Cognex Corp Q4 FY2022 Earnings Call

Greetings, and welcome to the Cognex Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Nathan McCurren, Head of Investor Relations. Thank you. Please go ahead.

Thank you, Dona. Good evening, everyone, and thanks for joining us. With me on today's call are Rob Willett, Cognex's President and CEO; and Paul Todgham, our CFO. Our results were released earlier today. The press release and annual report on Form 10-K are available on the Investor Relations section of our website. Both the press release and our call today will reference non-GAAP measures. You can see a reconciliation of certain items from GAAP to non-GAAP in Exhibit 2 of the press release. Any forward-looking statements we made in the earnings release or any that we may make during this call are based upon information that we believe to be true as of today. Our actual results may differ materially from our projections due to risks and uncertainties that are described in our SEC filings, including our most recent Form 10-K filed tonight for 2022. With that, I'll turn the call over to Rob.

Thanks, Nathan. Hello, everyone, and thank you for joining us. We continue to navigate a challenging environment. Our fourth quarter results were largely in line with our guidance, but are not representative of our long-term growth expectations. The focus of my remarks today will be on the near-term challenges we're facing, and then on the reasons why we remain excited and confident in our long-term growth opportunities. Our largest challenge within our logistics business is that we continue to see a post-pandemic slowdown with a few of our largest e-commerce customers who have temporarily reduced their investments to absorb excess capacity. Looking beyond this temporary pause, we continue to expect logistics to be our highest growth end market over the mid to long term. We also saw lower new business activity in the quarter. Bookings were below our expectations and generated less revenue in the quarter than is typical. Despite these challenges, revenue increased on a constant currency basis by 1% for the full year compared to 2021, a year where we reported strong growth of 28%. Outside of logistics, revenue from the remainder of our end markets grew in 2022 roughly in line on a constant currency basis with what we would expect over the long term. As our history demonstrates, we can experience periods of softness in between periods of robust growth. Our revenue growth target of 15% is a multi-year annual target. With that lens, revenue of over $1 billion in 2022 represented double-digit annual growth compared to 2020 and 2019. Gross margin is 71% in Q4 and 72% for the full year, which was in line with our latest expectations. Margins in both periods were below our long-term target mid-70% level due to the elevated purchase of scarce components through brokers. Before I go into detail on our end markets and an outlook for Q1, I'd like to turn it over to Paul to walk you through more of the results.

Thank you, Rob, and hello, everyone. Revenue was $239 million in Q4, a 2% decline year-on-year or an increase of 4% on a constant currency basis. This includes the approximately $20 million catch-up from deliveries that were delayed in Q3 following the fire. In addition to the slowness with a few large e-commerce customers throughout the quarter and slower business activity more broadly at the end of the year, foreign currency translation lowered revenue by $45 million or 4% in 2022 and by 6% in the fourth quarter. Looking at the change in revenue for Q4 from a geographic perspective, each primary region grew year-on-year on a constant-currency basis. Asia increased by 9%, excluding an 11 percentage point reduction from currency exchange rates. Revenue growth from semi and automotive more than offset softness from the challenging environment in China. Revenue from Europe increased by 4% excluding an 11 percentage point reduction from currency exchange rates. Growth was led by revenue from automotive and consumer electronics that offset a decline in logistics. In the Americas, revenue grew by 1% year-on-year. Lower investments by a few large customers in logistics were offset by growth in automotive, consumer electronics, food and beverage, and medical-related industries among others. Gross margin was 71% in Q4 compared to 72% in Q4 of 2021 and 73% in Q3. The decline from Q3 is due to the significant premiums we've been paying to replenish component inventory destroyed in the fire. These purchases negatively impacted gross margin by approximately 500 basis points in the quarter and approximately 400 basis points for the year. We are pleased that our broker buy activity is winding down, now that we've replenished post-fire and the supply environment has improved. We expect it will take a couple of quarters for the higher-priced components to work their way through the P&L, resulting in a minimal impact by the second half of 2023. Moving on to operating expenses. Our reported operating expenses included a fire loss in both Q3 and Q4 of 2022 and a modest restructuring charge in Q4. Excluding these charges, Q4 operating expenses increased by 3% from Q3. Comparing year-on-year, operating expenses decreased by mid-single digits, primarily due to the favorable impact of currency exchange rates and lower incentive compensation. These benefits were partially offset by the incremental investments we've been making in sales and engineering headcount. Operating margin on a GAAP basis was 23% in Q4. Non-GAAP operating margin was 24% in Q4, an improvement from 23% in Q4 of 2021 and 20% in Q3. This level of profitability is below our 30% long-term target due to lower gross margin and operating deleverage from revenue softness. The effective tax rate excluding discrete tax items was 22% in Q4 and 16% for the full year. Reported earnings were $0.32 per share in Q4. Non-GAAP earnings per share were $0.27 in Q4 compared with $0.30 in Q4 of 2021 and $0.21 in Q3, excluding the one-time charges mentioned earlier in tax adjustments. Turning to the balance sheet, Cognex continues to have a strong cash position with $854 million in cash and investments and no debt. The strength of our balance sheet enabled us to aggressively replenish components lost in the June fire. As a result, we caught up on customer deliveries quickly during the second half of the year and ended 2022 in a healthy inventory position. During the year, we also had a substantial return of capital to shareholders with over $200 million of share repurchase activity and more than $45 million of dividends paid. Now, I'll turn it back over to Rob for color on our end markets and on our outlook.

Thanks, Paul. I would like to now give a little historical context. You may remember, we went through a restructuring in 2020. As part of that action, we reorganized our R&D and engineering teams. These teams are focused on groundbreaking edge learning technology and standard product architectures that can deploy innovations more efficiently and at a faster rate. As a result of these improvements, we now have many new products coming to market in 2023. Recent product launches include our new DataMan 580. This fixed-mount barcode reader is designed for five and six-sided Cognex modular vision tunnels for use in the most demanding logistics applications. Pairing this product with Cognex 3D vision systems helps logistics customers apply a label on a package in a spot that does not cover other information on that package, a surprisingly difficult task to automate. This results in optimizing processes by increasing line speeds and traceability without lowering read rates. In another product launch, we expanded the capabilities of our Insight 2800 vision system to include deep learning-enabled optical character recognition. This allows customers to deploy powerful AI-based OCR technology regardless of their skill level. Prior industry solutions required hours of programming by highly trained engineers, preventing many companies from automating this type of inspection. Now, models can be set up and deployed directly on the device in minutes, provided users have 10 sample images. Food and beverage manufacturers will be able to easily read expiration dates, even on curved metal surfaces. Electric vehicle manufacturers can quickly locate and read the alphanumeric text etched on the bottom side of EV batteries for traceability. And logistics businesses can decipher codes and text on a variety of package types to ensure proper routing and prevent rework. We believe these products and many others planned for 2023 launch position us to broaden the market we serve and capture more share. With that, let's jump into more detail about what we're seeing in each of our end markets. Our largest end market in 2022 was automotive, which represented approximately 25% of our revenue. We reported record revenue from automotive and double-digit growth year-on-year in constant currency. This is primarily driven by the increase in electronic components in vehicles and the ongoing transition to electric vehicles. The transition to electric vehicles has generated an increase in new model introductions and demand for EV batteries. We have strong relationships with the major EV battery manufacturers who are projected to continue growth within Asia and new growth in the Americas and Europe. In the fourth quarter, we acquired Sirius Advanced Cybernetics GmbH or SAC, a German computational lighting company. Combining SAC's capabilities with Cognex's vision and AI tools equips us with an industry-leading offering for battery inspection. The SAC acquisition will support our strategy to capture a larger share of the high-growth battery inspection market. Moving on to logistics, logistics represented approximately 20% of our total revenue in 2022. After over 60% growth in logistics in 2021, annual revenue from logistics contracted by 25% in 2022. Aside from the few large e-commerce customers who reduced investment, revenue from the remainder of our logistics business grew both in the quarter and year. We believe logistics will continue to be an important growth driver for us over the long term. The market is still in the early stages of adopting machine vision; most companies are still highly reliant on labor and very few warehouses globally are realizing the full potential of automation. An example of the type of opportunities that exist in logistics is a recent win with a Fortune 50 retailer that was previously a relatively small customer of ours. In 2022, we deepened our relationship with this company, which had previously announced a multi-billion-dollar investment to enhance its shopping experience. They are establishing regional sortation centers and converting in-store stockrooms into sortation centers to pack and ship orders direct to consumers. Cognex was chosen to provide machine vision because of our best-in-class algorithms that can reliably read barcodes at angles. Our tunnel solutions enabled our customers to increase the number of products on a high-speed conveyor by reducing the gaps between them, while still reading barcodes at near-perfect read rates. After initial wins and excellent execution support, the customers asked Cognex to add value in additional areas, such as converting manual operations to automated tunnels, to offset labor shortages and costs in existing regional distribution centers. Shifting to consumer electronics, our third largest end market in 2022 represented approximately 20% of revenue. Consumer electronics grew in the mid-teens year-on-year on a constant currency basis. Growth was primarily driven by the premium end of the smartphone market, with an additional contribution from other consumer electronics products such as tablets and accessories. We had particularly strong demand for our deep learning and 3D solutions in this market. Turning now to our outlook, we expect revenue in the first quarter will be between $180 million and $200 million, which represents a meaningful step down year-on-year. You may recall that the first quarter of 2022 was an exceptionally strong one for us as we reported an unusual sequential increase in revenue, led by our second highest quarter ever for logistics. We had strong demand broadly across our business even from consumer electronics, which is typically quiet in Q1. We also caught up on $20 million of orders in backlog caused by supply chain delays in the fourth quarter of 2021. In contrast, new business activity at the end of 2022 was slower than we anticipated, and we had a slow start to 2023. Lower activity with our largest logistics customers continues, and we're also seeing a broader slowdown across many of our end markets as customers are wary of committing to significant investments. We believe gross margin in Q1 will remain in the low 70% range. The supply environment has improved and our broker buy activity has wound down; however, the impact of what we've already purchased will take a couple of quarters to flow through our P&L. We expect operating expenses in Q1 will increase by approximately 10% on a sequential basis, excluding the charges related to restructuring and the fire in Q4. This increase is driven by investments we're making in our new emerging customer sales force, along with merit increases and a weaker US dollar. Throughout 2023, we expect to see a ramp-down in the impact of broker buys and a ramp-up in our emerging customer sales force investment. From an operating margin standpoint for the year, we expect these two drivers to roughly offset. We expect the emerging customer initiative to broaden our reach, increase penetration, and further diversify our customer base, representing potentially hundreds of thousands of businesses. This customer segment is looking for automation solutions that are easy to implement, easy to use, and provide the highest performance. Our newest edge learning and ID products position us well for this initiative. To directly reach these customers, we're expanding our sales force. We've already hired the initial sales personnel focused on this segment. We will onboard and train more in the quarters ahead. We expect costs from this initiative to ramp through the first three quarters of this year. While our continued investments during a slower growth period will result in near-term operating deleverage, we believe it's an important initiative for long-term growth. We remain committed to tightly managing operating costs in this environment, and we also believe it's important to continue to invest in high ROI initiatives. We're excited about our long-term growth prospects. Though timing is uncertain, we expect large e-commerce customers to shift back into investment mode, EV battery growth to continue, China to more meaningfully reopen, and our emerging customer initiatives to start to deliver. I'm proud of how Cognex has responded in a year with many challenges. It gives me even more confidence in having the right team to deliver strong growth and new customer value together in the years to come. Now, we will open the call for questions. Operator, please go ahead.

Thank you. The floor is now open for questions. Our first question today is coming from Josh Pokrzywinski of Morgan Stanley. Please go ahead.

Hi, good evening, all.

Hi, Josh.

Just first question on sort of the 1Q guide. I know that we've gone through a decent amount of, call it, off-cycle revenue volatility with the fire and some of the supply chain stuff and the catch-up on the other side, backlog position in e-commerce. But should we think of 1Q as kind of representing normal seasonality without any kind of unusual big items as we think about the rest of the year? I know you don't give guidance, but just trying to make sure there's no other kind of noise in there?

All right, yes. So, Q1 is looking slow. We've seen slow periods like this before and we've come out of them and delivered meaningful growth. I think, you know that our business can flex quickly and it's not kind of backlog-driven as some of our peers. And additionally, we're comparing to what is a particularly tough Q1, given last year's unusually high revenue from logistics and other markets. But I think it's also fair to say that we see lower PMI data across all of the regions that we serve in our regular business, and that's certainly reflected in the activity that we're seeing, which is at a lower rate than we were expecting a few months ago. And then, of course, as I think I've explained quite a lot, the logistics business is really at a very low level, really as a result of the large customers pulling back on e-commerce spending. So, that's the kind of color that we're looking at. For those of you who have followed Cognex for a long time, we know that historically Q1 was always our lowest quarter that somewhat got changed with large logistics orders coming in or sometimes high consumer electronics business in Q1, but this looks like a quarter without any of that.

Got it, that's helpful. I appreciate that color. And then just thinking about something you said in the prepared remarks that I want to make sure I’ve understood better. A reduction in broker buys through the year sounds like a good guy. And then you mentioned a ramp in some of these target investment customers like – sorry, I get the exact phrasing wrong, but both of those sound good. Are you saying it's a ramp in the expense to develop that sales force that product capability like, is it a ramp in the expense or that customer revenue?

It's an increase in expenses. We had a significant impact on gross margin from broker buys in our 2022 results, which was around $40 million from roughly $0.5 billion in revenue. This year, we anticipate seeing about a $25 million to $30 million reduction in that expense, increasing gradually over time. In the first quarter, we expect our gross margin in the low-70s to still reflect an impact of about 300 to 400 basis points from broker buys. However, we should also see savings of $25 million to $30 million in gross margin due to those broker buys, which aligns with the investment we plan to make in our emerging customer initiative within our operating expenses. This increase will ramp up over the first three quarters, and part of it is already included in our Q1 operating expense guidance, which accounts for the sequential rise from Q4. We expect to observe more of this in Q2 and Q3.

Crystal clear. Thanks, Paul.

Thank you. The next question is coming from Joe Ritchie of Goldman Sachs. Please go ahead.

Thanks. Good afternoon, everybody.

Hi, Joe.

Hey. So, I wanted to touch on the logistics commentary a little bit further. So, as you think about the rest of the year, clearly, there is volatility throughout the year in 2022. It sounds to me like things have kind of worsened and so, while logistics might have been down 25% for the year, it's probably down a lot more maybe in the fourth quarter. I'm just trying to understand going forward, where would you expect logistics, particularly the bottom just based on what you see in the conversations that you're having with your customers?

So yes, logistics represent about 20% of revenue in 2022 approximately $225 million, and it was our second largest market, right? And it contracted. And we saw that contraction kind of increase as we earned through the year; it was relatively strong in the first half and then I think it's really a story of two different customer types. We've got regular logistics customers who are growing nicely, and we expect those to continue to grow with little less than half of that overall logistics business roughly. And then we've got large customers, very few of them, some of them pretty famous businesses, and they've all really overinvested for a period through COVID and now have really reined in investments. Some of them are going through restructuring. And that's going on right now, and we expect they'll emerge from that. Then as we get through the year, they'll start to invest again. That may not happen until late in the year or even next year, right? But we do expect to see more investment going on. But even at those customers, there's still significant work that goes on with kind of productivity improvements, regular business, regular automation projects. So, it's not like that business has gone away completely. But certainly, a lot of the greenfields, really all of the greenfields for some of these bigger customers have been stopped or significantly delayed. So, that's really the state of play.

And Joe, to your question about quarterly versus annual growth rates and so on, again, we don't consistently provide data on each end market by quarter. But I think we did call out in the Q3 earnings that Q3 2022 was a particularly unfavorable comparison. It was very low for logistics in 2022, and that was I think our highest ever logistics quarter in Q1 of 2023. So certainly, that quarter was difficult. In Q4, our growth rate or contraction in logistics was pretty comparable to the year-on-year and then I would say we're up against another tough compare in Q1. Q1 was the biggest logistics quarter of 2022 and then, obviously, there were some announcements about pauses in new capacity expansion and so on that muted our logistics revenue from Q2 to Q4 last year.

Got it. That's super helpful. If I could ask just one more; it is interesting. It was very helpful to get the color on the 2022 baseline, right, for the three biggest end markets. I feel bad asking for like the fourth but I'm curious, as one of the end markets maybe just emerged and now is like a sizable percentage of your business as well? And if you maybe want to provide, I don't know if it's in like food and beverage or consumer products or semis, but just provide some color around that end market and what your expectation is for 2023?

Yes, Joe, we discussed our major end markets, which include consumer electronics and automotive as the largest segments, along with logistics. Cognex operates in a variety of other markets, such as medical-related industries, consumer products, food and beverage, and product security. If I understand your question correctly, you're inquiring about these markets in general. They contribute solid growth for us, aligning with our overall expectations. While there is some variation among these markets, they generally continue to grow similarly to the rest of our business. But could you clarify if you were asking about a specific market?

Yes. I was just wondering whether one of the end markets has grown to be more substantial than the others. And what's really been driving that?

Yes, we have some good growth drivers, particularly in life sciences and food and beverage. However, I don't believe these will have a significant impact on our results at this time.

We have discussed this previously, but in the last couple of years, the semiconductor sector, which is relatively small for us—maybe around 5% of our business a few years ago and still under 10%—has shown significant growth. Consequently, we are witnessing some cyclicality there. Overall, growth in the medical sector has reached about 10% of our business, which we talked about at Analyst Day. Generally, aside from the more volatile semiconductor sector, trends across the diverse range of our business have remained fairly consistent.

And building on that, I think the medical business is growing nicely and steadily. And the semi business has had a great run. I think we're into a slower period as many semiconductor companies are reporting as we look.

Okay. Thank you for the color.

Thank you. The next question is coming from Joe Giordano of Cowen. Please go ahead.

Hey, guys.

Hey, Joe.

I wanted to just follow up on logistics a little bit. Obviously, it's not surprising to hear the commentary about the large players. And I think most people appreciate that the outside of those mega players, kind of like ground floor logistics is much stronger. But Rob, you talked about the declining globally. When does that start to impact that group of customers? Is it likely that PMI is trending lower below 50, that logistics or even for those people who are behind, but are they still going to reflect the economic cycle and likely decline in that sort of environment?

Right. So Joe, I think your question is how is sort of lower PMI affecting our base logistics business, is that what you're getting at?

Yes.

Yes. Yes. We have really strong underlying technology and growth trends in our base business, and we still have a relatively low share and a lot of great growth drivers. So I would say that as we're looking at that business, we're expecting good strong growth from it as we look forward. But it's not immune either to PMI activities. So we do see customers being more tentative about placing orders, longer cycles to close business, et cetera, in that space too. But the underlying growth prospects are very good, I think really regardless of the kind of PMI data we're seeing now, although it will slow it down a little bit.

Yes. Many of those customers postponed investments early in COVID and are just now starting to return to those plans. Depending on their consumer exposure, the consumer data is often more reliable than the manufacturing production data we've observed. In a low PMI environment, we may see a higher percentage of projects delayed, but generally, the investment cycles for building new distribution centers tend to extend beyond short-term economic cycles.

And then I would say, as we look at that business, too, we really have so much opportunity to grow our business in Europe and Asia where we still have low share and a lot of competitive advantage. So certainly, we're expecting outsized and seeing outsized growth in those areas of our business.

Okay. So just, is it fair to say that that base business and logistics in the environment that we're in right now, you'd still expect it to grow? I mean, things can obviously change between now and the end of the year. But given where things are, that would be a fair statement to make.

Yes.

And then my follow-up would be on the emerging customer stuff that you're doing. Where are you on the actual products? Like I know you're talking about developing like smart sensors and things that are easier to use and kind of like a different type of product than you've done historically. So I know you're ramping up the sales organization to support this, but where are you on the products themselves?

Yes. We currently have a strong lineup of highly competitive products for our emerging customer sales team to offer. There are more products on the way, and our team is active in the field, well-prepared to secure significant business from these smaller clients.

I'll pass it on. Thanks, guys.

Thank you. The next question is coming from Guy Hardwick of Credit Suisse. Please go ahead.

Hi, good afternoon.

Hello.

I know you mentioned in your introduction that the year started slowly, particularly regarding logistics and the semiconductor market. Are there any other markets experiencing weakness? Can you provide a bit more detail on that?

Yes, I believe the weakness is quite widespread as you mentioned and as reflected in the PMI data. If I were to highlight additional overarching themes, one would be the ongoing disruptions in China at the beginning of the year. Additionally, rising interest rates are complicating capital improvements, and much of our business relies on capital expenditures. I would also mention a couple of regulatory factors. The Inflation Reduction Act is expected to significantly boost EV battery investment in the United States, diverting some of that investment from Asia and Europe. Consequently, projects that we anticipated completing in Europe or Asia have been postponed as they shift to the U.S. A similar situation is occurring with the CHIPS Act, which is limiting exports to China and leading to changes among those customers. I expect that in the short term, they will be reducing their spending, but in the long run, I anticipate that they will invest more in facilities outside of China, which is also causing some delays.

So just as a follow-up, if Tier 1 logistics CapEx comes back in 2024, I mean, what are your logistics partner integrators telling you? Do discussions on projects have to start really by the middle of this year to have any impact in 2024, given typically 18-month lead times?

Yes, you're right. Was there a question there?

General what are your partner integrators telling you in terms of potential outlook longer-term? If you want to return back to the logistics growth that you referenced at the Investor Day, you've got to have kind of recovery in 2024.

Yes. It's important to note that for our large clients, we work directly with their company and often collaborate with their engineers on implementing their technology strategies and rollouts. We view integrators as additional resources to help execute these plans. Currently, we are in a lull, and it's uncertain when it will recover, definitely not in the first half of the year. We will provide more detailed information once we have something more concrete and significant this year. We believe recovery will occur, and we feel optimistic about it. However, it is unclear if this recovery will take place in the second half of this year or in 2024, and we don’t think our customers have clarity on that either.

Okay. Thank you.

Thank you. The next question is coming from Jacob Levinson of Melius Research. Please go ahead.

Hi. Good evening, everyone.

Good evening.

Regarding the acquisition of SAC that took place this quarter, it sounds intriguing. Could you provide some insight into what distinguishes this technology and its significance within the battery inspection process?

Thank you for the question. In machine vision, the process begins with acquiring an image, followed by employing vision tools to interpret that image. Cognex excels in interpreting images, especially with our deep learning technology, which provides us with exceptional capabilities in that field. However, we recognized the need to enhance our image acquisition compared to our competitors, as there is significant demand in the market for improvement. The company we acquired, SAC, is a leader in computational lighting and optics. Their technology operates like a dome of light over the image under analysis. Through controlled illumination via sophisticated software, it generates a 3D representation of the object being examined, effectively highlighting dents and scratches on surfaces. This technology performs this function rapidly and with impressive precision, setting it apart from other market offerings. This advancement will enable us to address critical needs in battery production, specifically in the electric vehicle sector. For instance, defects like dents and scratches on cylindrical batteries, commonly used in EVs, can lead to serious issues such as fires. This concern is particularly relevant as companies invest heavily in new EV battery technologies and manufacturing capacities. We believe this technology will be highly valuable and contribute significantly to our growth in the coming years within that sector.

Super interesting. And just one for Paul quickly. I know you guys prior to the fire in Indonesia that we're embarking on a supply chain diversification plan for lack of a better description, but maybe you can just update us on what you've been able to qualify some other contract suppliers or manufacturers rather?

Yes, thanks, Jacob. We have previously discussed this in our past quarters and in our latest report. Since 2021, we have been onboarding a second contract manufacturer along with a few additional sites for our main contract manufacturer. We are making good progress, and the second manufacturer is already producing in the first quarter. We are pleased with this development and the capacity to increase production further. We will continue to enhance that throughout the year. While this will be a gradual process, we believe we are moving in the right direction. Additionally, we are taking steps to mitigate supply chain risks, such as our distribution centers. We upgraded to a larger distribution center in the Americas earlier in 2022 and are exploring potential global distribution and warehousing opportunities.

Perfect. Still welcome 2023 guys. Thank you.

Thank you. The next question is coming from Jim Ricchiuti of Needham. Please go ahead.

All right. Thank you. You've given some commentary and some color around many of the end markets. And Rob, I'm wondering if you would maybe talk a little bit more about your expectations for automotive. You've got some puts and takes. Obviously, the EV market still seems like it's fairly healthy. What's your sense as you look at the automotive part of your business this year?

Yes, I am quite optimistic about the automotive market overall. Revenue from automotive in 2022 increased by 13% in constant currency, which is higher than our long-term expectations for that market. We are witnessing significant multiyear investments in new capacity, especially in EV battery manufacturing, which is being developed. Additionally, more of this investment is being directed toward the United States. We have a strong market presence and a capable team to meet the demands of these companies. Furthermore, our acquisition of SEC provides us with a powerful tool to tackle a challenging manufacturing issue. Our deep learning capabilities and edge learning tools will be highly valuable in these applications. Therefore, I believe we remain very optimistic about the automotive outlook in the coming quarters and years.

I understand that you usually don’t provide much insight into the consumer electronics market. My question is about the recent reports indicating an increase in production and a shift of consumer electronics operations to countries like India, particularly for smartphones. Are you noticing any signs of this trend? How soon do you anticipate seeing orders as this capacity develops in those regions?

Some major smartphone manufacturers are on a long-term journey to diversify where they produce their products. Recent global events are definitely influencing that trend. Production is being shifted to countries like India and Vietnam, which has been happening for several years and is now accelerating. We are receiving orders and conducting business that would have traditionally occurred in China but is now taking place in India.

Okay. Thank you.

Thank you. The next question is coming from Rob Mason of Baird. Please go ahead.

Yes, good evening. I have a question about the ongoing shift in production to markets like India and Vietnam and how it impacts our business.

Hi, Rob.

Good evening. I had a question about the growth of the emerging customer sales force. By the end of this year or over the next two years, what percentage of your sales headcount do you expect this sales force to make up?

Yes, I do think we're going to get that information just for competitive reasons. We have competitors in this space that are very tight-lipped about their own investments, et cetera. But certainly, if you do the math on kind of what Paul told us about investment, it's going to be a significant number of heads we would expect to add this year and train and put into the field. I could see this as being an initiative that's going to build, really deliver for us over many, many years as our products get better for that market and our sales force becomes more established. Maybe there's another kind of trend or data point I'd point to is like certainly a few years ago when we were talking about, and about 50% of our business was going through distribution, right? But as our products have got more powerful and easier to implement and our business has got bigger, it's really 70% of our business now is direct and only 30% through distribution. So certainly, we recognize that continued growth is going to mean continued end-user direct sales head count. And that's a path we're on and we'll continue to be on.

I understand. As a follow-up, similar to the previous question, I’d like to discuss consumer electronics. I realize you might not have full visibility at this stage of the year. Considering the previous year, which turned out better than expected, do you see any signs that suggest growth this year, considering the usual trends in that sector? Is there anything specific we should keep in mind as we plan for 2023?

Rob, I think you're right in the characterization of last year. We, as normal last year, as I'll tell you now, we really don't have a clear picture of how it's going to play out, and we'll have a much better picture when we talk next in May, and we'll give you, I think, a clearer read at that point. Last year, yes, we saw high single digits, and our growth rate was substantially north of that. So as the year played out. But there are things that drive our growth in electronics. And I think there are factors that are coming together quite nicely as we look out over longer periods, right? Certainly, continued waves of investment in consumer electronics. There are a lot of new innovations coming, and we see it particularly in areas like virtual reality and augmented reality. We see electronics manufacturers beginning to diversify their supply chains outside of China, particularly. And generally, that's new equipment that we're helping them install in those markets. And then I think a really major trend really links to deep learning and edge learning, which is the desire to replace there are millions of visual inspectors that are working in these markets today where I think COVID has made customers particularly sensitive to their vulnerability to large numbers of human inspectors. As a result, I think we're seeing a lot more interest in applying our technology to help address that vulnerability that they have. So I don't really know how this year is going to shape up; I have a lot of optimism about our future in electronics, and we'll have a clearer view on this year's kind of CapEx and timing and spending. We certainly expect to at least maintain, if not gain share with some of those large consumer electronics customers that we have, where we've built such great relationships over time. And you can see one of them referenced as one of our largest customers last year as they have in a number of years.

Fair enough. Thank you.

Thank you. The next question is coming from Paul Chung of J.P. Morgan. Please go ahead.

Hi, thanks for taking my question. I noticed that there's a significant sequential increase in the first quarter. Will the operating expenses remain above $110 million on a quarterly basis for the rest of the year? You mentioned some offsets, but how should we consider the overall operating expense levels as we approach the end of 2023?

Yes. Paul, this is Paul. We again don't have full year guidance on that. However, I think our sequential increase of about 10% is driven by several factors. It results from our investment in our emerging customer sales force and a slightly weaker dollar, which benefits us from a revenue perspective but has some negative impact on our operating expenses, along with investments in product launches and other areas. This provides a decent starting point for modeling the year. If I compare this guidance to a year ago, with a 10% average sequential increase, we are up slightly less compared to Q1 2022. We expect our emerging customer expenses to gradually increase over time. Therefore, I could see us achieving more than a 5% to 10% increase overall for the year. This projection is a combination of being very disciplined about discretionary expenses while investing in a few key long-term growth initiatives.

Great. That's very helpful. I would like to follow up on the product mix by vertical. Consumer electronics continues to shrink relative to logistics and auto, given their growth rates. How should we consider the long-term impact on gross margins? You previously mentioned that logistics has a slightly lower gross margin. How should we think about these dynamics as we model gross margins in the long term? Thank you.

Yes. I mean I think on a long-term basis, our mid-70s gross margin target is really the right way to think about that. And I expect and hope that you will be able to see that in the second half of this year. By far, the biggest contribution to getting back to that will be the wind down of the broker buys. And again, from a new purchase activity, that wind down has already occurred; absent some new crisis emerging, now it's just a function of how it flows to our P&L in the current quarter we're in and next quarter and ideally by then, we're mostly through it. The mix between industries, certainly, as logistics remains slightly dilutive to our margins overall. We have some good initiatives including the modular vision tunnel and session, some of the standardized solutions that we've spoken about before, and Rob spoke about in the prepared remarks. That I think will help on that front. But overall, the product mix factors and the industry mix factors, I feel like we're quite manageable within our mid-70s target. Obviously, as we continue to grow, we get some leverage on our fixed costs that may offset if a disproportionate out of that might be coming from a slightly lower gross margin area.

Great, thank you.

Thank you. The next question is coming from Matt Summerville of D.A. Davidson. Please go ahead.

Thanks. So really just have one at this point, Rob. Just curious about that emerging customer initiative. I guess why now? Why not a year ago? Why not a year from now? What sort of end markets and applications are you targeting? Is this broad from a geographic standpoint? And maybe more importantly, how much does this widen your TAM? Thank you.

Thank you for the question. The reason we are moving forward now is that we have the right products ready. We have been developing our edge learning technology, which you can see in our Insight 2000 and the OCR version we recently launched. Cognex is known for addressing the most challenging applications, and we have been successful in partnering with some of the most sophisticated companies to solve complex machine vision problems. However, edge learning technology makes our capabilities accessible to individuals who may not have the training of automation engineers or vision experts. Along with our ID products, which are also becoming easier to use and more powerful, we now have a broad range of products that we can provide to relatively inexperienced sales personnel that we can train. This initiative reflects our current strategy, and it’s crucial to note that our competitors hold significant market share in these areas. We are eager to introduce our products to a variety of customers across different industries who may not yet have automation or machine vision technologies but are interested in adopting them. There is significant global potential to implement these initiatives.

Thanks. And then Rob, if you've mentioned this already, I apologize. But can you maybe talk about it sounded like 2022 auto had a record year for you guys, up double-digits constant currency. What's your kind of big picture expectation for auto and EV battery this year particularly with the ongoing cutover to EV? Just maybe your overall thoughts on how auto plays out this year versus 2022.

Automotive saw significant growth in 2022, around 13% when adjusted for constant currency. We have observed positive momentum and substantial growth potential in this sector. The increase in electric vehicles (EVs), EV batteries, and the incorporation of more electronic components in automotive design, such as sensors and entertainment systems, are key factors driving the demand for machine vision. This growth is somewhat balanced out by a decline in the internal combustion engine business, particularly in powertrains, where most machine vision sales previously occurred. We remain optimistic about the long-term growth prospects in this area. While we anticipate some challenges related to the timing of EV investments, which may introduce some volatility, we believe we are entering a favorable three-year period for the industry, bolstered by our capabilities, the SEC acquisition, and various other growth drivers.

Yes, if you want a breakdown by quarter, Rob mentioned the slow start to the year more generally. I would say automotive is a part of that. There are references to some legislation that, along with PMI, may be causing delays in investment and changes in plans, which affects automotive as well. Traditionally, the automotive sector is one of our more stable industries from quarter to quarter. Therefore, we believe we are starting off slower this year. Compared to last year, Q3 was particularly low for automotive due to a fire and other factors. So, we see Q1 as being low, and ideally, Q3 should improve, leading to a more positive outlook for the second half of the year.

Thank you, guys.

Thank you. The next question is coming from Jairam Nathan of Daiwa. Please go ahead.

Hi, thanks for taking my question. I wanted to explore the auto opportunity further, particularly regarding the battery segment, as it appears to be an addition to what Cognex had previously. Considering the Inflation Reduction Act and the shift toward the U.S., how does the battery market opportunity compare to what you observed in China over the past two years? Can you quantify this opportunity? Also, last year you mentioned an addressable market of $1.5 billion in automotive. Has that figure increased in light of the Inflation Reduction Act and the battery segment?

Yes, we discussed the size of our automotive market and its long-term growth potential. We estimate it at $1.5 billion, with an anticipated long-term growth rate of 10%. This growth will likely fluctuate over time, but I believe that investments in EV batteries and their timing will contribute to higher growth rates for us, as we experienced last year, and I hope to see that trend continue in the future. There is clearly a significant demand for our technology in this area. Some of our recent initiatives, like the SEC acquisition, aim to enhance our market share and provide better solutions for our customers. We'll see how this unfolds and what our competitors do as well, but we remain optimistic. Additionally, the IRA investment plans from the U.S. government are expected to lead to increased investments in the country, where we have a strong presence, a solid reputation, and considerable experience with U.S. automotive companies that are investing in this sector. Therefore, we are optimistic about the opportunities in this space.

And just finally, related to that, I think, historically, you guys have talked about how you are more focused on the auto supply base rather than the OEMs. Is that still the case? Or do you see some of that changing, especially given the move away from ICE?

Yes, it's a really interesting question. So yes, I think historically, we've seen the majority of our automotive business being with Tier 1 automotive suppliers. And that dynamic may change over time. You're seeing a lot of kind of joint ventures and relationships between brand names and then big Asian technology suppliers. We see that playing out in partnerships. And then you see also pure-play companies that are really going to business to manufacture batteries. So certainly, there's plenty of change going on in that space. But quite where that ends up, I wouldn't claim to know. We tend to look at applications and needs and often those are driven by the end users themselves and how they're executed can be through third parties like Tier 1s or in partnerships between end user brands and Tier 1s. So yes, it's an evolving space, one I look forward to talking with you about in future.

Thank you. Unfortunately, we are out of time for questions today. I would like to turn the floor back over to Mr. Willett for any additional or closing comments.

Yes, well, thank you for joining us tonight. We look forward to speaking with you again on next quarter's call. Good night.

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines at this time.