Watch the Horizon
Special situations provide investors with the ability to generate market insulated returns and an opportunity to benefit from market inefficiencies. While the universe of special situations is vast, one of the most accessible types of special situations to retail investors is spin-off investing. Spin-off investing provides investors willing to endure near-term volatility the opportunity to realize higher value from the parts of a company rather than the whole.
A situation unfolding with The Timken Company (NYSE:TKR) is one such event that I believe has the potential to reward investors in the long run. Despite announcing a spin-off earlier this year, the shares of the company have declined in price significantly since this announcement, something which is the opposite of what is often observed in the course of such events. I believe that investors should welcome these price declines as it increases both the company's dividend yield prior to its spin-off and further increases the chance of the company's assets appreciating to a higher price when they are separated.
What The Timken Company Does
The Timken Company is a venerable business, having been operating for over a century. Based in Canton, Ohio, the Timken company "develops, manufactures, markets and sells products for friction management and mechanical power transmission, alloy steels and steel components. The Timken Company manufactures and manages global supply chains for two core product lines: anti-friction bearings and adjacent mechanical power transmission components, as well as specialty steel and related precision steel components."
The company sells its products to a number of large companies including Caterpillar, Boeing, National Oilwell Varco, John Deere and AutoZone and enjoys both a strong domestic presence and growing exposure to emerging markets.
In September 2013, Timken announced that it would be spinning out its steel alloy and components division to create a new company, thus furnishing current shareholders with two separate entities through which will likely be a tax free distribution.
An in depth discussion and valuation multiples can be found in the company's investor presentation as well as an excellent article written by a fellow contributor here. The market reacted well to the news - pushing the stock from $56 to a 52-week high of $64 after the announcement in September
Despite the fact that the steel industry in America is both capital intensive and has underperformed in recent years, I am optimistic about the company's prospects in the future due to the fact that it has repeatedly demonstrated an emphasis on quality, has an established customer base and specializes in providing "made-to-order" solutions which help avoid excess production. Labor relations in the steel industry are also important, and the company has also said that its pension plan for both companies will be fully funded, something that is often not the case as many other companies often face significant pension shortfalls.
While I believe that the steel portion of the company will be attractive, I am of the opinion that the real prize is the company's core bearings and power transmission business for several reasons. The first is the fact that the production of bearings and power transmission components is significantly less capital intensive than steel production. In addition, a comparable company such as RBC Bearings (NASDAQ:ROLL) has witnessed significant appreciation in share price over the recent years.
The Numbers on The Timken Company
The company has market capitalization slightly under $5 Billion. With a P/E of 15.9, and currently priced at $52.13 per share against $24.33 of book value, investors are paying a premium for the company. Insider ownership of the company is relatively high - currently standing at 15%. The company also operates with a moderate amount of debt that ($476 Million) which, measured against the company's cash reserves of $418 Million indicates the company is adequately capitalized.
The company also pays a dividend yielding 1.76% annually with a payout ratio of .31, a very low number that indicates to me there is the potential for dividend increases in the future or that the company is able to retain and compound its earnings internally at a higher rate, something further validated by its low double and high single digit returns on assets.
Another explanation for this low payout ratio could be the significant capital expenditure requirements in the heavy industry and steel segments of the company's operations. I believe that The Timken Company post-spinoff will be in a better position to increase its dividend from earnings generated from its bearings division after spinning off its steel division.
A Lesson on Spin-offs From the Master
In my opinion, one of the most gifted investors of our generation is Joel Greenblatt. In addition to producing stellar returns, Mr. Greenblatt has contributed a large amount of knowledge that benefits practitioners in the field of investing. In his great work "You Can Be a Stock Market Genius," Mr. Greenblatt discusses a myriad of special situations that can translate into considerable profits for investors willing to do their homework. One of Mr. Greenblatt's favorite situations in the marketplace is Spin-Off investing, largely because of the opportunities created by irrational market behavior in the period following the distribution of shares in the new corporate entity.
Why Spin-Off Investing Can Unlock Value
Investing in Spin-Off's (either before or after the event) can provide outsized returns to investors for several reasons, which I will briefly mention.
1. The newly separated corporate entities will be able to more effectively focus on their core business, streamlining operations and increasing efficiency. Often times operating segments of conglomerates are almost wholly disconnected from each other (For example, Shipping and Real Estate in the case of Alexander & Baldwin before it spun off its subsidiary, Matson Shipping)
2. Divided companies are able to contain risk more effectively and allow investors to make a better choice about which company they want to invest in going forward.
One particularly salient example of this is the story of Eastman Kodak. While the Eastman Kodak that many investors knows has since descended into bankruptcy, its former chemical subsidiary - the Eastman Chemical Company (NYSE:EMN) continues to both grow and thrive in the marketplace after being spun-off in 1994.
3. Structural factors that are unrelated to the intrinsic nature of the newly separated businesses can also create near-term opportunities. For large index or mutual funds that operate with certain mandates - holding shares in a spun-off subsidiary is likely not feasible and can lead to massive near-term selling pressure.
If an index fund oriented towards mid-cap consumer product companies paying dividends suddenly receives shares in a small-cap company that specializes in medical devices paying no dividend - it is obvious that shares in the company will need to be liquidated in order to conform with their stated mandate. This sort of forced selling in the near term can be exploited by enterprising investors who are willing to let the market gradually appraise the value of a business, often reaping significant benefits.
Explaining the Recent Decline: Near-Term Pessimism
Shares of the company have declined significantly since the management discussed their Q3 earnings on Thursday, October 24th. Management cited slow global recovery in heavy industry, particularly from infrastructure and mining segments located in emerging markets as adversely impacting earnings. The company also expressed a more muted expectation for the rate of future growth.
Despite these disappointing results, the management of the company has discussed their attempts to adjust to this new, slower growing environment through repositioning assets, optimizing margins and positioning the company to take advantage of a more gradual recovery going forward. In addition, the management of the company confirmed that they would proceed with the planned separation of assets going forward. Given that Wall Street as a collective entity operates with a quarterly attention span, an event that is almost a year away is barely on their radar, despite the willingness of the market to appraise the company's shares significantly higher after the announcement of the pending spin-off.
With a Spin-Off Looming: The Lower the Price of the Parent, the Better
For investors that are waiting to exploit the spin-off, I believe that these near-term price declines are a boon coming into the new year. Given the fact that it is likely that recently spun-off companies will suffer heavy selling pressure - price declines in the parent company will provide even more opportunity for value to be realized going forward.
Since the separation of the company's assets was announced, a process that management expected to be concluded in a 12-month period, investors examining the company now will find themselves presented with a much better deal - the company is cheaper and there is less time (around 9 months), likely in Q3 2014, for this catalytic event to occur.
How Will These Spin-Off Mechanics Play Out?
When I look at companies that are candidates for spin-off investing, I am concerned with several things. The first is time until the event and the second is price of the company. The closer we get to the event and the more the price of the company declines, I become very interested.
Since the company's spin-off was announced in early September of this year, almost a full three months have elapsed. The price of the company has also declined considerably, approximately 17% since the announcement. This is important not only because investors are going to be able to purchase both companies more cheaply, but because of the ramifications in the structural realm when it comes to spin-off investing.
In September, Moody's downgraded Timken due to concerns that the bearings and power transmissions business would carry more debt after the companies have been separated. Despite the fact that in the short term the bearings division could carrier a larger debt load, it is important to understand that in a low interest rate environment and with less stringent capital requirements, the bearings division could be shouldering more than its fair share of debt in an effort to benefit the steel division.
Are Concerns About Debt Justified?
Observing past spin-offs, there have been situations where debt has been transferred between divisions prior to the spin-off event by management in order to maximize the success potential for both companies after separation. One example is the recent division of Alexander & Baldwin (NYSE:ALEX), which left its former subsidiary Matson Shipping (NYSE:MATX) with a seemingly large debt burden relative to its market capitalization (a 60/40 split of debt in "favor" of Matson). While in the short term this debt burden did weigh on the company, the dependable earnings of Matson (derived from operating a necessary trade route between Hawaii and the Mainland) and its robust free cash flow made this debt burden manageable while the real estate division, a considerably more volatile business, was left with less debt and thus more freedom to maneuver. Matson has since been able to both reduce its debt burden and increase its dividend as its debt levels normalize.
In the case of Timken's bearings division, I believe that there is a higher chance that this division will be able to satisfy this larger debt requirement in contrast to the steel division which, while niche, is vulnerable to the broader vicissitudes of the price of steel and a higher cost of capital given the heavy infrastructure investments required.
Once debt levels normalize in the bearings division, something which I believe is very likely, investors will have the opportunity to have this excess cash returned to them through share repurchases or increased dividends. I believe that these outcomes are both logical and beneficial given the management's assessment of the slower rate of growth and global demand uncertainty going forward.
Before or After? One or the Other?
Given the fact that the price of the Timken company has declined significantly from its 52-week high after the spin-off announcement, I believe that investors are well situated to initiate a fractional position in the company in the current market and then to purchase more shares after the event occurs.
If I had to pick between these new companies, I believe that the steel division is attractive for several reasons - particularly due to the fact that it has been implied that some of its debt load will be transferred to the bearings division and the fact that the company focuses on making purpose-built high quality steel products for an established portfolio of consumers in addition to having fully funded pensions. I also believe that as more details become clear, the price of this company is likely to decline due to its small size relative to its parent.
Over a longer time horizon, I believe that investors are also well served to monitor the bearings division, particularly when its debt levels normalize given the fact that the company has revised its outlook about the potential for future growth, making it very likely for the company to return excess cash to shareholders through increased dividends and share repurchases.
When examining the current corporate entity, the management has repurchased 1.8 million shares this year and is authorized to repurchase an additional 5.7 million under the current buyback program. While I believe that this program will not persist in its current form in the aftermath of the spin-off, the company's relatively low debt, ample cash holdings, low payout ratio, and free cash flow indicate to me that there is a significant chance of future programs being implemented after a period of restructuring and debt normalization.
I believe that The Timken Company deserves a place on investors' watch lists going forward due to the significant declines in share price and the potential value to be unlocked through a separation of the company's assets.
In addition, after the company spins its steel business off, I believe that entity will experience significant selling pressure in the near term - potentially increasing the potential value to be had in that newly independent segment of the company and opening up short-term opportunities.
If the shares of Timken are further battered before the separation occurs, I will be an active buyer of the parent company, particularly if its shares decline to twice book value (approximately $49 per share) and will remain very interested in the shares of the steel company post spin-off and the bearings division over a longer time horizon.