Value Investors Club / GENTEX CORP (GNTX)

Description

GNTX makes interior and exterior mirrors.

I am recommending it short. The pictures and quote above tells a thousand words.

I think at just under 3x sales and 2.5x book with the highest margins by a huge amount in the auto supplier universe from selling external and internal mirrors, the short pitch can be articulated just by

showing the above photos and seeing the plans of many major OEMs to move away from mirrors as we know them; the theoretical terminal value is much closer to $0 than the current price. Further, with MBLY and TSLA already trading at valuations that imply huge addressable markets that will be monetized in a fairly rapid and sizable secular change in the auto business, there is a clear disconnect

in what they are pricing and terminal value implied in GNTX stock price. The room for error in MBLY/TSLA investments is small and can come from pushing adoption out, competitive entry, and/or business model shifts. However, I do believe the secular change toward autonomous vehicles and more and more connected and integrated technology content in cars is a worthwhile investment theme. As such, I believe an easier trade is to short GNTX which also has put optionality on a waning auto cycle. I don’t believe the market can be right on MBLY and on GNTX at the same time given current valuation levels of each but I do believe that the industry is spending and shifting away from GNTX technologies and products. Either MBLY valuation is right and GNTX terminal value is in serious trouble, MBLY valuation is wrong and its due to gross margin pressure or competitive entry which again would be bad for GNTX terminal value, or GNTX is pricing in a high probability that it needs to come up with a breakthrough technology to maintain their currently strong position in auto mirrors. It’s an interesting investment because it’s not about a near term implosion in numbers; in fact, I’m not really going to pitch a case on my estimates versus consensus estimates. Rather I believe this is a short case on the terminal value here which in a reasonable case could be closer to zero than where the stock is trading. Sort of like buying a market dominating type-writer company in 1985.

Business Description:

GNTX has a near monopoly is the auto mirrors business. It trying its best to evolve with the shifts and direction of technology but its position as a niche-auto mirror (interior and exterior) manufacturer leaves it in a precarious position. The standard car is becoming increasingly integrated with the mirror being an extension of a central system as opposed to a scaled advantaged, self-contained mirror. Within mirrors, interior mirrors represent ~75% of total mirror shipments and ~25% go to exterior mirrors. The company uses the interior as the focal point that integrates the exterior mirrors with it. In fact, its mirrors are generally integrated and sold together. As management has publically said, “On outside mirrors worldwide as we've tried to do a better job of explaining, we very, very intentionally always have worked and continue to situationally adapt now to aggressively apply outside mirrors everywhere we he have an inside mirror. And so, with our inside mirrors required for the performance of outside mirrors and because we have more applications in vehicle production in the market for inside mirrors, we always have growth opportunities there. We are as the results should indicate for outside mirrors continuing to succeed at that. We continue to focus heavily on that.”

So the real issue to track is the growth rate and penetration of interior mirrors even though there seems to be more opportunity on exterior basis from a mix perspective. Precariously, most of the technology comes in the interior mirror and yet the exterior mirror apparently carries higher gross margins. So as the growth rate / penetration of interior mirrors slow, I think the gross margin of the exterior will slow. In management’s words: “We have a wide variety of products and exterior mirrors don't exist without an interior mirror. And so what we try to do, is communicate and three mirror systems. One inside mirrors and two outside mirrors, as our optimum success. And so we do these together and in parallel, since we can't sell an outside mirror unless our inside mirror is there.” Overall, GNTX penetration of interior mirrors in North America has been very impressive going from high 20s% last cycle in 2006/7 to north of 50% this cycle. In Europe/Japan/Korea, it’s been a similar ramp from mid-teens to ~40% this cycle. This has provided handsome industry outgrowth but the problem is that the NA penetration has flattened out and is now receding. For example, penetration in 2012 for this cycle peaked at 50% and has dipped below 50 in more recent years. It’s market position today is robust as the product is solid and has achieved strong penetration and market dominance. Because they make so much the industry’s mirrors, their unit cost advantage makes competitive entry difficult. However, it is this very position that has caused a “first mover disadvantage”, as no one today would enter what is likely to be a dead market within years. The company’s technologies are simply not where the industry is going.

Here is how Delphi Automotive—the best auto supplier in the world in my opinion—sees the car evolving. GNTX has relevance in Level 0 but decreasingly so as we move across the chart. And below the first chart is how DLPH views content on the car:

And here is who DLPH calls out as their partners in moving toward the car of the future—not no GNTX.

To put it bluntly, GNTX makes typewrites and computers have typewriters built-in as part of the computing system. So if a company had a very strong market position in typewriters 25 or 30 years ago, you would have had the same terminal value issue. Or you could have tried to build the computer with the typewrite as the focal point but obviously that didn’t and wouldn’t work. In auto industry terms, cars are moving toward full active safety systems and GNTX lacks anything that remotely resembles a full active safety system. Mirror are their bread and butter. It’s a component manufacturer structurally entrenched in its way in an industry moving toward comprehensive, integrated systems. I thought this slide from a deck a few years ago was telling especially when juxtaposed against the DLPH slides I pasted above.

In short, the industry is aggressively trying to build and implement integrated “active” and “passive” safety systems. So you have collision detecting form radars and cameras around the car and these signal warnings to the driver, and features such as collision avoidance, lane control, etc., all the while connected with the airbags and seat belts—a truly integrated solution. With cameras increasingly prevalent in the car, the mirror, as we know it, will become obsolete.

This flies in the face of GNTX strategy. GNTX is using its interior mirror as the focal point of the features it provides; that is fine for now but the reality to work, the mirror would have to be the central point of car’s operating system. We are way too late in the game for this to happen and GNTX doesn’t have the electronic architecture expertise of someone like Delphi. Nor do they bring anything particularly useful to the table other than a gross margin that is too high for a product with no future. An interesting case in point here is when they tried to put rear view camera in the interior mirror. While some initially adopted, many of those adopters moved it to the center console. As the company said, “The company has previously disclosed its four customers for rear display mirrors had notified the company of their plans to have the primary display for rear camera video and a radio display in the vehicle center console instead of in the rearview mirror. “

So, in my opinion, the auto supplier with the highest gross margins in the industry it starting down the slope of being a type-writer supplier.

What Could Happen Here?

Gross Margin Erosion

The most striking characteristic of the financial statements to me is the high gross margin. I think it makes sense historically as the company was increasing capacity and utilization thereof as the penetration of their products where increasing with increasing bells and whistles on them. However, I think this part of the company’s maturation curve is behind us and I expect margins to come down over time more closely to theifcr peer set. In the longer term, I believe the outgrowth will turn into under growth.

As the history shows, even in the period of industry out-growth, gross margins has pressure. What happens when the outgrowth ends and highly effective substitute products take the baton of outgrowth?

Here is the yearly gross margin progression from 2002 to 2015 (sorry, chart wouldnt post):

30.0%

32.0%

34.0%

36.0%

38.0%

40.0%

42.0%

44.0%

M&A

In my experience, many companies faced with this type of looming threat to their business model embark on precarious M&A activity. GNTX has already embarked on some questionable M&A. In 2013, the Company acquired “HomeLink, a wireless vehicle/home communications product that enables drivers to remotely activate garage door openers, entry door locks, home lighting, security systems, entry gates and other radio frequency convenience products for automotive applications, wherein the Company had previously been a licensee of HomeLink® and had been, since 2003, integrating HomeLink® into its interior automatic-dimming rearview mirrors.” I suspect we’ll see more M&A and increasingly off-point. At least, you can put your garage opener on your rear view mirror but I expect future M&A to be in unrelated areas.

Customer Concentration

From the risk factors in the 10k:

“We have a number of large customers, including three automotive customers which each account for 10% or more of our annual net sales in 2015 (including direct sales to OEM customers and sales through their Tier 1 suppliers): Volkswagen Group, Toyota Motor Company, and Ford Motor Company. The loss of all or a substantial portion of the sales to, or decreases in production by, any of these customers (or certain other significant customers) could have a material adverse effect on our business, financial condition, and/or results of operations.”

A move by any major customer to shift away from GNTX mirrors in an attempt to further their active safety and connected car implementation would probably destroy the multiple here. Please note, Japan was already recently allowed the replacement of mirrors with cameras. It will be very interesting to see how this market evolves.

Other regulatory developments

From the 10k risk factors:

“On March 31, 2014, the National Highway Traffic Safety Administration issued a final rule requiring rearview video systems in U.S. light vehicles by May 1, 2018, with a phase-in schedule requirement of 10% of vehicles after May 2016, 40% of vehicles after May 2017, and 100% of vehicles after May 2018…The Company’s rear camera display mirror application meets all the technical requirements of the

NHTSA ruling when installed in a vehicle and appropriately paired with an OEM specified camera. The NHTSA ruling that rearview video systems are required has increased competition for systems capable of

rear video in a variety of locations in the vehicle. Our Rear Camera Display (RCD) mirror application has and will continue to be affected by this increased competition.”

It's anyone’s guess who this will evolve but I think it’s a reasonable assumption to make that as regulation and the car’s general evolution push forward, OEMs will want comprehensive, integrated, and seamless solutions. Not good for GNTX….

Numbers:

Once again, I'm not making a pitch for earnings to miss expectations in the very near term but longer term I think gross margins are under serious pressure as is outgrowth and topline as substitutes come in. A move in gross margins to 30% with a minor, cycle-related sales drop can cut earnings to ~$.70-$.80 and over time, I think earnings basically go away. I would expect a transformative and probably highly dilutive deal here.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Regulatory announcements pushing change toward cameras instead of mirrors.

New technology announcements from competitors

OEMs shifting strategy toward integrated solution that doesnt include mirrors.

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			2016	2017
Price:	16.85	EPS	1.21	1.31
Shares Out. (in M):	287	P/E	13.8	12.4
Market Cap (in $M):	4,830	P/FCF	0	0
Net Debt (in $M):	491	EBIT	0	0
TEV (in $M):	4,250	TEV/EBIT	0	0
Borrow Cost:	General Collateral