MorningWord 10/27/14: Recalculating $GRMN

by Enis October 27, 2014 9:30 am • Commentary

Correct vs. incorrect timing is often the key differentiators of a good trade.  I’m not just referring to whether your entry or exit was timed well.  I also mean the timing of a fundamental thesis, such as when the market will start to pay attention to the key drivers of a stock, whether higher or lower.  The key drivers might be moving in your anticipated direction without the stock joining.  Stock market history is filled with months or years on end where the fundamentals have improved while a stock has stagnated, or vice versa.

Garmin was upgraded by GS Research this morning, and the stock is up 3% in the pre-market.  After reading the analysts’ report, my first impression was that my view on the stock differs from theirs mainly because the analysts are taking a one to two quarter view on GRMN, whereas I’m thinking one to two years out.  Timing.

Here was their rationale for the upgrade:

GRMN has pulled back to $55 from its July high of $62, we think on concerns of cannibalization from the Apple Watch and the broad-based market sell- off. We view this as an attractive entry point for three reasons: (1) we see upside to estimates into 4Q and 2015 driven by the Outdoor/Fitness and Auto/Mobile segments; (2) Garmin is finally transitioning to sustained growth after five years of declines, as PNDs shrink to <30% of sales and <20% of profits in 2015, while fitness products drive outsized growth as Garmin rides the wearables and wellness waves; and (3) Garmin consistently has a top- quartile CROCI in the sector. We see 16% upside to our price target.

Putting aside all the acronyms, the analysts are essentially saying they are optimistic about holiday season sales for Garmin’s fitness products, they are not as concerned about continued contraction in the Automotive GPS segment because it has become a much smaller portion of the overall business, and GRMN has achieved strong return on capital metrics throughout the past 5 years.

I took off a profitable bearish trade on GRMN early this month.  Here was my original rationale for the trade:

I have been bearish on GRMN for the past 6 months because the stock’s valuation has expanded in the past 2 years even as the underlying business has not materially improved in my view.  The stock trades at a 17x P/E, with expected EPS growth of only 3% over the next two years.

I would much rather be the dominant leader in one growing category, as Garmin was in the GPS arena before the smartphone took over, rather than a hustling competitor in various growth categories, which is Garmin’s current situation in the wearables market.  Two-thirds of Garmin’s EPS still comes from the automotive GPS segment, where revenues are expected to continue to decline.

Apple’s entry into the wearables sector is simply the latest headwind for Garmin’s desperate hardware strategy. Management has actually done an admirable job of filling in the revenue gap from the decline in GPS use. Nonetheless, the long-term business prospects for Garmin are murky and difficult at best.

The GS analysts are very focused on whether GRMN can beat consensus estimates for the holiday season. One positive they cite is that since Apple Watch does not come out until early 2015, it won’t compete with Garmin’s fitness watches for holiday sales.  In addition, the Apple Watch does not have built-in GPS, and is somewhat higher end than Garmin’s existing offerings.

While I don’t disagree with that analysis, I do disagree on their focus on only the next 6 months.  Apple Watch and increased competition in the smart watch sector is undoubtedly going to impact Garmin’s fitness and outdoor business.  As the smart watch ecosystem proliferates, Garmin will have increasing difficulty differentiating itself and its products.

Moreover, my skepticism regarding Garmin all along has been the sustainability of its current lead in the fitness and outdoor segments.  The GS analysts cite the secular trend in favor of those sectors, such as expected fitness band growth:

Screen Shot 2014-10-27 at 9.19.08 AM

However, that does not necessarily mean increased profitability.  Oftentimes, a niche business is more profitable than a high volume business in a competitive sector.  My hunch is that Garmin will encounter significant margin problems as competition increases over the next 1-2 years.

At a P/E of 18x with expected sales growth of 2% and expected EPS growth of 5% over the next 2 years, GRMN’s valuation looks rich to start.  Considering my view that the business risks are skewed to the downside as well, I don’t see the bullish case for GRMN at these levels.  Having said all that, the GS analysts present good evidence that the holiday season could be a good one for GRMN.  With that in mind, I’ll hold off on a trade for now, but will be looking to fade strength into or out of this holiday season.