This Undervalued Tech Play Is Running on All Cylinders

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Sensata Technology (NYSE: ST)is a manufacturer of highly customized sensors and controls that are sold to customers in the industrial, aerospace, automotive, military, commercial and residential end markets. It is a market leader for the right reasons and is likely to remain in the driving seat with its products riding on long-term trends.

Leading the pack

It is the market leader for more than 80% of its products and maintains its strong leadership position for a few reasons.

First, Sensata benefits from high customer switching costs. Customers find that the high switching costs in terms of getting their systems certified and qualified again with competing sensors or controls installed typically outweigh the benefits of better pricing. Customers are typically ‘locked-in’ once Sensata’s sensors or controls are installed in their systems.

Secondly, when customers have limited choices or no choice at all, suppliers like Sensata benefit. Sensata is the sole source supplier for many of its customers historically, according to its most recent 10-K.

Last but not least, Sensata’s products offer a strong value proposition. While sensors or controls are a small proportion of the total cost of their customers’ systems, they are critical to the overall performance of systems. For example, Sensata’s products are used in vehicle airbags, which help to minimize injuries and save lives in accidents.

Attractive low cost structure with room for improvement

Besides benefiting from economies of scale, which drive costs on a per-unit basis, Sensata has substantially all of its manufacturing done in low-cost locations, with the bulk of it concentrated in China and Mexico. This was the result of a conscious shift of its manufacturing sites from higher-cost locations to lower- cost ones over more than a decade. According to its most recent investor presentation, about 70% of Sensata’s manufacturing was completed in the U.S. and higher-cost countries such as the Netherlands, South Korea and Japan.

Sensata has consistently delivered gross margins above 34% for the five-year period through 2012. In addition, there is significant room for margin enhancement given that Sensata sources less than half of its supplies from low- cost countries. It relies on supplies of manufactured components, sub-assemblies and other metals in the manufacture of its products.

Growth drivers

There are several trends driving growth in demand for Sensata’s components in its customers’ products, such as energy efficiency and environmental concerns.

One example is the new version of Sensata's cylinder pressure sensor (CPS), which is gaining traction among diesel automakers, as the key in increasing fuel efficiency and reducing exhaust emissions in engine combustion systems. According to Sensata customer Daimler, its combustion pressure sensors reduce fuel consumption and nitrogen oxide raw emissions by 2% and 30%, respectively. Stricter emissions standards for light vehicles such as the Euro 6 to be introduced in 2014, and more countries including China proposing tighter fuel economy standards are all signs pointing in the same direction.

In its first-quarter fiscal 2013 results, management guided for decent 7.1% year-on-year growth in full-year fiscal 2013 net income. This is despite a weak macro outlook for Europe, which accounted for about 29% of its fiscal 2012 revenue.

Peer comparison

Sensata’s peers include Amphenol (NYSE: APH) and TE Connectivity (NYSE: TEL). Amphenol and TE Connectivity are two of the largest connector manufacturers on the planet.

Amphenol is among the top connector manufacturers in various regions, except for Japan where it is not among the top 10 players, according to research from Bishop. It has paid dividends since 2005, but the forward dividend is meager at 0.5%. Amphenol revised downward the lower end of its full-year 2013 diluted EPS guidance slightly from $3.76 to $3.72, which still represents a 8% growth over fiscal 2012.

I am not considering Amphenol because of its huge cash drag and significant exposure to defense spending. Amphenol has accumulated a record-high balance of cash and short-term investments amounting to $1 billion, and if it could not find accretive acquisition opportunities, this cash balance could be a drag on its profitability metrics like ROE. Also, it generated about one-fifth of its revenue from military and aerospace customers, which are susceptible to budgetary cuts.

TE Connectivity is the world’s largest connector manufacturer across all regions including the U.S., Europe, Asia and Japan. It initiated dividends in 2008 and currently sports the highest forward dividend yield of the group with a 2.2% yield. It raised the lower end of its fiscal 2014 full-year adjusted EPS guidance from between $3.05 to $3.10 on the back of better-than-expected revenue from its transportation solutions segment and improved margins.

Despite this, I am concerned about TE Connectivity’s weak performance for its telecommunication networks and sub-sea communications business. This is a result of telecommunication companies in Asia and Europe spending less on broadband networks equipment and lower project activity in the sub-sea communications market. Also, while TE Connectivity has delivered positive initial results from its restructuring efforts, I am typically wary of associated execution risks.

Conclusion

Sensata is dominant in the sensors and controls market because of high customer switching costs, sole-source supplier status and the mission critical nature of its products. It already boasts of a lean cost structure by virtue of its manufacturing footprint in low-cost locations,with sourcing being a key area of margin enhancement in the future. Sensata is undervalued on a relative basis, with the lowest PEG of 1.1 among its peers. I will advise investors to consider taking a position in the stock when it falls below 1.0 times PEG.

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