Thesis

Timken (TKR) is a market leading manufacturer of anti-friction bearings that trades at a discount to peers. The current 5.5x EV/EBITDA multiple is difficult to defend, but TKR suffers from a conglomerate discount because it also has a specialty steel business. There is currently activist pressure from Ralph Whitworth and CALSTRS, which has helped put Timken in the spotlight. Based on my conservative 2013 estimates, TKR should trade at $65.00 or a 27% premium to 1/22/2013’s closing price.

Business Description

Timken develops, manufacturers, and sells products for anti-friction bearings (ball bearings), mechanical power transmission components, and specialty steel components. An anti-friction bearing is a component that enables equipment to move, turn, or twist in an efficient and often low-noise manner. A power transmission component facilitates the transfer of energy from one object to another. Examples of power transmission components are chains, gear boxes, and augers. TKR utilizes its own sales staff and has strong relationships with major companies such as Deere, Caterpillar, Ford, GM, General Dynamics, and Joy Global.

Segments

The bearing and power transmission segments are divided into three sub-divisions: Mobile, Process, and Aerospace & Defense. Although it might seem counterintuitive, branding is very important in the bearing business. This is because end market users do not have the expertise to produce these products and bearings are an essential component of these end market products. TKR has been able to consolidate the domestic market and by some estimates has a 47% market share. This competitive advantage can be seen in its strong 15-16% EBIT margins. TKR’s Mobile Industries (34% revenue) segment has broad exposure to different industrial end markets including light trucks, rail, passenger cars, and off-highway vehicles. The Process Industries (26% revenue) segment caters to heavy machinery industries such as mining and energy. Aerospace & Defense (7% revenue) components are found in power transmission systems in military and civilian aircraft. The Steel business (36% revenues) has the most industrial diversity and is a leader in the production of alloy steel bars, tubes, and precision components.

TKR has performed very well during the recovery and has averaged a 17% ROIC over the past three years.

Valuation

My conservative model has bearings revenue down slightly and steel segment revenue up slightly. Unless demand for industrial goods falls sharply in 2013, the steel segment’s revenues should probably be somewhat higher than what I’m currently modeling. Bearings revenue should grow at the rate of economic expansion, but I want to buffer in the possibility of firms delaying capital goods expenditures. The various comparable steel and bearings multiples are higher than what I’m applying to TKR (6.5x) because I do not think that the spin-off will occur in the near term, but that TKR deserves a higher multiple than its current valuation.

Catalyst

Ralph Whitworth of Relational Advisors disclosed a 5% stake in TKR this past November and presented his case for spinning off the steel business. I recommend that you read his presentation here. His thesis is that the steel segment is adding earnings volatility and that a spin-off would unlock value. I agree with his logic although I don’t think that the board will support the spin-off, because it is conservatively run and there is local community pressure to keep the steel business with the parent. The board also argues that there are significant synergies related from the vertical integration of the steel business. I believe that this is overstated, because only 10-15% of the steel segment’s revenues come from other TKR segments.

I believe that RA’s articulation of the discount is accurate and that this mispricing will narrow in three discrete scenarios. First, if the spin-off occurs. Second, if the publicity of the discount leads to a greater following and subsequent multiple expansion. Alternatively, if the US suffers a manufacturing/inventory driven recession and the steel segment performance disproportionately affects TKR’s earnings, then management would concede the benefits of a spin-off.

Conclusion

TKR is cheap, high quality business with a strong competitive position in a mature industry. In the absence of macro shocks to industrial demand, TKR will continue its above average operating performance. Shares are currently undervalued by at least 27% and TKR trades at a levered FCF yield of 10%, which presents a compelling value especially considering the credible probability of multiple expansion due to the presence of a constructive activist investor.