SKFRY - SKF's Rally Into 2023 Seems Overdone

Summary

• Like many industrial stocks, SKF saw its shares rally strongly in the last three months of 2022 on expectations of a more mild downturn in 2023.
• I'm expecting a more meaningful downturn in short-cycle industrial end markets, and I think SKF may see greater price/cost pressure from limited incremental pricing power and stubborn costs.
• Autos should be a relatively healthy end market, and both aerospace and wind look good, but general industrial (mostly short cycle) is at risk given weak macro readings.
• SKF shares don't look particularly overvalued now on my below-Street modeling assumptions, but I'm concerned about near-term sentiment risk from a tougher earnings reporting cycle.

Industrials have certainly recovered of late. With investors feeling more confident that the impending downturn will be mild and that rate hikes are close to an end, the industrials have climbed about 20% over the last three months, and Sweden’s SKF ( SKFRY ) has gone along for the ride, though the shares are still down about 20% over the last year.

I think this rally may prove to be too much too soon. With global PMIs falling and the company likely to see weaker end-market demand coupled with price/cost pressures, 2023 isn’t going to be an easy year and if the market is wrong about a mild slowdown, there could still be meaningful downside to estimates. I don’t think SKF is particularly expensive now (and my near-term expectations are below sell-side averages), but I see a relatively unfavorable risk/reward balance going into the fourth quarter reporting season.

Short Cycle Will Be The Tail That Wags The Dog

Compared to many industrials, SKF’s end markets are not particularly diverse, and I do think that concentration will be a mixed blessing in 2023. Looking at the overall macro environment, S&P reported a 48.6 global PMI reading in December (anything below 50 is contraction), following a 48.8 reading in November. That marks four months of contraction and the lowest reading in two and a half years, and with 22 of 29 countries contracting, it was broad-based. New orders were even weaker at 46.3.

The auto business makes up about one-quarter of SKF’s business mix (closer to 30% in more normal times), and this is probably the strongest market of material significance for the company in 2023. Auto OEMs are still working to normalize inventories through the channel, and while I do have some concerns that demand could start falling off later in 2023, production growth in the mid-single-digits should support decent demand for SKF.

General industrial is a catch-all category that contributes more than a third of SKF’s revenue. About a third of this (so, close to 10%) is in end-markets like machine tools, fluid-handling machinery, motors, and material handling, and I think these markets are going to see a noticeable slowdown in 2023 – volumes were already weak in the third quarter for many companies, and I expect further deterioration. Heavy machinery is likewise to be noticeably softer, though mining and cement should remain comparatively healthy.

Trucks make up around 6% of revenue, and this is a more challenging market to assess. OEMs are going into the year with sizable backlogs, and that should support healthy activity through midyear, but I’m worried about a sharper drop-off in demand beyond that point… though the full brunt likely won’t be felt until 2024 and a new order cycle could begin soon after.

On the more positive side, I’m generally bullish on the company’s wind exposure (mid-single-digit) given ongoing demand for clean energy installations. I’m also positive on the aero exposure (around 6%), as this end-market recovery accelerates. Oil/gas should be another positive end-market, but it’s too small within SKF’s business mix to help much.

Limited Self Help And Maybe More Price/Cost Risk

One of the big drivers of SKF’s weak relative performance over the past year (down close to 20% versus a flattish industrial sector) has been surprisingly weak margin results in recent quarters – the third quarter saw a 20% miss at the operating income line (280bp in margin terms) after a 9% miss in the second quarter (150bp), with both the industrial and auto segments coming in below expectations on higher material, energy, freight, and wage costs.

I don’t expect much respite. Material and freight costs should ease off, but I think component costs and wages will prove to be stickier. At the same time, while SKF showed surprisingly good pricing power this year (pricing drove 10% of the 11% organic revenue growth in Q3’22), I think that will be very difficult to replicate in 2023, and I think SKF may see pricing pressure as the year goes on, particularly if short-cycle industrial markets weaken more than I currently model.

As far as self-help goes, I don’t think management has too many tricks left up their sleeves. Pricing has probably been tapped out and weaker volumes in key markets won’t help. There have been some positive developments in the auto business, where the company has seen EV-related sales more than double and where the company has been enjoying very strong share (well ahead of its broader auto bearings share) in these early days, but I don’t see similar transformative drivers in the industrial business (perhaps some in the aero market, but not nearly the same scale).

The Outlook

In many ways, SKF is an “is what it is” short-cycle industrial. The company is well run (a five-year average ROIC of over 16%), but the nature of the bearings business (and other related components like linear motion and power transmission systems) is that you pretty much have to take what the macro gives. I think that’s a meaningful risk over the next 12 months, given that I expect a meaningful slowdown in the U.S. and European markets and we’re already starting to see destocking in some sub-sectors.

I think SKF will see a mid-single-digit revenue decline in 2023 followed by recovery in 2024 and 2025, though I do see a possibility of a gentler but longer slowdown (a smaller decline in ’23, but also a sluggish ’24). Long term, I’m expecting revenue growth in the 2-3% range.

I expect another year of soft margins in FY’23, but I do think mid-teens EBITDA margins are attainable again in FY’24/25. Likewise, while I don’t think SKF can break out of its traditional range of FCF margins in the “high mid-single-digits”, that should still support healthy mid-single-digit FCF growth and enough cash flow to support future dividends and possible M&A.

Discounting those cash flows back, I don’t see SKF as particularly cheap, with a long-term annualized prospective return on the low end of the high single-digits. I could of course be overestimating the extent to which industrial markets will weaken in FY’23, and perhaps SKF has more margin leverage opportunities than I see, but I just don’t see a tremendous value here.

I will note, though, that the EBITDA-based valuation is more forgiving, with a 10.25x forward multiple (based on my expectations for operating margin, ROIC, and other inputs in FY’23) supporting a fair value close to today’s price. Should margins come in better than I fear, there’s certainly some re-rating potential here.

The Bottom Line

I like SKF as a business, but this late rally into 2023 seems like too much to me for many industrials given the risks to the 2023 outlook. Perhaps fourth quarter earnings and 2023 guides will be better than I expect across the sector and support this rally; in that scenario, I’m definitely too cautious/negative on SKF. I do think we’re going to see more signs of weakness, though, and should that lead to a sell-off in SKF shares, this is a name I’d look to reexamine again later in 2023.

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