Timken Company (TKR) designs, manufactures and sells products for the friction management and power transmission industry, specializing in tapered roller bearings. As such, the firm generated $5 billion in sales in 2012, with 60% deriving from the domestic market. However, it operates in a highly competitive industry, with both foreign and local rivals like SKF Group, Schaeffler Group and RBC Bearings Inc. (ROLL). In addition to the bearings business, the company operates in the steel industry, producing around 450 grades of carbon and alloy steel. The company will soon be splitting its two main businesses into separately traded firms, so let’s see what motivated investment gurus Robert Olstein (Trades, Portfolio) and Jean-Marie Eveillard (Trades, Portfolio) to sell out their shares in this company.
In an effort to boost profitability, Timken recently announced that come 2014 it would be shedding underperforming business lines, focusing on the specialty bearings segment. The mobile and process industry segments generate the most profit, but the latter is this firm’s crown jewel. With customers in the energy, industrial and infrastructure sectors, this business line not only profits from selling bearings, chains, gears and services, but earns two thirds of this segment’s revenue through aftermarket sales. While the equipment sold is generally maintained and rebuilt throughout the machine’s life cycle, Timken profits from the higher margin in this market. However, the lack of switching costs for consumers makes it easy for these to seek out similar products from a competitor with lower prices.
The steel business follows a similar scenario. Timken produces and sells carbon and alloy steel to automotive, energy and industrial customers, with a strong focus on specialty steels applied in oil or gas explorations, which allows for higher margins than commodity steel. But in the challenge of outranking competitors Steel Dynamics Inc. (STLD) and Nucor Corp. (NUE), who also produce specialty steel, is yet to be won. Moreover, with an estimated average cost of capital scraping the 10% mark, the firm has struggled to generate healthy returns on invested capital. In fact, Timken’s ROA strongly decreased since the end of fiscal 2012, dropping from 11.7% to a mere 5.9% in fourth quarter 2013. Nevertheless, this downward trend may be reverted if management’s plan to decrease exposure to lower-margin markets that lack an aftersales segment is successful.
Valuation and Uncertainty
Although Timken will continue to enjoy operating margins above 10% for the next five years, due to the changes in the company’s business mix, I’m somewhat worried regarding the near term future. The firm’s sales are highly leveraged to the global economy, and could decrease severely if the global GDP drops (sales fell 38% from 2008 to 2009). Also, the last fiscal year was rather rough for the company, seeing drops in nearly every metric. Revenue decreased from almost $5 billion to $4.3 billion at the end of 2013, and EPS suffered a severe drop from $5.07 to $2.7 in only one year.
And despite forecasts expectance of 7% five-year revenue CAGR, due to growth in the process industries, I remain cautious regarding the company split this year. While EBITDA growth looks solid with an 81.4% rate and a 1.58% dividend yield which is still above average, I believe investors would be wise to wait at least until mid-2014 before buying into this company’s stock.
A firm splitting can be profitable at times, but can also cause financial imbalance if not managed properly. I also find the current stock price of $60.2 to be overvalued, considering the downward spikes experienced during fiscal 2013. However, I do believe that the company split can be a profitable move for Timken’s long term future.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.