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Morningstar | Garmin 4Q Results Surpassed Expectations; Raising FVE to $70; Shares Slightly Overvalued. See Updated Analyst Note from 20 Feb 2019

Garmin reported better-than-expected fourth-quarter results as acquisitions and organic growth in the firm’s narrow-moat segments along with fitness more than offset expected decline in auto. Strong growth in the higher margin outdoor and aviation segments drove overall gross and operating margin expansion. Management provided revenue guidance above our projection and consensus, helped partially by the recently announced acquisition of Tacx, a maker of widely used indoor bike trainers. However, the firm expects a slight decline in operating margin in 2019, after which we think it will expand again. We adjusted our estimates higher accordingly, and after rolling our model forward, we raised our fair value estimate of Garmin to $70 per share from $62. Our fair value estimate represents 2019 EV/Sales and EV/EBITDA multiples of 3.3 and 12, respectively, which we think is appropriate for a firm growing its top line at a single-digit rate accommodated with slightly lower margin this year, followed by moderate margin expansion through 2023. Garmin did raise its 2019 dividend by 8% that now yields 2.7%. We think this narrow-moat and high uncertainty name is now overvalued as the stock is surging 16% in response to fourth-quarter results.

Garmin’s total revenue of $932 million during the quarter represented a year-over-year growth of 4%. Outdoor and aviation segments led the way with their revenue increasing 25% and 22%, respectively. Product refreshes, like the fenix 5 watches which were launched in late 2017 and include new features such as payments capabilities, music storage, and pulse oximeter (which measures blood oxygen levels), drove outdoor revenue growth. With launches of Descent watch (a dive computer with GPS navigation) and the more rugged Instinct watch mainly for hikers, plus likely the next version of fenix (fenix 6), outdoor revenue is expected to grow at least 10% in 2019, according to management.

Aviation revenue grew 22% year over year to $158 million as the segment continues to benefit from adoption of ADS-B (Automatic Dependent Surveillance-Broadcast), which helps more easily and quickly track planes using satellites to broadcast their position rather than radar, the latter of which may not allow planes to fly as directly from one location to another. The FAA requires planes to be ADS-B enabled by January 2020. By the end of 2019, most of the planes with an ADS-B requirement will likely be equipped according to Garmin. We think growth in aviation revenue, which the last two years has been on the back of more Garmin ADS-B solutions being deployed, is likely to decelerate in 2020. However, as more Garmin ADS-B solutions are being used, there will likely be more switching costs, which we have long viewed as one of Garmin’s aviation moat sources. For this reason, while we may see slower growth in aviation post 2019, we believe the firm is well-positioned to cross-sell other aviation products, thus limiting the slowdown in growth and strengthening switching costs, possibly creating further barriers to entry.

The acquisition of Navionics in late 2017 helped Garmin post impressive 13% growth in marine revenue. The deal has already led to the launch of Garmin’s Panoptix LiveScope which with its video capabilities makes the jobs of fish finders easier. Marine’s revenue increase was also driven by the exclusive supplier deal that Garmin closed with Sportsman Boats in mid-2018. Going forward, management expects this segment to grow around 10% in 2019. We have modeled an 11% growth as we think the unique and innovative features of LiveScope are likely to generate sales higher than expected.

The fitness segment during the quarter was pretty much flat compared with last year, with revenue of $277 million. However, for the year, fitness revenue was up nearly 13% driven by some refreshers including Vivosmart 4. Garmin also added indoor products to its fitness product portfolio as it announced its intention to acquire Tacx, maker of widely used indoor bike trainers based in Netherlands. While no figures were disclosed, management said sales of Tacx likely will represent about half of the 13% growth that is expected in fitness in 2019. The acquisition is likely to close in the second quarter.

While the Tacx deal may create some cross-selling opportunities within the fitness segment, we continue to believe that the popularity of basic tracker wearables is declining, and will create further pricing pressure, which we think will continue to force the firm and its peers to further invest in more advanced wearables. In 2016 and 2017, investments in R&D in this segment outpaced increase in sales and grew at the same rate as revenue last year. We expect R&D expenses to go up at least at the same pace as revenue during the next five years, limiting margin expansion in that segment.

The secular decline in the PND market continued as Garmin’s auto segment posted a 28% year-over-year revenue decline. We foresee such weakening of the auto segment to moderate slightly but are still expecting more than a 5% average decline during the next five years. While management hinted that auto may return to growth after 2020, we remain doubtful as currently there are many substitutes for those products that are well integrated in the widely used consumer mobile devices and in cars’ infotainment systems.

Fourth-quarter operating margin improved 350 basis points to nearly 24% with strong top-line growth in outdoor, aviation, and marine generating operating leverage which more than offset the continuing decline in the auto margins. While higher gross margin is expected this calendar year, management guided for slightly lower operating margin in 2019. The dip expected in operating margin is mainly due to the Tacx acquisition, which likely will push SG&A higher. Plus, we think higher investments in fitness R&D to better integrate the platforms behind its wearables with Tacx indoor products are necessary for the firm. However, given the continuing high demand for Garmin’s high-margin aviation and outdoor offerings due to ADS-B requirements and new product launches, we think 2019 operating margin is more likely to be comparable with what we saw last year, a bit above 23%.