The Timken Company: Ready To Keep Rolling

May 03, 2019 6:27 PM ETThe Timken Company (TKR)1 Comment2 Likes
John B. Rogers profile picture
John B. Rogers
91 Followers

Summary

  • Timken's corporate transformation is bearing fruit.
  • The company is an established global industrial supplier.
  • Shares trade at an attractive valuation.
  • Timken is also returning cash to shareholders.

With roots dating back over a century, The Timken Company (NYSE:TKR) is the epitome of an old line industrial company. While that description does not engender excitement for many investors, the ongoing transformation of the business and leverage of its established leadership position across the globe as a supplier of specialized and highly engineered industrial components has positioned the company as a highly profitable and sustainable business, which does not appear to be fully appreciated by equity investors. At current price levels the shares of TKR are trading at low valuations levels on an absolute basis and relative to other industrial companies, offer solid cash returns and longer term growth potential.

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Timken was founded in 1899 to produce tapered roller bearings and became a specialty steel producer as well. In 2014, the company took a major step in transforming the business with the spin-off of its steel operations TimkenSteel (TMST) and focused on building its historical global leadership in friction management and mechanical power transmission. Friction management improves the efficiency of mechanical systems throughout the use of bearings to reduce the impact of resistance and improve efficiency as well as longevity. Power Transmission utilizes, belts, chains and lubricants to allow for the effect transfer of torque, force and speed. These components are used in a variety of industrial and vehicle applications.

Today the company is organized into two divisions, Mobile and Process Industries. The mobile segment (53% of revenue) serves OEM customers in the off road vehicles (including agricultural, mining and construction), highway (cars, light/medium and heavy duty trucks), rail equipment, outdoor equipment, aircraft and other vehicles. The Process segment serves a wide range of heavy equipment intensive process industries, including industrial manufacturing, mining/metals, pulp & paper, power and other industries.

As shown the company's products are sold into a range of end-markets and across multiple geographies.

Most of these products are produced under established brands for bearings, gears & drives, lubrication systems, clutches brakes & couplings, and belt & chains. These established branded products provide the company with competitive market advantages.

Improving Financial Returns

Historically, Timken's continuing operations have generated solid, albeit cyclical returns. Following the restructuring/refocusing of the business which began in 2014, the company has successfully expanded the business into new markets and improved margins. Growth has been derived from both organic improvements and acquisitions. These benefits have been leveraged by substantial share repurchases.

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As shown above, the company produced record profits in 2018. For 2019 the company has forecast further gains, including record revenue and earnings. In conjunction with the first quarter earnings report, the company raised it guidance for the year by $0.40 per share ($0.45 adjusted) to $4.95 to $5.15 per share on a GAAP basis ($5.15 to $5.35 adjusted to exclude restructuring charges) with revenue growth of 8% to 10% (3% to 5% organic + 6 1/2 to 7% from acquisitions - 1 1/2% from currency translation effects).

A substantial portion of these profits and cash flow have been returned to shareholders in the form of dividends and share repurchases. Notably Timken has paid a quarterly dividend continuously for over 95 years. Management and the BODs appears committed to continuing to share with investors and has raised the dividend over time (current yield of 2.2%).

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Growth Prospects

Timken serves a variety of traditional capital goods industries, but also some notable emerging markets. Management expects organic revenue growth in 2019 to be driven by several end markets including notable gains in Aerospace, Industrial Distribution and Wind. Sales into the renewable energy market, including both wind and solar, offer substantial long-term global opportunities. These gains are expected to offset relatively flat contributions from other transportation markets and modest gains from general industrial, heavy industry and industrial services.

Sales in international markets have been growing and offer significant future potential. Revenue in the most recent quarter grew by 12% in Asia, 8% in EMEA, 6% in North America and decline 11%in Latin America.

Acquisitions have also been and should continue to be a key contributor to growth. In recent years, acquired businesses have added mid-single digit gains to revenue. Management's strategy has been to add businesses which complement and extend its market reach with the goal of being accretive to EPS in the first year and earning more than cost of capital by year 3.

In addition to top line improvement the company has also focused on improving productivity to enhance margins. Over the past decade the company has increased production capabilities into lower cost geographies including substantial manufacturing capabilities in Asia and Europe. These investments are expected to produce record margins in 2019.

Attractive Valuation

Despite the solid financial results, returns to shareholders and recent growth, the shares of Timken trade at relatively low multiples of earnings and cash-flow. We attribute the discount to investor concerns over the sustainability of current financial results given the company's cyclical earnings history, particularly relative to automobile supply industry as well as the legacy of the steel business. Although we expect some future volatility of earnings given the normal swings in industrial activity, Timken's increasing broad diversification and divestiture of steel should substantially reduce these risks and support higher returns and earnings growth.

As financial consistency improves, we look for the shares to trade at higher relative and absolute multiples. Currently the shares trade at a 20% to 30% discount to a group of 17 comparable industrial suppliers based on trailing and forecast earnings, cash flow and EBITDA. This group includes several companies which are substantial auto parts suppliers and offer much lower growth prospects.

Potential Risks

Investing in Timken offers risks, including substantial macro economic factors which could reduce industrial activity. The company's breadth of end-markets reduces the exposure to the potential cyclical growth in demand from customers. Recently imposed tariffs on imports has negatively impacted earnings, but the company's sourcing has reduced the impact.

Over the next several years, we see the most prominent risk related to the ongoing acquisitions and expansion into non-bearing businesses. To date acquisitions appear to have added to growth but also increased debt levels. At 49% of capital, debt levels are above historical levels for the company but at only 2.4X EBITDA, not excessive. The relatively smaller profile, "tuck-in" type acquisitions appear to offer lower risk than the major "transformative" type which have several disrupted other organizations. Furthermore the apparent commitment to returning cash to shareholders, appears to limit the risk of a large and potential disruptive purchase.

Attractive Current/Long-Term Opportunity

The shares of Timken appear to offer an attractive opportunity for investors seeking long-term appreciation potential and returns. With solid growth prospects, a relatively secure competitive position and an increasingly diverse customer base, we look for the shares to benefit from growth in earnings, dividends and valuation improvements.

Based on earnings growth potential of high single digits, we estimate these shares can trade over 12X earnings and 7X to 8X EBITDA, which would support a share price closer to $70 over the next 18 to 24 months, offering investors over 40% total returns from current levels.

Over the long term, the opportunity for Timken should be even greater if the company can continue to outpace its market with ongoing improvement in operations, selective acquisitions and cash returns to shareholders.

This article was written by

John B. Rogers profile picture
91 Followers
Independent consultant working with institutional investors, public companies and others. Prior experience includes 30+ years as a sell-side Analyst and Director of Research.
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Disclosure: I am/we are long TKR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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