Shares of TE Connectivity (NYSE:TEL), a supplier of electronic connectors, have been on the rise for the past couple of years. I outlined in a previous article a few reasons why the stock could continue to rise in the long term. However, TE Connectivity is not without challenges, and there are also a few things that could lead the stock to decline. Let's take a look.
U.S. auto sales could be peaking
Over 40% of TE Connectivity's revenue is derived from the transportation segment, and with an adjusted operating margin in excess of 20% during the most recent quarter, transportation represents an oversized portion of the company's bottom line. A strong worldwide auto market has been driving revenue growth in the segment since the end of the financial crisis, and the U.S. auto market in particular has made a very strong recovery.
But auto sales in the U.S have now reached prerecession levels. From 2000 up to right before the financial crisis, U.S. auto sales were essentially stagnant. Now that sales have fully recovered to those levels, it's unlikely that growth can continue at the same pace as the past few years.
The U.S. is one of the largest automobile markets in the world, and a slowdown in growth would negatively affect TE Connectivity. Auto sales could eventually begin to shrink as an increasing number of people move to cities, reversing the decades-long trend of people moving out into the suburbs, where cars are essentially required. If this trend continues, we could be approaching the peak of the U.S. auto market, and that's bad news for any parts supplier.
Slowing growth in China
China is an important market for TE Connectivity across all of the company's segments. In the transportation segment, about one-third of revenue comes from the Asia-Pacific region, which includes China. This percentage is smaller for the industrial segment, about 20%, but industrial sales derived from the Asia-Pacific region grew by 20% during the most recent quarter, far faster than 6% growth in the Americas and flat growth in Europe.
One of the key drivers of the global automotive market in the coming decades is expected to be China, but signs that the Chinese economy is slowing could lead to trouble for TE Connectivity. The company expects to grow revenue by 5%-7% in the long term, excluding the effects of acquisitions.
TE Connectivity is diversified across many different countries, with China only accounting for $2.2 billion in revenue in 2013, or about 16.5% of the company's total. However, with both the U.S. and European economies far more mature than China's, a significant portion of TE Connectivity's growth assumptions are likely based on continued growth in China. If Chinese economic growth continues to slow, TE Connectivity's guidance may prove overly optimistic, and that could send the stock price falling.
TE Connectivity has announced two big acquisitions this year. In April, the company announced that it would be paying $490 million for the SEACON group, which specializes in underwater connector technology. A few months later, the company announced the $1.7 billion acquisition of Measurement Specialties, which once completed will put TE Connectivity in a leadership position in the sensor market.
This isn't the first time TE Connectivity has turned to acquisitions to fuel growth. During fiscal 2011 and fiscal 2012, the company spent over $2 billion on acquisitions. Since then, revenue has actually declined, and operating income in fiscal 2013 was well below the value from 2011. It takes time to integrate companies, of course, so the benefits of any acquisition may not be immediately apparent.
TE Connectivity is paying more than four times fiscal 2014 sales for Measurement Specialties, a hefty premium considering that the acquired company only generated $50 million in operating income during fiscal 2014. Combining the two companies may make a lot of sense from a strategic point of view, but paying too high of a price for acquisitions could ultimately drive the stock price down if things don't work out as planned.
TE Connectivity posted strong growth in its most recent quarter, and it expects to continue to grow revenue and earnings in the long term. But a peaking automotive market in the United States, slowing growth in China, and the potential for expensive acquisitions to go awry are all good reasons to carefully consider the pros and cons before investing in TE Connectivity.
Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.