sophisticated deep learning, but most of that power with dramatically lower ease -- barriers to entry ease-of-use, improve deployment. So that's been driving a lot of innovation for us, a lot of new applications. You can give it to an engineer at a plant who doesn't have a ton of vision experience, and they can take and be like, oh great, I can solve this problem, I never could have solved or whatnot. So we're still in -- we're still the technology leader in vending at sort of the forefront of bigger, faster, smarter, less -- lower cost, while also innovating significantly on ease-of-use. It's those 2 vectors, I would say.

Great. Thank you. We'll take one back here.

I was wondering, in your logistics business with as many customers, you mentioned that there are 30,000, you have 30,000 customers or 30,000 potential customers, are you typically selling directly to the e-commerce provider or do you sell oftentimes to a vendor that implements your solutions for the e-commerce provider? It just sounds like it's a -- with 30,000, it's a lot of folks to sell to, how do you get to a smaller number of people effectively?

Sure. So first, to clarify, Cognex' total customer base is about 30,000, across all of our markets. So -- and I don't have our logistics customer market, but logistics was about 20% of our business last year with meaningful customer concentration. So, I would guess that it's kind of less than 20% of that 30,000, but still a large universe. And the answer to your question is, is really we do both. We have direct relationships with end customers and that's usually our strongest relationships. But then we also sell significantly through machine builders or integrators who are doing that. In many cases, even when we're doing -- when the sale is with an integrator, the partnership is actually with both because in some cases, the integrator has full flexibility to figure out, which machine vision solution they want. In other cases, the end customer is saying, "No, we've standardized on Cognex technology. Our engineers who run maintenance in the plants are all trained on their systems, and we have a support contract with them or whatnot, so you're going to use Cognex for this." So I would say our business mix is both and our relationships are also both, but even when it's going through a machine builder, the end customer relationship is critical.

When a customer -- when a client moves his capacity, manufacturing capacity from one country to another, say, a consumer electronics company moving from China to India. Does he typically take his capacity, your products with him or does he buy a new in his new location? And then maybe just a word on typical product life cycles?

Yes. No, they're related. I mean, our products tend to last for 5 years, let's say, or more sort of very rare that they don't last at least 3 years, but usually more like 5 to 7 years. Our own lifecycle of introducing new products for a given product family, let's say, a low-range barcode reader or a mid-range 2D vision system also tends to be around that time, sort of a 5- to 7-year replacement cycle -- or sorry, new before lots of the next version of better or faster or cheaper. So because of those factors, generally, when someone is moving their plant, they're buying new. It just makes sense to do so. The scope of the investment they're making to build a new facility just say, well, let's just get the newest stuff and reset back clock of 5-plus years. So, I do think that's a benefit to us as there's more sort of diversification away from China, broadening kind of the supply chain diversification, that should lead to a little more new builds. In consumer electronics, it's a bit more of a modest impact than you would think just because most of our business in consumer electronics is pretty tied to software. It's -- there is a hardware component to it. But in Asia, in particular, and in consumer electronics, in particular, we have a higher percent of our kind of pure software business. So, it's maybe a little bit less of a benefit there than in other, but it certainly is still a benefit.

Maybe let's just pull on the thread of that last question, a little bit here with kind of 2 follow-ups. Would you talk maybe broadly about what you're seeing in consumer electronics, what are things that are going to help create opportunities for Cognex to reaccelerate that vertical market? And then also, I get a lot of questions on what China reopening could mean for Cognex. So maybe just kind of weave those 2 things together?

Yes. So you say sort of reaccelerate that market, consumer electronics had a pretty good year last year. If we take a step back, logistics was down 25%. Most of our other end markets, we target for sort of 10% to 15% growth, and automotive grew, I think, 13% last year, consumer electronics in the mid-teens or mid-double digits in constant currency, currency was a few point headwind to us. The other businesses did reasonably well. So I'd say overall, we're starting at a reasonably healthy point. The year-to-year dynamics are very hard to call, early in the year. You know us really well, Brian. So you've heard me or Rob say this 20 times. But we tend -- a lot of the business still is tied to smartphone deployment cycle. Over half of our business is still tied to kind of annual smartphone deployment cycles. The revenue for us tends to be in Q2 and Q3 from that, the bookings in kind of late Q1 and Q2. We have a sense by our Q1 earnings call, which is at the beginning of May, kind of what that year looks like. Is it a lot of innovation, a little innovation, a lot of capacity expansion. So, I would say the things that are positive is, yes, certainly broadening geographies is generally a positive for us, just diversifying away from China. China is a tough market to compete in, lots of local competition, lots of state preferences for using certain suppliers and so on. I think that's one positive for us. Last year, we grew pretty well, but it wasn't really grown based on technological innovation. When there's big technology, that's a good thing for us. Too soon to say whether this year will be a good year for that or will next year be a really big year for that. You had a second point to your question, Brian...

Well, maybe I'll just add a third while we're at it since your answer took me this way. Should we think about augmented reality, virtual reality, as opportunities for Cognex?

Yes. Medium-range opportunities for Cognex, I would say. I think -- and again, this could be one of these industries that has many false dawns, right? Like video conferencing, I felt like, I was using Skype back in 2002 and big technology was pretty clunky. And then all of a sudden, for many years, I was skeptical about these videoconferencing technology into the last 5 years, it's been amazing, right? Like it's worked really, really well. So, AR/VR could be the same thing, right? It could take a while, but it does lend itself really well to automation because, again, it tends to be very small parts, with quite a lot of technical sophistication in it. So you need powerful machine vision to do that and then to produce anything at scale, you need to do it in an automated way with machine vision. I don't think that's going to be a growth driver for us this year. I think, we're well positioned with what we're -- the relationships we have, sort of the engineering investment we make, it's still in the kind of early stages, I would say. But, could that be a medium-term growth driver for us, absolutely. Yes.

Great. Maybe just move on a little bit to a major kind of strategic initiative that you've talked about over the last several months, and that's really addressing smaller-sized purchasing customers. You're investing in a sales force, you've got a strategy, it seems to be gross margin neutral or accretive. Maybe just take us through the rationale behind that, the opportunity set and the investments you're making.

Yes. No, sure. So we got our start 40-plus years ago, as the vision scientists, right? The sort of pride ourselves on great engineers, solving the most complicated problems. If you look at kind of a pyramid, sort of solving that top of the pyramid with the fewest customers with the most sophisticated problems in machine vision. And then when you solve those, you're getting massive revenue, massive business with those customers. And that's been sort of our heritage, and then we moved down the stack to from solving customers' problems at a few hundred thousand dollars or $1 million or whatnot, then tens of millions and whatnot. And we've innovated a lot in ease of use over the last 5 years, I would say. So Cognex, I think for all the years we've been around, people would say, surveys would say, and so on, that we have the best technology. They would not have said we are the easiest to use and to deploy. And again, with large customers, we can solve that via engineering resources and customization and application knowledge and so on, and a really highly trained sales force, but that doesn't -- that model doesn't work as you go further down. Now with the innovations we've had in edge learning, which is that sort of simpler version of deep learning, trained on 5, 10 images really easy to get up and running, along with just the tremendous growth we've had in our ID business, our barcode reading business has become about half of our business over the last few years, whereas it was maybe 10%, 10 or 15 years ago. That gives us a much bigger portfolio of products to sell to smaller customers. So the kind of why we're going after, I'd say, is primarily because we have -- we feel like we have the products to be able to do that efficiently now that we maybe didn't before. And then like Cognex were pretty aggressive. We're going after it pretty hard. We're going to make about a $25 million to $30 million investment this year, primarily in kind of sales force investment. We're going to get leverage on the R&D spend we're already making. So it's not really a new R&D investment. And basically feet on the street calling on customers that historically we haven't called on or our channel partners haven't really focused on, selling the sort of simpler portfolio of goods to them. And very early days, we're sort of in pilot programs now, while we're out aggressively recruiting for folks who are going to graduate from college in early this year, or mid this year, and we'll see how it goes. But overall, we're very optimistic. There's proof of concept of this in the market, but I also don't think it's overly competitive, too. Because frequently, when we're calling on customers, they may or may not have been called on by our largest competitor. And even if they were, and we're coming a month later, the month later may have been the right time to get the sale, than it was previously.

Great. Maybe let's just move a little bit into gross margins. You've always been a high gross margin business. Price has never been kind of the gating factor for deployments from your customers, but the margins have been under a little bit duress, supply chain, currency, perhaps. Can you just maybe talk about some of the headwinds you faced this year and how you unwind some of those as we move forward?

Sure. Yes. So, you all are looking at a whole lot of different companies with -- but my bet is 75% of the companies you looked at, have had gross margin challenges over the last 2 years. I think, for Cognex what's -- and it's often many, many different factors. For us, it's one massive factor and then a bunch of puts and takes. The one massive factor for us has been broker buys. And it's basically, if they might take 50 parts to make one of our embedded camera -- smart cameras, 1 or 2 of those parts for maybe half the products are 25%, we just couldn't -- we couldn't buy at the volume we needed from the direct market. And, so we're buying them basically from kind of a third-party distributors who eat up a bunch of supply and then in downtimes, they don't do so well and they make a tiny profit and then supply constrained times, they make gangbusters. So literally like a $4 part or a $6 part, we might have been paying $200 or $400 for -- and thankfully, with our gross margin profile, we can afford to do that. And for us, disappointing our customer and not meeting their near-term needs, is worse than paying that premium even though it su*** to be the guy signing the check to pay that much money. So that's been about a 400 basis point impact for us over the last 6 quarters, last 2 quarters of 2021 and all 4 quarters of 2022, and it's reflected in our Q1 guidance of a similar impact in the low 70s. So, when that goes away, and we believe it will go away. I believe it will go away by the end of -- and I believe it will be under a 100 basis point impact by the third quarter this year. Our gross margin, all of a sudden gets way better. There are other puts and takes too. We've had core component cost inflation, meaning buying your SEMI chips from -- directly from the supplier, that's maybe costing 10% or 15% or 20% more than before. We're more than offsetting that by our own pricing initiatives. So, I'm not worried about -- we have a put and take on component cost inflation in our own pricing business mix can also shift things. Logistics is a little bit lower margin than the rest of our business. So, when logistics is down, that's kind of a benefit to gross margin, when it's up, it's a headwind, but we also get scale our fixed cost in our gross margin. So, when our revenue overall is at higher levels, we get more leverage on our fixed costs. So the other things basically all, work themselves out.

Great. We're going to end it there, Paul, you've been great with the Q&A. Audience, appreciate the questions. We will be adjourning to the breakout room to continue the discussion. Thanks so much, Paul.