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

Well, good morning, everyone, and thanks for joining the fireside chat with Sensata. My name is Craig Hettenbach, Semiconductor Analyst at Morgan Stanley. Just before we kick off, I do need to remind investors about research disclosures. They can be found at www.morganstanley.com/researchdisclosures. And so with that, I want to welcome in CEO, Jeff Cote; and CFO, Paul Vasington. So good morning.

Good morning, Craig.

So Jeff, maybe we can kick off just at a high level kind of Sensata, key technologies and growth drivers to help kind of as we drive the discussion?

Yes. I'd be glad to provide that. It's a little bit of a dangerous open-ended start, but let me provide a little bit of context, and I'll try to be brief. So just as a backdrop, I think folks that are following Sensata know that we're a 100-plus-year-old industrial technology company. And although some may not know the name, you use our products every day in your homes, your cars. About a $3 billion in revenue in 2020, employ over 19,000 people globally, operate in a global environment. And we have a strong legacy of designing and manufacturing, very hard to do mission-critical sensors and electrical protection, which, at the core, help our customers solve their most difficult challenges. We focus on the high-value, high growth segments. We have a low-cost, variable cost model, and we have a history of continuous improvement that allows us to generate differentiated margins and premium margins relative to our peer group. We're CapEx-light 4%, 5% of revenue, which allows us to convert those great earnings into cash flow. Serve a number of OEMs, tiers and aftermarket customers in the automotive, heavy vehicle off-road spaces, aerospace as well and a variety of industrial markets. And Craig, we benefit from a number of trends that are occurring in the marketplace and a number of trends that have been in the marketplace for a long period of time, such as the need for more clean and efficient systems. Obviously, the trend of electrification is a major market trend that's driving growth for us as well as broad IoT-related applications. We refer to that as Smart & Connected in terms of our initiative as a company, and those trends drive secular growth for us as a company. They have, for many decades in the past, and we see them as continuing. Those secular growth trends post a 400 to 600 basis point automotive outgrowth and a 600 to 800 basis point HVOR outgrowth. And the way we measure those trends, because we're a long-cycle business, is on our new business wins. So we're transparent in terms of sharing with investors what our new business wins are annually. Over the last 5 years, it's been over $440 million of average win, which gives us confidence in that secular growth going forward. So the combination of market recovery, off a low in 2000 secular growth associated with outgrowth and some of the M&A activity, which I'm sure we'll talk about, sets us up for some really nice growth going forward. So hopefully, that gives you a sort of high-level view of Sensata.

Yes. I think that's great. And before we dig into some of the more secular growth drivers, I did want to touch on just kind of current business conditions. Maybe just starting with the supply chain. I mean, there's tightness throughout the electronics supply chain, more so in semiconductors, understandably. But even with that said, like how is it impacting Sensata in your business with this tightness?

Yes. So I think you hit it. It's specific to the electronic shortages. This is a challenge that's facing a lot of companies more broadly. We're working directly with our customers and our suppliers real-time to match that capacity. The volatility and demand that we've seen over the last year from our customers has created challenges associated with doing that, but we're working very closely with them. In some instances, we're extending the order rate that we have with our suppliers to make sure that we get -- early in queue to make sure we get our fair share or more and also to avoid some pricing increases that we may see, given tight capacity on that front. I'm really proud of the team's effort here. Because we're mission-critical, because we're designed in, because, in many instances, we're sole-sourced with our customers, we need to be a reliable source. And I think we've navigated what has been, volatile would be an understatement right, given what we've seen in our markets over the last 12 months, but I think that we've done a really good job of managing through that. And it's -- we're not through it, right? 2021 is going to continue to see some supply chain shortages, but I think we're managing through it quite well.

Got it. And how about just the overall business? I mean, certainly, you've rebounded sharply since the lows last year, as you discussed. How is business kind of feeling today? And are there any different trends by geography that you would call out?

Yes. So we're on track. We provided guidance for the quarter and for the year. We felt as though there was enough stability that has returned to the market to be able to provide that look. We've talked about the tightness in the supply chain. We factored that into where we felt we were going and what we would see during the year. And I think things have been on track to what we would have expected so far. In terms of notable highlights, we serve the automotive industry, which has seen a really nice recovery over the last couple of quarters, and we'd expect that to continue, for the most part, into 2021. We're seeing our HVOR market come off an 18-month to 2-year decline, cyclical decline, which is now starting to recover. We talked about the fourth quarter getting to equilibrium on revenue on a lower market because of our content outgrowth. So from here, we'll start to see really nice comparisons on a quarterly basis. Industrial market didn't go down as much, but we're seeing good momentum there. PMI, which is a good indicator in terms of watching what ultimate demand would be in our diversified industrial segment, remains in positive territory and geographies around the world. So we feel good about that. The one area, which continues to be a bit of a laggard, is our aerospace business. It's the smallest end market that we serve. But I think that folks know that with air traffic miles, where they are and people not getting on airplanes to go on vacation or to do business travel, that's one that's been lagging in terms of the overall market recovery. And we'll -- I think we expect to see that in 2021. I think we forecasted that market to be about flat to where we were in 2020. But all the other markets tend to be going in the right direction.

Understood. All right. So let's switch gears to kind of some of the secular growth drivers, and particularly for Sensata, the mega trends, Smart & Connected EVs. I want to start with EVs. And just -- it feels like investors are still trying to kind of understand your positioning in EVs. And so maybe you can kind of just shed some light in terms of some of the key applications in EVs that really are going to be driving growth for the company?

Yes. So let me start with the punchline, right? We're really comfortable with the fact that EVs represent a tailwind for us as an organization. And to be more specific, we believe -- well, we don't believe, we see it in our current business that there's about a 20% uplift, right? We measure that by content on a pure battery electric vehicle of about $50 per unit versus a combustion engine environment where the average is about $40. So this trend is a good thing for us. We've made a lot of internal investment, and we've done some very strategic M&A to allow that to happen. And so the trend associated with migration to electrified platforms is happening. It's only accelerating. And the last thing I would note on this is I think it's a little misunderstood. I think folks think that all the content we have on a combustion engine goes away, and about half of that content carries over. So hydraulic braking systems, environmental control and applications that we serve in that environment today continue in a battery electric environment. So about $20 of the $40 of content ports over, and then we've added to that with high-voltage contactors, e-motor positions, other thermal management applications that are mission-critical, hard to do in the new environment of an electrified platform.

Got it. And you mentioned strategic M&A. If I look back to the GIGAVAC deal, it's certainly timely ahead of this inflection. So what did that business do for you in terms of technology and kind of the portfolio that you have now that you can address in EVs?

Yes. So it was very thoughtful. We're so excited about the fact that we did that transaction back in 2018 when, clearly, everybody knew that there was going to be a migration toward more EVs, but that has accelerated dramatically. So it was well-timed in terms of the acquisition of GIGAVAC. I think folks know that what they brought to us was a capability in high-voltage contactors, which, at the core, what that does is it protects the most valuable asset, the most valuable component in a battery electric vehicle, the battery. It also protects the equipment that's charging that battery and the individual that's applying the charge. So it's a very important application in a broad EV environment. And it extends way beyond electric vehicles, light vehicle environment. It applies in battery electric applications for on-road truck buses, for stationary equipment for the energy storage market. And candidly, that's where that company was serving, mostly industrial markets, to begin with. So we're really excited about it. We have very strong engagement with all of our customers' advanced engineering organizations around helping them solve for the development of their EV platforms. We've got great momentum in terms of wins in electrification. In 2020, we won $180 million of business associated with electrification, 4 of our 5 largest wins last year as a company. Of our total $465 million of new business wins, 4 of the 5 largest were electric vehicle and EV-related. And so we're really excited about the momentum that we have here, the relationships that we're establishing, the fact that our key customer relationships, that have been around for decades serving our customers on the combustion engine side, have ported over and allowed us to be able to serve them as they pivot their portfolio to more electrified vehicles. And GIGAVAC was an important part of that, but a lot of the organic effort that we've done has been a major player there as well.

Got it. And on the recent earnings call, you guys had a slide deck in terms of who you work with from a design? Of course, it's a who's who of all the auto OEMs, you have legacy upstarts. Would love to get your take on just the design process. If I think about some of these upstarts that appear to be moving quickly, in terms of the inflection, and then you have the legacy OEMs who are putting a lot of effort and energy, but it might be a little bit different. So what are you seeing in the marketplace from an EV from upstarts to legacy?

Sure. So I guess I would start with -- the commercial engagement is very similar, right? Because we're serving applications that are mission-critical, because the design cycles and the testing and qualification process required for our customers is very similar, whether it be a combustion engine or an electrified platform, the commercial engagement is similar. The competitive set is different, but similar. Let me expand on that. A handful of competitors, right? Because they're hard to do applications, there's a natural moat that occurs associated with who can serve that customer need. You need credibility to be able to serve these customers. So the competitive dynamic is similar. The design cycles are faster. Some of the new entrants to electric vehicles are setting a standard for the rest of the industry around how they need to move more quickly. In addition, what you're seeing is because, in the new environment, software plays a more important role in terms of the drivetrain process, if you will, you're seeing companies design for future-proofing on components, right? So that's changing a little bit. Whereas in the past, you bought a vehicle and essentially, everything stayed the same in that vehicle for the life of the vehicle. Now we know that there are online updates associated with vehicles to increase charging or to reduce charging times and to do other things, to manage that process, so that the hardware components that are designed into those applications need to be more durable and future-proofed. And so some unique differences that are being driven by some of the new entrants and many of our OEMs that we serve. They're very good at this. They know how to adapt to this environment, and they're moving at a very rapid pace.

Got it. Let's switch gears to Smart & Connected. And I'd love to spend some time just on the organic efforts, in terms of what you've been doing in the investments you're making and then we can kind of segue into Xirgo in terms of why that deal made sense to kind of layer on as this opportunity evolves?

Yes. So some may say, why is Sensata even playing in a Smart & Connected environment? What right do they have to play here? So let me maybe start with that. We produce over 1 billion products every year that are out in market in harsh environments collecting data and serving that data up to a control module to optimize and keep that process safe. So our Smart & Connected initiative is simply saying, "How do we figure out how to harness that data?" And we've started in an on-road truck environment to say, we started providing tire pressure monitor vehicle area network, which was the foundation of our Smart & Connected initiative in the OEM market. And then we realized there is a very large aftermarket with fleet managers that need more information to feed their fleet management systems to make them more efficient and more safe. And so essentially, that's what the organic effort is doing is. It's going after the pain points for those fleet management customers to help bring more data, more information, more insight to the fleet environment. And so that's what the organic effort is. That's what our M&A effort will focus on.

Got it. In the Xirgo acquisition, in terms of I know you work with that company, so there's familiarity to the technology in the business. What does that do for this effort as we move forward?

So it's very complementary, right? So it's a great example of a strategic -- strategically driven M&A area. It wasn't a business that's available. Let's go out and buy it and try to figure out how it fits into our strategy. It's very aligned with our Smart & Connected strategy. They bring a large group of very talented engineers that know this ecosystem. They bring a revenue base and key customers that essentially demonstrates their 2, 3 years ahead of our organic effort. It's also very fast growing. We quoted a expectation of a 20% growth rate, so it's accretive growth for us as a company. It opens up an additional $8 billion addressable market by expanding from on-road truck and trailer to cargo containers, other cargo applications and some light vehicle, largely around usage-based insurance tracking. And it expands the offering set to be a full stack solution. So if you think about Sensata bringing sensor content, vehicle area network to capture that sensor content, Xirgo brings telematics device that collects it at the vehicle and allows us to bring that information to the cloud, a cloud solution that captures the accumulation of that data and a connection to fleet management software solutions, both fleets directly and through fleet management providers. So it's a really complementary acquisition. By the way, Xirgo will also brings some sensor capabilities, some emerging sensor applications around cargo monitoring and also dashcam for driver event and monitoring -- cabin monitoring. So it's a perfect match. And you're right. We've got to know them because one of our joint customers asked us to work together to bring a more wholesome value proposition to them. And that's after working with them for about 1 year, we realized that it's a great example of 1 plus 1 equals 3.

Great. And they also have really high gross margins, 50%. Can you maybe just talk about the sustainability of that gross margin? And then also from an operating leverage perspective, if this is a business that's going to grow 20%, what are the benefits as it scales up in terms of dropping through to higher operating margins?

Yes, Paul -- Craig, you may be tired hearing my voice. Maybe Paul will jump in here and share some of his thinking on that topic.

Sure, Jeff. Can you hear me okay, hopefully?

Yes.

So really excited about Xirgo. It's a business that's been built over the last 14, 15 years. Great, great market position, great customer base. And the gross margins show, in my mind, the differentiated value that they bring to their customers. The EBITDA margins are in the mid-20s. And we expect that to be -- the trajectory of the business will be on as we continue to invest to grow that business, develop that business, and turn into what we think the potential can be long term. So excited about where it is. It's been -- going to run it together with our organic effort. And really combine those business to be a strong force, a leading competitor in that emerging space.

Got it. Paul, maybe we can just stick through discussion of margins and free cash flow? The company implemented a restructuring last year. I know some of that is just in terms of where you want to prioritize spending. But can you talk about just the operating leverage that you're seeing overall to the company in the rebound this year?

Sure. I think it's important to start with that Sensata delivers premier margins compared to others in our space. We're a very profitable company. Proud of that ability to be incredibly profitable, high-margin profile. We are balancing our operating income growth with the investments that we're making for our future in terms of future growth, exceeding our growth platforms for these fast-growing emerging markets, like Electrification and Smart & Connected. We expect our margins to grow as we recover. You can see where we were in 2020, we're guiding to about 20.5% to 20.6% operating income margin in '21. So we're growing quite a bit as the business is recovering from the lows of 2020. So we're seeing about a 40% drop through to profit, operating profit based on the growth in revenue. So strong conversion. Of all that said, I think longer term, as we think about where we're going strategically and expanding into Electrification and Smart & Connected, and we start moving up value chain, offering integrated solutions and data insights, we expect very fast growth in terms of the top line, very fast operating income growth, offering services and products that offer differentiated value and differentiated margins. But with that said, that may result in those margins being lower than our component business that we have today. So more to come, obviously, as we continue to make progress there. But, all in all, really excited about the core business, its financial strength, cash flow generation that has improved dramatically over the last a couple of years, our conversion rate on free cash flow was in the mid-70s prior to 2020. We were struggling with -- on the inventory side, the inventory management. We definitely cracked the code in 2020. Saw tremendous free cash flow conversion in 2020. We're about 130% of adjusted net income. And for 2021, we're looking at free cash flow conversion in the low 8s, which I think is very strong performance. It's a much better performance in normal times than we've seen in the past. A lot of that is being driven by the improvement in working capital management, specifically inventory. I think the other dynamic that's different than '20, just to remind everyone that in 2020, we were in a mode of cash preservation, maintain our financial flexibility, and we defer a lot of capital expenditures out of '20 into '21. So we only spent about $107 million on CapEx in 2020. That's going to get more up into the $165 million range as we look to 2021. So that's good investment for growth, for expansion of capacity and productivity, but it will get the free cash flow conversion back down to what is more normal assets which is in that mid-80s range for us.

Got it.

So a lot covered -- got a lot of landscape there, but I appreciate the opportunity to share.

Yes. No, it's great context. And maybe, Jeff, we can kind of build off of that, improve free cash flow performance, the balance sheet in the last couple of years certainly has been strengthened. And here we are, right, you're putting $400 million of work in Xirgo. Can you just talk about the optionality as you see it in the business in terms of balance sheet, free cash flow and what you're trying to prioritize in terms of -- for growth?

Yes. So our primary focus is on the growth of the core business, right? We're going to see really strong momentum in terms of overall market recovery that's going to provide growth opportunity for us. We have a last 3 or 4 years of NBO wins that will convert to really nice outgrowth to that market growth. So that's the core of what we are focused on every day in terms of driving growth in the company. In addition to that, as Paul mentioned, we have great cash conversion of a very high earnings base that allows us to have a capital deployment strategy that will add to that core growth. And the focus areas there are very simple. Across all the end markets on 3 -- excuse me, 2 growth factors: Electrification and Smart & Connected. So that's where our focus areas are from an M&A standpoint. And the criteria is accretive growth, differentiated margins #1 or #2 positions in the applications that we serve, so differentiated offerings. And so you'll continue to see us focus on those areas for M&A-related activity. We're going to be balanced in that in our capital deployment, so we'll stay within a responsible level of leverage. But even with that, we have a lot of cash generation that will allow us to deploy capital in a way that will be accretive to the overall company over the next 3, 5 years.

Got it. I want to touch on just the industrial market. And you mentioned commercial air, of course, is weak. And at some point, hopefully, that turns into a tailwind. But just more broadly across industrial, how do you see that business? What are some key applications for growth you see in industrial?

Yes. It's a great point. Industrial, we'll see some nice growth. I've mentioned that the PMI indicators are very positive globally. And so we'll see some growth there. Industrial doesn't have the same level of outgrowth opportunity that we see in aerospace and HVOR. But I'll tell you, when you think about the scale and capability that we have, with our product portfolio in auto and HVOR, and being able to bring that capability to the industrial market, it's an enormous competitive advantage. And we've been, historically, selective, but we have acquired businesses that have expanded that sensing portfolio. CST acquisition was a great example, where we broadened the portfolio of offering in the industrial space and the other end markets that we could serve. But really, the opportunities in industrial are similar to what we're seeing in HVOR and aerospace, and we're leveraging the capabilities we have in those end markets to be able to bring a premium offering to our customers and help them solve their challenges in that market.

Understood. And then on HVOR, you mentioned it's been a tough kind of couple of year period that were coming off of the bottom end. So cyclically, it's going to improve. But maybe you can just touch on kind of that 600 to 800 basis points of outgrowth? Do you think some of those drivers are still sustainable as you look out in time?

Yes, they absolutely are. And so the HVOR market is pretty broad, right? Obviously, with more light-duty and medium-duty vehicles, there's a move toward more electrified platforms for delivery -- last mile delivery trucks and so forth. But we believe the range requirements and the horsepower requirements associated with long-haul trucks, construction, agriculture, we've got a lot more runway than we would on light vehicle with combustion engines. So we'll continue to see a trend that will be very positive there. We do see good content outgrowth associated with those markets, associated with making those platforms more efficient. But we're not neglecting or not focused on the electrified platforms in that market as well. We talked in our last earnings call about a big win in a bus platform associated with an electrified platform. So we'll bring all that Sensata has to offer there to make sure that we're full advantage of the opportunities that we see in that end market as well. And it's translated to higher outgrowth than HVOR than we've seen in our auto business. So it's played out in the wins that we have in the past in terms of NBOs support that continued into the future.

Okay. I think that brings us right up on the time limit today. So Jeff and Paul, thanks so much for the discussion. Great insights into your business today. And thanks for the investors who are on the webcast. Appreciate it.

Thanks, Craig. I appreciate it.

Thanks a lot. Appreciate it.

All right. Take care.