Autos' Increased Sensor Content Drives Sensata's Growth
The firm is positioned to benefit from stricter emissions, vehicle safety, and fuel efficiency standards.
Sensata Technologies (ST) is a leader in mission-critical sensors and electrical protection and is engaged largely in the development, manufacture, and sale of automotive-related sensors and controls. We think the firm is positioned well to benefit from increased automotive sensor content as stricter emissions, vehicle safety, and fuel efficiency standards are forcing automakers to use more sensors. We believe Sensata’s near-leading share in its major end markets is sustainable, thanks largely to switching costs faced by its customers.
In the near term, we believe Sensata’s top-line growth will be largely derived from increased automotive sensor content on the back of low-single-digit global automotive production growth. Continuous technological developments, modestly increasing vehicle production, and customer preferences for additional safety and comfort features have contributed to the increase in sensor demand.
Tire pressure monitoring sensors, advanced driver assistance systems, and hybrid vehicle systems are among the applications that will require the greater use of sensors. Further, regulatory authorities in China are recommending that Chinese original-equipment manufacturers OEMs put tire pressure monitoring sensors in new vehicles beginning in 2019, which should support Sensata’s long-term growth.
While Sensata operates in a very competitive space, content growth opportunities should translate to mid-single-digit revenue growth for the firm. Additionally, integrating past deals, leveraging its low-cost manufacturing infrastructure, and deleveraging the balance sheet should support improved profitability margins and cash flow conversion. While Sensata’s current corporate strategy has been primarily focused on the automotive market, the fiscal 2015 acquisition of CST provided more exposure to the industrial, medical, and aerospace and defense end markets. OEM customers in these markets are experiencing the same need for sensing solutions as in the automotive space. As the integration process moves forward, we think the acquisition will provide ample cross-selling opportunities for Sensata while benefiting from an improved level of profitability.
Switching Costs Dig Narrow Moat
Sensata is a world leader and early innovator in mission-critical sensors and electrical protection. The company is engaged in the development, manufacture, and sale of sensors primarily for automotive applications, although it has recently increased its presence in industrial sensors. Because of the mission-critical nature of Sensata’s sensors and strict quality standards in the automotive end market, high quality is a key determinant in customers’ purchasing decisions. Further, customers trying to switch sensor suppliers would face considerable time, effort, and financial costs to redesign and retest products to ensure that a new sensor will work as well as the incumbent. Combined with our expectations that the firm will earn healthy excess returns on capital, we think Sensata benefits from sufficient switching costs, resulting in a narrow economic moat.
Sensata operates its business through two segments: performance sensing (79% of fiscal 2015 revenue, 75% of fiscal 2015 operating earnings, and 26% adjusted operating margin) and sensing solutions (21% of fiscal 2015 revenue, 25% of fiscal 2015 operating earnings, and 32% adjusted operating margin). Performance sensing is geared toward the design and manufacturing of automotive-focused sensors such as pressure sensors, temperature sensors, speed sensors, and position sensors. Bosch was the market share leader in automotive sensors in 2015, accounting for 30% of the industry’s revenue. Infineon (IFNNY) and Sensata followed, each accounting for 14% of 2015 industry revenue. Sensing solutions is composed of devices that are embedded in systems to protect them from excessive heat or current.
The automotive sensor market is characterized by high switching costs and barriers to entry. Sensors are critical components that enable a wide variety of applications, many of which are essential to the proper functioning of the product in which they are incorporated. Sensor application-specific products require close engineering collaboration between the sensor supplier and the OEM or the Tier 1 supplier. As a result, OEMs and Tier 1 suppliers make significant investments in selecting, integrating, and testing sensors as part of their product development. Switching to a different sensor results in considerable additional work, both in terms of sensor customization and extensive platform/product retesting. This results in high switching costs for automotive manufacturers once a sensor is designed in and is a key reason that sensors are very rarely changed during a platform life cycle, which is typically five to seven years. Because of the importance of reliability and the fact that the sensors have to be supported through the length of a product life, OEMs and Tier 1 suppliers tend to work with suppliers that have a long record of quality, especially if a historical business relationship exists, as well as the scale and resources to meet their needs as the car platform evolves and grows. Sensata has relationships with its top 10 customers that average 26 years.
Sensata penetrates a market by starting small. Once established, Sensata signs long-term contracts with its customers and embeds its mission-critical technology through customization. Going forward, content growth will be the major revenue growth driver for Sensata. Stricter emissions and fuel efficiency standards are forcing automakers to use more sensors. Also, tire pressure monitoring systems, advanced driver assistance systems, and hybrid systems will require greater use of sensors. Although competition continues to increase in response to the promising revenue opportunity, we believe Sensata’s switching costs and sticky customer base will allow the company to more likely than not generate excess returns on capital over the next 10 years.
End Markets Are Cyclical
We assign a high uncertainty rating to Sensata based on several factors. Sensata sells into cyclical markets, and its revenue and margins are susceptible to economic downturns. Further, a rising number of used cars could provide too many cheap alternatives to buying a new car, resulting in slower new-car production growth. Additionally, Sensata faces integration risks surrounding its acquisitions of Schrader and CST, each of which it purchased for $1 billion in fiscal 2014 and fiscal 2015, respectively. Given the immense size of these purchases relative to historical acquisitions, integration could prove quite complex and distract management from focusing on Sensata’s core operations and strategy. Further, if the acquisitions fail to live up to their performance expectations, Sensata runs the risk of its goodwill becoming impaired.
In our view, Sensata generates sufficient cash flow from operations to finance its modest capital spending requirements without having to rely on outside funding arrangements. Sensata maintains a balanced capital-allocation policy that includes a share-repurchase program as well as ongoing strategic mergers and acquisitions. The remainder of Sensata’s free cash flow is used to pay down debt.
Timothy Feeney does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.