Sensata Technologies Holding plc (ST) Earnings Call Transcript & Summary

Okay. Thanks a lot. Excited for the next session here with Sensata, the premier supplier of measurement devices to a variety of industries. They produce well over 1 billion parts per year, $3.5 billion of revenue in 2019 with a very strong operating margin of 23% and really good free cash flow conversion. Market cap is around $7 billion. The business is quite diversified. A little bit below 60% of the revenue goes into light vehicle auto; around 16%, heavy vehicle and off road; 10%, industrial applications like factory automation; 6%, appliance and HVAC; and 5%, aerospace. And the growth has been really brisk. At its 2017 Analyst Day, Sensata projected revenue growth at 4 to 6 points above market. And they've been consistently achieving that since. We've been covering this company since October and have found quite a bit of controversy around the name, largely around the sustainability of content growth and whether electrification is good for Sensata or not. Some think EVs will have less relevant, high-value content and an increasing market share for EVs could lead to less content for Sensata. Our view is that most pure ICEs are going to eventually hybridize, clearly a positive for Sensata. And on the EV side, the ability to measure temperature, position, pressure is critical, and Sensata's capabilities should translate really well, not to mention other opportunities that we'll dig into during Q&A. But first, I'm going to turn it over to Paul Vasington, the company's CFO; and Joshua Young, Head of Investor Relations, for some opening remarks. Thanks.

Good morning. Thanks for having us. I agree with everything you said. We are a company that is benefiting from some very strong secular growth trends. If you step back, think about Sensata at a very high level, we are developing sensor-rich solutions for mission-critical applications and systems of our customers. And they focus on some key secular trends. One of the biggest and the most relevant today is around clean and efficient. So a lot of vehicles, heavy vehicles, farm equipment, stationary equipment is in need, either through regulation or through customer preference and needs, to be more efficient, to be clear, to be safer. And that's where we're seeing a lot of our business today, a lot of our revenues today. And that growth will continue for many years to come. A lot of the business is currently gas- and diesel-driven powertrains. There's tremendous amount of content on those systems. And we enjoy that content per vehicle. We enjoy our leadership position in the markets and the customers that we serve today. We have great margins. You talked about the 23% operating income. Very strong free cash flow, about $450 million-plus of free cash flow last year in 2019. Our conversion of our free cash flow to our adjusted net income is around 80%, so a highly cash-generative company, a strong balance sheet with net leverage around 2.8x. Over the last 4, 5 years, we've been very acquisitive. We bought a company back in 2014 called Schrader. This business has been incredibly important to our tire pressure -- or it is the leader in tire pressure modeling systems and has also enabled us to take their wireless capability and expand that out across our business, particularly into our heavy vehicle business, which we'll talk a little bit more about how that's manifested into a new vertical for us in terms of tire pressure sensing and also the clouds for our Smart & Connected initiatives in the trucking industry. Our business is made up of automotive. About 60% is automotive. You talked about the 16% heavy vehicle. And then we have this large Sensing Solution business, which is primarily an industrial business, around $725 million industrial business and then a $200 million-ish aerospace business, both very profitable pockets of growth in that Sensing Solutions business that are leveraging the secular growth that we're seeing in our Performance Sensing business. In terms of where we are today in terms of Electrification, which is one of our biggest end market that we're pushing for both from an organic and inorganic perspective, back a couple of years ago, we bought a company called GIGAVAC. And there is some question about you're a powertrain company, you focus on powertrains that use fossil fuels. What does it mean when you become electrified or that market becomes more electrified? And we recognized that early on and looked for both organic and inorganic ways to intersect that. And one of the inorganic ways was a company called GIGAVAC that we acquired, where it has a great position, premium position, differentiated position in high-voltage contactors, were really, really important in the performance of electric vehicles as voltage levels rise and as charging times are -- come down. That's an inorganic activity. That's really built a nice platform for us in terms of our content per vehicle and our future in Electrification. We also have a very strong organic platform that's leveraging our core technology to intersect the Electrification trend. And that means pressure sensing that is being utilized in a number of different systems on electric vehicles. You mentioned hybrid. Hybrids are great for us. We take a gas powertrain engine that gets converted to a hybrid vehicle. And we get more content primarily on the braking system, which adds to the content we already have. As you move up the scale to purely electric, what we're seeing is that they don't have a gas or diesel powertrain any longer. But what they do have is a need for more sensor capability and more efficient subsystems around in the cabin or in the thermal management system or regenerative braking, which so -- which means we want a vehicle that has greater range, is more safe, is more efficient. And we're finding that pressure sensing and our core pressure sensing technology today is -- can be used and is in need or is in demand in those more advanced systems that are developing over time. So we think the Electrification trend is going to be very, very relevant for Sensata. Our goal and view is that we're going to become agnostic about whether it's gas or diesel or purely electric or hybrid, that we can serve all those different platforms with equal or more content per vehicle than we've seen in the past.

Great. Thanks for the intro. And I guess when you talk to investors, I mean basically, what are the common themes that they want to see out of the company over the next few years? And I guess if you were on their side, like why would you want to dedicate capital toward Sensata?

I think the things we talked about is where we have this great position, a leadership position in many of the markets that we serve with -- these are not me-too products. These are really great mission-critical or, I say, rich -- sensor-rich solutions that are serving very hard to do mission-critical applications. And so we see ourselves as being able to offer a differentiated solution. It's a sticky business. It's a long-cycle business. Incumbency matters. The relationship with the customer matters. So we feel like we're really well positioned with our customers to continue to evolve with them. We see that the growth in the company will continue for the next 3 to 5 years based on the core technology and the core position that it has today. So we have a very strong pipeline of new business wins that we're executing on. One thing about Sensata that you have to understand is that the business that we win today, it takes a few years before that product actually gets launched into a system. So it's a long design cycle, that there's years of validation that goes. Then when it launches, then you see a big ramp-up over a 5-year period with revenue. So we're really well positioned to say with a lot of good business that we've won, that we're executing on, that will continue to propel our growth for the next 3 to 5 years. And we talked about something about outgrowth to the market. Our markets, we can't control the market. And as all of you know, in this industry, in our industry in particular, we've seen a lot of decline in end markets around the world. But we are outgrowing those markets substantially. Over the last couple of years, we've averaged about 500 basis points of outgrowth to the market in automotive. Our heavy vehicle and off-road business, we've outgrown that market nearly 700%. And so we're well outgrowing the markets that now we know that the market -- net-net, the growth hasn't been as great as we would like. But we're certainly continuing to get more than our fair share of that market with the new business wins that we've been launching and the execution around that. And then the continued priming of that pump for future new business particularly on the electrification side, so we see the Electrification pipeline growing, which is really exciting because that will be the future of growth as EVs become more and more significant in the carpark.

You've got a CEO succession happening at the moment. Where do you think Jeff's leadership will be a continuation of Martha's vision? Where might they differ? And then where does the company really need to be diligent about, making sure that the transition is smooth?

So Jeff's been with the company for 13-plus years and has had a number of different roles within Sensata. So he is deep into what has been happening in Sensata over that period of time. In the last, I guess I'd call it, 5 or 6 years, he's been more -- in more operating roles. So he ran operations for a number of years, moved into a responsibility for the Sensing Solutions business. In the last year, as President, he's had responsibility for all the businesses. He's been incredibly critical and deeply involved in some of our initiatives around Electrification, such as the acquisition of GIGAVAC. He's been driving the Smart & Connected initiative with our Chief Technology Officer, Steve Beringhause, to really get that thing going because we see there's a tremendous opportunity for Sensata. So he's been deeply involved in all these key strategies and the things that are disrupting sort of our traditional markets. And so I have great confidence in him and his leadership and his understanding of our business and the strategy going forward. I think you're going to see a similar -- very similar approach than -- as to what Martha put in place over the years. So again, it's going to be around growth, innovation, productivity, leading margins, great cash flows, smart capital deployment. Those are the things that's going to continue with the same kind of approach and feel that you've seen with Martha over the last 6, 7 years.

Okay, got it. I think one of the things that we've been impressed by is that you've -- the light vehicle development process is long. There's huge investments into validation. Things need to work for 12, 15 years. It's a serious engineering validation process. You guys have shown the ability to kind of take products developed through that process and kind of port those over to other end markets using similar building blocks.

Yes.

Can you give us an example of that and talk about what opportunities you see to do this in the future?

If you -- the automotive market was the biggest sensor market out there for Sensata. And so we developed a number of different sensor capabilities, take pressure as an example, and brought that to the market for a certain application and then fanned it out into other applications within systems within the vehicle and then took that pressure sensing capability and then took it into a new vertical, call it heavy vehicle & off-road, which have the same needs around cleaner, more efficient operations of the powertrain. We then took that pressure sensing capability and brought it to the industrial landscape where we saw the need for pressure sensing and getting in ventilation and air conditioning systems. So you kind of build capability and scale. You spread it out across that industry, and then you push out into other verticals. And why that makes so much sense for us is that we get to leverage a huge amount of scale in our main -- in both in engineering and also in our production. So now you're building similar products at a much larger scale. You're getting the cost benefit of scale. The other thing that's interesting about Sensata, even though we get the scale benefit, all of our products are highly customized to the needs of our customers. So we're ultimately delivering a customized sensor for a specific application that's built off a global footprint with significant scale, where the differentiation is happening late in the manufacturing process. So it really drives a very productive, efficient manufacturing process. We're also -- we're using engineering design. And it's not so much the technology. We're taking existing technology. It's in our ability to package that to optimize that for the needs of the customers. So it's highly engineered, and we can leverage a significant common footprint or baseline to be able to then expand from.

And that's what leads to the higher margin.

And that's what leads to the higher margin over time.

Got it. Got it. So I think you've had some tailwinds over the last few years around regulatory, tire pressure monitoring, regulatory around different type of exhaust after-treatment in heavy truck, industrial, light vehicle. I guess how do we get comfortable -- and maybe there's -- those -- some of those tailwinds continue. But how do we get comfortable that the outgrowth is not really just related to regulatory, that there's opportunities to kind of continue that out into the future, out over the next few years?

Okay. I think regulatory is an important attribute that sort of drives the urgency for improvement in the ultimate systems and applications on the vehicle or the equipment. And our close relations with the customers allows us to have the opportunity to develop sensors that are helpful in that regard. I'd also think there's a significant customer pull for higher-performing, safer, more efficient whether it's vehicles, or it could be heavy vehicle, it could be farm equipment, it could be air conditioning systems. I mean so I think it's a combination of regulatory, efficiency, greater productivity. I mean one of the productivity elements, I think, of our business that's not talked about a lot is, take our heavy vehicle & off-road business, which we talk a lot about trucking, well, one of the things we did, we bought a company a few years ago called DeltaTech, which has designed and developed a very robust electronic interface in the cabin for the operator to operate large construction equipment and farm equipment to get away from all the hydraulic controls. So now you've got a very sophisticated armrest with a very sophisticated technology that allows the operator to work it like a joystick. So that is not regulatory-driven, but that is productivity, efficiency, a better customer experience. And we're seeing a lot of that in parts of our business. But there's no doubt regulatory tightening or improvements are going to drive the industry to continue to evolve. There's the modernization of China in terms of just the general improvement that you're seeing in the sophistication of those -- of passenger vehicles or trucks. Tire pressure sensing is a great example where we knew there was a mandate coming into the '19, '20 -- 2019, 2020 time period. We actually saw a ramp-up in demand for tire pressure sensing in China because customers wanted it. And OEMS were looking at their competitive set and said, "We need to offer this because we need to be competitive because it's a feature that customers want." And so we saw an uptake or take-up rate that was greater than what the regulation would have driven. So there was a combination of both regulation and customer preference, I think, is driving the continued demand for better, more efficient, cleaner, higher-performing product.

Got it. And kind of on China, can you remind us what your content per vehicle is there versus kind of on average, sort of?

So it's about $18, approaching $20 versus...

$18 per vehicle.

$18 content per vehicle. So it's the kind of average across the fleet. I mean we -- in any car, you could have much higher, but we don't obviously have content in every car. So we look at the average content per vehicle across that market. In I would say North America and Europe, it's going to be in the high 30s. So there's a lot of runway in terms of what's possible.

Is there a path to get to that high-30s level? Or is it a more fragmented market?

No, I definitely think over time, there's a path. As those vehicles become more and more sophisticated, as the regulation continues to drive them to be more efficient, to be cleaner, to be higher performing, to be safer, there's definitely a path to that over time.

The outlook in 2020. One of the things that we've kind of heard from investors is that, that the guidance requires kind of a larger margin uplift in Q2 to Q4, which is typically higher margin than Q1, but maybe it's a little bit larger uptick than a normal year, even ex kind of coronavirus type of impact. Can you talk about like kind of what your confidence level is in achieving those margins? And what are some of the drivers of why the gap is a little bit bigger this year?

Sure. In the first quarter of every year as a supplier in automotive industry, a lot of our customers receive an annual price down at the beginning of the year. So you get immediate impact from that. How we offset that is through cost reduction. We look at our manufacturing footprint, our fixed cost structure and we're always looking to optimize and improve that. Material is a big part of our building materials, and we constantly look to design our products at a lower cost point. It could be just a different design, less -- different materials, less materials. It could be just working with suppliers to create a better economic situation. It could be increasing the efficiency in which we would produce products or taking less waste out. It could be having a faster cycle times with lower logistics costs. So I mean we are obsessed with driving cost out of the business because we have to, because we're dealing with a large customer base that is looking for annual productivity gains, understandably, because they're giving you business for many years. And so you're on the platform for many years. And so it's important that we work with them to -- and they're willing to work with us to try to find that balance. But those productivity initiatives are more -- happen in a ratable way versus the impact of price. So it's always tougher on us in the first half in terms of margin profile. The margins typically improve as the year goes on as those productivity initiatives are generating more and more savings on the volumes that we're producing. Second half of the year, we expect to see better volumes. Volume is clearly something that allows us to drive productivity. When we have a declining market, when volumes are down, they're typically in product lines that are more mature, that are higher profitable -- have a higher profitability to them because they've been running for a long time. They're a higher scale. And so our business has a dynamic of today, and we talked about in the earnings call, where it has some relevance to the second half where we've been scaling up some new products that are being driven by regulation in China and in Europe which is related to gas direct injected engines and gas particulate filters, which we provide sensors that serve those applications. And we won a lot of business in 2017 that accelerated that demand, and we've been working really, really hard to -- and effectively to meet that demand. And so that -- so we've been ramping up these products. As the products ramp in a large scale, they're not going to be as profitable as something that's been running for a number of years. So we're growing in new scaling products which are -- currently have a lower margin rate because they're scaling and they haven't hit their level of maturity and efficiency. And we have a decline of products that are highly profitable, that are declining, which is creating an unfavorable mix. That impact will be less so in 2020. And as you get into the second half, we expect to see better volumes of more higher-margin, mature products that will help push margin rates up. I guess the other thing that you're going to see is that last -- in 2019, because of the lower performance, we did not perform to the promise, and so incentive compensation was much lower. We're looking to bring that back to more normal levels to ensure that employees are engaged and everyone's working hard for the future of the company. So there's going to be a year-over-year impact as it relates to incentive compensation. We're going to benefit from some of the repositioning actions that we saw, so that will help in sort of the second and third quarter and a little bit in the first quarter. So there's a number of different moving pieces, but I think in general, the key takeaway here is productivity and volumes improve over the course of the year. It's going to drive continued margin expansion.

Got it. Getting into just kind of some of the kind of the more unique opportunities, recurring revenue is something we hear about a lot from the supply chain. And kind of you guys have what's been one of the few to kind of really hone in on a specific opportunity there, which is the Smart & Connected efforts. Give us a brief rundown of what that is, where you stand and kind of what's the key value proposition you're offering to customers.

We're really excited about the Smart & Connected initiative. It goes back to your earlier question about how we take it to existing technology and fan it out. So when we acquired Schrader, we acquired its great direct tire pressure monitoring system business, the industry leader, but it came with very robust wireless protocol, so a sensor wirelessly communicates with it, with the vehicle. We took that tire pressure business. We brought it to the heavy vehicle knowing that there's a need, there's a regulatory need necessary at the time. With that, it provided a savings to the owner-operator and certainly provides safety when you're monitoring your tires and making sure they're properly inflated. So now we have -- take a big 18-wheeler, you've got a whole bunch of sensors on that truck, on those wheels, and you have to aggregate all that data to know what's happening in all those wheels. And so we had to put in place a network on that vehicle, created a wireless network on that vehicle to receive the inputs from these wireless sensors. And that led to an understanding that there's a lot more that we could do on the truck in terms of information needs that the owner has by using sensors to sense what's happening on various applications on the vehicle. It could be the tires. It could be weight load. It could be the need to have a truck in the trailer -- in the back of the trailer being able to be connected. So we saw all these sensor needs -- all these needs, I should say, that the customer had that was -- they are unmet, pretty basic stuff, where we can provide sensors to help understand what's happening in those areas and aggregate that data into a wireless network. So what we're focused on primarily is that sensor layer. How do we continue to proliferate sensors on a large truck, that information will be helpful to improving the performance of that truck for the owner-operator. And it could go through the OEM channel. And that's about a $1 billion market, we think, TAM. Or it can go through the retrofit channel, which we think is about a $6 billion TAM. So a very large market opportunity to get after that sensor layer, to proliferate sensors on that vehicle, to aggregate that data into a wireless network and then be in a position to then provide that information to an owner-operator because they want to know what's happening on the truck. They want to know what's the load. They want to know the tire pressures. They want to know how the load is distributed. When they're backing it up, they want to be able to see what's behind them. They want to be able to connect the truck and the trailer together so they're integrated. Now trailers -- not every truck is now aligned to that trailer. There's many, many, many trailers there could be without a truck. And so how do you create that connection? Today, you don't have a wired connection. We can bring a wireless connection. We are bringing a wireless connection. You could also take that to measuring the temperature within the trailer. So a lot of different things, there are a lot of things that the owner-operators want to know. And our ability to have -- already have a position on the sensor layer of that vehicle and I think is incredibly powerful. The next step would be how do you then take that -- how do you get that information to the cloud either through a telematics provider or to a user-operator who wants to be able to understand that information and use that information to manage the performance of that vehicle. We think it's really exciting. It's early days. We're doing proof of concepts with a number of large leading freight carriers. We're running tests. We've got sensors on the trucks. They're gathering data. And so we can see how it's all working in getting a reaction from the, actually, owners-operators of those vehicles.