We are reinitiating coverage of 
Garmin (GRMN) with a narrow moat and a fair value estimate of US$48. Although the firm is best known for its portable navigation devices (PNDs) used in cars (which is a business in secular decline), it has a strong position in other niche markets. We believe Garmin can continue to grow revenue in those markets to offset the decline in the auto segment. Further, we expect Garmin to generate long-term excess returns and continue to distribute dividends to shareholders. Nevertheless, we recommend a wide margin of safety before investing, as the shares currently are trading in 3-star territory and slightly above our fair value estimate.
The firm has maintained a strong position in the outdoor, marine, aviation and fitness markets, which have been profitable and growing. For example, Garmin has been delivering technology products for boats and aircraft, where GPS accuracy and reliability are critical because of possible dire consequences if the navigation system malfunctions. Some barriers to entry in these markets, such as compliance costs brought on by government regulations, may also prove to be advantageous for Garmin.
While Garmin also has successfully become one of the top consumer wearable device providers in the fitness space, we believe it faces fierce competition from Fitbit, Apple (AAPL), and Samsung. Ultimately, we believe Garmin may have to compete on price, possibly compressing margins within its fitness segment.
We think Garmin's outdoor business will grow at a 10% compound annual growth rate (CAGR) through 2020, helped partially by the acquisition of DeLorme. We expect operating margin for this segment to remain steady between 32% and 33% through 2020. Regarding the aviation segment, given the expected growth in sport aircrafts manufactured over the next five years, as indicated by the Federal Aviation Administration, along with the firm gaining traction in the business jet market, we have modelled a 6% CAGR for aviation revenue, with operating margin increasing from 28% today to 29% by 2020.
For the marine segment, we project a five-year 6% CAGR in revenue. The top-line growth coupled with lower SG&A expenses, as legal expenses are likely to decline, and R&D being a lower percentage of revenue given the Fusion acquisition in 2014, will create margin expansion, driving marine annual operating margin to 18% by 2020, from 10% in 2015.
Garmin navigates to a narrow moat
Our narrow-moat rating is due to Garmin's intangible assets from design expertise and regulatory approvals for its GPS-based technology, especially in mission-critical use cases. We also believe that as Garmin's technology becomes more ingrained within the aviation and marine markets, customer switching costs are likely to be created for its clients. The firm maintains solid profitability and we believe it has a leading position as one of the top players within the outdoor, aviation and marine navigation technology markets. Garmin has generated excess return on capital historically. We are confident that the firm's GPS expertise will help it generate modest revenue growth with practically constant margin levels in its outdoor, marine and aviation segments, which, when coupled with its overall lean operations, will help generate excess returns that are likely to continue over the next 10 years.
Garmin is one of the leading providers of GPS mobile navigation hardware and software. The company has five business segments--outdoor, fitness, marine, auto, and aviation--which represented approximately 15%, 23%, 10%, 37%, and 15% of Garmin's total revenue in 2015, respectively. The outdoor segment's offerings are sold to consumers and include mostly handheld and wearable devices used in outdoor activities like hiking, hunting, climbing, skiing and swimming. In fitness, Garmin also provides consumer wearables such as smartwatches that track various fitness and sports activities. They also include safety devices such as Garmin's Varia product that lets cyclists know of vehicles behind them. Garmin's marine products include chartplotters, fishfinders using GPS technology with sonar systems, autopilot systems for sailboats and powerboats, and communication radios. Garmin's main auto product is a line of personal navigation devices. The company also offers infotainment software to original equipment manufacturers (OEMs). Its aviation offerings consist mainly of avionic systems that include communication and navigation features used on smaller or light-sport and business jet aircraft.
We believe Garmin's technology has helped the company deliver outdoor, marine and aviation products that have proven to be independent, fault-tolerant and reliable products over time. Furthermore, we note that there are also some barriers to entry such as compliance costs brought on by government regulations. Garmin's systems have certification requirements from the Federal Aviation Administration, the European Aviation Safety Agency, and other organizations. These certifications are not especially easy to obtain, in our view.
Flight navigation GPS creates switching costs
We also think that as Garmin's more integrated, advanced and complete flight deck offerings, such as the touchscreen G3000 and G5000, make headway with OEMs like Cessna, there will be switching costs. Once some trust is built between product suppliers and aircraft manufacturers, the risk of newer suppliers possibly failing to deliver might give customers like Cessna less of a reason to look for alternative suppliers. It appears that Garmin has gained traction as its G3000 and G5000 are the flight decks installed on some of Cessna's new business jets such as the Citation Longitude and the smaller Denali. In addition, we see some switching costs associated with pilots, captains and navigators needing to learn new products and operating systems if they were to switch to another vendor.
In total, we expect operating profits from these three segments (marine, aviation, outdoor) to make up more than 65% of Garmin's total operating profits in a few years, up from 50% currently. Profitability from these segments should allow Garmin to earn excess returns on capital for the entire company.
We should note that we do not see any economic moat sources around the firm's automotive and fitness products, and expect the two segments' operating profits, as a percentage of Garmin's total operating profits, to decline significantly during the next five years. Yet, we don't expect profitability from these segments to fall so far as to limit Garmin's ability to earn excess returns on capital, in total, in the long term.
Although Garmin has gained traction in the consumer wearables space, we do not see any network effect or switching costs providing Garmin with a sustainable competitive advantage in the long run. By utilizing its navigation technology, and combining it with a variety of smartphone and fitness wearables features, Garmin has successfully gained market share. According to IDC, as of the first half of 2016, Garmin holds the second spot behind Fitbit. However, we don't see these early advantages holding up in the long run. Part of our switching cost argument for Apple's iPhone, for example, is compatibility with other iOS devices--customers are less likely to depart from the iPhone because they will lose capabilities within their Apple Watch. We don't see Garmin's wearables offering similar compatibility benefits for customers, as it has not created a large communicable ecosystem.
In an effort to expand its ecosystem and create a network effect and/or switching costs for consumers in wearables and fitness products, Garmin has added features and apps such as Garmin Connect, a desktop and mobile app that helps users analyze data related to their fitness or outdoor activities, and Connect IQ, Garmin's app store, giving developers a chance to create, customize and market various apps to run with the wearables. While we applaud these moves, we do not see much differentiation from what other companies provide in this fiercely competitive space. In the long run, we expect most of the companies in this space to face pricing pressure, as it will likely become the main differentiator.
Revenue from the firm's auto segment has been declining consistently the past seven years, as the lack of technological advantages, network effect and switching costs has allowed substitutes to displace Garmin's products. The firm dominated the PND market until 2009, when navigation apps such as Google Maps began improving and becoming more widely available for free on smartphones. Neither lower prices nor newer features, such as built-in dash cams, has helped Garmin turn around the decline in its auto segment. In addition, while the company also provides in-dash navigation systems to OEMs, it faces stiff competition from Apple's CarPlay and Google's (GOOG) Android Auto, which basically connect car infotainment systems with drivers' mobile devices and provide user interfaces very similar to what the drivers are more accustomed to on their smartphones.
