Is the Short Term Risk Worth Taking for This Growth Story?

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Anyone left with any residual doubt that the industrial sector is slowing would only need to look at Cognex’s (NASDAQ: CGNX) latest set of results in order to have their worst fears confirmed. Overall revenue was flat and sales in its factory automation segment were only up 4% and were flat on a sequential basis. However, don’t be too put off by this intro. This stock has some great long term growth drivers and is well worth a look for those willing to take a long term view.

Introducing Cognex

Cognex is the global leader in ‘seeing machines’ that monitor automated processes in factories. Of course its products will see their earliest adoption in industries that are heavy users of robotics, so it is no surprise to see that automotive is its biggest industry vertical. In fact, the early adopters tend to be in the highly cyclical industries and this means the company is exposed to movements in global industrial output.  I’ve written a primer post on the company in an article linked here, and I would encourage those who don’t know the company to read it first.

There is not much that Cognex can do to reduce the cyclicality of its end market customers, but it is trying to diversify and sell into other industries that are only starting to use advanced automation. In addition, it can expand into new geographies that are adopting vision machines as part of their manufacturing processes. Longer term investors can expect more focus on end markets like medical devices and logistics, but for now it is the automotive and consumer electronics that guide its revenue movements.

A quick look at the revenue split demonstrates the reliance on industrial production.

Turning to the actual results, the story is on one of weakness in areas like semiconductors and solar (which declined by $10 million alone) with some stronger sectors like automotive, logistics and medical.

Cognex Q3 Results

Looking in more granular detail shows 4% growth in factory automation offset by weaker results from the electronics industry, while the semiconductor segment revenues were down 5%. With regards to semiconductors, Intel (NASDAQ: INTC) recently lowered expectations for full year revenues, and there is no sign of the anticipated recovery in the electronics market in 2012. Going by Intel’s guidance for gross margins, things are going to get worse before they get better for the industry.

There is better news if we look at Cognex’s biggest industry vertical, which is automotive. I always think it is interesting to look at what Alcoa (NYSE: AA) is saying about their end markets. In fact, a quick look at Alcoa’s recent results reveals that the automotive sector is the only one that it has raised guidance for in 2012. In fact, Cognex’s overall factory automation closely mirrors what Alcoa is reporting by geography.

Going forward, the great imponderable will be China. There are signs of the economy slowing but Cognex can still generate growth thanks to the relative under penetration of its type of machines within factory automation in the country. Factory automation revenues grew 42% on the year and 12% sequentially while Japan declined 13% and 11% sequentially. The latter is a concern because there are some political differences that are causing a boycott of Japanese electronic goods by Chinese consumers. As for China, Cognex’s management was clear that there is a lot of short term uncertainty here.

Moreover, part of the growth this year has come from the launch of four new products and the acceleration of growth in less mature industry verticals like ID products in logistics. I think this is a key area of growth, and if you look at something like Roper Industries (NYSE: ROP), you can see that RF devices and ‘smart’ technologies are increasingly being adopted by this traditionally conservative industry. I‘ve discussed Roper here, and while its latest results demonstrated revenues in the RF segment down 1%, operating profits increased 10% with strong growth traffic and freight matching software.

Indeed, as e-commerce revenues are likely to grow as a percentage of overall retail sales then the pressure for the likes of Fedex (NYSE: FDX) and UPS to introduce such technologies will only increase. In addition, as both logistics companies are seeing slower growth in light of weaker global trade, they should be looking to introduce measures that generate long term operational improvements.

Where Next For Cognex?

Cognex looks set for strong growth in the years to come. Secular demand trends from increased factory automation and robotics should ensure good growth. Moreover, it should start to diversify its revenue streams so as to find a way to reduce cyclicality. The long term China growth story is intact but the concerns here are with the short term.

Frankly, I haven’t heard anything positive coming out of the semiconductor and solar industries in quite a while, and it is safe to conclude that the near term risk is on the downside here. As for China, I think a cautious approach needs to be taken here and, to be fair, Cognex is downplaying expectations. All of which leads to a classic investment conundrum. Do you want to buy a stock whose long term prospects you like but which you also consider to have near term downside risk?  Cautious investors may want to wait and watch events in China.

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SaintGermain has a position Roper Industries . The Motley Fool owns shares of Cognex, FedEx, and Intel. Motley Fool newsletter services recommend Cognex, FedEx, and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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