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Morningstar | Gentex Weathers Tariffs and Order Changes in 3Q

We are not changing our Gentex fair value estimate after incorporating third-quarter results into our model. Production slowdowns all over the world and tariffs for goods in and out of China did cause management to reduce 2018 revenue and gross margin guidance, but these changes are offset in our model by share repurchases and time value of money. Revenue increased 4.9% year over year to $460.3 million but missed consensus of $467.9 million. Diluted EPS rose 35% to $0.42 to match consensus, but we calculate that EPS grew 26%, excluding buybacks. We also calculate that EPS was flat year over year at $0.31 excluding the favorable change in tax rate (14.7% this quarter versus 31% in third-quarter 2017) and excluding buybacks. Management said on the call that it believes Gentex's current stock is undervalued, and 12.2 million shares of repurchase authorization remains after $172.5 million of buybacks in the third quarter.

Tariffs on electronic components imported from China as well as tariffs on Gentex's finished products into China are hurting results. Gross margin declined by 140 basis points year over year to 37.6%, and management said tariffs contributed 60 basis points of the decline. These pressures will likely get worse as the Trump administration added more Chinese imports (List 3) to a 10% tariff on Sept. 24. List 3's tariff rises to 25% on Jan. 1. Since President Donald Trump's hard-line stance against China is not likely to stop soon, we understand Gentex cutting its full-year 2018 gross margin guidance to 37.5%-38.0% from 37.5%-38.5%. Revenue guidance for 2018 is now for $1.854 billion to $1.872 billion from $1.88 billion to $1.91 billion, but the company is maintaining its 2019 revenue growth rate of between 5% and 10%. CEO Steve Downing told us on the call that even if Europe does not recover from production delays, that would mean revenue growth closer to 5% rather than a guidance cut next year.

Gentex is fighting frequent last-minute order changes from customers, which have increased in the past six months. Europe is a big culprit of this problem because new emission testing there called Worldwide Harmonized Light Vehicle Test Procedure, or WLTP, has caused many European OEMs to delay production while they work to comply. We expect WLTP to remain a problem in fourth quarter's results, and Downing is not 100% confident that there will be a production recovery once WLTP is under control. However, we think his tone was cautiously optimistic that there will be some improvement either in the fourth quarter or in 2019.

We expect that tariffs will remain a headwind into next year as well, and for the fourth quarter the company expects total incremental costs from tariffs to be $5.5 million to $6.0 million. Gentex always produces in Michigan for quality reasons, but Downing did seem open to foreign production if tariffs are not resolved. Still, we would not expect an announcement on that until at least late 2019, if at all. We think Gentex, for quality reasons and to integrate best with its own chemistry research efforts, will prefer manufacturing to remain in Michigan. Management said on the call that excluding tariffs, 2019 gross margin will be similar to 2018 levels. Although some offset can come from alternative sourcing, we don't think there's much management can do quickly to avoid the pain, and we hope the U.S. and China resolve their trade differences soon.