Zebra: Post Mortem Of Why My Investment Thesis Broke (Rating Downgrade)

As a few of you might know, Zebra Applied sciences (NASDAQ:ZBRA) has been part of my private portfolio for over a yr. Nonetheless, in my current efforts to pay attention my portfolio on my finest concepts, I made a decision to promote out of the corporate on July tenth at $306 per share or a 5% loss. On this article, I am going to mirror on my errors in analyzing Zebra and what I count on from the corporate sooner or later. Whereas I offered the corporate, I nonetheless need to comply with it as it’s a high-quality firm. It’s at all times difficult to confess errors, however being open about them is a crucial a part of investing.

This isn’t my first Put up Mortem; take a look at my others and what I discovered from them:

My preliminary thesis

I first coated Zebra Applied sciences on Searching for Alpha in Might 2022 and purchased my first shares across the similar time. I used to be drawn to the inventory by a very good long-term tailwind from the warehouse automation and machine imaginative and prescient markets. These are development alternatives for Zebra. Moreover, they’ve a unbelievable market share in cell computing, knowledge seize/scanning and specialty printing/barcoding, with Honeywell (HON) being the main competitor.

I used to be drawn to the superb improvement of Free money flows, however even again in 2022, we may see that Zebra was previous its peak. Margins have been broadly constant, however the capital allocation seemed excellent: Precedence in inside investments or acquisitions assembly inside hurdle charges to extend the product portfolio, with a 1.5-2.5 occasions leverage and opportunistic share buybacks. Returns on Capital have been at 15%, a very good worth. The inventory traded at 15 occasions ahead earnings and a 4.5% FCF yield, whereas I anticipated FCF development to proceed at a teenagers price. In hindsight, that was approach too optimistic and did not contemplate the related dangers.

The place it went mistaken

Cyclicality

In my complete write-up and private notes, I didn’t point out the cyclicality of being closely uncovered to retail and industrial clients. Over the past decade, we noticed a very good financial atmosphere and Zebra grew effectively, however in 2022, fundamentals began to deteriorate. Zebra primarily sells to distributors, with three principal distributors accounting for 50% of gross sales. This leaves them very weak to destocking after stock was rushed throughout the pandemic.

We will see that free money circulate didn’t develop however deteriorated rapidly. This was primarily attributable to growing stock ranges, the settlement funds to Honeywell and different working capital adjustments. Nonetheless, even after adjusting these, we noticed adjusted money flows plummet to $450 million for the final twelve months. EBIT and gross revenue margins stayed per a slight deterioration in order that the bull case could possibly be a return to historic money conversion.

Bettering income high quality

My bull thesis included the continual transition from {hardware} gross sales to companies and software program gross sales. This is able to counteract cyclicality and make revenues extra steady and predictable. Whereas clients may delay shopping for new units, they would not cease utilizing the present ones so rapidly. Zebra has extra software program engineers than {hardware} engineers, which I favored, however {hardware} gross sales account for 79% of income. Whereas the gross sales combine continued to shift, it was not significant sufficient to counteract the cyclical nature of the enterprise. As a substitute, I made a decision to place my cash into Napco Safety (NSSC), an organization with the same technique of enhancing software program gross sales. Sadly, I added to Napco earlier than it plummeted to an accounting challenge. At Napco, recurring gross sales are rising quickly and are anticipated to achieve 50% of income within the subsequent few years.

Lack of M&A info

Zebra has been fairly aggressive with M&A over the past decade, however they hardly share details about the acquisitions’ progress. The corporate solely experiences in two segments: EVM (Enterprise Visibility and Mobility) and AIT (Asset Intelligence & Monitoring). These present little info and make it arduous to see if costly acquisitions like Matrox work out. I would like that investor relations be extra clear with traders, particularly as fundamentals deteriorate.

Rising debt

As a result of weak spot in money flows, Zebra needed to lever the stability sheet with over a billion in debt taken on since I began my place. The leverage degree remains to be okay at 1.9x, however the firm wants to start out producing money flows once more to handle it. A lot of the borrowed cash went into buybacks, which didn’t go effectively, whereas fundamentals deteriorated quicker than administration anticipated.

Deteriorating outlook

The FY23 outlook for Zebra deteriorated quickly over current quarters. In This autumn 2022, Zebra guided for FY23 with web gross sales between -3 and +1% and a 22-23% AEBITDA margin with $650 million in Free Money Flows for the yr. Under, we will see the up to date outlook after two quarters. Gross sales outlook fully collapsed to a 20-23% decline, AEBITDA margin is anticipated to be 400-500 bps decrease and Free money circulate is anticipated to be detrimental for the total yr. This exhibits how quickly and violently fundamentals deteriorated and the way unhealthy the cyclicality hit Zebra.

Valuation is alright

To worth Zebra, I am going to use an inverse DCF mannequin. I adjusted FCF with web working capital adjustments and added the settlement funds. This leaves us at $453 million in proprietor earnings. Zebra must develop Proprietor earnings by 15% over the subsequent 5 years, adopted by 10% the next 5 years. This doesn’t appear unrealistic if the macro is of their favor once more and distributors return to stocking their inventories. I lately began to extend my low cost price on cyclical firms to account for the added threat; I began my funding in Zebra at a ten% low cost price, so I am going to maintain it for this valuation, however remember the fact that one could possibly be extra conservative and use the next low cost price. I’ll proceed to comply with the corporate from a distance and see the way it manages to show across the fundamentals. I discovered quite a bit from my funding in Zebra and managed to get out with solely a 5% loss. I’ll price Zebra a maintain as a result of it stays a very good enterprise.