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Gentex GNTX

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By IMRichdad
July 13, 2006

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

This is a follow up to a post I made on this board sometime back (a link is below). Some have suggested more emphasis should be placed on DD on this board. Here is my attempt at doing just that.

Gentex is an auto parts supplier that has fallen on hard times along with the rest of the industry. The stock closed Friday at $13.15 per share (a new 52-week low). The stock hit its all time high of $22ish back in December of 2003 and it has been a long, excruciating decline for shareholders. I am pleased to report that I am not a current shareholder but was considering shares in December of 2003 and never pulled the trigger. The stock has been on my watch list on and off over that time frame.

Initially, the fall in stock price could be attributed to a slowing of earnings growth from the high teens to low twenties down to virtually flat-line last year. This compares to a negative 20% growth for the industry average in 2005, owing to the cyclic nature of the auto industry. So, maybe, flat-line isn't so bad?

More recently, the declines can be attributed to concern over what GM's (and to a lesser extent Ford) situation will have on parts suppliers as a whole. The most recent news being that a potential Renault/Nissan alliance with GM could put additional pressures on parts suppliers to lower prices (and margins) even further than they already have.

Gentex is putting the finishing touches on a major plant expansion at its home office site in Zeeland, Michigan. When finished, the plant will double manufacturing capacity and management has emphasized potential improved efficiencies can be expected.

Historically, Gentex has been able to maintain relatively high profit margins (best, or nearly best in the industry, BTW) even in the face of price cut demands by the OEM's. Margins have been maintained through improved efficiencies and through improved (more profitable models) designs.

A Little Business History

The following historical description of Gentex is basically from the 2005 10K, with a little editing to make it, almost, pleasing to read:

Gentex designs, develops, manufactures and markets proprietary products employing electro-optic technology: automatic-dimming rearview mirrors and fire protection products.

Gentex got its start as a manufacturer of residential smoke detectors in 1974. Product line enhancements later led to commercial applications. An automatic interior rearview mirror for automotive application was first introduced in 1982 which offered an alternative to the manual day/night mirror you are most likely familiar with. An interior electrochromic (EC) auto-dimming mirror was the first successful commercial application of EC technology in the automotive industry and the world. This mirror is continually variable and automatically darkens to the degree required to eliminate rearview headlight glare. Gentex introduced an exterior version of the auto-dimming mirror in 1991.

SmartBeam, Gentex's newly developed, intelligent high-beam headlamp (automatic high-beam control) control feature began shipping for the Cadillac STS and Jeep Grand Cherokee in 2004. Also during 2004, the Company began making shipments of its auto-dimming mirrors to Peugeot, the Company's first automotive OEM customer in France.

During 2005, the Company began shipping auto-dimming mirrors with SmartBeam for the Cadillac DTS, the Jeep Commander, and BMW 5, 6 and 7 Series.

In December 2005, the Company reached an agreement with PPG Aerospace to work together to provide the variably dimmable windows for the passenger compartment on the new Boeing 787 Dreamliner series of aircraft.

Over the years, Gentex has continually added features to auto-dimming mirrors it produces. Features that have been added to the mirror include an electronic compass, outside thermometer, LED map lamps, and an OnStar (R) interface. OnStar is the registered trademark of OnStar Corporation.


Initially, Gentex supplied mirrors primarily to GM. But in more recent years has expanded its sales to virtually every automotive OEM � even Kia.

Currently sales can be divided among OEM's as follows (from the 2005 10K):

During the years presented, the Company had four automotive customers, which individually accounted for 10% or more of net sales as follows:


                     Customer
           ----------------------
                                           
           #1        #2       #3        #4
           ---       ---      ---       --
2005       24%       14%      12%       11%
2004       31%       13%      13%        *
2003       38%       12%      13%        * 
 
* less than 10%



It is widely recognized that Customer No. 1 is GM, I am unsure as to the identity of the others. One conclusion stands out from examination of this table; sales to GM makeup a large percentage of Gentex sales. It is because of this fact that I passed on Gentex shares in 2003. However, things are a little more palatable now, but recognize that significant improvement at GM will be driven by increased sales there and also at Gentex, so the percentages may return to near 2003 levels should a turnaround occur.

Competitive Advantages

Gentex's primary competitive advantage is the numerous patents held on the products it invents and manufacturers. It is also a very efficient manufacturer who in the face of continual pressure from OEM's (GM does this constantly) to lower prices, has been able to maintain net profit margins remarkably well.

Competition

Here is what Gentex has to say about its competition in the 2005 10K:


Gentex is the leading producer of auto-dimming rearview mirrors in the world and currently is the dominant supplier to the automotive industry with an approximate 80% market share worldwide in 2005, as compared to an approximately 78% in 2004. While the Company believes it will retain a dominant position, one other U.S. manufacturer (Magna Donnelly Mirror Systems) is competing for sales to domestic and foreign vehicle manufacturers and is supplying a number of domestic and foreign vehicle models with its hybrid or solid polymer matrix versions of electrochromic mirrors. In addition, two Japanese manufacturers are currently supplying a few vehicle models in Japan with solid-state electrochromic mirrors.

On October 1, 2002, Magna International acquired Donnelly Corporation, which was the Company's major competitor for sales of automatic-dimming rearview mirrors to domestic and foreign vehicle manufacturers and their mirror suppliers. The Company also sells certain automatic-dimming rearview mirror sub-assemblies to Magna Donnelly.

The Company believes its electrochromic automatic mirrors offer significant performance advantages over competing products. However, Gentex recognizes that Magna Donnelly, a competitor and wholly-owned subsidiary of Magna International, is considerably larger than the Company and may present a more formidable competitive threat in the future. To date, the Company is not aware of any significant impact of Magna's acquisition of Donnelly upon the Company; however, any ultimate significant impact has not yet been determined.

There are numerous other companies in the world conducting research on various technologies, including electrochromics, for controlling light transmission and reflection. Gentex believes that the electrochromic materials and manufacturing process it uses for automotive mirrors remains the most efficient and cost-effective way to produce such products. While automatic-dimming mirrors using other technologies may eliminate glare, each of these technologies have inherent cost or performance limitations.


I don't know anything about Magna Donnelly. But I've worked as an engineering consultant to Donnelly before they were bought out (or merged) by Magna. At that time (it was about 10 years ago, I'd guess), Donnelly was a highly regarded company in the community that employed a lot of people. However, the management style of the company was that of "ruled by committee." It was a very difficult environment in which to work as a consultant as meetings were held periodically and decisions never seemed to be made for one reason or another. It wasn't the committee structure itself that was so difficult, it was just that if someone key wasn't at the meeting that may (or may not) have an opinion on the matter, the issue was tabled until the next meeting. Trying to get a major project completed within an aggressive schedule is difficult enough, doing it with a committee that cannot make decisions timely is nearly impossible.

All the consulting engineers with whom I worked on that project came to wonder the same thing: How can Donnelly ever get anything done?

Based on my limited experience with the competition, I would be extremely surprised if they mounted any kind of real competitive threat. This potential threat has been widely recognized on "the street" and can be considered "discounted" in the current stock price.

My first hand knowledge of Gentex is nil. I lived within 3 miles of there home office and plant for the better part of 13 years. They are a highly regarded company with a strong presence in the community.

Of course, from time to time there are articles in the local paper discussing recent happenings at Gentex. I posted my comments regarding one recent article concerning the sudden departure of the heir-apparent to the CEO's job:

http://boards.fool.com/Message.asp?mid=24008691

My take from the whole situation discussed in the thread is that management acted in the best interest of shareholders and not in their own personal best interest. This is a trait I specifically look for in a company and it is what has renewed my interest in the shares.

Personally, I prefer to invest with the industry leader � the "best of breed", as a certain guru is fond of saying. Gentex is beyond a doubt (in my mind anyway) the best of breed. In addition, it is run by capable and honest management not willing to sell out the shareholders for their own benefit, IMHO. A refreshing change of pace, from the stock option abusing companies so often discussed in the press.

Growth Drivers

Looking forward, growth will come from added features and further market penetration for the interior and exterior auto-dimming mirrors already on the market. Only 18% of the 59 million light vehicles produced annually around the world currently offer an interior electrochromic mirror and just over 5% had at least one auto-dimming exterior mirror. That means Gentex, with current annual mirror sales exceeding $500 million, stands to gain the lion's share of an auto-dimming mirror market that may one day reach $2.5 - $3 billion.

Growth will be further advanced by the market penetration of its SmartBeam auto-dimming headlamps recently brought to the market place.

A big wildcard here is the agreement signed with PPG Aerospace for providing Boeing's 787 with variably dimmable windows for the passenger compartment. No details of the agreement have been announced, but I think it's safe to say that profit margins will be a wee bit better in the airline industry than in autos.

The bringing on line of the new factory addition is expected to improve efficiency across the board and should add to the bottom line as well.

Much hinges on a turnaround of the auto industry as a whole. You can't live in Michigan for the better part of 47 years and not know a thing or two about the auto industry. It is highly cyclical and its cycle is not necessarily tied to the economy as whole. It has always recovered. This particular trough in the cycle is about one year old by my recollection. It may go another 3 or 4 years, but it will recover as cars sold in past years wear out � about 5 years. But before that, expect share prices of auto related companies to begin to recover in anticipation of a turnaround. Before that, I plan to own shares of Gentex � Mr. Market willing.

Valuation

The earlier post, linked above, contained my first blush rough cut valuation of about $18 per share based on a dividend discount modeling of the equity. In hindsight, that valuation was based on too optimistic assumptions about growth and failure to account for necessary adjustments to GNTX's financial statements.

Here I will present my current analysis, step by excruciatingly long step. (For those still learning like me, it may be instructive. For those more skilled please check my thought process and let me know if you see anything wrong).

I will use both a dividend discount model (DDM) and a free cash flow to equity (FCFE) approach to arrive at an intrinsic value for GNTX.

To arrive at an estimate of GNTX's cost of capital (discount rate) I first obtained estimates of Beta based on various sources as follows:

Beta =             1.25  For Company from Prof. Dam
Beta =             0.87  Industry Unleavered Beta from Prof. Dam
Beta =             0.99  From Reuters
Beta =             0.82  From Google


The CAPM provides a means for calculating the appropriate discount rate (cost of equity) given a beta, risk free rate and a risk premium as:

Discount Rate = Risk Free Rate + Beta * Risk Premium

Treasury yields are inching ever so closely towards 5.5% so that is my risk free rate and my risk premium is 5.0%. I've established my minimum discount rate to be 12%, which corresponds to a Beta of 1.3 given the above risk free and risk premium rates.

So, for the "high growth" period I used a Beta = 1.3 giving a discount rate of 12%. For the stable growth period, I allowed the Beta to fall to 1.0 recognizing that GNTX is in a cyclical industry and will always be at least as "risky" as the market. These Betas correspond to discount rates of 12% and 10.5% for the high growth period and stable growth period, respectively.

For all valuation calculations I've assumed a 10-year high growth period, a 5-year transition period and a growth rate of 4% for the terminal growth period.

There are two adjustments to GNTX's financial results that warrant attention: excess cash on hand and R&D expenditures.

GNTX's balance sheet includes over $500 million in cash and short term investments and no debt. This amounts to about $3.25 per share or about one-year worth of sales. Review of Gentex's balance sheet over the last 10-year period indicates that this cash horde has been building since about 2000 with a big jump in 2003.

Why is Gentex accumulating so much cash? Two reasons are apparent; management may have foreseen the industry's current downturn coming and chose to accumulate cash in anticipation of hard times, or, they may not have any suitable reinvestments available, currently.

I trust current management to deploy the cash in a manner that is in the best interest of shareholders over time. An acquisition may come about, but it will only be done if it can be done profitably � management has said as much.

In the meantime Gentex pays an attractive dividend (yielding 2.7%) and announced an 8 million share buyback in May. So, Gentex is returning cash to shareholders and will likely continue to be able to do so for a long time into the future.

For now, the large horde of cash sitting idle on the balance sheet is skewing Gentex's ROE calculation. As I intend to calculate a growth rate from fundamentals, an accurate analysis of ROE is important. Keep in mind I am trying to estimate the value of Gentex's current business operations and will treat the cash separately.

My adjustment for cash on hand was to remove (ignore) all interest income from the income statement and remove the "excess cash" from the balance sheet. What is left is a more accurate estimate of the income from Gentex's operating business and the portion of shareholder equity that is truly deployed and earning money for shareholders, IMHO.

I arbitrarily defined "excess cash" as anything above 2*current liabilities. This implies a target current ratio of 2, which is conservative and reasonable for a manufacturing operation.

The R&D adjustments were calculated as Prof. Dam suggests and I used his spreadsheet for the calculations. A 5-year amortization period was used.

Here is a summary of the results of these adjustments:

Unadjusted ROE for GNTX

ROE Components                    Company  Industry  Sector  S&P 500
Net Profit Margin (TTM)           20.07     2.75     5.51    13.91
Net Profit Margin - 5 Yr. Avg.    21.64     3.53     4.56    11.36
Asset Turnover (TTM)               0.6      1.53     1.18     0.97
Leverage Ratio (Avg.)              1.14     N/A      N/A      N/A
ROE = NPM*Turnover*Leverage       13.7% 


                                              2005
Net Income per share (reported)    $          0.70
Add for R&D Adjustment             $          0.05
Deduct Interest Income per share   $          0.15
Adjusted Net Income per share      $          0.60 


                                           
                                  2004     2005
Shareholder Equity (reported)    $783.3    $841.6
Less Excess Cash                 $393.0    $256.2
Net                              $390.3    $585.4
Research Asset                   $83.1     $99.0
Adjusted Equity                  $473.4    $684.4
Book Value per share             $3.07     $4.42
2005 ROE                                   19.5% 

My calculations have yielded an adjusted ROE of 19.5% compared to the unadjusted ROE of only 13.7%, this difference is quite significant.

Growth from fundamentals can be estimated by the following equation:

Growth Rate = Equity Reinvestment Rate * ROE

My equity reinvestment rate is summarized in the following:
Equity Reinvestment Rate:          2005     Per Share
Capital Expenditure               $53.50   $0.35
Less Depreciation                 $25.50   $0.16
Plus Change in Working Capital    $7.00    $0.05
Less Debt Issued                  $ -      $ -
Equity Reinvested in business     $35.00   $0.23
Adjusted Net Income               $92.81   $0.60
Equity Reinvestment Rate                   37.7%
 
Growth Rate from Fundaments                 7.3% 


Now this growth rate is somewhat low for a high growth stock and perhaps it is representative of Gentex's future growth. I'm not so sure. As I've mentioned, a portion of Gentex's future growth will come from the new "SmartBeam" product and from new sales to Boeing for dimmable windows. Neither product has produced any meaningful results appearing in the financial statements, yet. So, I conclude that the growth rate from fundamentals cannot possibly account for these new and developing products.

To account for these two new products in Gentex's growth rate, I took a look at how sales have increased over the last 10 years:

Project Sales Growth    1996    2005   10 Yr Change
Sales                  148.70   536.50    387.80 


I assume that in 10 years, sales for "SmartBeam" (nearly zero sales currently) will be equal to $387.8 million (equal to the aggregate growth in dimmable mirrors over the last ten years) and sales for dimmable windows will be half that figure (one-half is a wild guess at this point). On top of that, I take current sales and grow them at 7.3% to reflect fundamental growth in the mirror products. Total sales in 10 years are then

Sales 2015 = 536.5*(1+0.073)^10 + 387.8 + 387.8/2 = $1671.7

CAG = (1671.7/536.5)^(1/10) � 1 = 12.0%

Analysts' estimates for growth vary wildly. According to Reuters there are 8 analysts reporting a long term growth rate. The high estimate is 20%, the low 12% and the average is 14.9%.

So, after all that, I will assume GNTX's growth to lie somewhere between 7.3% and 12.0% for the high-growth period for my valuation.

There remains one aspect left unresolved before I present my estimates of Intrinsic Value. That is how to account for the excess cash removed from the analysis thus far. IIRC, Prof. Dam suggests that excess cash should be handled separately (as I've done) because it poses no risk and therefore should be discounted at the risk free rate. So, that is what I'll do.

Value of Excess Cash:                     2005    Per Share
Interest Income                           $23.60   $0.15
Total Cash                                $507.00  $3.27
Excess Cash                               $256.2   $1.65
Proportion of Interest that is Excess     $11.93   $0.08
Excess Interest/Risk Free Rate            $216.83  $1.40
Value of excess Per Share                 $1.40 


So, I value the excess cash at $1.40 per share. Remember the actual value of all the cash is $3.25 per share of which $1.65 per share is considered excess.

Other information entering the valuation includes:

Capital Spending per share  $0.35
Depreciation per share         $0.16
Revenue per share               $3.46


Here are my results for intrinsic value:

               Without Cash                        With Cash
Valuation Summary    DDM      FCFE    Cash Value   DDM    FCFE
Growth Rate = 7.3%   $ 7.99   $9.51   $1.40        $9.39   $10.91
Growth Rate = 12.0%  $12.11   $14.31  $1.40       $13.51   $15.71 


Gentex closed at $13.15 Friday. Even at that price it offers a compelling value in my opinion.

Differences between the two models calculations may lie in the fact that the DDM discounts what shareholders are anticipated to receive in the future. The FCFE model discounts what the Company is likely able to pay in the future. Since, GNTX has been accumulating cash, it is not distributing all that it is able to to shareholders and the impact this has on the valuation is the difference between the two methods results.

Conclusion

Gentex possesses many of the attributes I look for in a company before I buy shares:

- No debt
- Management working in the interest of all shareholders
- Favorable long term prospects
- Pays an attractive dividend yield
- Buying back shares
- A Best of Breed company
- An attractive net profit margin
- A sustainable competitive advantage

Given Mr. Market's mood of late, I see no hurry to begin accumulating shares. The stock price has been in decline for a long time � a trend I fully expect to continue until a general turn-around for the auto industry occurs.

Since I am most convinced that the long-term growth rate for GNTX will exceed the 7.3% I calculated from fundamentals, I will begin adding shares at below $11.00 regardless of the markets prevailing mood at that time. Otherwise, I will initiate a position in about a year or so as the downturn in the auto industry will be approaching a recovery soon thereafter.

All comments, suggestions and criticisms welcome.

Thank you for reading.

Rich


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