Description

Timken (TKR) is the largest manufacturer of tapered roller bearings in the US. The company recently completed a spin-off of its specialty steel segment as the result of an activist shareholder (Relational). The company’s transition to the appropriate capital structure combined with strong operating performance is likely to result in share price appreciation. TKR materially reduced its exposure to low margin auto OEM bearings over the past six years (from 50% of revenue to less than 20% today). This has acted as a headwind to revenues over this period. The company is done reducing exposure to this sector however. Moving forward margins will continue to expand and the quality of business is much improved (specialty vs commodity bearings). Timken was able to keep revenue flat while making this transition (~$3.3 billion) but has grown EBITDA by 50% (from $400mil to $600 mil) as a result of margin expansion. This transition is misunderstood by the street. At a peer multiple (8.5X EBITDA on 2015 estimates) and the correct capital structure, TKR is worth $55 or 35% above the current share price. Further upside from smart capital deployment, economic growth and potential M&A is expected.

The company’s management are smart operators with meaningful skin in the game (insiders own 9%) and are likely to continue to grow the profitability of the business over time.

It is our belief that consensus fails to take into account the cumulative effect of share repurchases as the company transitions to an appropriate capital structure

“We announced our strategy at the June Investor Day, to get to our targeted debt levels by the end of next year depending on where M&A would shake out, we need to buy north of 600,000 shares a month on average over an 18-month period to get to the bottom-end of that threshold. (Represents 12% of current float). And we're not going to unveil how we intend to do that.”

Richard Kyle, TKR CEO Q2 2014 Earnings Call – July 31, 2014

Investment thesis – Timken is an attractive investment opportunity for the following reasons:

Favorable Trends - Bearings are a small part of the cost of most industrial equipment. As industrial activity continues to increase, more bearings have to be purchased both to replenish depleted inventories as well as for immediate use

Variant Perception - Consensus fails to take into account the impact that Timken’s transition to a better business mix and an appropriate capital structure will have on the company’s EPS

Operational Capability - The company has successfully grown EPS at a 10% CAGR since 2007 across both up and down cycles

• The bearings business has successfully transitioned from commodity auto OEM bearing manufacturer to high value add specialty bearing maker (sales to auto OEM was 50% of company revenues, now less than 20%)

• Dominant player in the North American bearings market with both scale and meaningful brand recognition

• Successfully restructured costs during the down cycle and poised to reap the benefit during up cycle period

Change in Capital Structure - Timken is significantly under levered relative to its peers

• Bearing Manufacturers have ~3.5x Debt/EBITDA on average

• Timken has 1.0x Debt / EBITDA currently

• An increase in the company’s debt to 2.0X Debt/EBITDA with the proceeds used to repurchase shares would meaningfully increase the return to shareholders. At current prices, TKR could repurchase ~15% of current shares outstanding.

Business / Segment Overview

TKR has three segments organized by end market.

Mobile Industries 45% of Total FY2014 Revenue | 36% of Total FY2014 Operating Income

This segment sells bearings, power transmission components & related products/services

• Mobile Industries primarily serves both on-highway and off-highway equipment manufacturers

• Timken has moved to diversify this business away from the reliance on light vehicle markets which has resulted in lower sales but higher profitability

• Timken now targets more harsh operating environments where the company can command premium pricing for higher levels of technology required

• Topline weakness in 2013 was predominantly driven by long term plan to exit low margin auto OEM business ($150 mm of exited business) as well as lower volume across mining, construction and rail sectors

• The automotive repositioning is now complete, positioning this segment for growth in 2015

Process Industries 43% of Total FY2014 Revenue | 56% of Total FY2014 Operating Income

• Process industries serve diverse end-markets in the Rail, Wind, Industrial, and Infrastructure sectors

• Approximately 75% of this business’ revenues are higher margined aftermarket products.

• EBITDA margins in this segment are typically in the mid 20’s

• Process is a consistent, profitable business

• Weakness in 2013 was driven by weaker demand in the metals and wind energy markets. Wind energy sales have picked up and are expected to be a growth driver in 2014

• Growing market share in spherical & cylindrical roller bearings, housed units, other bearings & services

Aerospace Industries 11% of Total FY2014 Revenue | 7% of Total FY2014 Operating Income

• Aerospace Industries sells flight critical components and services for fixed-wing and rotorcraft applications

• Timken primarily provides bearings to Aerospace and Defense markets, but also sells power train systems for fixed wing aircraft, drive trains for rotary crafts, landing gear for airplanes, and other flight critical parts

• Approximately 70% of revenues are generated from the aftermarket

• The company recently announced a restructuring program for this segment and it will be reported as part of Mobile industries

Valuation

Given the significant barriers to entry to this business, the value of Timken’s brand and the requirement that its customers have to keep repurchasing Timken’s bearings, I believe that this business should trade at ~8.5X EBITDA, which results in a share price of $55. Timken’s closest comp, SKF, trades at 8.5X and is more levered, has markets that are structurally challenged (Europe) and is growing at a slower rate. Timken will generate ~$3.50 per share in FY2015 with that number growing to over $4 in FY2016. A $55 price target represents ~13x FY16 FCF. TKR will generate $3.30 in EPS in FY2015 with that number growing to $4.00 in FY16. A $55 price target represents a 14x P/E multiple for a high quality, growing business. (Free cash flow is greater than net income because D&A is expected to be higher than CapEx for the next few years). The sector is also consolidating. The most recent comparable transaction was SKF’s purchase of Kaydon (a comp for TKR) in Sep 2013 for $1.3 billion which represented 12X Forward EBITDA.

Risks

Primary risks are: Cyclicality, energy sector exposure (2% of revenues), FX (24% of sales are to Europe and Latin America)

Catalyst

The company delivers earnings above street estimates and conducts a large scale buyback