The world has changed so much over the last few decades that we now take for granted things that were once not even imagined by most of us. From some of the everyday technologies we use, like cell phones and computers, to cures for once fatal diseases to self-driving cars, I’m always amazed by what scientists and engineers have been able to create.
There are a lot of steps involved for all of this cool stuff to see the light of day, and one that we can easily overlook is testing. This is done through instrumentation that’s used to observe, understand and manage the real-world (or analog) phenomena, such as voltage, current and power, as well as temperature, pressure, and more.
We all use instrumentation pretty much every day without even realizing it. Home security systems consist of sensors (like switches to detect door openings or algorithms to detect intrusion), as do refrigerators and toasters, which operate by temperature measurements, and so much more.
To conduct these tests, engineers and scientists have historically used a variety of expensive systems that operated independently and were difficult to customize. Adapting them to ever-changing needs is expensive and time-consuming, and users often had to purchase multiple single-purpose instruments.
The game has changed when it comes to testing thanks to National Instruments (NATI). This company is one of these great entrepreneurial stories where, just like some of the most successful companies in the world (like Apple, Amazon.com and Google), NATI was started in a garage in 1976 after its founders grew tired of the status quo.
Data collection methods they were using to conduct research were inefficient, and the founders set out to find that better way and simplify the process. From that garage, the company has grown to more than 35,000 customers around the world, which gives it a nicely diversified revenue base. I like that no single customer accounted for more than 3% of total sales last year.
So how did they do it? They call their approach the NI graphical system design. It is an integrated software and hardware platform for measurement and control systems that can be defined entirely by the customer, a significant improvement over traditional systems that were defined by the vendor. With NI’s products, the customer can more easily adapt to changing requirements and technologies over time. As a result, the systems are more flexible and cost-efficient, and all stages of testing are significantly sped up.
Customers generally purchase the company’s hardware and software packages together. Management believes that the strength and flexibility of its software packages help promote hardware sales.
NATI’s flagship product the last 25 years has been LabVIEW, a comprehensive development software program with hardware integration and wide-ranging compatibility that engineers and scientists need to design and deploy measurement and control systems. LabVIEW has been used in lots of interesting ways, including helping secure airports by creating a more cost and time-efficient baggage screening system, and even controlling a robot to make it walk!
Other software products include TestStand, which is used in test and measurement applications in a manufacturing environment; VeriStand, which configures real time testing applications; and DIAdem, which configures test technical data and reports back to users to help them make informed decisions.
Improving Profitability and Future Growth
While these products have helped establish NATI within its industry, the real driver of future sales growth will be new products. National Instruments believes strongly in ongoing innovation. President and CEO Dr. James Truchard cites Thomas Edison’s goal of building a small invention every 10 days and a big invention every six months. The company has plans to introduce new radio frequency (RF) controllers, a new enterprise software tool for distributed systems, big analog data for condition monitoring and a new platform for semiconductor test equipment built on the company’s PXI platform.
The pipeline of new products has caught the attention of analysts and industry consulting firms like International Data Corporation (IDC), which has said that the next few years will be a transformative time for National Instruments, as it will evolve from a test management company to an enterprise class systems company driven by opportunities in software design and big analog data management. I agree.
I like that NATI already has a solid sales base to grow from, as it has benefited nicely over the last few years from its own innovations along with industry growth and improving world economies. Revenues from 2009 through 2013 more than doubled from $676.6 million to $1.72 billion, with gross margins remaining relatively stable at high levels of 74%–77%. Earnings growth has not been as consistent, coming in as high as $1.05 a share in 2010 before falling to $0.89 a share in 2013, but it’s important to note that the lack of growth here is largely due to investments in research and development (R&D) and developing the sales force, which will benefit the company in the long term.
We’re starting to see the payoff now. Profitability improved nicely through the first nine months of this year as NATI has begun to realize some operating leverage from the sales growth. Revenues were up 4.6% to $911 million through the first nine months of the year, with the fastest growth of 8% coming in the third quarter.
Higher sales were driven by the company’s line of CompactRIO controllers, PXI sales and data acquisition products. In addition, renewal rates for LabVIEW were at record levels in the third quarter. Gross margins held steady at 74%, and a pause in R&D investments allowed adjusted EPS to increase to $0.82 from $0.57 over the first nine months of the year and to $0.37 from $0.19 in the third quarter.
For the fourth quarter, management guided for revenue growth of 9%, with EPS ranging from $0.29-$0.41 a share. If the company earns just the midpoint of that range at $0.35, earnings for the year will come in at $1.17 a share – an impressive 31% improvement from 2013.
NATI has underperformed the last couple of years, trading mostly between $27 and $33. While the market respected the company’s revenue growth, the limited improvement in profitability restricted share gains. In addition, NATI’s quiet nature and limited analyst coverage has kept the stock off of many investors’ radars.
That is now changing. With profitability improving, I believe the company can earn $1.40 a share (adjusted) next year, which would be strong growth of around 15%. I also like that NATI generates a lot of cash, giving it a very strong balance sheet with cash and investments of $448 million (or $3.52 a share) and no long-term debt. Adding to the attraction, we can collect a 1.9% dividend yield while we own it.
Buy NATI under $33 for our $40 target. This is a strong company with good growth potential. The stock is not cheap, but it’s not overly expensive considering the growth potential, so I’m assigning NATI a moderate risk rating.