Novanta shares: overpriced in a weak demand market. Here’s Why It’s a Hold (NASDAQ:NOVT)

Novanta Inc. (NASDAQ: NOVT) is a leading provider of core technology for advanced industries. Its growth has almost flat-lined given a weak demand environment and other headwinds. I think the company’s top and bottom numbers will come back, but it is the rating is too high for me to recommend a buy rating. I rate the stock a Hold for now.

Company overview

Novanta Inc. is a technology specialist, supplying the medical and advanced manufacturing sectors with some of the most sophisticated machinery. It has divided its core offerings into the following segments:

1. Precision medicine and manufacturing
2. Medical solutions
3. Robotics and Automation

For over 30 years, Novanta Inc. has established itself as a market leader in laser technology, precision movement and vision-based systems. Over the years, it has established strong relationships with a wide, global network of original equipment manufacturers (OEMs), working closely together with them to provide holistic solutions that are part of wider and complex systems. Honing its craftsmanship over time (through substantial investment in research and development), Novanta occupies an advantageous market position in the advanced medical and industrial spaces through its intelligent and critical solutions.

Today, the company has a market capitalization of $6.6 billion, generating annual revenue of nearly $900 million. With its “sticky” business model, it typically caters to long-life customers that range from diverse backgrounds and industries. Broader tailwinds from robotics and automation have proven favorable to the company’s prospects, which it has capitalized on in an otherwise intensely competitive space.

Macro-stresses

Novanta has faced a difficult macro environment lately. Inflation has applied to almost all of its variable costs, such as raw materials, labor costs, and component prices. The company has normally been able to offset these pressures by passing on the cost burden to its customers as well as through a wide range of cost-cutting measures. However, given the weak demand climate, passing on inflationary costs to suppliers is no longer a viable solution, which already faces thin margins when passed on to end customers. Similarly, there is a limit to inflationary pressure that can be offset by cost cutting.

Given the high interest environment, last week’s US Commerce Department report confirmed a loss of momentum in US business equipment orders. Although Fed Chairman Jerome Powell has indicated that interest rate cuts are imminent, it may take an extended period of time for those effects to filter through to the real economy. Novanta’s management also hinted at a market-wide recovery in capital spending that won’t materialize until at least 2025. Note that translating that recovery into Novanta’s orders could take even longer.

The Manufacturing Purchasing Managers’ Index (PMI), by which Novanta assesses its business environment, also indicates a sustained contraction on this front:

These macro pressures have been affecting Novanta’s financial results for more than a year. In particular, the precision medicine and manufacturing segment saw a noticeable 14% decline in annual revenue in its most recent quarter. Similarly, its robotics and automation segment saw a slowdown of 6.16%. Overall, revenues managed to grow by 2.79% (despite expectations of 1.82%), driven by a 25.45% increase in the medical solutions segment.

To add, the company also faces international headwinds. Germany in particular, which is Europe’s largest economy, is undergoing a noticeable contraction, with its manufacturing PMI falling from 43.5 to 42.6. I think this is especially noteworthy for Novanta, as Germany alone accounts for 13.5% of the company’s revenue, while the rest of Europe accounts for 13.8%.

In fact, the manufacturing PMI of the 3 largest Novanta markets shows a manufacturing PMI of less than 50 for the month of July, signifying a contraction and subsequently slowing demand for industrial capital goods:

I believe these long-term PMI charts are among the most telling data sources by which to assess the broader macroeconomic climate in which Novanta operates. The United States, accounting for more than 52% of company revenue, saw a peak manufacturing PMI decline in 2024. According to Trading Economics’ global econometric models and analyst expectations, September 2024 is likely to return an even lower PMI figure.

Overall, I think it would be risky to take Novanta management’s optimism about an improved macroeconomic climate in 2025 at face value. Moreover, I think it would be even riskier to make an investment decision about the company based on these comments. For now, the best course of action would probably be to wait and watch for concrete recovery indicators and then decide to enter a position in the stock.

Financial results

Having presented the bigger picture of the environment in which the company operates, we now turn to the financial results for FY24Q2. As already mentioned above, the company posted a sluggish topline growth of 2.79%, driven mainly by impressive performance in the medical solutions segment.

Gross profit in the period fell 0.42% to $103.7 million, while gross profit margin fell 142 basis points. However, excluding the impact of the Motions Solution acquisition, the company’s adjusted gross margin actually increased by 100 basis points.

The company did very well in its operating cash flows, delivering a 57% year-over-year increase to $41.1 million. However, its operating income for the quarter fell from $33.4 million to $28.3 million.

Moving to the bottom line, the company’s net income fell from $20.9 million to $13.8 million, reflecting a 34 percent decline. In terms of EBITDA, however, this decline looked less worrying, with a decline of “only” 6.6%.

Management clearly anticipated this slowdown and set their expectations accordingly. By taking a cautious approach, the company protected its shareholders from a shock and met expectations. Even looking ahead, Novanta has made it clear that it does not expect markets to recover before 2025, and has thus set its guidance for the coming quarters accordingly.

ASSESSMENT

Looking at NOVT’s price trajectory, it’s clear that the stock hasn’t exactly seen a significant boom this year. Its sluggish 16.6% gain over the past 12 months is overshadowed by the S&P 500’s more than 27% gain. This is understandable given its relative sensitivity to manufacturing PMI.

However, despite these limited gains, the stock price remains inflated relative to its financial performance. The trailing twelve month P/E (GAAP) ratio of 106.71 is stunningly higher than the IT sector median of 29.67. Normally, when such a discrepancy exists, it is usually because the company is experiencing rapid growth, relative to the sector, in such a way that the market willingly applies a premium to its price.

Looking at Novanta’s growth metrics, we see that this is clearly not the case:

As we can see, in most growth metrics, NOVT lags significantly behind the IT sector. The only positive numbers are found in its forward values, and even these do not show a substantial lead over the sector that could justify the enormous price multiples it demonstrates. These metrics could help explain why Seeking Alpha Ratings rated the valuation side of the company an F, even though the Quant rating of 3.12 implies a hold.

Given the truly difficult macro conditions in which Novanta currently operates, such a premium cannot begin to make sense. In an ideal demand environment with high capital and industrial spending, a P/E ratio of more than 3.5 times the sector average could be justified, but certainly not in the current climate, when the company’s growth is in clearly hit and will continue. to do so until at least 2025.

Thesis risk

While macroeconomic uncertainty is clearly troubling for Novanta, it certainly does not spell doom for the company. This period of (potentially) prolonged demand slowdown will pass given the cyclical nature of the economy. Similarly, the nature of the company’s mission-critical solutions in the advanced industrial and medical sectors makes its eventual turnaround inevitable. These sectors, by their very nature, are core, making them less susceptible to long-term downturns compared to more discretionary industries.

Novanta’s strong market position, strong relationships with OEMs around the globe and deep expertise in advanced and highly specialized products are a major advantage for the future. Even in such a tough macro climate, the company managed to push slightly above linear revenue growth, which shows that it is fully capable of weathering the storm.

Management further announced that it will focus on a strategy that maximizes growth by committing to a record number of product launches, particularly in the medical device end markets. This is clearly driven by the stellar growth that has come through the medical solutions segment. Similarly, Novanta will continue to prioritize strategic acquisitions of affiliates that its team considers to be high value investments.

Overall, it’s pretty clear that the company still has a number of cards on the table to not just survive, but thrive in the long run. Its strong competitive position and brand value are sure to act as its key strengths as it moves forward in the current phase of soft demand.

Take away

NOVT is a fundamentally strong stock that is going through a difficult period of soft demand. However, despite the headwinds, the company has been able to meet expectations for almost flat revenue growth, and it looks like that will continue until at least early 2025.

I don’t see these macroeconomic headwinds continuing indefinitely, given Novante’s market strengths and the nature of the industries it targets. An eventual return to the top and bottom lines is inevitable and could be accelerated by its strategic decision to focus on new product launches in the high-potential medical device industry and through strategic acquisitions.

The only reason I think a buy rating on NOVT would be unfair is its significantly high valuation multiples. I think a Hold rating, as suggested by the stock’s Quant Score of 3.12, would be the most appropriate position on the stock.