Description

Investment Thesis

Despite the stock having increased significantly this year (along with everything else), we still think there is compelling value in Timken (TKR). Admittedly, we are not finding much value these days as I am sure most investors on this board would agree with. We think Timken is one of those rare values in the current market that is not in decline. The underlying thesis here is very simple in that Timken is a high-quality industrial company that trades at a cheap multiple and it should be able to compound value through organic and inorganic growth over time. We see the stock trading for less than 9x EPS and 7x EBITDA on 2020 numbers. We would argue this is much too cheap (on both an absolute and relative basis) for an industrial company with 20% EBITDA margins and a history of strong operational performance. Clearly many of the company’s end markets are cyclical but we think you are being compensated for this and the company has a history of maintaining robust margins and producing significant cash flow even in the face of demand declines.

Company Overview

Timken is a relatively simple company to understand and is far from sexy. It primarily produces various kinds of bearings that are utilized in industrial motion applications. These bearings represent a small portion of the overall equipment cost but are vital to operations so quality and reliability are paramount. There has always been fear of the Chinese flooding the market with bearings but many OEMs will not purchase them due to high quality standards.

The end markets are relatively diversified as can be seen here:

Timken End markets (% of Rev):

Industrial 22.0%

Auto 13.0%

Heavy Truck 9.0%

Agriculture/Turf 8.0%

Rail 8.0%

Aerospace 7.0%

Mining 6.0%

Construction 6.0%

Renewable Energy 5.0%

Metals 5.0%

Fossil Fuels 4.0%

Marine 3.0%

Cement/Aggregates 2.0%

pulp paper 2.0% 

It is important to note that only 13% of revenue is derived from the automotive market (with the majority of that going into the US light truck market). This is in contrast to SKF (main competitor based in Sweden) that has ~30% exposure to automotive.

Timken has a history of tuck-in acquisitions (three in 2017, three in 2018 and they already made one this year) and all margins/return on capital metrics have continued to improve. Management is conservative and focused on return on capital. It would be very out of character for them to engage in large, dilutive M&A. In fact, we think it is much more likely that Timken could be a target. Management and the board are aligned with shareholders as they hold ~11.5% of the stock. Besides small acquisitions, cash is used for dividends (currently ~2.2% yield) and share buybacks.

Valuation

On our assumptions, Timken is trading at ~9x 2020 EPS and <7x EBITDA. The company should also produce ~400mm in FCF in the next year (~$5.20/share), which is equal to a levered yield of ~10%. The balance sheet is conservative and we see leverage at ~2.2x PF for its recent acquisition. Over the next 2 years the company should produce enough cash flow, after dividends, to move to ~1x leverage (assuming no acquisitions). Bringing leverage back to 2.5x would be equivalent to 30% of the current market cap. We feel comfortable that management will either engage in attractive acquisitions or will be more aggressive with buybacks.

Overall, think Timken is relatively cheap for a high-quality industrial company. Many investors always comp Timken to its closest, and larger, competitor: SKF. SKF currently trades at ~7.5x EBITDA vs. TKR at ~7x. Clearly they are similar businesses but we think Timken deserves to trade at a higher multiple for numerous reasons. One pushback on the bearings companies is automotive exposure. However, Timken is only 13% exposed vs. SKF with 30% exposure. The higher quality of Timken’s offerings is evident in EBITDA margins, which stand at ~20% for TKR vs. ~15% for SKF. Lastly, we think there should be an M&A premium in Timken due to the fact that it is 1/3rd the size of SKF (not that we necessarily would be playing for that). On a relative basis, both Timken and SKF trade at a discount to the majority of similar industrial businesses. We see many of these smaller industrial companies currently trading at 8-10x (not saying that they should).

We think, at a minimum, Timken should trade at 8x EBITDA which is a slight premium to SKF and at the bottom of the industrial peer group. At this valuation (on 2020 numbers) Timken would trade at ~$65/share or ~25% upside from today’s price.

Major Risks

- Clearly a recession is the biggest risk here

- Chinese bearing quality improves significantly and the stigma attached with them is removed

Catalyst

 - Earnings

- Attractive tuck-in acquisitions

- Potential M&A target