ST - Sensata Technologies: Near-Term Headwinds Raise Uncertainty

2023-04-28 15:44:07 ET

Summary

• ST is a manufacturer and distributor of electronic components with a strong market position in the growing automotive sensor market.
• There is a way for the company to manage its pace of margin expansion if they choose the route of cost optimization.
• The resilience of auto demand is something to watch, given the high likelihood of the macro environment worsening before turning for the better.

Overview

Sensata Technologies ( ST ) manufactures and distributes electronic components. Some of the products they offer includes automotive sensors, motor protectors, circuit breakers, thermostats, pressure sensors, and switches. I have a positive view on ST's business, for two reasons. First, ST has a strong market position in a growing market (automotive sensors). Second, ST is highly leveraged to the megatrends of increased fuel efficiency, decreased emissions, and enhanced safety in the automotive sector. I believe these two megatrends will ensure ST's long-term growth, despite the inevitable cyclical downturns. I think the 1Q results are decent when viewed in the big picture, but the company will likely face headwinds due to its exposure to China. While I would have liked to see a faster rate of margin expansion, I am heartened by the fact that ST's strong bookings over the past few years indicate that the company is likely to increase the proportion of its content dedicated to EVs as opposed to ICE vehicles. Over the next three years, management hopes to double the content's current 20% annual growth rate to 40% annual growth rate by 2026. Given the near-term uncertainties but long-term mega trends, I recommend to stay neutral on the stock for now and await better clarity on how existing and upcoming headwinds will play out.

1Q23 earnings

The $998 million in revenue and $0.92 in non-GAAP EPS that ST reported for 1Q23 were about in line with expectations. Automobile sales increased by roughly 6% y/y. HVOR saw a 9% increase in revenue y/y, while Aerospace saw a 33% increase and Industrial and Other saw a 7% decrease. Management has projected that revenue will be $1.02 billion in 2Q23, with earnings per share in the range of $0.88 to $0.98.

Strong revenue growth was evident in the reports and guidance, and I expect this to continue as long as the automotive industry continues to be strong in the near-term. On the other hand, I was mildly dissatisfied with the rate of margin expansion, and consequently, I have revised upward my estimate of the margin expansion that can be achieved in the coming quarters, given the current state of the end market volume. The belief is that while the end markets have held up well, the expected amount of sales has not materialized. As a result, it is wise to adjust expectations because the overall economic situation is predicted to worsen before getting better in 2023. Although management has reiterated a target of a 21% operating margin, I believe it is more probable that this target will be achieved later than originally planned because of the challenging macro conditions and limited increase in sales volume. However, if management is committed to pursuing a tighter cost structure in the meantime, they can reach their goal in FY23. In fact, I believe this to be the best outcome, as they will emerge as a stronger company with improved profitability in a favorable macro environment if they take this course of action. Given that they can "hide" cost-cutting measures under the guise of bad macro, now seems like the ideal time to do so.

Concerns

I think something to consider and think about is how the narrative revolving around the resilience of auto demand will remain. How long this will last and what effects will it have on ST is an open question. The exposure to China is the immediate headwind that is being flagged. If China's market share is taken over by domestic OEMs, it would be a headwind for ST as ST has lower content per vehicle as compared to Western OEMs. In my opinion, it is too soon to make any definitive statements about the future of the growth rate. Ultimately, the net impact to ST is somewhat neutralized if ST is able to continue improving its content per vehicle, which management targets to double on domestic OEM vehicles. The second challenge is the extent to which the market can absorb the industry's surplus of products. In the worst-case scenario, I see a drop in production volume as a result of an accumulation of inventories that clash with a sharp drop in demand (for any reason triggered by this weak macro). When this occurs, ST will be directly impacted as well.

Conclusion

The 1Q23 results were decent, but ST is likely to face headwinds due to its exposure to China. While I recommend staying neutral on the stock for now, I expect strong revenue growth to continue as long as the automotive industry remains strong in the near-term. However, the rate of margin expansion needs to improve, and management should pursue a tighter cost structure to emerge as a stronger company with improved profitability in a favorable macro environment. Overall, ST's long-term growth potential remains strong, but near-term uncertainties and headwinds should be carefully monitored.

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