Sensata Technologies Holding NV Management Discusses Q3 2013 Results - Earnings Call Transcript

Oct.29.13 | About: Sensata Technologies (ST)

Sensata Technologies Holding NV (NYSE:ST)

Q3 2013 Earnings Call

October 29, 2013 8:00 am ET

Executives

Jacob A. Sayer - Vice President of Investor Relations and Global Communications

Martha N. Sullivan - Chief Executive Officer, President and Executive Director

Jeffrey J. Cote - Interim Chief Financial Officer, Chief Operating Officer and Executive Vice President

Analysts

Wamsi Mohan - BofA Merrill Lynch, Research Division

Jim Suva - Citigroup Inc, Research Division

Ambrish Srivastava - BMO Capital Markets U.S.

Steven Bryant Fox - Cross Research LLC

Mark Delaney - Goldman Sachs Group Inc., Research Division

Robert Wertheimer - Vertical Research Partners, LLC

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Shawn M. Harrison - Longbow Research LLC

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

William Stein - SunTrust Robinson Humphrey, Inc., Research Division

Operator

Good morning, and welcome to the Sensata Technologies Holding N.V. Third Quarter 2013 Earnings Conference Call. At this time, I would like to inform you that this conference call is being recorded. [Operator Instructions] For opening remarks and introductions, I will turn the call over to Jacob Sayer, Vice President of Investor Relations and Corporate Communications. Mr. Sayer, you may begin.

Jacob A. Sayer

Thank you, Joni, and good morning, everyone. Earlier today, Sensata issued a press release describing our financial performance for the third quarter of 2013. If you did not receive a copy, you may obtain it in the Investor Relations section of our website at sensata.com. This call is being webcast live, and a replay will be also available on the Investor Relations section of our website.

Before we begin, let me remind everyone that today's discussion contains forward-looking statements based on the business environment as we currently see it and, as such, does include certain risks and uncertainties. Please refer to our press release and our 10-Q and 10-K filings for more information on the specific risk factors that could cause our actual results to differ materially from projections described in today's discussion.

In addition to U.S. GAAP reporting, Sensata reports certain financial measures that do not conform to Generally Accepted Accounting Principles. We believe these non-GAAP measures enhance the understanding of our performance. Reconciliations between these GAAP and non-GAAP measures are included in the tables found in today's press release, as well as on the Investor Relations section of our website under Financial Reports. Comments made during today's call will primarily refer to our non-GAAP financial results.

On the call with me today are Martha Sullivan, our President and Chief Executive Officer; and Jeff Cote, our Chief Operating Officer and Interim CFO. Martha will review some highlights and will discuss trends in the end markets that we serve. Jeff will then provide a more detailed review of our financial results, including segment data for our Sensors & Controls business units for the third quarter. He will also outline our financial guidance for the fourth quarter 2013 and some of the estimates underlying that guidance. We'll hold questions until after our prepared remarks. [Operator Instructions]

I'll now turn the call over to Martha Sullivan, our President and Chief Executive Officer. Martha?

Martha N. Sullivan

Thank you, Jacob, and thank you, all, for joining our third quarter conference call. I'm pleased with our results during the quarter. We delivered net revenue and adjusted net income slightly better than our expectations for the quarter. The financial highlights include: net revenue for the third quarter of 2013 was $499 million, an increase of approximately 5.7% from net revenue of $472 million in the third quarter of 2012; adjusted EBITDA for the third quarter of 2013 was a record $140 million, an increase of approximately 13% from adjusted EBITDA of $124 million in the third quarter of last year; and adjusted net income for the third quarter was $98 million or $0.55 per diluted share, a substantial increase of approximately 17% from adjusted net income per diluted share of $0.47 in the same quarter last year. Sensata's earnings during the quarter grew over twice as quickly as revenue.

The macroeconomic landscape today continues to be choppy in certain of the end markets we serve, most notably the European automotive market, with some economic input still uncertain for the balance of the year. In the third quarter however, there were some positive developments that helped us perform slightly better than expected.

In Europe, production for the third quarter was better than expected, up 2.3% year-on-year, and our revenue from the European automotive sector grew faster. In addition, vehicle registrations turned positive in the third quarter. According to third-party data, for September, European light vehicle registrations were up 5.4% from a record low month in September of 2012, helped by an extra selling day this year, government incentives in Spain and higher rebates offered by OEMs in Germany. However, it does not appear that this uptick in registrations has transitioned into forecasted production growth at our customers. And as a result, Europe remains an area of potential volatility for the balance of the year.

In the U.S., the market for light vehicles is clearly improving as indicated by a higher SAAR and low inventory levels on certain vehicles. Our sales on this market segment continued to underperform the market due to greater-than-normal product obsolescence, which will continue into 2014. Note that North American automotive sales represent less than 17% of our revenue.

According to third parties, during the third quarter, light vehicle production in China grew approximately 8% year-on-year, slowing from earlier in the year as predicted. Included in this growth is the impact of a long-term production shift out of Japan and Korea and into China. Revenue from our Asian automotive end market was impacted in the third quarter by this production shift, a weak yen and increasing sales of microlight vehicles in Japan, which require fewer fuel economy enhancements and, therefore, contain less sensor content.

Our Controls business serve end markets such as HVAC, appliance and a variety of industrial segments. We believe a good leading indicator for the Controls business is Manufacturing Purchasing Managers' Index data. Chinese PMI in July hit an 11-month low of 47.7, but has been improving since then, reading 50.2 in September and 50.9 in October. While still signaling expansion, U.S. PMI statistics have fallen recently from a reading of 52.8 in September to 51.1 this month. And in Europe, PMI is improving from a reading of 51.1 in September to 51.3 this month.

Despite heavy vehicle off-road challenges and -- our revenue from the HVOR market segment is up 50% in the third quarter and up over 20% in the first 9 months as compared to last year. This is due to increasing production of on-road heavy trucks in North America and strong design wins.

During our prior earnings call, we have shared our expectations for content growth in the 5% to 6% range for 2013, and our current expectations remain consistent with that guidance. While content growth tends to correlate with economic cycles, we are convinced in our ability to generate strong organic revenue growth from increasing content over the long run.

Regulatory requirements for higher fuel efficiency, lower emissions and safer vehicles continue to drive the need for advancements and engine management and safety features that, in turn, drives the need for more of our sensors in vehicles. In Europe, for example, Euro 6 requirements coming into force beginning in the fourth quarter of next year through 2017 are compelling OEMs to launch upgraded engines with increased sensor content. However, OEMs will continue to offer Euro 5 engines alongside the newer, cleaner Euro 6 alternatives. In the intermediate period, OEMs are expected to allow consumers a choice between the 2 engines until the Euro 6 deadlines are reach. In the meantime, take rates of Euro 6 engines will have an impact on our revenue in Europe.

I'll now turn the call over to Jeff to review our third quarter results in more detail and provide market and financial guidance for the fourth quarter. Jeff?

Jeffrey J. Cote

Thank you, Martha. Third quarter 2013 net revenue of $498.9 million increased 5.7% compared to the third quarter 2012. Sequentially, revenue fell 1.5% from the second quarter of 2013, much less than normal seasonality. Adjusted EBITDA for the third quarter was $139.9 million or 28% of net revenue. Adjusted net income was $97.9 million or 19.6% of net revenue. Profitability indices were better than the third quarter last year due primarily to benefits from cost-reduction programs and synergies from acquisitions.

In the third quarter, cash taxes were 6% of adjusted EBIT at the high end of our guided range. We now expect cash taxes for the full year 2013 to be slightly higher than the 6% of adjusted EBIT.

During the third quarter, $1.8 million of restructuring add-backs, related primarily to the movement of manufacturing lines from Korea, were offset by $5 million of insurance proceeds, and the resulting net gain was deducted in determining adjusted net income. While the timing of the charges and proceeds from insurance will be lumpy quarter-to-quarter, including some insurance proceeds expected in the first half of 2014, we continue to expect restructuring add-backs due to the events in Korea to be close to 0 overall. Also in the quarter, we excluded from adjusted net income a $12.7 million gain related primarily to commodity hedges that are marked-to-market from a GAAP perspective but not yet matured.

Cash at September 30, 2013 was $348 million. For the third quarter, we generated $107 million in free cash flow. Cash provided by operating activities was $129 million. Cash used in investing activities totaled $16 million and cash provided by financing activities totaled $2 million.

Capital expenditures were $22 million. We expect to spend between $75 million and $85 million on capital improvements during the course of the full year 2013.

Capital allocation is a very important activity for us at Sensata. We continue to believe that acquisitions will provide the highest return for shareholders. The acquisition pipeline remains full, and the cash generated by the business, combined with our available revolver, gives us plenty of resources to pursue transactions.

In addition, we believe share repurchases can provide an attractive way to return capital to shareholders. Under a plan approved by our board last October, during the past 12 months, we have used approximately $141 million in cash to repurchase 4.4 million shares. We announced today that our Board of Directors has approved an updated $250 million share repurchase plan to facilitate share repurchases going forward.

As of September 30, our gross debt stood at $1.6 billion and our net debt was $1.3 billion. Our gross leverage stood at 3.1x, and our net leverage ratio was at 2.4x. Our target net leverage ratio continues to be in the 2 to 3x of adjusted EBITDA range.

Now I'd like to comment on the performance of our 2 business units. Sensors net revenues was $358 million for the third quarter, up 5.4% from the year-ago quarter as a result of strong content growth in HVOR. Sensors net revenue fell only 90 basis point sequentially from the second quarter of 2013 despite seasonally weaker light vehicle production in every region around the world. Light vehicle production was off over 13% in Europe in the third quarter as compared to the second quarter this year.

Sensors profit from operations was $110 million or 30.7% of Sensors net revenue. Sensors profit from operations index was higher than the third quarter of 2012 and the second quarter of 2013 due primarily to synergies from acquisitions and cost-reduction efforts, offset somewhat by higher spending on research, development and engineering.

Controls net revenue was $141 million for the third quarter, up 6.5% from the year-ago quarter and down 3% sequentially from the second quarter of 2013. Year-on-year growth was driven primarily by Controls successfully integrating a small tuck-in acquisition and from share gains in appliance end markets. Seasonally, in the third quarter, driven by the HVAC market, was partially offset by capacity coming online during the quarter to replace the lines damaged by the fire in Korea at the end of last year.

Controls profit from operations was $41.6 million or 29.6% of Controls net revenue. This is lower than Controls profit from operations in the second quarter of 2013 and the third quarter of 2012 due to lower volumes, product mix and an increased investment in growth.

For the fourth quarter of 2013, current third-party estimates call for year-on-year automotive production growth of approximately 6% in North America, 8% in China and 4% in the rest of Asia. European production is expected to be flat as compared to the fourth quarter of 2012.

We are not yet providing guidance for 2014. However, third-party estimates call for vehicle production growth in North America and Europe to be nearly offset by shrinking production in Japan and Korea. As a consequence, automotive production in these mature markets is expected to be up less than 1% next year.

Having surpassed Europe in production volume this year, China light vehicle production, where Sensata has the lowest dollar content per vehicle, is expected to continue to grow in the high single digits next year.

Turning our attention to the fourth quarter of 2013. Our financial guidance includes the following: net revenue of $485 million to $505 million, which, at the midpoint, is an increase of approximately 11% from the fourth quarter of 2012 and a sequential decrease of approximately 1%, given the better-than-normal seasonal performance in the third quarter of this year; our fill rate stands at approximately 88% of the midpoint of this guidance; adjusted EBITDA of $140 million to $148 million, approximately 29% of net revenue at the midpoint; adjusted net income per diluted share of $0.53 to $0.57, approximately 20% of net revenue at the midpoint. Revenue guidance remains consistent with the full year guidance we gave in July, and our earnings guidance is slightly higher.

In summary, we are pleased to report that third quarter results came in slightly better than expected. Earnings grew over twice the pace of revenue, and we achieved another record adjusted EBITDA quarter. With some end markets remaining uncertain, most notably the European light vehicle market, the business is performing well and the way we would expect it to.

With that, we will now open up the line for questions. Operator, please introduce the first question.

Question-and-Answer Session

Operator

[Operator Instructions] Okay. Your first question comes from the line of Wamsi Mohan with Bank of America Merrill Lynch.

Wamsi Mohan - BofA Merrill Lynch, Research Division

Can you comment on how the obsolescence issue is progressing here in 2013? Martha, it sounded like the issue could linger into 2014. Can you give us some sense of what sort of headwind it could pose higher than the normal level of obsolescence in '14?

Martha N. Sullivan

Yes. The comment I would make, Wamsi, is we're recognizing that while we're facing obsolescence in a particular area, we've talked about our occupant weight sensing, we do have revenue through the second half of this year. And so on a comp basis, as we get into 14, that's going to have an impact. At this point, we're not really guiding on 2014, but I think you're aware of what that particular vector is in our overall revenue today. So we do see some overhang as a result of revenues still being in the current quarters.

Wamsi Mohan - BofA Merrill Lynch, Research Division

Okay, Martha. And quick follow-up, maybe for Jeff here. Can you comment on the uptick in inventory in the quarter, what drove the increase there?

Jeffrey J. Cote

Yes. So the inventory balance was up by a day or so compared to last quarter. I think at the end of -- actually, it was -- the total -- excuse me, the total cash conversion cycle was pretty consistent. But in terms of days on hand, we had 49 days at the end of last year. So we're up about 3 or 4 days. I think there are variety of things that are continuing to drive that, but I think it's the line level loading to make sure that we can optimize on the profitability of the business and also some -- carried some strategic inventory with certain suppliers. But there's nothing really out of the ordinary there. We would expect to stay in the range of the 50 to 55. But this quarter, we happened to land a couple days higher.

Operator

Your next question comes from the line of Jim Suva with Citi.

Jim Suva - Citigroup Inc, Research Division

As a follow-up, Martha, regarding the late Sensor obsolescence, can you remind us about when that will lap and when we should expect to see some acceleration? Because I assume you have some new products that should be getting some traction at some point.

Martha N. Sullivan

Yes. I think relative to the obsolescence piece, and let's recognize, there is always an underlying element of obsolescence. And when we consider our content growth, it's net sort of normal obsolescence. In 2013, we talked about being at about twice our normal rate because of a very specific program. To the extent that, that lapse next year, that's a little tough to call without understanding exactly how vehicle production will play out and how demand for those vehicles that has the products that is obsoleting will play out, so a little difficult to say when that will lapse. But we would expect some level to have an impact throughout the year. Although as we get late into the year, that may not be all that material. So as we're not guiding today, I can't -- on '14, I really can't be more specific than that.

Jim Suva - Citigroup Inc, Research Division

Okay. And then, theoretical, after we reach that lapping point, do we then enter into a forward year or 12 months of some revenue acceleration from that? Because I'm assuming you have a new product now that really gains traction back in your market share.

Martha N. Sullivan

To the extent that that's not going to be a headwind, that will have a tailwind impact on our overall content growth.

Jim Suva - Citigroup Inc, Research Division

Great. And then maybe a follow-up, probably more specifically for Jeff. It seems like the tax rate appears to be gradually going up a little bit. Is this a trend that we think will continue going forward kind of long term for investors, or do you have confidence that we're kind of locked down into a low single-digit -- I'm sorry, a single-digit rate?

Jeffrey J. Cote

Yes. We still have confidence in our long-term rate being in that 4% to 6% of adjusted EBIT, Jim. I think that there's a couple of items associated with where profitability landed by jurisdiction that could -- that's causing us to be a little bit higher in this quarter and for the year. But we still have a high degree of confidence in staying in that range going forward.

Jim Suva - Citigroup Inc, Research Division

Okay, perfect. So nothing structurally has changed with product sourcing, product sales or laws and taxes that would, long term, impact that 4% to 6% range?

Jeffrey J. Cote

No. There -- obviously, there are always laws those around the world that are in flux, but there's nothing that we believe, at this point, will have an impact on that long-term rate.

Operator

Your next question comes from the line of Ambrish Srivastava with Bank of Montréal.

Ambrish Srivastava - BMO Capital Markets U.S.

I just wanted to go back to the obsolescence issue. How much did it end up impacting content growth this year?

Martha N. Sullivan

Yes. I think we've been consistent, saying it averages at about twice our normal rate. Our normal rate is in the 1.5% to 2% of obsolescence. That should give you a sense of scale on that issue.

Ambrish Srivastava - BMO Capital Markets U.S.

Okay. And then could you just remind us what should the normal seasonality be for the first quarter?

Jeffrey J. Cote

Normally, the fourth to first is up. I believe it's up in the 6% to 8% range is my recollection. We're digging into it, and we'll let you know if we -- when we put our finger on the data, whether or not there's a change. 8% to 10% actually is their typical seasonality, and that's over the last 7 or 8 years, taking out the abnormal years around the downturn.

Ambrish Srivastava - BMO Capital Markets U.S.

Okay. And then my last one is on -- are you aware of any program share losses that you're seeing right now which might offset any design wins that you have heading into 2014?

Martha N. Sullivan

No, Ambrish. We've not seen any surprises from a share standpoint. As we continue to increase content wins, it actually has the impact of increasing share. So certainly nothing surprising on that front.

Operator

Your next question comes from the line of Steven Fox with Cross Research.

Steven Bryant Fox - Cross Research LLC

Just 2 questions for me, please. First off, you mentioned a couple of times some higher investments might have impacted margins a little bit. I was just curious if that's a longer-term trend to ramp up your R&D or more near-term project related, and any other color on that would be helpful. And then secondly, I know it's a relatively smaller market, but it sounds like heavy truck market was helping you and you're also getting some new wins. I was just curious where you are on the new wins, whether there's more to come to help the growth over the next couple of quarters or is it more now about just engine shipments.

Martha N. Sullivan

Sure, Steve. So in terms of RD&E, our -- we try to maintain that spend within the 5% to 7% spend of revenue index. That will move up and down if we get spikes in revenue either way. We are gradually moving towards the high end of that range, and we're running at about just over 6% right now. That tends to be, in some quarters, a bit lumpy, depending on what's happening in a particular program. But you can expect to see us stay in that range, more towards the higher end of the range. Relative to HVOR, I think your question was do we continue to see increase in content wins? We do. As we enter into a year, it really does become a function of what are the take rates now of the applications that we're designed into, and that's the case in both light vehicle and our heavy vehicle market as well. But you can see we've done very well in that particular segment in terms of content growth.

Steven Bryant Fox - Cross Research LLC

And just as a quick follow-up to that. I think you were a little more cautious on that the market last quarter. As you look out to 2014, do you have a little bit more optimism around take rates, or is it about the same what you were thinking 3 months ago?

Martha N. Sullivan

Yes. I think we've not been expecting the end market dynamics to drive -- the overall macro demand to drive our overall growth in that segment, and that is still the case. It's still a segment where we expect to see much disproportionate growth of our revenue versus that end market. So we feel confident on that front.

Operator

Your next question comes from the line of Mark Delaney with Goldman Sachs.

Mark Delaney - Goldman Sachs Group Inc., Research Division

The gross margins were very strong this quarter and have been improving over the last several quarters. Can you help me understand what the trajectory from margins can be as you look out toward 2014, what are the puts and takes?

Jeffrey J. Cote

Yes. So the gross margin expansion is not a surprise. Obviously, the synergies associated with the acquisitions are the primary driver there, but there's an ongoing effort around best cost sourcing that will impact gross margins as well. So we would expect that gross margins will continue to tick up over the next 3-year timeframe. We -- what we've talked about is that -- the fact that we intend to invest a little bit of that savings into research, development and engineering to drive growth. So we're forecasting the fourth quarter from a bottom line standpoint, adjusted net income margins, in the frame that we've targeted for ourselves of 20% to 23%. So at the low end of that frame a little bit of incremental margin over the longer term will come primarily from gross margin expansion associated with those activities.

Mark Delaney - Goldman Sachs Group Inc., Research Division

That's helpful. For my follow-up, you guys talked a little bit about what the Euro 6 standard and what the impact could be next year. Can you help us understand what the difference in your content is on a Euro 6 engine versus a Euro 5 engine? And then related to that, is there anything that your OEM partners are doing to help drive sales of Euro 6 engines as opposed to Euro 5?

Martha N. Sullivan

Yes. The content is -- difference is significant, and it can range from a low end of say 5 to a high end of about 25, depending on the overall producer and what applications they've selected. I think, on average, it's going to be, at least, low double-digit increase in overall content. The dynamic around how many Euro 6 engines will sell is one that we're very alert to, and it's got a lot of moving parts. And so we're not in a position right now to talk about what that's going to look like. We see practices kind of all over the region, where we've got some regions that are actually looking at changes in the way they incentivize higher mileage engines. That's going to be one dynamic. We've got customers who are looking at whether or not that's an optional offering or a standard offering, and that is still very much in play. And so a lot of the cautionary notes you hear on Europe from us have to do with this overall dynamic.

Operator

Your next question comes from the line of Rob Wertheimer with Vertical Research.

Robert Wertheimer - Vertical Research Partners, LLC

So a quick question just on the HVAC and appliance segment. We had a lot of reports on -- at least resi HVAC and some commercial growth, and you didn't see a lot of growth in that segment. So what was the offset there? Have you lost share within a segment? Is it just appliance is softer? Maybe you could just sort of break that down.

Martha N. Sullivan

The -- our overall performance in appliance is up year-to-date, not in the quarter. On the HVAC segment, I think that's where we're more flattish on a global basis. We're seeing some strengths in the Americas, but offsets in China. That's the area where we've seen less market strength, and we're seeing the difference in prior years around incentives, around construction. So that continues to be a segment that's challenging for us in China. China being a region that, overall, is a very positive one for Sensata.

Robert Wertheimer - Vertical Research Partners, LLC

Okay. That's a lot interesting in there. So you basically tracked the market, you think, in North America. And then in China, you're saying that maybe you're seeing some weakness in appliance, but overall, the economy, from what you can see, looks good. Have I interpreted that correctly?

Martha N. Sullivan

No -- let me be really specific. In China, we're doing very well in the appliance segment, so growing year-over-year strongly, actually double digits in China in the third quarter. HVAC in China is an area where we're seeing much weaker demand than we've seen in prior periods.

Robert Wertheimer - Vertical Research Partners, LLC

Okay, perfect. And is that HVAC in China, is that -- I'm sorry, is that like an aftermarket retail, somebody's buying small units, or is that going up with construction out of curiosity for your product?

Martha N. Sullivan

It's actually a number of different dynamics, Rob. In some cases, we're shipping into a room air conditioner that get shipped out of China. In some cases, we're shipping into new construction and even commercial construction in China. So there are a lot of moving parts on the China HVAC. Overall, it's a segment that is weaker than we saw in the year earlier.

Robert Wertheimer - Vertical Research Partners, LLC

That's great. And then if I -- not to beat a dead horse, I'm sorry for this. But on the obsolescence issue, did it extend the past what you had thought? And is that just because people kept producing the old product longer, or is this kind of what you thought and you're just sort of seeing it play out?

Martha N. Sullivan

Yes. I would say it's in line with our expectation. I think when we initially looked at this, we were looking at it sort of on a macro level. As we get into quarter-by-quarter, you see some puts and takes. So, not way outside of what we would've expected.

Operator

Your next question comes from the line of Ric Kwas with Wells Fargo Securities.

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

I guess I'll continue to beat a dead horse. But on the obsolescence, just to be clear, is this still the one -- the program that you discussed in the past and the incremental impact or the continuing impact of that, or is there anything new on that front? I just want to make clear on that.

Martha N. Sullivan

Yes. It is absolutely the program we've discussed in the past, so no new dynamic here.

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Okay. And then incrementally though, as you move into the next year, my impression was that the big hit was this year, and there's a hit next year but it's less impactful. Is that still the right way to think about it?

Martha N. Sullivan

Yes. Again, it's going to be a function of where does demand land on those models this year and what does it look like next year. So if it gets very vehicle-specific, there's been some volatility on the sales of those vehicles, so that's what's driving sort of the spillover into '14 and the sizing of that impact on '14. Again, not guiding on '14, so I'm not going to comment beyond that.

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Okay. And then, Martha, on the -- Jeff, you've made a comment about developed market production at 1%, thinking about it initially for '14. But the early read on Europe is up 3-ish or thereabouts for next year, and you have more content there. So on a broad basis, shouldn't that be a little bit more beneficial to you as we think about the developed market production prospects for next year?

Jeffrey J. Cote

Certainly, we've talked about the fact that Europe is our highest content market. This Euro 5, 6 transition is something that's still to be unfolded in terms of how that folds out in '14. But you're absolutely right. When you think of markets and where the highest Sensata content exist, it is in Europe first, developed Asia and North American next and then China last.

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Okay. And then just on the Euro 6 as a follow-up. I guess, just to clarify. I know there's some moving parts in there. But generally speaking, incrementally, there's probably going to be more Euro 6 engines introduced as 2014 unfolds ahead of the formal implementation. So incrementally speaking, is this just you don't know what production is going to be and how it's going to play out, but generally speaking, there should be some momentum, from a program standpoint, from the OEMs as you move out to next 6 to 12 months? Is that the right way to think about it? I mean, I'm just trying to think about -- I know mix can move from quarter-to-quarter, but generally speaking, the OEM should be moving towards Euro 6 as we head into the regulation.

Martha N. Sullivan

Yes. To the extent that you would have seen almost no Euro 6 engines, let's call it, first quarter 2013, you'll see incrementally more. The dynamic that we're looking at and we've gone back to look at historical periods, for example, Euro 4, Euro 5 transition, the dynamic we're seeing is the move towards more optionality on Euro 6 engines. And so that becomes now a consumer choice, and the question is what does that overall market look like and how will the consumer choose. So a little different than we've seen in past Euro transitions.

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Great. So the take rates for the next year until this becomes 100% implemented, right? Is that...

Martha N. Sullivan

That's right.

Operator

Our next question comes from the line of Shawn Harrison with Longbow Research.

Shawn M. Harrison - Longbow Research LLC

I know you're not guiding to '14. But trying to add together everything that was mentioned this morning in terms of, I guess, uncertainty about the Euro 6 take rate, the obsolescence in North America and then the commentary that you'll see the -- at least, the market will see the greatest growth next year in your lowest content region and, at least, at first blush, adding that up to me means that you're trying to, at least, point us toward maybe content toward the lower end of that 7% to 10% or even a little bit below, so maybe if you could comment on how I was adding things up.

Martha N. Sullivan

Yes. We're -- I think we're just trying to give you a sense of the things that we are looking at. And so it -- since we're not guiding, I'm probably not going to make a lot of comment on that overall observation.

Shawn M. Harrison - Longbow Research LLC

Am I directionally correct even? It's -- I guess it's -- I mean, the concern is that we model 7% to 10% for content next year, all these things come up and there's an earnings miss out there waiting to happen. So just trying to make sure we don't get ahead of ourselves is really what I'm looking at.

Martha N. Sullivan

Yes. And look, I appreciate that. I think that's why we're trying to be transparent on the things that will be more of the takes than the puts when we look into next year.

Shawn M. Harrison - Longbow Research LLC

Okay. And then just as a follow-up. M&A was touched on in the prepared remarks, but are you closer to a deal? How does the pipeline look? I know it's a full pipeline, but just in terms of pricing and as you move along down that road.

Martha N. Sullivan

Yes. Look, the pipeline is full, and we are very, very active, a number of very active dialogues. And so even some of the growth investment areas we've talked about are in resources that are dedicated to that task, so very active time for Sensata.

Operator

Your next question comes from the line of Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

A couple of questions for me. One, could you just talk about your December quarter guidance? You guys are actually lowering estimates a little bit versus where most of us are sitting at. And if I think about the last 90 days, at least most of the production that, at least from IHS has been getting revised upwards, at least in Europe, yet you guys are talking about December being modestly worse than what you thought it would be 90 days ago. So maybe talk about what are the offsets that you guys are seeing that isn't getting captured in the broader production data that we see in Europe.

Martha N. Sullivan

Yes. Amit, at this point in the quarter, we really move to a very granular understanding of our backlog. And so we talked about the fact that we're sitting at 88% filled on the call that we just made, on the guide that we're giving you, and we think that, that is appropriate. And so when we look at the actual demand coming out of Europe from customers and recognize that there's a bit of a supply chain there, it supports the guide that we're giving you. It's very often after the fact we'll be able reconcile what would've been different. But I think the most important thing to understand is that the production plans are not in line with an improving market in the fourth quarter in Europe.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Got it. And then I guess Martha, I mean, you -- just going back to the last question. You talked about obsolescence headwinds. You talked about the E-6 not being fully mandated by late 2014 as something we should consider. When you think about this long-term 7% to 10% content growth target you have, what are some of the positive things in 2014 that can enable you to get there? Are there different fuel efficiency emission standards elsewhere going to get implemented that can help drive some of these offsets away and sustain that growth number? I'm trying to think what are the content drivers that you are excited about in 2014 right now.

Martha N. Sullivan

Yes. Look, I appreciate that question, because it really is the flip side of some of what we're talking about here. I think the thing we've recognized over the past 18 months or so is that a down market has an impact on content. So even though quite independently, we're being designed into new applications and new engines, the timing of those launches, the take rates on those things can be impacted by macro forces on an end market. That can go either way. And so if you look at what these regions of the world have been willing to do to incentivize more fuel-efficient vehicles to get their credits from the regulatory agents ahead of time, there is an upside case. There's no question about that. And so that's part of how we look at this as well.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Got it. Just finally, any update on the CFO search, and what's the timeline for that from here?

Martha N. Sullivan

We continue to be a very, very active in that process. Given our Interim CFO, we have very high standards for what their performance should be. It's not an area where we're going to compromise. But it's an active search. We're meeting a number of very interesting candidates, holding ourself to high standards.

Operator

Your next question comes from the line of Christopher Glynn with Oppenheimer.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

On the sourcing, you mentioned that being a continued gross margin driver. I had tended to think about that as more of a offset or a wash with the annual price down. So can we just kind of dive into that math a little bit?

Jeffrey J. Cote

Yes. So we'd -- certainly, that's a big target item for us and in terms of offsetting the 1% to 2% price downs every year. But just to be very clear, we target a little bit more than what we need to achieve there. So there is best cost-sourcing opportunities in terms of negotiation with our suppliers. There's also efficiency in terms of how we manufacture product. There's some leverage associated with scale. So there are a variety of things in the gross margin line that will create some leverage that will allow us to offset pricing, but also allow us to increase our investment in growth as we go forward. But by far, best cost sourcing is the biggest chunk of that.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

Okay. And then the horse is still a little bit alive here. On the obsolescence, I was wondering if you'd be willing to maybe size what you are selling into that area this year. Maybe that would help people understand kind of what remains as a headwind.

Martha N. Sullivan

Yes. No -- look, I really do think having indicated how much this has increased the obsolescence rate in 2013, you probably have -- can get to a pretty good sense as to what percentage of our overall top line that that's been. I think that's where we're going to leave the remarks.

Operator

Your next question comes from the line of William Stein with SunTrust Robinson and Humphrey.

William Stein - SunTrust Robinson Humphrey, Inc., Research Division

On the last call, I believe you highlighted some -- an anticipated inventory correction in Q4. And I'm wondering if we're seeing that play out in the guidance today.

Martha N. Sullivan

I would say to the extent that we're guiding mainly on what's in our backlog and to the extent that customers are not pulling an increase, given, let's say, somewhat recovering market, although I think that's still optimistic, they may be anticipating vehicle inventory corrections. We think those are already comprehended in our backlog. So we're not anticipating a major cut at the end of the year as we've seen in past quarters.

William Stein - SunTrust Robinson Humphrey, Inc., Research Division

Great, that's helpful. And then I'm wondering if you can give us a competitive update in the sensor market. In particular, there are a lot of semiconductor companies that are getting more active in their discussions of building sensor products. And my understanding is this would be an input to your product, not a competitive threat. Can you elaborate on that, please?

Martha N. Sullivan

Yes, that's correct. If you look at what constitutes one of our sensors and the packaging dynamic and the level of customization involved, it's not an application set that lines up with the semiconductor offering, where you need to have fairly standard offerings. They have fairly standard packaging techniques. Very often, these semis are providers to us to the extent that we're using, for example, a MEMS based sensor technology. So it's not a development that's new nor is it one that has a negative impact on our business model.

Operator

As there are no more questions, I'd like to turn the conference back over to Mr. Sayer for closing remarks. Mr. Sayer?

Jacob A. Sayer

Thanks, Joni. I'd like to thank you, all, for joining our financial results call today. Later in the quarter, Sensata will be participating in RBC Capital Markets Technology Investor Conference in New York on November 12 and BMO Capital Markets Technology Investor Conference also in New York on December 10.

We appreciate your continued interest in and support of Sensata and look forward to speaking with you on the road and, again, next quarter. Thank you and goodbye.

Operator

That concludes today's call. You may now disconnect.

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