By Thomas Mullarkey, CFA
We believe Timken (NYSE:TKR) has ample opportunity to increase its top line, expand profits, and generate returns in excess of its cost of capital. Including acquisitions, the industrial bearing firm plans to increase revenue during the next three years at a 7%-12% compound annual rate to $6.3 billion-$7.3 billion and increase earnings per share from $4.59 in 2011 to $6.50-$7.00 by 2014. This is measurably more than our 2014 EPS estimate of $5.57, which does not include future acquisitions and anticipates a slightly more competitive marketplace than Timken's forecast.
Still, we believe the company is successfully executing its strategy of focusing on demanding power transmission applications that require a steady stream of aftermarket replacement parts and lessening its emphasis on light-duty tapered roller bearing applications. Timken aims to differentiate its product portfolio, expand sales via international growth, further penetrate industrial markets, and make strategic acquisitions. We believe that much of this growth is obtainable, and we are maintaining our $61 fair value estimate.
Timken expects 5%-8% revenue growth in 2012 and aims for a 7%-12% compound annual growth rate through 2014. During 2012, its aerospace and defense and process industries segments should deliver double-digit revenue growth as industrial and civil aviation end markets experience increased demand.
Longer term, Timken will continue to seek out attractive acquisition candidates. It is focused on acquiring companies that provide highly engineered products or services for critical end user applications in the power transmission or friction reduction markets. Ideally, these acquisitions will have a significant portion of aftermarket sales, which typically provide beefier profit margins than original-equipment manufacturer sales. Additionally, the company wants to pay a fair price, with acquisitions being accretive in year one and earning their cost of capital by year three.
Industrial and aftermarket applications continue to be high-margin opportunities for Timken. While automotive applications account for almost 40% of the worldwide bearing market, they tend to be much more commodified than industrial applications. Typically, the bearings inside cars last longer than the car itself, so there is limited aftermarket opportunity in the automotive sector. However, industrial bearings used in heavy-duty end markets such as mining, energy exploration, and power generation operate in extreme environments and require more specialization. Additionally, industrial equipment is frequently used for decades and will require multiple replacements of bearings. This aftermarket opportunity for Timken is a tremendous annuity-like stream of revenue that tends to be high-margin. Since the cost of downtime in an industrial environment is very high, aftermarket bearings can be more aggressively priced than those for OEMs and typically generate loftier margins.
Timken's process industries segment should continue to generate robust operating margins. In the coming years, we believe this division is poised to capture additional growth as the world's thirst for more energy and more commodities leads to increased demand from the energy exploration, mining, and infrastructure end markets. Additionally, Timken is well positioned to capture its share of business in the emerging markets of Asia. While the company has a meaningful presence in China and India, these markets are more immature than its core North American market. Consequently, emerging-market sales tend to be weighted slightly more to lower-margin OEM customers. Nonetheless, we believe these Asian OEM sales are planting the seeds for decades of aftermarket business.
The mobile industries segment, which drove $1.8 billion in sales (34% of the company total) in 2011, should see growth in off-highway, rail, and heavy-truck industries, offsetting declines caused by OEM attrition in light vehicles. During the past decade, North American automakers have been successful at squeezing prices for needle bearings used on light vehicles. As a result, Timken has chosen to reduce its mix of business coming from the low-margin light-vehicle segment and to focus on more demanding mobile applications. It has accomplished this by selling its needle bearing business in 2009 and being willing to walk away from unprofitable automotive OEM business. In 2005, 54% of segment sales were to the light-vehicle market; by 2011, this figure decreased to just 35% of the segment's top line.
Acquisitions will target industrial and aftermarket applications. To increase the top line by more than 7%-12% in the next three years, Timken will need to be acquisitive. Its shopping list will include firms that focus on the industrial and aftermarket segments and have solid management. Industrial applications and aftermarket sales should play to Timken's strengths of engineering excellence and customer service--both of which are differentiating qualities that should enable healthy profit margins. Each acquisition is targeted to be accretive to earnings in year one and to earn the project's cost of capital within three years.
In 2010 and 2011, Timken acquired Philadelphia Gear, Drives, and QM Bearings. Combined, these firms generate roughly $200 million of revenue and provide Timken the opportunity to cross-sell to its growing customer base and launch its new product portfolio into international markets. We believe that in each of these acquisitions, Timken will be able to achieve its objective for earnings accretion and return on invested capital.
Timken's steel business is looking to increase capacity and improve efficiency. Its specialty products are in high demand--throughout 2011 and thus far in 2012, the steel business has had to place its customers on allocation. The company produces high-performance alloy steel that is in big demand for use in energy exploration, industrial equipment, power transmission equipment, and bearings.
Currently the steel segment's break-even point is 60% capacity utilization, and the company has plans to reduce this even further. To accomplish this, Timken will invest $225 million in its Faircrest steel mill in order to shift its manufacturing method from ingot production to continuous casting. Unlike ingot production, which has a maximum yield of 83%, continuous production can generate a 97% yield. Now that the United Steelworkers union has approved a new long-term work agreement, we expect the company's Faircrest improvements will be completed in 2014. Following these investments, the steel business should be able to break even while running at just 50% capacity.
Timken's balance sheet remains strong. The firm ended 2011 with $468 million of cash and $515 million of debt; net debt/total capital was just 2.2%, well below its long-term leverage target of 30%-35%. We anticipate that during the next five years, Timken's earnings before interest, taxes, depreciation, and amortization will cover its interest expense more than 20 times. The firm has $1.3 billion of liquidity and no meaningful debt maturities until 2014. Given the company's strong balance sheet and ability to generate strong cash from operations, we believe Timken will continue to make acquisitions, pay its quarterly dividend, fund its underfunded pension, and repurchase its shares. The board recently authorized management to buy back as many as 10 million shares (about 10%) within the next four years.
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