Sensata Technologies: Beaten Down By Macro And Margins (NYSE:ST)

This has been another tough year for companies leveraged to the passenger vehicle market. The year started off with projections of mid-to-high single-digit unit growth in vehicles for the U.S. market, but semiconductor and component shortages have decimated that forecast, with actual year-to-date sales trending down about 9% (this is production-driven, as inventories are still thin). At the same time, electronic component shortages and other inflationary drivers have made life difficult on the margin side for many companies.

Sensata Technologies (NYSE:ST) has seen its share price fall a little more than 20% since my last update. While I suppose that’s not terrible next to other broadly comparable suppliers to the auto and commercial vehicle markets, including Aptiv (APTV), Dana (DAN), and TE Connectivity (TEL), it’s not the year I expected for this sensing and controls company, and 2023 isn’t offering much in the way of macro certainty.

I do think that Sensata looks undervalued, but I also thought that in the high-$50’s. Now Sensata is looking at a potentially softer auto demand environment, as well as weaker trends for highway/off-road business and industrial markets. Provided that mid-single-digit growth is still viable, which I believe it is given the company’s higher EV content and its growth opportunities elsewhere in electrification, these shares offer a worthwhile return at today’s price.

Autos – A Little Good News Would Be A Nice Change Of Pace

Although Sensata has by and large held its own against a challenging auto backdrop in 2022, there were more significant challenges evident in the third quarter. Auto OEMs had been building inventory to smooth over supply interruptions, but that started to reverse in the third quarter with customers unwinding some of their excess inventory. With that, it looks as though auto customers are shifting back toward pre-pandemic ordering patterns.

This is troublesome on at least two levels. First, it creates revenue headwinds for Sensata at a time when the company has already had issues with revenue growth, leading to relatively disappointing-looking organic growth at a time when many suppliers have seen a big improvement. Second, it doesn’t speak well to the level of demand that these auto OEMs anticipate in 2023. The economy is definitely slowing in response to interest rate hikes, and while auto inventories still need to be rebuilt, the rebound in auto production next year is looking more modest as time goes on.

I suppose it’s not entirely fair to say that there hasn’t been some good news in Sensata’s auto business. In recent quarters the company announced a meaningful EV charging win (worth about $60M/year) and the company’s biggest-ever win, a $1B-plus award for battery disconnect units that could contribute $150M or more of revenue starting in 2025.

Multiple Markets Looking Softer In 2023

It’s not just autos where I have concerns about the level of end-market demand growth in 2023. Management once again lowered its end-market growth expectations with third quarter results, including a guide for 13% contraction in the HVOR (highway/off-road vehicles) segment and 7% contraction in the Industrial segment. While Aero is expected to grow 17%, it’s too small to make a meaningful difference.

With the HVOR business, I do expect companies in the commercial truck, ag/construction equipment, and related businesses to see healthy deliveries in the first half of the year as they deliver on their backlogs. Orders, though, I expect will start to show sharper contraction, and I believe there will be some potential inventory-management issues here as well – I don’t think there is evidence that Sensata is losing share in HVOR (or in autos), but inventory management could lead to revenue headwinds on top of weaker order trends.

In the industrial end-markets, several CEOs of short-cycle industrial companies have forecast a recession in 2023, and I would expect weaker demand for motors, electrical subsystems, and the like. HVAC could be relatively stronger for at least the first half, but not unlike the situation with HVOR, I expect backlogs to deplete pretty rapidly for HVAC manufacturers, and I’d also note that Sensata’s Industrial and HVAC sales tend to be lower-margin (electrical protection products).

Electrification Could Produce Fireworks, But There’s A Long Fuse

I do remain bullish on Sensata’s leverage to vehicle electrification, as well as its growth initiatives in other areas of electrification. High-voltage contactors could be worth over $60 per vehicle in content (against a historical average in traditional gasoline-powered cars of around $30-$40), with additional opportunities in areas like battery management (including disconnect), brake regeneration, temperature management, and climate control.

Sensata is also looking to be a bigger player in components and subsystems, with a long-term electrification revenue target of $2 billion. Part of this is based on high-voltage junction boxes, a system-level solution for electrification (including charging and battery management), as well as more integrated storage offerings that combine high-voltage distribution units with batteries.

The Outlook

I’m certainly less bullish on 2023 than before, as Sensata’s core end-markets look weaker now and I’m less bullish on margin leverage. It’s an open question as to whether input cost inflation will ease significantly, and weaker end-markets are likely to undermine attempts to offset costs with higher pricing. What’s more, I could see Sensata incurring some manufacturing inefficiencies if inventory winddowns at auto and HVOR customers aren’t done transparently (and it seems as though the company was surprised by the moves in the third quarter).

My 2023 revenue number is about 10% lower than before, and while I do think business will pick up again in 2024 and 2025, I’ve taken a more conservative approach with modeling for the time being. That takes my long-term revenue growth rate number from close to 7% to closer to 5.5%; the opportunity to hit 7% is still there, but it may well end up being predicated more on future EV launches rather than recoveries in the traditional auto business.

On the margin side, I believe a 21% operating margin in FY’23 is likely out of reach now and may not even be an easy bogey to hit in FY’24. Longer term, I do still think that low-to-mid-teens free cash flow margins are attainable, driving about 100bp of FCF growth in excess of revenue growth.

Discounted cash flow (using a high single-digit discount rate) gives me a prospective total annualized return in the high single-digits with the aforementioned growth rates, which I consider “okay”, but not necessarily compelling given the headwinds to the business (and the likely impact on sentiment). Likewise, I can argue for a high-$40’s to low-$50’s fair value based on near-term margins and ROIC, but clearly the Street isn’t on board with that today.

The Bottom Line

Is the Street overly negative on Sensata today? From a long-term perspective, I think so. In the near term, though, I can’t say that fears about weaker auto demand, weaker commercial vehicle build-rates, softer short-cycle industrial demand, and iffy margin leverage are unreasonable. Sensata continues to build up a book of attractive wins for the long-term growth of the business (in both electrification and telematics/asset tracking), but the Street is notoriously short term.

I see more upside than downside from here, but I can’t say that another trip below $40/share is out of the question if the next few months see uglier readings on the macro environment in the U.S. This is a name I still have high on watchlist, but it’s tougher for me to argue for it as a must-buy when end-market pressures are likely to weigh on sentiment a while longer.