Gentex: When Bigger is Not Better[Fool on the Hill] April 17, 2000

An Investment Opinion

Gentex: When Bigger Is Not Better

By Brian Graney (TMF Panic)
April 17, 2000

One trend that investors have seen in the stock market over the past several years has been the rise of the big firms at the expense of the small. In sector after sector, there are plenty of specific examples of where this has been the case. Who wants to own Wet Seal when you can own Gap, or Bank of Granite when you can own Citigroup? Regardless of how well the smaller companies may be performing from a business standpoint, the overriding investing philosophy in many areas has been to shun the small and load up on the large.

In a lot of ways, going for the big fish of American business instead of the guppies makes a good deal of sense. Larger businesses have, ahem, largely consolidated their smaller brethren over the past decade or so, wringing cost efficiencies out of the combined systems in the process and strengthening their competitive positioning through economies of scale and vastly improved bargaining power with suppliers. Those smaller firms that were not gobbled up or did not find a way to compete along the same lines as the industry leaders have been, in many cases, run right out of business.

Given the tenor of this environment, it's no surprise the market-capitalization-weighted return on invested capital of the "big boy-heavy," 360 member-plus S&P Industrials index rose from 15% to 26% between 1995 and 1999, according to research by Credit Suisse First Boston analyst Michael Mauboussin. One notion that can be taken away from this statistic is that the more efficient the business, the higher the returns -- from both a business economics and a share price appreciation standpoint. All of this supports the here-and-now viewpoint among investors that "size matters." And in many of today's sexiest industries, it can matter a whole lot.

One area where this strategy has backfired in a big way of late is the cyclical, humdrum business of auto parts. Granted, auto parts is about as sexy as George Will on a bad hair day. But following the recent de facto trend in other industries, one would think that any investor money directed toward auto parts would be flowing into the large players, such as Johnson Controls, Dana Corp., and Federal Mogul, where the efficiencies associated with consolidation are supposedly being reaped.

In fact, just the reverse is happening, as all three of those firms (and many others) have watched their share prices tank over the past year or so while smaller companies have raced ahead. One small company in particular that has bucked the "buy it big" trend and is attracting more attention relative to its larger auto part peers is Gentex Corp. (Nasdaq: GNTX), whose main business is supplying electrochromic automatic-dimming rearview mirrors that cut down headlight glare at night. As a business focus, that's about as narrow as Ally McBeal's waistline.

But despite its niche status, Gentex has been growing faster than the overall auto parts industry for many years. The firm's automotive-related sales rose 19% last year, as net income jumped 29% and mirror shipments increased 22% year-over-year. As a result, Gentex's share price was driven up for a 38% gain in 1999, which followed 49% and 34% jumps in 1998 and 1997, respectively.

An indication that the Gentex growth train is still on track in 2000 came this morning, when the firm turned in its first quarter results. The facts and figures included much of the same -- total revenues up 13%, mirror shipments up 16% from a year ago, earnings per share up 14% and in line with analysts' expectations. The firm also makes photoelectric smoke detectors, but automotive mirrors make up more than 90% of total revenues and operating profits.

The nice thing about a niche player like Gentex is that even though its ability to drive the bottom line through increased internal efficiency is rather limited, the opportunities for growth within its targeted market are not. By its own estimate, the company dominates the market for automatic dimming rearview mirrors with an 86% share. However, that's small potatoes considering only an estimated 10% of all rearview mirrors produced each year are of the automatic variety.

Of course, supplying high-end interior rearview mirrors does not sound like the most defensible, long-lasting business in the world, especially considering the nature of auto parts. The auto industry has a way of introducing new technologies and safety systems in its pricey luxury models first, with the innovations gradually working their way down through the rest of the product lineup. Witness the recent proliferation of passenger side air bags and anti-lock brake systems. Needless to say, by the time auto dimming mirrors eventually show up in every brand-new Chevy S-10 pickup driven off the dealer's lot, most of the profits from the supplier's point of view will have been already sucked out of the product.

But until that day arrives, Gentex is having a great time flying under the radar of the larger auto part suppliers. Making its mirrors standard equipment on a greater percentage of new vehicles is a primary goal and could provide the firm with plenty of growth for many years by itself. Long-term supply agreements have helped ensure that each year Gentex's mirrors find their way into more makes and models, both domestic and international. With only a few direct competitors, profit margins are not under any kind of major threat and have actually ramped up to 25% from 19% over the past three years. Those high margins translate into plenty of operating cash flow for covering annual capital expenditures, allowing the company to operate without a lick of debt.

Steady free cash flow is important as it allows a small company like Gentex to search out and beat its larger rivals to the next growth market. Among the areas management is targeting are three-way systems of interior and exterior auto-dimming mirrors and developing cost-effective, high-intensity light-emitting diode (LED) interior lighting technologies, which one day could replace traditional incandescent lamps.

If it executes as it has in the auto-dimming mirror market, the LED opportunity could propel Gentex into the big leagues of the auto parts industry and perhaps into other industries as well, since cars and trucks are not the only products out there that require interior lighting. However, that's a long ways out. In the meantime, Gentex will continue being a big value creator in a small body -- an increasingly rare and lucrative combination in an investing environment where the current bias favors the concept that "big is better."