2023-06-29 11:53:07 ET
Summary
- The Timken Company's stock has performed exceptionally well, but investors are advised not to chase the rally and wait for a lower entry price.
- The company has also been actively repurchasing shares, contributing to the growth in EPS.
- Current shareholders should hold onto the stock for the long term, while new investors should wait for a pullback.
In my last analysis of The Timken Company ( TKR ) in October 2022, I rated it a hold. Since then, the stock has performed spectacularly. But, it is best for investors not to chase this rally and wait for a lower entry price. The Federal Reserve is focused on bringing inflation down to 2%, so further interest rate hikes are on the table. Higher interest rate increases will put pressure on industrial investments globally and may cause Timken’s share price to fall. Even the company’s management pointed to uncertainty in the second-half of this year.
I have owned the stock for a while with a cost basis of around $63, and I was waiting for a drop in its price so that I could add more to my holding. I have stated this in my previous article; The Timken Company is a stock worth holding for the long term. I am reinvesting the dividends and plan to do so for years. If I generate close to or over 100% returns, I will take some money off the table but may not sell my entire holding.
As Jim Cramer says: “Bulls make money, bears make money, pigs get slaughtered.” It is a warning against being excessively greedy. No company is immune to poor management, wrong-doing, excess competition, or any other factor that could negatively impact a stock. So, when an investor is sitting on good gains, it is best to take some profits. I apply this rule to the single stocks I own in my portfolio and not to the mutual funds and ETFs.
Let the winners run
At the same time, investors need to let their winners run. Premature profit-taking can severely limit a portfolio’s returns. Since owning the stock, it has returned about 41% on a price return basis, and it may be premature to sell the stock now since it may have more gains in the next decade as the company benefits from investments in manufacturing and renewables globally. Robotics is another long-term favorable trend for the company. I might add to my holdings, even if it increases my cost basis if the stock drops to the mid–to–low seventies. The reinvested dividends have gradually increased my cost basis as the stock has gained.
Strong revenue growth continues
The company has exhibited strong revenue growth over the past couple of years (Exhibit 1) and is projecting another strong showing in 2023. In the March 2023 quarter, the company grew revenue by 12% (Exhibit 2) , driven by strong demand in China and India and superior pricing power, and registered record gross and operating margins of 33% and 17%, respectively.
Exhibit 1:
Timken Annual Revenue, Gross, Operating Profits, and Margins (%) (Seeing Alpha, Author Compilation)
Exhibit 2:
Timken Quarterly Revenue, Gross, Operating Profits, and Margins (%) (Seeking Alpha, Author Compilation)
Over the past decade, the company averaged gross and operating margins of 28.5% and 11.9%, respectively. Similarly, the company averaged a quarterly gross margin of 28.2% and an operating margin of 14.2. In short, The Timken Company is registering record revenue growth and profit margins. This strong growth and improved profits and margins are behind the stock’s stellar run.
Strong performance of the stock
The stock has performed extraordinarily well over the 1-, 3-, and 5-year period compared to the S&P 500 Index (Exhibit 3) . Based on the RSI and MFI technical indicators, the stock is approaching overbought levels and may be due for a pullback (Exhibit 4) . The stock has returned 62% over the past year, while the S&P 500 Index has returned 12.5% on a total return basis. The industrials sector has done exceedingly well over the past year, with the Vanguard Industrials ETF gaining 21%.
Exhibit 3:
Exhibit 4:
The Timken Company is featured in the Vanguard Small-cap Index ETF ( VB ), which has gained a middling 8.7% compared to the S&P 500 and Industrials index performance. Among the top 200 holdings in the Vanguard Small-cap Index ETF, the median return was 19.1%, 25% of the companies in the top 200 gained less than 1.7%, and 75% in the top 200 gained less than 44% (Exhibit 5) . But, given the size of the Vanguard Small-cap ETF, with 1,456 holdings, it is not surprising that it is lagging behind other much smaller indexes, such as the S&P 500 and the Industrials.
Exhibit 5:
VB ETF 1-Yr. Return Statistics (barchart.com, Data Provided by IEX Cloud, Author Calculations)
Super Micro Computer ( SMCI ) was the best performer in the small-cap index, which attached itself to Nvidia and the AI hype, and the stock is off to the races with an astounding 400% return over the past year (Exhibit 6) . Generac Holdings ( GNRC ) and NovoCure Limited ( NVCR ) finished at the bottom, losing over 40% over the past year (Exhibit 7) . Although, Generac has found renewed strength recently due to the heat wave sweeping Texas, which comes with the potential for disruption in energy supplies and increased demand for its products. In my analysis of Generac in February, I mentioned that the long-term prospects for the company look promising .
Exhibit 6:
VB ETF Top-20 Best Performers (barchart.com, Data Provided by IEX Cloud, Author Compilation)
Exhibit 7:
VB ETF Bottom 20 Worst Performers (barchart.com, data provided by IEX Cloud, Author Compilation)
Share repurchases and dividend
The company does a lot of share repurchases. For example, since September 2020, the company has repurchased $419 million worth of its shares and has taken the share count from 76.3 million to 73.4 million during this period (Exhibit 8) . The share count has dropped from 95.8 million in 2013, a reduction of 23% over ten years. The share repurchases, strong revenue growth, and higher profit margins have contributed to the growth in EPS. The rise in share price has led to a drop in dividend yield. The stock yields 1.4% compared to the 1.5% for the Vanguard S&P 500 Index ETF ( VOO ). The low yield is another reason not to chase this rally in The Timken Company.
Exhibit 8:
Timken Quarterly Share Repurchase (Seeking Alpha, Author Compilation)
Valuation
The stock looks attractive on a forward PE and EV to EBITDA basis, trading at 12.9x and 8.6x, respectively. On a PEG basis, the stock looks fully valued, trading at 1.1x. A discounted cash flow model estimates the per-share equity value at $111 (Exhibit 9) . This model assumes a 4% revenue growth rate, an 8% free cash flow margin, and an 8% discount rate. The free cash flow margin is optimistic, given that the company registered 5.7% and 6.3% in 2021 and 2022, respectively. A 6% free cash flow margin would put the per-share equity value at $75. The company's cash flow can vary between 6% and 10%, so the valuation can see a massive fluctuation due to its cash flow variability.
Exhibit 9:
Timken Discounted Cash Flow Model (Seeking Alpha, Author Calculations)
The Timken Company has had a stellar run due to Federal spending in the U.S., China's reopening, and India's economic growth. An investor who owns the stock should continue owning it for the long term. I certainly have no plans to sell my shares at this time. New investors and existing shareholders looking to buy should wait for a pullback. A weakening U.S. and global economy may provide such a buying opportunity.
For further details see:
The Timken Company: Firing On All Cylinders