After years in the wilderness, this company is on its way back to restoring and growing its stock for its shareholders, writes Michael Tian and Stephen Ellis of Morningstar Opportunistic Investor.
Finding companies with decades of shareholder value destruction is relatively easy. However, finding companies that are poised to transition from destroying value to creating value is fairly difficult.
In our experience, thanks to their inglorious past, these companies are often underestimated by the market. Today’s case is Timken (TKR).
Timken is decidedly rooted in the Old Economy. The company provides boring machined parts such as ball bearings, friction management products, and power-transmission components. To round out this medley, Timken also sells specialty steel into niche markets like oil and gas drilling, where performance and special machining characteristics are important.
The specialized nature of these products is an important barrier to entry and helps protect returns. Nevertheless, without some fundamental changes, Timken wouldn’t have passed our initial screens. The company’s average return on invested capital between 1991 and 2009 averaged an unimpressive 7%.
So why are we even considering this company now? We think Timken has made a number of strategic decisions over the past few years that dramatically improved its outlook, yet it is still in some ways being priced by the market as a perennial value destroyer.
At a recent $34, Timken traded for seven times our 2012 earnings estimate, which is much lower than most industrial companies. Investors are clearly still holding quite a few reservations, which we think are likely overblown.
You wouldn’t know it from glancing at Timken’s historical financials, but we think selling bearings is actually a pretty decent business. The firm is one of six major global suppliers of antifriction bearings for autos, trucks, trains, and wind-energy machines, which combined control about 70% of the global bearing market.
What’s even better is that only three of the suppliers (Timken, SKF, and Schaeffler) compete in the premium bearings market. We think the consolidated nature of the industry lends itself to sticky pricing and attractive returns on invested capital over time.
SKF and Schaeffler have decades-long track records of attractive margins and returns on capital. For example, SKF is targeting 27% ROICs in the near term, and its ten-year ROIC average is 20%. With its new focus on profitability, in time we think Timken could approach similar numbers.
Second, many of Timken’s products have significant barriers to entry. They are not going into Volkswagens or $500 motors, but massive off-road mining trucks or NASCAR race cars.
Understandably, the needs of these constituencies are very different. Timken typically works with a customer for years to determine the specifications required, and then designs the product to meet environment, loading, and life-expectancy requirements.
Developing this expertise, which includes knowing how steel reacts under certain pressure loads as well as machining to incredibly narrow tolerances, is quite difficult. Moreover, its customers are risk-averse, because if the bearing fails, a multi-million-dollar piece of equipment may become a hunk of very expensive scrap metal.
Therefore, Timken’s products are typically designed into the piece of equipment for its useful life, which could be 40 to 50 years. This gives Timken a significant opportunity to sell very profitable aftermarket parts (40% of bearing revenue). Thus, the bearing industry strikes us as a good business that, properly managed, can generate attractive returns over time.
Timken hasn’t always been a good company. In the early 2000s, roughly 40% of its revenue came from light autos, which is a commodified and extremely competitive market that faces continuous pressure from auto companies to lower prices. During this time, the entire ball-bearing industry suffered from overcapacity, driven by the recession and brutal Asian competition.
For a time, Timken actually earned substantial antidumping fees as the US government had slapped penalties on foreign competitors. Furthermore, ball bearings improved over the years so that they often outlasted the vehicle, reducing the profitable aftermarket opportunity. As a result, operating margins barely hung on above zero.
In 2007 and 2008, Timken finally decided to make changes. The firm was suffering from higher raw-material pricing and increased pricing pressure from the auto companies.
The company basically decided it was going to make a profit from autos or exit the entire business altogether. First, it moved its ball bearing prices upward by double-digit percentages right into the teeth of the Great Recession in 2008 and 2009.
Then, Timken included provisions in its contracts that pass to customers any increases in raw-material costs. Lastly, Timken sold its unattractive needle-bearing business to a competitor in the middle of 2009 for $330 million.
Timken ultimately lost a lot of revenue from these actions—light autos now contribute less than 20% of sales—but mobile-segment operating margins increased to 14% in 2010 from just 2% in 2007. Unsurprisingly, Timken’s ROICs also improved greatly, and the firm now earns returns over its cost of capital..
We think Timken will gradually shed its reputation as a bad business, especially as it continues to deliver superior margins and returns on capital. The change should lead to the market awarding Timken a higher valuation than it had in the past.
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