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

Good morning, everyone, and welcome back to Day 2 of our RBC Global Industrials Conference. We're kicking off the session or the day today really with Sensata. I'm Joe Spak. I'm the lead autos analyst here at RBC Capital Markets. And as I mentioned, we are very pleased to have Sensata. We have CEO Jeff Cote from Sensata. The format for today is a fireside chat. We prepared some questions. Jeff and I are going to have a conversation. But I do encourage investors on the line to get involved. To do so, it's pretty easy. There should be a question box on your web app. Type in the question and they'll pop up in my -- and I can integrate it into the conversation. So with that, Jeff, good morning, and thanks for joining us today.

Joe, thank you very much. I appreciate the opportunity to be here, and I appreciate everybody joining this morning.

So let's start with some of the more topical sort of headlines we've seen in the news over the past week. And I want to start with some of the shutdowns we're seeing, announcements -- or downtime announcements we're seeing from some of your automotive customers because that's obviously an important end market for you. You sort of guided global production to be flat quarter-over-quarter, third quarter versus second quarter. It looks like that might be down a little bit now, although I think Toyota is a big driver of that global decrease. And I know you guide sort of ex Toyota, but -- so -- but in any respect, like I think when you sort of gave that, it could have been viewed as maybe conservative. It turns out it was probably more prudent than conservative. But maybe you could talk a little bit about what drove you to sort of think about the business that way and what you've seen since then.

Yes, sure. So if you sort of think about the full year, we had originally guided to about 13% automotive growth for the year for the company. In our most recent guidance, we brought that down to about 5%. And yes, it was -- there were a lot of questions because, at the time, we were expecting production in the second half of the year to be lower than what third-party forecasters had guided to. Since then, IHS and other forecasters have lowered their expectations for the balance of the year, and we've seen a series of extended shutdowns at some of our customers through the summer months here into September. I'd like to say that we were brilliant on that call. I think it's a matter of us just listening to what our customers have to say, deep engagement with them. Obviously, given the shortage -- the supply chain shortages that we've experienced, the level of dialogue with our customers and in many instances, our customers, us and our suppliers is at a very high level. So we feel as though both order book and those dialogues gives us a pretty good perspective as to where things are going in terms of automotive production. So a 5% increase overall year-over-year is sort of where we are right now. I believe the shutdowns that were announced post our guide were baked into our guide. So we're continuing on that path right now in terms of the automotive side.

Yes. That's good to hear. And you talked about the connectivity with customers and staying on top of things. When you see announcements like another shutdown in Malaysia, and I know that's sort of a big fab area, does that -- how -- what's the connectivity with the clients then and sort of thinking about what you can do, what you can get for them? And -- because I think one of the things that sort of consistently has sort of come up, I think, across a broad swath of industries really is there's just not -- like the level of visibility you have into schedules is not as high as it normally is because you get very short-term notices. And of course, that can have an impact on your business because -- your cost structure. If you fully load for -- to run at 100% and then it turns out you have to shut it down, it becomes a little bit more difficult. So can you talk a little bit about when you see an announcement like that, how Sensata reacts?

Yes, absolutely. And so the theme over the last 18 months has been communication, communication, communication over and over again. Not only with our customers, Joe, but also our supply base, with our people and with our investors, we've spent more time communicating what's going on. And in times of volatility, we're big believers in being transparent and communicating everything that we know as soon as we learn it. So that's served us quite well over the last year. And so keeping that communication flow open allows us to make sure that we're getting very immediate response from our customers. Now like I said, the shutdowns that they announced didn't really impact things in a dramatic way. And candidly, our customers will take just about whatever we're able to produce at this moment in terms of getting product out the door for them. That demonstrated itself in the second quarter with a little bit of what we refer to as inventory build in the pipeline because customers were saying, "Hey, we'll take it because we don't know when other suppliers will be able to deliver and we don't want to be caught short." But also, we're trying to be extremely responsive when they do see a dip to honor that. We don't want to see massive amounts of inventory buildup in the supply chain. We pride ourselves in being able to deliver when our customers want the product. They're being a little hesitant on that. And so they're building a little bit of buffer into their SIOP process. But we're going to respond to whatever changes there may be. As you know, we try to maintain a pretty highly variable cost structure in our manufacturing sites so that we can turn it up and down as we need to. And again, that muscle and that expertise has served us well over the last 18 months of these tough times.

Yes. I want to touch on a couple of things there. So look, ultimately, it seems like the message coming from a whole bunch of people, and maybe we sort of can tack onto this, is that this is not really demand-driven. This is sort of completely supply-driven and that there is sort of underlying demand. It's just unable to be met because some key components, not just in automotive but, quite frankly, across a lot of sort of end markets, are sort of being impacted. So when you talk about things -- like I think you mentioned in the second quarter like a $25 million inventory build, and I think you had expected that to sort of unwind. I hear that and I know you sort of measure that in terms of sort of how Sensata performed versus sort of how you think the industry performed. But if it's true that there is strong sort of underlying demand, I guess like why would that really unwind? Because it would seem like the end markets and sort of customers would sort of continue to sort of take product to be able to fulfill this -- what's becoming, it seems like, a greater and greater pent-up demand issue.

Yes, yes. So on the first part of your point of demand versus supply challenge, there is no question that across many of our end markets, there's more demand than supply right now. And we all experience that as consumers. Try to buy a car right now, right? The wait time or lead time on vehicles if you want a particular vehicle is at a point that we've never seen or I've never seen. And so there is clearly more demand than our customers are able to deliver. On the second part of the question -- so that's the gate there. On the second part of the question, I think it boils down to a say-do ratio, right? So -- and we do this with our suppliers. When our suppliers deliver when they say they're going to, we carry less buffer because we can count on them to deliver. And our customers do the exact same thing with their supply chain. So as we're working through these kinks in the supply chain, they're naturally going to buffer a little bit. They're going to build more buffer where they feel as though there's less predictability, and they're going to reduce buffer where they see their suppliers delivering for them. So it does boil down to a say-do ratio. Is there a chance that some of that inventory -- and by the way, it's not a lot of inventory. We called $25 million of inventory build in the first half of the year, primarily in the second quarter. That's small relative to the overall size of the business. We forecasted that, that would unwind. Our perspective is that it will. But we'll update that based upon conversations we see with our customers. There is a chance that, that won't unwind and we'll wait until 2022 or later to unwind that. But the broader question -- I think eventually, our customers will go back to a just-in-time inventory model. It's just a matter of how quickly they can get there. I don't think there's a new normal where everybody is just going to carry lots of extra raw material as the supply chain issues are worked through.

And maybe we could switch a little bit, Jeff, to some of the other supply chain challenges that are going on. So obviously, we've seen a run-up in a lot of key raw materials. Maybe you could sort of update us or remind us sort of what you're looking for there and what you've seen since then. And then the second one is freight, right, which is -- I'm sure everyone has sort of seen the prices for ocean containers. I'm not sure how much you sort of ship on ocean or not, but what you're seeing basically from a raw materials and logistics perspective.

Yes. So we've spoken about 3 primary drivers associated with cost in our business. The first were just costs associated with implementing COVID-related protocols and shift staggering and so forth. We're learning how to manage that better. So that will dissipate, I think, even without COVID going away completely. The other 2 big portions which you point out are raw material input, largely driven by chip or electronic supply, but there are some other areas that there are shortages where there are some pricing elements that are coming into play. And then on the logistics, given that there's essentially lower volume of flights -- and we try to put things on boat, but in a constrained supply chain, it's hard to do that. And even ocean-going vessels have -- over last year have experienced issues with canal shutdowns and other issues. So at the end of the day, we want to serve our customers. If we have to use expedited freight methods at a higher cost to be able to do that, we're going to do that. And that will, again, start to diminish as the challenges go away. In the meantime, we're having very productive conversations with our customers regarding them bearing a burden of some of that. If it persists, we're going to be going back, obviously, looking for more recovery on that to make sure that we don't become the squeeze point. But it's a very strategic decision. We'll do it every time to make sure we can deliver for our customers. And we'll provide the transparency to where the cost is and what the impact is and when we would expect it to diminish.

Yes. And maybe if we could use semiconductors as an example here because, as you mentioned, that's sort of one of the key areas you're sort of seeing inflation. I mean it stands to reason that pricing on semiconductors, given just capacity shortages and then, quite frankly, it takes a while for capacity to increase, like could remain in place for '22 and maybe longer. So that's something you'd try to go back to your customers and renegotiate with. And like -- and is that sort of a constant conversation? Or are there sort of points in time in the contract when -- or end-of-year conversations where that more naturally occurs?

It's both, right? It depends on the individual customer and where we are with them at that point in time. But clearly, if our cost structure is going up -- the dialogue with the customer is they want us to make sure we can deliver product, they want us to expedite. And pricing is never an easy conversation with customers, don't get me wrong. It's always a difficult conversation, but it's a conversation that must be had to make sure that we can protect our overall margin profile. And again, it gets back to the communication point. They know we're doing everything we can to deliver for them. They know that we are delivering, we believe, better than most. And so they're willing to, in most cases, share some of that. And again, they just want transparency and understanding. It's well documented that not only is the supply increasing prices, but we all know that a lot of our customers are getting a premium for pricing given the shortage of... [Technical Difficulty]

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And additional costs associated with keeping things moving.

Yes. Maybe just to sort of wrap up the conversation, and I want to move on to a lot of the strategic vision of Sensata and a lot of the stuff that you're sort of investing for in the future. But look, I think as we start to -- we're at the time of the year when, I think, investors are going to start to think about next year, 2022. And I know you're not going to give us guidance here for 2022 today, but what would be helpful is if you could talk about some large puts and takes. More of that, I think, are in Sensata's control. Because -- volume, it's clear like there's not a ton of visibility we can make. Everyone can sort of make their assumption as to sort of what they think will happen with volume. And we know generally what type of incremental margins can sort of be on volume. But what about things like -- how are you beginning to plan for things like the chips, like commodities, the mega trend investment? Because it would seem like at least chips, like if you -- or commodities broadly and logistics, if they were like raised here higher in the back half, it seems like that should at least annualize into the first half of next year. Maybe then you start to get some relief. And then again, some of the factors that you have under your control, like SG&A spending, mega trend investment, et cetera.

Yes. So we're starting our planning process, obviously, right? It's that time of the year, as you mentioned. And you're right, we're not guiding yet for 2022, but from a volume standpoint, you know our business model. We'll sell as much product as our customers need based upon what's going to happen in their businesses. So it is a highly predictable business in terms of what the revenue will look like based upon the product that our customers sell. So it's not a -- we're not selling business next quarter that we didn't have. It's long-term contract related. So I think our investors and others can sort of get a feel for -- auto is expected to grow again next year at a pretty good clip, probably a little bit better than 2021. At some point, aero has got to recover, so that will create a tailwind for us. And we're not at peak cycle in any of the markets that we serve. So not necessarily just for '22, but there's growth to come if the economic expansion that the globe is experiencing continues, right? Market-wise, we know there's content growth or outgrowth coming because we've built it into our understanding based on NBOs, new business that we've won over the last 3 to 5 years. So we know content -- or outgrowth will continue going forward, and we're very confident in that. And then the third leg of growth is around M&A... We've talked about a serial M&A strategy. I suspect we'll dig into that a little bit more in other questions. But we're going to really focus on making sure that every year has some element of inorganic growth in it. So those are the 3 pillars of our growth strategy. That's how we'll model it. From a cost standpoint, the supply chain shortage is going to persist into 2022. As I've talked over and over again, we have a lot of dialogue with our supply chain on this. The problem goes away when capacity comes up or demand goes down, right? We don't want demand to go down, to be the solution to this. It doesn't look like that's going to be the issue. It's going to be capacity coming online. And that's going to start to lessen, I think, a little bit in the latter part of the fourth quarter, but it's going to be in 2022. So we're going to see some of these costs persist into '22. And again, we'll look for recovery to the extent we can as we manage through that. From a mega trend standpoint, we talked about a $50 million to $55 million spend this year. We've spoken about it being success-driven. We're going to continue to point to the commercial success and the business wins that we experienced that justify the spending on that. It is not our intention to dramatically increase that spend, just to set the stage for that. But we may tweak up or down a little bit based upon what we're experiencing. And with the opportunities that we see, we'll provide that guidance. But we're not going to sort of surprise anybody next year with we're going to -- we want to spend 3x the amount that we spent this year on mega trends. Things don't get digested that quickly. So we'll provide more color on that as we get into the first part of 2022.

Perfect. So I like the way you frame that. And let's -- as you sort of lay out, let's set the cycle aside for a second because cycle is going to cycle, I guess, to use a bad turn of phrase. But on the outgrowth stuff for instance, and I want to talk about a couple of different avenues here, but let's start with automotive, where I think long term you sort of talked about 400 to 600 basis points. I believe that was set a number of years ago. You've clearly been well above that this year. And if you look at sort of major trends within the automotive industry, whether it's electrification or whether it's connectivity, I would argue both seem to be accelerating faster than probably what people thought a number of years ago. So can you talk about, I guess, one, level of comfort with that 400 to 600? But really also like does -- when are we at the point where that needs to be reviewed for maybe a little bit more upside?

Yes. The last 3.5 years, it's been an average of 650 basis points, so above that range. That's a great place for us to be. And so we're excited about that. Similarly on HVOR, by the way, right? So from an HVOR standpoint, we're 950 basis points, above the 600 to 800 on HVOR. So we feel as though we're in a really good place, but it's not by accident, right? These are investments that we've made. They are NBOs that we've won. And there's probably -- it's probably somewhat driven by more take rate on the thing -- the applications and the products where we have more outgrowth, right? So that does have an impact on things. And so we're very comfortable with the range of 4% to 6% in auto and 6% to 8% in HVOR. And you're absolutely right, given that we've beat those for the last 3.5 years on average, we're going to relook at that as we go into 2022 and guide on it. Now there are some specific things that have driven these higher, right? So the implementation of NS VI in China, operate and control launches in terms of pivoting from hydraulic -- or manual hydraulic to electronic hydraulic controls, and agricultural equipment and construction equipment drive some of that. And so as we build up all those wins in the new applications being launched, we'll provide an updated view on where we are. But I feel really good about the fact that the last 3.5 years since our last Analyst Day, that we're at the -- above the high end of the range and obviously, very proud of that success.

Yes. Maybe just on sort of battery electric vehicles, like you've done a really good job of late sort of talking about the content opportunity there in terms of how that compares and contrasts versus an ICE vehicle. One thing I haven't heard you talk as much about is, I guess, the margin profile or the ultimate sort of profitability. And is -- can you shed a little bit of light on that? And I guess I'm just wondering about that in the context of some of the mega trend investments because I know not all of it is going towards electric vehicles and some of it was from acquisitions. And -- but like I guess what I'm wondering is where are we today on some of the EV content versus ICE content from a profitability standpoint and where can we be in maybe 5 years.

Yes. So let me start by making sure that all investors know that our focus on where we want to play will always be differentiated. So that will translate to differentiated margins. Now the challenge is what is the definition of differentiated margins. We all know that 5%, 7% margins are not differentiated. They're more commoditized margins, highly competitive environment. But we're at a margin level that I think most would have a hard time arguing that what we offer to our customers isn't differentiated because they're willing to pay for it. And we will always focus on that. Now as new products launch at lower volumes, they naturally have lower margins. But there's always a mix of that in our business. And we have very specific road maps for our products that are tied to individual launches by customer that give us high levels of confidence that we'll be able to get to these differentiated margins that we enjoy in our business as those products start to scale. And so pick any one, right, high-voltage contactors e-motor position, battery pressure, monitor for thermal runaway. The newer applications that we're launching to specific -- that are specific to battery electric vehicles, there's a lot of content that carries over. That's not, I think, completely understood in the market as well. But there's a lot of our product that we sell into combustion engines that apply in a battery electric vehicle market. Those margins will continue to be in a great place. And the new products, as they ramp, as we gain momentum on those, will experience similar margins to what we have in our business today.

Yes. Let's slip over a little bit to Xirgo and the subsequent formation of Sensata Insights because this is another area that you've sort of highlighted for growth and there's been some investment. I think one of the things that comes up a lot in conversations with investors -- and for instance, we had the CEO of Ford Pro at our conference yesterday, and they're trying to sort of integrate more of this sort of telematics connectivity into their vehicle. That's sort of historically what is Xirgo and maybe some other stuff that's sort of been more on an aftermarket perspective. So how do you sort of see that market evolving? And does the combination of Xirgo and Sensata need to maybe pivot how they sort of pitch some of that product to your customers?

Yes. So I guess let me start with our Sensata Insights business is really focused on niche markets where there's an unmet need today, right? So we're not starting with light vehicle auto in terms of connected vehicle and telematics. We do have a portion of that business that's around usage-based insurance, which is a growing trend and we believe will be a continued trend that will be fast growing given remote work and so forth because everybody wants discounts on their insurance not only for their driving behavior but how much they drive. And so that's something that is growing quite quickly. And Xirgo has just an absolute excellent product that they've designed to a point where it's highly competitive and differentiated in that market, and I think that will continue to grow in light vehicle and on-road. But the other areas that we're focused on are around on-road truck construction, sea-going transport where there is an unmet need today. Now I recognize that many of the OEMs that produce vehicles and equipment for those markets have telematics offerings as well. But the way that fleet managers buy vehicles and equipment, it's across a bunch of different platforms. So it doesn't work if they have 6 different vehicle platforms all trying to get the telematics solutions to talk to their fleet management system. And so they're looking for a solution that cuts across all of those different equipment types. And that's where Sensata steps in. We provide the ability to collect information on that equipment because we're a leader in sensing, right, across whatever parameter. Xirgo brought to us the ability to collect that information and sort of combine their telematics device with our vehicle area network to have that accumulation layer. And then you bring it to the cloud, analyze it and provide insight. And so it's growing because there's value. And we've already -- since acquired, we've added an incremental $20 million of business to that. We know that, that business will significantly outgrow Sensata's. And it's not one size fits all. It's a vertical stack offering that will sell to the fleet manager whatever they want. If they want us to stop at the telematics device, that's where we'll stop. If they want us to go all the way up to insight, we'll do that. And it's being received, again, very well in the marketplace.

Great. And maybe just to close, and you sort of alluded to this earlier sort of, I think. I don't want to mischaracterize what you're saying, but I believe you -- the phrase you used was sort of entering a sort of serial acquisition sort of portion -- time frame for the business. You obviously did Xirgo, which you just talked about. I think in August, you made a smaller acquisition, Spear Power. When we look at your cash balance, it's still like well above sort of pre-COVID level. So should investors expect that this is -- that cash is going to continue to go to acquisitions? And what kind of size range should we be thinking about? Are they more tuck-in at this point because you need to digest some of the ones you've recently done? Or what could other uses for that cash be?

Yes. So M&A is the primary area for capital deployment, but we will continue a balanced approach in terms of buyback and M&A. From an M&A standpoint, the focus is on the 2 growth vectors that we've talked about, right? So it's around the insights business and it's around electrification. So those are the focus areas. And they're -- we're focused on them because they -- those areas will grow faster, much faster than the company over the next 10 to 20 years. So that's where we're focused. We've got a good pipeline. It will be more toward bolt-on, right? Again, we want to have M&A-related growth every year. Size-wise, it can vary. There is nothing huge in the pipeline that's very close. But if something is truly transformational for the business, we might lean in a little bit more on that. But again, the primary focus is around doing M&A every year to make sure that we could have inorganic growth. We'll stay very disciplined. That's just part of our DNA.

Perfect. Well, Jeff, a lot more to dive into, but unfortunately, we are at the half hour. So I want to, on behalf of everyone at RBC, thank you for joining us today. Thanks for your participation in the conference. Really, really appreciate your insights. And thanks to all the investors for dialing in or joining on the webcast as well. So Jeff, have a good day. Thanks for your participation.

Great. Thank you very much. Appreciate it.

Take care.