ST - Sensata Technologies: Weak Win Rate Should Continue To Pressure Near-Term Valuation

2023-08-02 13:21:32 ET

Summary

• ST's current win rate and its potential impact on market share are key factors to monitor in the coming quarters.
• Despite operating margins still being below the 20% range, ST has shown strong incremental operating margin. If auto production continues to improve, margins are expected to increase, supporting earnings growth.
• Due to the uncertainty surrounding the win rate and its effect on market share, ST's near-term valuation is likely to remain under pressure, trading at around 10x forward PE.

Investment action

I recommended a neutral rating for Sensata Technologies Holding ( ST ) when I wrote about it the last time, as I wanted to wait for better clarity on how existing and upcoming headwinds would play out. Based on my current outlook and analysis of ST, I continue to recommend a hold rating. I am positive on ST’s ability to expand margins, however, its current win rate has me concerned about whether it is losing market share (a key KPI to track in the coming quarters to see whether it is due to delayed product launches). Given this near-term headwind, I think valuation will remain pressured at 10x forward PE.

Basic recap

ST manufactures and distributes electronic components. Some of the products they offer includes automotive sensors, motor protectors, circuit breakers, thermostats, pressure sensors, and switches.

Review

ST 2Q23 revenue of $1.06 billion exceeded the high end of guidance ($1 billion to $1.04 billion). This represented an increase of 6% sequentially and 4% annually. The adjusted operating profit was $206 million, representing a margin of 19.4%. Increases in organic revenue, productivity, and advantageous pricing contributed to a rise in adj operating income. The operating EPS of $0.97 was also near the upper end of the expected range of $0.88 to $0.98, which was $0.02 higher than the consensus estimate of $0.95. I believe this was a mixed quarter for investors with both good and bad.

Although adj operating margin is still under pressure at below the 20% range (with over a billion dollars in sales), the good news is that incremental adj operating margin remains very strong. On the positive end, when we compare 2Q22 to 2Q23, revenue increased by $42 million and adj operating income increased by $12 million, translating to an incremental margin of 28%. Based on this, I would expect margins to continue increasing in the coming quarter so long as auto production continues to improve. Growth comparables should also become less challenging in the coming quarters as the unusually strong headwinds to margins from acquired businesses and divestitures subside. ST's operating margins in the second quarter, excluding investments and FX, would have been 21.2%, I should add. This would mean that the incremental margin is a lot higher.

The main drawback is that the win rate is slowing down at the same time as the rate of improvement in automobile production. The poor performance was attributed to customers' inability to digest their inventories and management's inability to fully leverage the strong growth of the Chinese auto market, where domestic brands are driving the expansion and gaining market share at the expense of international OEMs. When compared to the previous year's goal of $1.04 billion, management is now anticipating new business wins of $600-$800 million in 2023, a big step down of 30%. Although ST appears to be losing market share due to its limited presence in China, I would wait a couple of quarters before drawing any firm conclusions. The reason for the lower revenue growth expectation could be that ST's customers are delaying the introduction of new products.

Put together, near-term uncertainties remain for ST in the near term. However, if we look at it over the next 3 to 5 years, product launches should recover and support the win rate. Revenue growth would continue to drive margin expansion as long as the incremental margin remained strong. There is a visible path for ST to continue driving earnings growth at a healthy pace in my view.

Valuation

I believe ST’s growth in FY23 will likely be weak given management’s weak outlook and the gradual recovery in global auto production. FY24 should see growth as the macro environment turns better, which is a positive tailwind for auto production. I am more positive on ST's ability to improve margin as the incremental margin continues to be strong, as per my analysis above. However, I think the near-term headwind (concern for the win rate) will put pressure on ST's near-term valuation until ST shows a growth rate that mirrors the market growth rate. This would suggest that ST is not losing market share. Hence, I expect ST to continue trading at the current 10x forward PE, which is in line with its peers group. I would, however, expect ST to rerate back to its historical average of 14x earnings in the median term as growth normalizes and margin continues to expand.

Final thoughts

In conclusion, ST's performance in 2Q23 showed mixed results with both favorable and unfavorable aspects. While there are positive indicators, such as strong incremental operating margin and potential for future growth as auto production improves, challenges remain. ST faces slowing win rates and limited presence in the Chinese auto market affecting market share. I recommend to stay neutral for the time being until we see a confirmation in win rate trend.

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