Research Alert
GNTX
A N A L Y ST : B R E N T M I L L E R
Gentex Corp.
600 North Centennial St.
Zeeland, MI 49464
(616) 772-1800
www.gentex.com
INDUSTRY
Auto Parts
PRICE
$29.64 (01/05/12)
MARKET CAP
4.25 billion
ENT. VALUE
3.80 billion
P-E RATIO
26.46
EV/REVENUE
3.85
DEBT/EBITDA
0.00
SHORT INTEREST
3.6%
DAYS TO COVER
5.1
Earnings Quality Thesis
We are initiating coverage of Gentex Corp. (GNTX) with a grade of D. A
growing gap between FCF and net income has led to total accruals
reaching a five-year high while FCF margin hit a five-year trough.
Inventory growth appears outsized relative to both trailing and forward
sales, as DSI and inventory-to-forward sales metrics both reached five-year
highs. Flat ASPs and higher input costs related to supply-chain
disruptions could threaten gross-margin targets, particularly if sales of
RCD-equipped mirrors fall below expectations. A significant spread
between CapEx and depreciation expense could raise the risk of EPS
misses in 2012. The company appears to trade at a significant absolute and
relative valuation premium, which may prove to be unsustainable given
our earnings quality and fundamental concerns.
EARNINGS QUALITY GRADE
Scale A - F
Increasing accruals may threaten
persistence of earnings
pg 6
Outsized inventory growth could
further pressure margins
pg 7
An increasing gap between net income
and FCF has led to total accruals
reaching a five-year high of 9.0% of
average total assets. FCF margin and
FCF-to-net income also have declined
to five-year lows. The deterioration in
FCF was primarily driven by growth in
inventory and a surge in capital
spending. As accruals inevitably begin
to decline, GNTX may be at risk of
posting lower-than-expected bottomline results.
GNTX’s three-month and 12-month
DSI metrics both reached five-year
highs as the firm’s inventory balance
increased by 64.1% YOY. Inventory
also appears outsized relative to
expected demand. Pricing pressure
and rising raw-materials costs
resulting from supply-chain
disruptions may result in gross
margin contracting by more than the
modest decline forecasted by
management.
14614 N. Kierland Blvd., Suite S-260
Scottsdale, Arizona 85254
Tel 480.998.8585 Fax 480.998.4747
05 J A N U A R Y 2 0 1 2
D
Surge in CapEx and unusually low
depreciation expense may threaten
earnings targets
pg 11
Prior-period cuts in capital spending
have led to unusually low levels of
depreciation and amortization.
However, a recent upswing in capital
outlays has resulted in the CapEx-todepreciation ratio reaching a five year
high of 2.48. As this ratio begins to
normalize, the firm may face a
heightened risk of EPS shortfalls, as
current sell-side estimates may
underestimate the level of depreciation
expense the company will incur in 2012.
products@gradientanalytics.com
www.earningsquality.com
2012 Copyright Gradient Analytics Inc.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
Company Background, Overview of
Recent Results, and Introduction to
Gradient’s Thesis
COMPANY BACKGROUND
Gentex Corp. (GNTX) designs, develops, manufactures, and markets electrooptical products to automotive, commercial building, and aircraft industries in
the United States and internationally. Over 98% of revenue for the nine months
ended 09/30/11 was due to sales of automatic-dimming rearview mirrors, which
utilize proprietary electrochromic technology to dim in proportion to the
amount of headlight glare from trailing vehicle headlamps. The firm also offers
camera-based driver-assist systems, which are increasingly becoming integrated
components of the company’s auto-dimming mirror products. GNTX also
provides commercial smoke alarms and signaling devices to the North American
fire protection market, as well as dimmable aircraft windows for the commercial,
business, and general aviation markets. The firm sells its automotive mirror
products directly and offers its fire protection products directly and through
manufacturer representative organizations to fire protection and security
product distributors, electrical wholesale houses, and original equipment
manufacturers of fire protection systems. The company was founded in 1974 and
is based in Zeeland, Mich.
INTRODUCTION TO GRADIENT’S THESIS
Our thesis centers on a number of earnings quality and fundamental signals that
could indicate a higher probability of near to mid-term share-price
underperformance. These issues include:

Rapidly expanding accruals and deteriorating FCF margin could indicate
that recent results may prove to be less persistent than expected, raising the
risk of negative surprises in coming quarters.

Unusual growth in inventory has led to GNTX’s three-month and 12-month
DSI metrics reaching five-year highs. Current inventory levels also appear
outsized relative to expected sales.

Flooding in Thailand has resulted in supply-chain disruptions, forcing
GNTX to order electronic components from non-Thai suppliers. Lower
supply and higher demand for raw materials have led to higher input costs,
which, when coupled with lower ASPs, could lead to greater-than-expected
gross-margin contraction.

The 12-month CapEx-to-depreciation ratio reached a five-year high in the
most recent period, indicating that depreciation and amortization expense
may be unsustainably low. Current 2012 sell-side EPS estimates may
understate the level of depreciation expense the firm will incur, possibly
raising the risk of the company falling short of consensus estimates in the
coming year.

The company appears to trade at a significant premium relative to its
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Research Alert
GNTX
01.05.12 GENTEX CORP.
industry peers and its own historical valuation multiples. Given our earnings
quality and fundamental concerns, this premium valuation may be
unwarranted, particularly if near-term demand for RCD-equipped mirrors
falls below expectations.
OVERVIEW OF RECENT RESULTS
In 2010, GNTX’s revenue grew by 49.9% to $816.3 million (see Table 1, Page
5), snapping a two-year streak of declining sales growth. In 2008, the
company’s top line came in at $623.8 million, representing a 4.6% YOY
decline. In the company’s 2008 10K, management attributed the decline to a
5% decline in auto-dimming mirror shipments, primarily driven by decreased
demand from “the traditional Big Three automakers.” The firm’s 2009 results
exhibited a more pronounced downward trend, with auto-dimming mirror
shipments falling by 19% YOY, which resulted in a 12.7% sales decline versus
2008 when netted against a higher ASP. Accordingly, a portion of the 2010
sales growth appears to have driven by this weak 2009 comp. In the
company’s 2010 10K, management attributed the revenue increase to a 46%
increase in auto-dimming mirror shipments resulting from “increased light
vehicle production globally and increased penetration of auto-dimming
mirrors with electronic content.”
The company’s low annual gross-margin watermark for the most recent fiveyear period occurred in 2008, with gross margin plummeting by 226 bps to
32.6%. Following flattish performance in 2009, the company’s 2010 gross
margin improved by 362 bps YOY to 36.2%, an expansion that management
attributed to “higher sales leveraged over fixed manufacturing overhead
costs.” The result also represented the firm’s highest gross margin over the
most recent five-year period.
GNTX’s operating margins followed a similar trajectory, as annual operating
margins fell by 499 bps to 17.4% in 2008 before retreating an additional 3 bps
in 2009. In the company’s 2008 10K, management cited a 13.5% increase in
R&D expenses (excluding one-time litigation charges) and a 20.2% jump in
SG&A expenses as being the primary drivers of the contraction.1 In 2010, the
firm’s operating margin displayed a 602 bps YOY improvement, an expansion
that was largely driven by the sharp increase in the company’s revenue, which
more than offset the 26.3% increase in operating expenses.
The material YOY operating margin expansion helped drive GNTX’s 2010 diluted
EPS up by 106.8% (123.6%) to $0.97 versus 2009 (2008). In 2008, the company
saw its diluted EPS fall by 49.5% YOY to $0.43, a decline that management
attributed to reduced operating margin and a $57.5 million decline in other
income from $40.9 million in other income in 2007 to $16.6 million in other
1
The increase in R&D expense was attributed to “additional staffing for new electronic product development, including SmartBeam, Rear
Camera Display and telematics, and new vehicle programs,” (2008 10K). Expansion of the company’s overseas sales offices and a higher
allowance for doubtful accounts were cited as the primary drivers of the increased SG&A expense (2008 10K).
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Research Alert
GNTX
01.05.12 GENTEX CORP.
expense in 2008.2 While other income increased by $18.4 million YOY to $1.7
million in 2009, the firm’s earnings only exhibited an 8.1% YOY increase to $0.47
per share as a result of the company’s depressed margins.
For Q3 2011 (nine months ended 09/30/11) GNTX reported net sales of $269.5
million ($763.4 million), representing a 30.3% (28.5%) YOY increase (see Table 2,
Page 5). The firm’s Q3 sales also exceeded the consensus sell-side estimate of
$259.6 million by $9.9 million. In the company’s Q3 2011 10Q, management
attributed the quarterly revenue growth to a 31% YOY increase in auto-dimming
mirror unit shipments, primarily driven by increased sales to European and Asian
automakers. GNTX went on to cite a 29% increase in auto-dimming mirrors as
the primary catalyst behind the top-line expansion for the nine months ended
09/30/11, a trend that management attributed to “increased light vehicle
production in North America and Europe as well as increased penetration of
auto-dimming mirrors on 2011 model year vehicles.”
Q3 2011 gross margin came in at 35.4%, representing a 30 bps decline and a
modest 12 bps sequential improvement. In the Q3 2011 10Q, management cited
“annual automotive customer price reductions” as the primary catalyst behind
the YOY gross margin contraction, a trend that was partially offset by “the
company’s ability to leverage fixed overhead costs and certain purchasing cost
reductions.” For the nine months ended 09/30/11, GNTX’s gross margin fell by 86
bps YOY to 35.5%, a decline management attributed to “annual automotive price
reductions” in the company’s Q3 2011 10Q (see Page 9 for a detailed discussion of
this subject).
Despite the YOY decline in gross margin, Q3 2011 operating margin increased by
39 bps YOY to 23.1% as operating expenses increased by just 23.3% YOY against
a 30.3% rise in sales. As a result, diluted EPS was in line with the sell-side
consensus estimate at $0.30. On a nine-month basis, the YOY gross-margin
decline and a 26.1% increase in operating expenses sent the firm’s operating
margin down by 62 bps YOY to 23.0% for the period ended 09/30/11.
Management’s Q4 2011 revenue guidance calls for sales to increase by 20% (to
25%) in Q4 2011 versus Q4 2010.3 The higher revenue-growth target relative to
the unit shipment forecast implies greater penetration in 2012 model years and/or
market-share gains, an outlook that is somewhat consistent with recent
management commentary and trends in GNTX shipments relative to IHS’
2
According to GNTX’s 2008 10K, the YOY decline in other income was the result of lower investment income stemming from “lower interest
rates and decreased year-end mutual fund distribution income,” as well as a noncash impairment charge for available-for-sale securities and
realized losses on the sale of equity investments.
3
This forecast is based on IHS’ September 2011 forecast calling for a 5.4% YOY increase in light vehicle production levels in the North American,
European, and Japanese/Korean geographic markets. IHS’ European light vehicle production forecast, which calls for a modest 2.0% YOY unit
decline, appears optimistic when compared to cautious comments from European auto part supplier SKF Group. In its 10/19/11 nine-month
update, SKF stated that Q4 demand in Europe and the Automotive Division were both expected to be lower relative to last year. In addition,
SKF CEO Tom Johnstone stated that the company expects to see weaker demand in the car market in Q4 2011.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
automobile production forecasts.4 Management’s target revenue-growth range
also implies that Q4 sales are expected to come in between $266.5 million and
$277.6 million, compared to the current sell-side consensus estimate of $273.4
million.
While GNTX does not provide quarterly EPS guidance, SVP Enoch Jen stated in
the Q3 earnings release that supply-chain disruptions were expected to have a 25
bps to 50 bps negative impact on Q4 gross margin, resulting in a slight sequential
decline versus Q3 (see Page 9 for a detailed discussion of this subject). The
current consensus sell-side estimate calls for the company to achieve Q4 2011
diluted EPS of $0.30. Given the earnings quality and fundamental concerns
enumerated in this report, however, we believe that GNTX may be at risk of
falling short of expectations in Q4 2011 and beyond.
Table 1. Summary of Recent Annual Operating Results
($ in millions except per-share data)
2010
$816.3
49.9%
36.2%
362
23.4%
602
16.9%
500
$0.97
106.8%
Revenue
YOY % change
Gross margin
YOY bps change
Operating margin
YOY bps change
Net margin
YOY bps change
Diluted EPS
YOY % change
2009
$544.5
-12.7%
32.6%
4
17.4%
-3
11.9%
192
$0.47
8.1%
2008
$623.8
-4.6%
32.6%
-226
17.4%
-499
10.0%
-872
$0.43
-49.5%
2007
$653.9
14.3%
34.8%
3
22.4%
13
18.7%
-33
$0.86
17.6%
2006
$572.3
6.7%
34.8%
-223
22.3%
-313
19.0%
-141
$0.73
3.0%
03/31/11
$250.9
35.1%
36.0%
-92
23.9%
-7
16.9%
-61
$0.29
26.1%
12/31/10
$222.1
25.1%
35.8%
-87
22.8%
-156
16.6%
-29
$0.26
18.8%
09/30/10
$206.8
32.8%
35.7%
76
22.7%
145
16.6%
121
$0.24
41.2%
Table 2. Summary of Recent Quarterly Operating Results
($ in millions except per-share data)
3M Ended:
Revenue
YOY % change
Gross margin
YOY bps change
Operating margin
YOY bps change
Net margin
YOY bps change
Diluted EPS
YOY % change
4
09/30/11
$269.5
30.3%
35.4%
-30
23.1%
39
16.1%
-47
$0.30
25.0%
06/30/11
$243.0
20.6%
35.2%
-142
21.9%
-229
15.8%
-106
$0.27
12.5%
For example, for the 12 months ended 09/30/11, GNTX’s unit shipments comprised 48.0% of IHS’ expected unit production versus 37.8% in the
year-ago period. The midpoint of GNTX’s Q4 revenue guidance implies that Q4 unit shipments will comprise approximately 48.3% of expected
production levels, assuming flat ASPs.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
FCF Lags Earnings by Wide Margin
TOTAL ACCRUALS JUMP TO FIVE-YEAR HIGH 9.0% OF AVERAGE TOTAL ASSETS
For the 12 months ended 09/30/11, GNTX’s cash flow from operating activities
(CFOA) increased by 35.5% YOY to $162.1 million (see Table 3, next page). The
207.9% YOY increase in net capital expenditures,5 however, resulted in FCF
falling by 31.4% YOY to $58.9 million. The YOY decline in free cash flow (FCF)
also represented a stark contrast to the increase in TTM sales, which rose by
27.7% YOY to $985.5 million. As a result of these diverging trends, FCF margin
declined by 515 bps YOY to 6.0%, reaching a five-year low in the process. The
FCF-to-adjusted net income6 metric also reached a five-year trough, coming in at
0.382, compared to the year-ago value of 0.658 and the trailing five-year average
of 0.952.
The primary working-capital drivers of the decline in FCF were inventory and
receivables growth, which consumed $59.0 million and $23.4 million,
respectively, in operating cash flow over the most recent 12-month period. The
inventory growth is particularly concerning, as it appears outsized relative to
both trailing and expected sales (see Page 7 for a detailed discussion of this
subject). In addition, a significant ramp in capital spending acted as a $102.6
million drag on FCF for the 12 months ended 09/30/11. By contrast, the company’s
average 12-month net capital expenditures over the most recent five-year period
was $46.5 million. As we discuss later in this report, the accelerating level of
capital spending could have negative consequences for the company’s margins as
additional depreciable assets come on line in future periods (see Page 11 for a
detailed discussion of this subject).
While GNTX’s FCF declined markedly, the company’s adjusted net income
(EBITDAS) came in at $154.3 million ($281.7 million) for the 12 months ended
09/30/11, representing an 18.2% (24.0%) YOY increase. Consequently, total
accruals jumped to 9.0% of average total assets for the 12 months ended 09/30/11,
representing five-year high for the firm and lying appreciably above the year-ago
(quarter-ago) value of 5.1% (5.5%). Additionally, while operating accruals
declined by 644 bps YOY to 8.2% of average current assets, the metric increased
by 338 bps on a sequential basis and remained well above the company’s trailing
five-year average of -0.1%. The unusual levels of both total and operating accruals
leave us concerned that GNTX’s recent accruals-based performance may prove
unsustainable.
(See table, Twelve-Month Trends in Accruals and Cash Flows, next page)
5
6
Net CapEx = capital expenditures – sale of PP&E.
Adjusted net income for the 12 months ended 09/30/11 excludes $8.8 million in stock-based compensation expense, $5.8 million tax benefit from
stock-based compensation, and $9.9 million in other income primarily stemming from investment related gains.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
Table 3. Twelve-Month Trends in Accruals and Cash Flows
($ in millions)
12M Ended:
EBITDAS
YOY % change
Adjusted net income
YOY % change
CFOA
YOY % change
Net CapEx
YOY % change
FCF
YOY % change
FCF margin
YOY bps change
FCF/Adjusted net income
YOY % change
Accruals to average total assets
YOY bps change
09/30/11
$281.7
24.0%
$154.3
18.2%
$161.5
35.5%
($102.6)
207.9%
$58.9
-31.4%
6.0%
-515
0.382
-41.9%
9.0%
391
06/30/11
$260.7
22.4%
$144.6
20.0%
$165.6
29.2%
($76.5)
168.5%
$89.2
-10.6%
9.7%
-418
0.617
-25.5%
5.5%
300
03/31/11
$252.0
40.0%
$142.7
45.4%
$144.2
-7.5%
($55.1)
113.4%
$89.1
-31.5%
10.1%
-1,033
0.624
-52.9%
5.5%
949
12/31/10
$234.9
70.9%
$133.5
92.3%
$128.1
15.8%
($46.4)
119.8%
$81.7
-8.7%
10.0%
-643
0.612
-52.5%
5.7%
825
09/30/10
$227.2
119.9%
$130.5
177.8%
$119.1
5.2%
($33.3)
40.2%
$85.8
-4.1%
11.1%
-717
0.658
-65.5%
5.1%
1,059
Operating accruals to average current
assets
8.2%
4.8%
7.1%
7.4%
14.6%
-644
-619
775
756
2,598
YOY bps change
Inventory Level Continues to Climb
THREE-MONTH AND 12-MONTH DSI METRICS REACH FIVE-YEAR HIGHS;
INVENTORY GROWTH ALSO APPEARS OUTSIZED RELATIVE TO EXPECTED SALES
For the 12 months ended 09/30/11, GNTX reported revenue of $985.5 million,
representing a 27.7% YOY increase (see Table 4, next page). By contrast, the
company’s inventory balance increased by 64.1% to $151.1 million. As a result,
the firm’s inventory balance comprised 15.3% of TTM sales, representing a
340 bps YOY increase and a five-year high for the firm. The 12-month DSI
metric exhibits a similar trend, increasing by 15 days YOY to 65 days, which is
also a five-year record.
Short-term trends—which we tend to view as more indicative of the direction
of the trend—are even more pronounced. Specifically, the aforementioned
64.1% YOY increase in inventory (see Table 5, Page 9) was more than twice
the rate of increase in quarterly sales (30.3% YOY to $269.5 million).
Consequently, inventory was 56.1% of three-month sales, representing a 1,155
bps YOY increase and 1,842 bps above the trailing five-year average of 37.7%.
Likewise, the three-month DSI metric increased by 12 days YOY to 71 days,
representing the metric’s five-year high.
GNTX’s Q3 2011 10Q attributed the increase in inventory to “higher sales and
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Research Alert
GNTX
01.05.12 GENTEX CORP.
production levels in conjunction with longer lead times for certain electronic
component raw materials inventory.” While we do not dispute that supplychain disruptions resulting from flooding in Thailand have resulted in longer
lead times for certain electronic components, the company’s current rawmaterials inventory of $97.4 million represents 64.5% of the firm’s total
inventory balance, which is in line with the trailing five-year average of 64.3%.
Accordingly, it does not appear that there has been a disproportionate rise in
raw materials.
In addition, the recent build in inventory does not appear to be entirely
congruent with expected customer demand. For example, the current inventory
level is equivalent to 12.9% of expected forward 12-month sales,7 representing a
353 bps YOY increase and a five-year high for the firm (see Chart 1, next page). In
addition, the company’s finished-goods inventory of $34.6 million constitutes
12.7% of the sell-side’s sales estimate for Q4 2011,8 representing a 354 bps YOY
increase and 411 bps above the metric’s trailing five-year average of 8.5%.
Accordingly, we question whether there is enough near-to-mid-term demand to
justify an inventory build of this magnitude. If not, the inventory build could
exacerbate recent weakness in gross margin.9
Table 4. Twelve-Month Inventory Analysis
12M Ended:
Revenue
YOY % change
Inventory
YOY % change
Inventory turnover
YOY % change
Inventory/sales
YOY bps change
DSI
YOY % change
09/30/11
$985.5
27.7%
$151.1
64.1%
5.59
-22.6%
15.3%
340
65
29.2%
06/30/11
$922.9
28.1%
$119.5
50.7%
5.99
-22.8%
12.9%
194
61
29.5%
03/31/11
$881.4
38.5%
$104.0
53.6%
6.35
-16.7%
11.8%
116
57
20.0%
12/31/10
$816.3
49.9%
$100.7
87.9%
6.62
-7.1%
12.3%
250
55
7.6%
7
09/30/10
$771.8
57.8%
$92.1
97.3%
7.22
9.9%
11.9%
239
51
-9.0%
For 09/30/10 and prior periods, forward sales were based on actual reported sales in the subsequent 12-month period. For periods ranging from
12/31/10 to 06/30/11, forward-sales estimates were derived by using a combination of reported sales and sell-side forecasts. For the 09/30/11
period, forward-sales estimates were based solely on the current forward sell-side forecast.
8
For 06/30/11 and prior periods, forward sales were based on actual reported sales in the subsequent quarter. For the 09/30/11 period, forward
sales estimates were based on the current sell-side forecast for Q4 2011.
9
Arguably, one potential reason for the inventory build could be that the company is expecting a surge in demand for rear camera displays
(RCDs) following the publication of the final rule related to the Kids Transportation and Safety Act (KTSA), which was expected by 12/30/11
but has been met by several delays and has not occurred as of this report’s publication date. The KTSA may require that all vehicles in the
United States be equipped with rear camera displays by September 2014. However, two issues lead us to believe that this is not a viable catalyst
for the recent inventory build. First, if the company expects a substantial increase in RCD sales in 2012, analysts covering the firm do not appear
to share this opinion, as the firm’s forward-sales estimates remain outsized relative to the inventory build. Second, even discounting the
probability of additional regulatory delays, the September 2014 deadline would not likely result in sufficient growth in 2012 model year RCD
implementation to justify a 64.1% YOY increase in inventory.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
Table 5. Three-Month Inventory Analysis
3M Ended:
Revenue
YOY % change
Inventory
YOY % change
Inventory turnover
YOY % change
Inventory-to-sales
YOY bps change
DSI
YOY % change
09/30/11
$269.5
30.3%
$151.1
64.1%
1.29
-17.1%
56.1%
1,155
71
20.6%
06/30/11
$243.0
20.6%
$119.5
50.7%
1.41
-18.9%
49.2%
983
65
23.3%
03/31/11
$250.9
35.1%
$104.0
53.6%
1.57
-18.8%
41.5%
499
58
23.1%
12/31/10
$222.1
25.1%
$100.7
87.9%
1.48
-34.1%
45.4%
1,517
62
51.7%
09/30/10
$206.8
32.8%
$92.1
97.3%
1.55
-27.2%
44.5%
1,456
59
37.4%
Chart 1. Five-Year Trends in Inventory-to-Forward Sales
14.0%
13.0%
12.0%
11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
Inventory/forward 12M Sales
Gross-Margin Contraction May Prove
to be More Material than Forecasted
Finished goods inventory/forward 3M sales
RISING INPUT COSTS, CUSTOMER PRICING POWER AND “DECONTENTING” MAY
THREATEN Q4 2011 AND H1 2012 GROSS MARGINS
One factor that may explain a significant portion of the outsized inventory
growth in the most recent quarter is higher raw-materials costs resulting from
the company sourcing parts from non-Thai suppliers. The July 2011 flooding in
Thailand caused severe manufacturing disruptions among roughly half a dozen of
GNTX’s electronic component suppliers in the country.10 Though management
did not disclose the exact percentage of electronic components sourced from
Thailand, several company disclosures seem to indicate that the amount was
10
SVP Enoch Jen, Q3 2011 analyst call.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
material. For example, in the company’s Q3 earnings announcement, SVP Enoch
Jen stated that the Thailand flooding and associated supply-chain disruptions
would negatively affect the company’s Q4 gross margin by 25 to 50 bps and
predicted a slight QOQ decline in gross margin for the quarter. Jen went on to
state that it “could take anywhere from three months to up to a year to restore
normal production for some of the facilities in Thailand.” Additionally, in
response to a follow-up question on the expected duration of gross-margin
contraction due to supply-chain disruptions, Jen stated that the “impact will go
into definitely the first quarter of next year, and then we would be hopeful that
there might be some sequential improvement after that.”
Compounding the problem of higher input costs, the company’s primary
customers are large automobile manufacturers that wield a comparatively high
degree of pricing power. Therefore, GNTX may be unable to pass on the bulk of
these cost increases. The company acknowledges this risk in its 2010 10K filing:
In addition to price reductions over the life of our long-term agreements,
we continue to experience significant pricing pressures from our
automotive customers and competitors, which have affected, and which
will continue to affect our margins to the extent that we are unable to
offset the price reductions with engineering and purchasing cost
reductions, productivity and manufacturing yield improvements, and
increases in unit sales volume, each of which pose a challenge. [emphasis
added]
Beyond pricing pressure, the company also appears to face risks related to
“decontenting” by a number of vehicle manufacturers. The 2010 10K describes
this risk as follows:
In addition, financial pressures at certain automakers are resulting in
increased cost reduction efforts by them, including requests for additional
price reductions, decontenting certain features from vehicles, customer
market testing of future business, dual sourcing initiatives and warranty
cost-sharing programs, which could adversely impact our sales growth,
margins, profitability and, as a result, our share price. [emphasis added]
An analysis of trends in the average selling price (ASP) for the company’s
automotive mirrors confirms this downward pricing pressure. For the nine
months ended 09/30/11, mirror shipments grew by 29% YOY, accounting for all of
the 29% increase in mirror-related sales. The flat ASP growth served as a sharp
contrast to the nine-month period ended 09/30/10, when ASPs grew by 8% YOY,
accounting for 12.5% of the 64% YOY increase in mirror-related sales (see Chart
2, next page). These pricing pressures, when combined with increasing input
costs, could result in a more material and sustained gross-margin contraction
than the 25 bps to 50 bps sequential decline implied by management’s recent Q4
2011 guidance.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
Chart 2. Trends in Nine-Month Automotive Mirror ASPs
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
9M ASP YOY % Change
Unusually Low Deprecation Levels
Appear Unsustainable
SURGE IN CAPITAL SPENDING MAY FORESHADOW HIGHER-THAN-EXPECTED
DEPRECIATION AND AMORTIZATION EXPENSE
For the 12 months ended 09/30/11, GNTX’s capital spending increased by 204.0%
to $102.8 million (see Table 6, next page). In the company’s Q3 2011 analyst call,
CFO Steven Dykman explained the increase in capital outlays as follows:
The company currently estimates that 2011 capital expenditures will be
approximately $100 million to $115 million, primarily due to the increased
production equipment purchases of approximately $70 million to $80
million and new facility costs of approximately $30 million to $35 million to
increase production plant capacity. 2011 capital expenditures will be
financed from current cash and cash equivalents on hand. Depreciation
expense for the 2011 calendar year is currently estimated at approximately
$41 million to $44 million.
The recent increase in capital outlays appears to stem in part from CapEx cutbacks
in 2009 and 2010. To illustrate this, consider that from 12/31/08 to 09/30/10 GNTX’s
average 12-month capital spending was just $30.6 million—a 40.0% decline versus
the preceding two-year period (12/31/06 to 09/30/08). An analysis of CapEx to sales
tells a similar story, with the metric falling from an average of 8.0% during
12/31/06–09/30/08 to 5.2% for the 12/31/08–09/30/10 period.
Despite the 204.0% YOY increase in 12-month capital expenditures, depreciation
and amortization expense rose just 7.5% for 12 months ended 09/30/11. These
opposing trends resulted in the CapEx-to-depreciation ratio coming in at 2.48,
representing a 182.7% YOY increase, a five-year high, and the third highest level
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Research Alert
GNTX
01.05.12 GENTEX CORP.
over the last 10 years (trailing only the 12 months ended 12/31/01 and 03/31/02). The
metric’s current value also lies 58.4% above its trailing 10-year average of 1.56.
Table 6. Twelve-Month CapEx-to-Depreciation and Amortization Analysis
12M Ended:
CapEx
YOY % change
Depreciation and amortization
YOY % change
CapEx/depreciation
YOY bps change
09/30/11
$102.8
204.0%
$41.5
7.5%
2.48
182.7%
06/30/11
$76.8
166.9%
$39.5
3.3%
1.95
158.4%
03/31/11
$55.5
113.5%
$38.6
1.9%
1.44
109.6%
12/31/10
$46.9
121.9%
$37.7
-0.3%
1.24
122.7%
09/30/10
$33.8
42.2%
$38.6
3.7%
0.88
37.1%
HAVE 2012 SELL-SIDE EPS TARGETS UNDERESTIMATED FUTURE
DEPRECIATION EXPENSE?
The growing disparity between capital spending and depreciation and
amortization implies that depreciation and amortization expense is likely to ramp
in the near future. To illustrate this point, we took the midpoint of management’s
CapEx guidance and the company’s previously disclosed depreciation schedules11
to arrive at an estimated level of incremental depreciation and amortization
expense for 2012. Based on these data points, we estimate incremental depreciation
and amortization expense of $12.9 million for the coming fiscal year. This figure
results in an estimated 2012 depreciation and amortization expense of $55.4
million,12 which would represent a 30.4% YOY increase versus the midpoint of
management’s 2011 guidance of $41.0 million to $44.0 million.
In a second, more-conservative base case approach, we assumed that 25% of the
capital equipment acquired in 2011 will not be put into service until 2013.
Alternatively, this method can also be viewed as providing a $3.2 million
allowance for assets that have reached the end of their useful lives and are no
longer being depreciated. Using this methodology, we estimate that depreciation
and amortization expense would still come in at $52.2 million, representing a
22.8% YOY increase versus the midpoint of management’s 2011 guidance.
In a third approach, we examined the historical relationship between the 12-month
CapEx-to-depreciation ratio and increases in depreciation and amortization
expense in subsequent periods (see Chart 3, next page). In the two historical
examples when the 12-month CapEx-to-depreciation and amortization ratio had
reached similar peak levels (12/31/01 and 03/31/06),13 GNTX’s 12-month
depreciation and amortization expense increased by an average of 24.8% over the
subsequent five quarters. This methodology results in estimated 2012 depreciation
11
According to GNTX’s 2010 10K, the depreciable life of GNTX’s machinery and equipment is three to 10 years (average 6.5 years). The
depreciable life of GNTX’s buildings and improvements is seven to 40 years (average 23.5 years).
12
Estimate assumes that 2011 depreciation expense comes in at $42.5 million, the midpoint of management’s guidance of $41.0 million to $44.0
million.
13
The CapEx-to-depreciation ratios for the 12 months ended 12/31/01 and 03/31/06 were 3.03 and 2.27, respectively.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
and amortization expense of $51.2 million, representing a 20.4% increase relative to
the midpoint of management’s 2011 target.14
While our analysis suggests that 2012 depreciation expense will fall between
$51.2 million and $55.4 million, the sell-side’s projection appears to reflect
expected depreciation expense of approximately $47.0 million to $49.0
million,15 the midpoint of which is 8.0% ($4.2 million) below our base case
estimate ($52.2 million, as discussed above on Page 12). Accordingly, we
believe the sell-side (and possibly the market as a whole) may have unrealistic
expectations regarding 2012 EPS for GNTX.
Chart 3. Ten-Year Trends in 12-Month CapEx-to-Depreciation Ratio and Forward Depreciation Expense
Rich Valuation Bolsters Earnings
Quality and Fundamental Concerns
RELATIVE AND ABSOLUTE VALUATION PREMIUM MAY SUGGEST THAT A
REVERSAL IS IMMINENT
Despite the deterioration in certain earnings quality and fundamental risk
metrics outlined in the preceding analysis, GNTX trades at a premium to its peer
group16 across a broad spectrum of relative valuation metrics. Trailing metrics
provide an illustration of this trend, as the company trades at a 114.0% (521.4%)
premium relative to the peer group on an EV/EBITDA (EV/TTM sales) basis (see
14
Analysis assumes that the relationship between the 12-month CapEx-to-depreciation ratio and forward 12-month depreciation expense is linear.
Morningstar and KeyBanc are forecasting depreciation and amortization expense of just $47.0 million and $48.7 million, respectively, for 2012.
Yet their 2012 EPS forecasts ($1.29 and $1.34, respectively) actually trail the consensus 2012 forecast of $1.38, leading us to conclude that the
majority of the current sell-side 2012 EPS targets may contain similarly (if not more) optimistic 2012 depreciation and amortization projections.
Accordingly, we believe GNTX may be at risk of falling short of sell-side EPS targets as a result of depreciation and amortization expense
coming in higher than what is currently embedded in consensus estimates. See 10/20/11 KeyBanc report and 10/20/11 Morningstar report.
16
GNTX’s relative valuation peer group consists of Dorman Products Inc. (DORM), Johnson Controls Inc. (JCI), Lear Corp. (LEA), Standard
Motor Products Inc. (SMP), and Visteon Corp. (VC).
15
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Research Alert
GNTX
01.05.12 GENTEX CORP.
Table 7, next page). Forward-looking measures paint a similar picture, as
GNTX’s forward P/E (TEV/forward sales) metric lies 96.4% (521.4%) above the
peer-group median. The degradation in GNTX’s cash flows is particularly
evident when examining the firm on a TEV/FCF basis, which results in the firm
trading at a 320.4% premium relative to its peer group. In addition, the firm
trades at a 119.6% premium on a P/BV basis.
One potential reason for the relative valuation premium is the earnings growth
that could result from the publication of the final rule relating to the Kids
Transportation and Safety Act (KTSA), which was expected by 12/30/11 but has
been met by several delays and has not occurred as of this report’s publication
date. The KTSA may require that all vehicles in the United States be equipped
with rear camera displays by September 2014. Accordingly, the KTSA could
trigger a surge in demand for RCD-equipped rearview mirrors, a trend that
would likely lead to a surge in RCD unit shipments from 2012 to 2014. However,
the company’s expected earnings growth does not appear to fully account for the
valuation disparity, as the firm trades at an 83.0% premium relative to its peer
group on a five-year forward PEG basis.
The company also appears to trade at a premium relative to its own historical
averages for most valuation metrics. On a TEV/sales basis, for example, GNTX’s
current value of 3.85 lies 12.9% above the firm’s trailing five-year average of 3.41
(see Table 8, next page). GNTX’s P/BV tells a similar story, with the metric’s
current value of 4.32 exceeding the company’s historical average of 3.37 by 28.3%.
The firm also trades at a TEV/EBITDA premium of 5.8% compared to its own
recent historical values. The only commonly used trailing metric in which the
company trades at a discount relative to its trailing five-year average is P/E,
whose current value represents a 24.2% discount relative to the recent historical
mean. After adjusting for nonrecurring gains and losses, however, this relative
discount drops to 1.7%. Based on our earnings quality and fundamental concerns
highlighted in this report, we believe there is an increased likelihood that
GNTX’s performance will lag that of the larger market, returning its valuation
multiples to levels more in line with peers and its own historical norms.
Table 7. Relative Valuation Analysis
TTM
TEV/EBITDA
14.14
6.84
10.09
3.18
6.37
5.66
GNTX
DORM
JCI
LEA
SMP
VC
Median
GNTX vs. peer median
6.60
114.0%
12M FWD P/E
25.48
12.57
10.90
7.77
13.37
13.87
12.97
96.4%
5-Yr FWD
PEG
1.35
0.79
0.69
0.58
0.61
0.99
EV/FCF
64.68
22.99
NE
7.78
6.89
NE
P/BV
4.32
2.23
2.00
1.60
1.94
1.93
TTM
EV/Sales
3.85
1.22
0.67
0.24
0.57
0.39
12M FWD
EV/Sales
3.66
1.19
0.62
0.24
0.56
0.39
0.74
83.0%
15.39
320.4%
1.97
119.6%
0.62
521.4%
0.59
519.4%
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Research Alert
GNTX
01.05.12 GENTEX CORP.
Table 8. Historical Valuation Analysis
Current value
Trailing five-year average
Current value vs. fiveyear average
Risks to Thesis
TTM
TEV/Sales
3.85
3.41
12.9%
TEV/EBITDA
14.14
13.36
5.8%
TTM P/E
26.46
34.93
-24.2%
Normalized
TTM P/E
29.56
30.07
-1.7%
P/BV
4.32
3.37
28.3%
The primary threat to our thesis is rapidly accelerating revenue growth, a risk
that is closely tied to the company’s rear camera display (RCD) products. The
publication of the final rule relating to the Kids Transportation and Safety Act
(KTSA) was expected by 12/30/11, but has not occurred as of this report’s
publication date. The KTSA may require that all vehicles in the United States be
equipped with rear camera displays by September 2014. For vehicles lacking a
built-in navigation system, the rearview mirror could represent the most optimal
display location. Accordingly, the KTSA could trigger a surge in demand for
RCD-equipped rearview mirrors, a trend that would likely lead to a surge in
RCD unit shipments from 2012 to 2014. Pushback from automakers, however,
based on implementation costs could delay the decision or result in a lessaggressive integration timeline. While these two scenarios may not have a
dramatic effect on the firm’s long-term RCD growth prospects, they would
certainly have a dampening effect on near-term (2012) RCD demand.
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Research Alert
GNTX
01.05.12 GENTEX CORP.
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{2012.01} © Copyright Sabrient Holdings, LLC 2012
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