An Overview of the Connectors and Sensors Industry
As intrinsic value investors, there are some key attributes we look for when evaluating companies. Long-term growth opportunities, products with high switching costs, an attractive industry structure, and a good management team are crucial, and we believe the connectors and sensors industry possesses many of these attributes.
Connectors and sensors are devices that join electrical circuits together or translate a physical phenomenon, such as pressure, temperature, or position into electronic signals. From a product standpoint, connectors and sensors often have high switching costs. They are a very small part of customers’ overall bill of materials, but their cost of failure can be very high, especially in critical applications such as automotive, industrial, medical, defense, and aerospace. Depending on the application, they must be able to withstand harsh environmental conditions, such as extreme temperatures, moisture, dust, and vibrations, throughout the product lifespan. Therefore, customers are reluctant to change suppliers to save a little on the component cost, and once a supplier for a connector or a sensor has been selected, it’s likely to remain there for the lifecycle of the product.
The industry has low dependence on any one customer or product category. There are thousands of different types of connectors and sensors sold across a wide variety of products, applications, and end markets. Every product and application is different, and components are often custom built to meet the design requirements of the specific product or application. Low dependence on any one customer or product, coupled with customers’ reluctance to change suppliers in the middle of a product lifecycle, makes the industry less susceptible to aggressive pricing pressure, with connector and sensor prices typically declining two to three percent annually. This level of price declines is manageable, and component manufacturers are usually able to offset it through manufacturing efficiencies.
Looking forward, the industry has attractive long-term growth drivers. Industry growth has averaged over four percent annually for more than three decades, as technological advancements, safety and regulation requirements, and performance and functionality improvements have driven the need for more electrification in various aspects of our lives, and we expect these trends to continue. For example, the automotive industry is one of the largest end markets for connectors and sensors, comprising over 20 percent of industry sales. Connectors and sensors are used in nearly all the systems in a vehicle, ranging from powertrain and safety to infotainment and connectivity. Automotive manufacturers are adopting more connectivity, safety, and driver assistance features, all of which require more on-board electrical systems and more electrical connections. As a result, the number of connectors and sensors in vehicles is growing. Similarly, in the aerospace industry, improvements in fuel efficiency, in-flight entertainment, Wi-Fi connectivity, and noise reduction are driving demand for more sensors and connectors. In the industrial space, automation, connectivity, and safety enhancements are driving the need for more electrical content as well.
In terms of industry dynamics, the industry is large and fragmented, with connectors and sensors markets estimated to be over $50 billion in size each. Due to low product and customer concentration coupled with customers’ aversion to change suppliers, market shares are stable and organic market share shifts happen gradually over time. This industry structure is attractive for large and established players, as they are not susceptible to rapid market share losses, and they have ample opportunities to augment their organic growth with small tuck-in acquisitions.
One of the businesses in the connectors and sensors space that we like and own is Sensata Technologies. Sensata is a manufacturer of automotive and industrial sensors, such as pressure, thermal, speed, and position sensors for harsh environment and mission critical applications. We believe Sensata is a very well-run business and are impressed by management from both an operational and capital-allocation standpoint.
From an operational standpoint, Sensata has consistently maintained above 20 percent operating margins, driven by its low-cost manufacturing footprint, high-scale sourcing strategy, and lean operating model. Management is always focused on cost and operational efficiencies, as continuous operational improvement is part of Sensata’s culture. The vast majority of Sensata’s manufacturing facilities are based in cost-advantaged regions and over 80 percent of Sensata’s labor force is variable, resulting in a highly-variable cost structure.
So, how has Sensata maintained such a variable cost structure? Management is very careful about build versus buy decisions and does not try to do everything in-house, outsourcing many low value-add manufacturing activities. Additionally, within its own manufacturing facilities, Sensata maintains high shop-floor flexibility by employing multi-skilled and multi-operations certified employees, resulting in its highly-variable cost structure. We believe the flexibility and competitiveness of Sensata’s cost structure allows it to maintain its industry-leading operating margins.
Sensata’s management is also very flexible and opportunistic with capital allocation decisions. Deployment of cash depends upon the best opportunity available on hand, be it acquisitions or share repurchase. Acquisitions are an integral part of Sensata’s growth strategy, and they have strict return criteria for acquisitions. Management does not engage in competitive bidding situations that could result in overpaying for acquisitions. Often, the businesses that Sensata acquires are subscale and operationally not as well run as Sensata. Therefore, they have inferior profit margins and are initially dilutive to Sensata’s margins. Through the integration of these acquisitions, Sensata is able to increase profit margins for these businesses, thus generating attractive returns on acquisitions.
One acquisition that Sensata has completed recently is GIGAVAC, a producer of high-voltage contactors and fuses used in industrial equipment and electric vehicles. At the time of acquisition, GIGAVAC had approximately $80 million in revenues and was growing over 30 percent annually. Sensata paid $233 million to acquire GIGAVAC, and we believe this was a very reasonable price considering GIGAVAC’s growth profile at the time of acquisition. Additionally, Sensata’s long-standing relationships in the automotive industry have given GIGAVAC the platform to immediately expand into the automotive space. Prior to the acquisition, GIGAVAC was primarily an industrial company, with only one automotive customer in the battery electric vehicle space. Within one year of acquisition, GIGAVAC is pursuing opportunities with several other automotive customers.
In summary, we believe that the connectors and sensors industry is an attractive place to look for investment opportunities. The industry structure is favorable, products often have high switching costs, and we believe the industry has attractive long-term growth drivers. These industry characteristics result in stable market shares, low pricing pressure, and opportunities to augment organic growth with acquisitions. As value investors, we find these qualitative aspects of the industry appealing. Therefore, we continue to monitor this space proactively and look for opportunities as they present themselves via a combination of valuation, management quality, and company-specific factors.
As of October 31, 2019, Diamond Hill owned Sensata Technologies, Inc. (equity).
Originally published on November 26, 2019.
The views expressed are those of the research analyst as of November 2019, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.