Sensata Technologies (ST) provides sensors to essentially all of the world’s automakers to make cars safer, more fuel-efficient, and less damaging to the environment. While global auto sales will likely grow at a low single-digit rate, the amount of sensor content per car is growing at a mid-to-high single digit rate and we expect this to continue for a long time. Sensata has no large, direct competitor for supplying these sensors. Rather than offering a catalog of parts, Sensata custom designs each sensor in collaboration with their customers’ designers to build a part that fits the needs of a given auto platform. Once one of these platforms (think the Honda Civic) is designed, it generally remains in production for decades with the automaker buying sensors from Sensata year after year.

Examples of Sensata sensors include:

• Safety: Electronic stability control systems require Sensata designed pressure sensors, which sense changes in brake pressure. While these sensors cost a couple of bucks, if they fail the car may experience a fatal crash. Government mandated quality standards require testing that shows quality issues in fewer than 5 parts per million.
• Fuel-Efficiency: Cylinder deactivation systems use Sensata sensors to deploy all cylinders for rapid acceleration while deactivating unneeded cylinders once a car hits cruising speed resulting in lower total fuel usage.
• Emissions Control: Selective catalytic reduction systems use multiple Sensata sensors to control the level of emissions produced by diesel engines. After the emissions test cheating scandal last year, VW announced they would be using these systems to reduce emissions to required levels.

Vehicles around the world are seeing increased levels of content per vehicle as manufacturers attempt to meet government mandated improvements in safety, increased fuel-efficiency and lower emissions. Interestingly, the content per vehicle varies by vehicle type in ways that give us confidence in the long growth runway that stretches out ahead of Sensata.

• Luxury cars with features such as headlights that point around corners during turns and offer multiple driving modes include Sensata content of over $100 per vehicle.
• Mid-market cars with standard features include Sensata content worth $30-$50 per vehicle.
• Cars produced in emerging markets such as China often lack basic safety features such as airbags or tire pressure sensors that have almost 100% penetration in developed markets. These cars have less than $10 of Sensata content per vehicle.

Of course, it is emerging markets that are seeing most of the growth in auto production. While U.S. and European auto sales have been growing in recent years, the longer-term trend is flat. So growth in these markets is almost entirely driven by increases in content per vehicle. But in countries such as China, not only are production rates projected to keep growing, content per vehicle is increasing rapidly. Sensata content per vehicle in China currently stands at $8 per vehicle, up from $4 per vehicle just a few years ago. With the country rolling out safety mandates and desperately trying to combat smog issues that plague many of their cities, we expect Sensata’s content per vehicle to continue to grow quickly.

So Sensata’s growth is driven by 1) growth in total global auto production, 2) growth in content per vehicle, and 3) a positive mix shift due to the geographic regions with the fastest growing auto markets also experiencing the fastest growth in content per vehicle.

But growth alone does not drive much shareholder value unless the growth opportunity is paired with an economic model that delivers robust returns on capital. The combination of growth and high returns on capital is what delivers a rapidly growing stream of free cash flow that can be distributed to shareholders over time.

At its core, Sensata is an industrial-technology design firm. They deliver an item which they jointly work with their customers to design into their customers’ products. These items are mission-critical, but make up a small portion of the overall cost of each vehicle. Demand for their products is driven by their customers’ need to compete aggressively to sell feature-rich vehicles as well as government mandates that provide multiyear visibility for demand.

The business of selling cars is highly competitive. Automakers face significant competition, which results in the economic value they create being captured by customers who benefit from falling prices and better features. A select set of suppliers to the automaking industry also capture a portion of the economic value generated in the automotive supply chain.

Sensata’s sensor business sports operating margins of 25%-30%. Their business only requires them to spend 3%-4% of revenue on capital expenditures despite their solid growth rate. The fact that they have a highly variable cost structure provides a buffer to the cyclical nature of the auto industry. This flexible cost structure means that while the automakers required government bailouts during the Great Recession to avoid complete failure, Sensata generated positive free cash throughout the crisis. This feature of their business model allows the company to utilize higher than average levels of debt in a sustainable manner, which reduces their cost of capital and gives them the flexibility to aggressively pursue acquisitions and share buybacks.

We calculate that the company generates an economic return on capital of approximately 40%*, which we expect will  increase towards 50% in the years ahead as operating margins march back towards the higher levels that they achieved in the past as the company digests the large acquisitions done in recent years.

Despite the highly attractive nature of their business, Sensata’s stock has suffered mightily over the last year declining almost 50% from a high of $58 in the spring of 2015 to just $30 at the recent market low in February. The stock has bounced back to $39, but this price still represents a PE ratio of just 13.7x 2016 consensus earnings estimates.

The decline was fueled first by early indications of turmoil in the Chinese economy and declines in the broader stock market. Then in the fall of last year, it was revealed that Volkswagon had been cheating on diesel emission tests. The fact that Sensata earns a higher level of content per vehicle in diesel cars triggered concerns that a move away from diesel engines in Europe (where half of all cars are powered by diesel fuel) might hurt Sensata’s results. However, despite the outdated belief among many Americans that diesel gasoline is dirty, in fact, diesel is cleaner than traditional gasoline and there seems to be no way for the European auto industry to reach required fuel efficiency levels without relying on diesel fuel. Indeed, the best way to understand the emissions scandal is to recognize that VW was spending less money on Sensata sensors and other emissions control technology than they needed to to reach mandated levels. Now that the cheating has been exposed, VW will be spending more money on the selective catalytic reduction systems described above and thus we expect the emission cheating scandal to drive additional purchases of Sensata’s sensors. Stricter emissions testing is likely to drive more spending on emissions reduction technology across the industry, not just at VW.

By year end 2015, Sensata’s share price still hovered around $45, down over 20% from its high. When the stock market began its sharp slide to open 2016, fears of a global recession gripped many investors. Since then, concerns have risen that global auto production may be on the verge of collapsing. Along with the stocks of many other auto industry companies, ST dropped an additional 33% in just six weeks to a $30 low that represented a forward PE ratio of just 10.5x.

At Ensemble, we do not attempt to make daring forecasts about the next move in the economy, as we believe the economic cycle is not predictable. Certainly, it is possible that auto sales go into decline. But despite the worries, auto sales have continued to grow each month this year. More importantly, when viewed over a long time frame, it seems obvious that the current level of US and European auto sales do not represent inflated demand. Chinese sales are at all time highs, but this appears due to a secular increase in vehicles per capita that is likely to feed growth for a long time (Chinese cars per capita is just 128 per 1,000 vs the US at 809 per capita).

Source: NY Times (click here to view the image if you are an email subscriber)

No matter the strong competitive position of the company and the long growth runway, an investment in Sensata is not without risk.

• Whether we’re entering a global recession now or the next one is years away, auto production is cyclical and when sales fall, Sensata’s results suffer.
• A future of driverless cars enabling far higher levels of vehicle utilization may be a headwind to long-term auto sales. But a recent report suggests that on-demand, shared, autonomous navigation systems may actually increase auto sales.
• While Sensata generates higher than fleet average revenue per vehicle in hybrid cars, it is unclear how the emergence of fully electric vehicles (EVs) will impact their results. Until recently the company said that EVs had less Sensata content per vehicle than the fleet average. But on the most recent earnings call, management said that they now sell $60-$70 of potential content for EVs and noted that the Chevy Bolt has $30 of Sensata content. They even went so far as to state, “there is no systematic risk to Sensata from a shift to electric vehicles.” We believe that the jury is still out on the impact of EVs on Sensata’s business. We do note, however, that EVs only represented 2% of global auto sales last year and even if they grow to represent 12% of global sales over the next decade (the higher end of most estimates), this would result in only a 1% headwind to Sensata revenue growth even under the draconian assumption that the company had no content on these vehicles.

Taken together, we think that Sensata represents a competitively protected company with a long period of potential growth stretched out ahead of it. At the current depressed valuation, we think the stock already discounts the potential for weakness in global auto production and offers significant upside should production levels remain steady and the company executes on its expectations for growth in sensor content per vehicle.

*After our post on Broadridge Financial, we received questions from readers about our calculation of the company’s return on capital. In a coming post, we plan to explore the concept of return on capital and the approach we take to calculating it.

Note: In the interest of keeping the length of this post reasonable, we did not discuss the non-automotive segments of Sensata’s business. These are made up primarily of selling controls and sensors into industrial and consumer appliance end markets. These non-automotive end markets make up approximately 25%-30% of Sensata’s total revenue.

Ensemble Capital’s clients own shares of Sensata Technologies Holdings NV (ST).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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