2023-09-13 05:22:13 ET
Summary
- The Timken Company is trading at fair value as I believe that the low P/E is justified.
- The metal fabrication industry is experiencing slow growth, which may impact TKR's revenue projections.
- Timken's financials indicate manageable debt, a healthy interest coverage ratio, and decent returns on assets and equity.
Investment Thesis
I wanted to take a look at The Timken Company ( TKR ) in more detail. I will look at the company's financials to see how healthy the company is and whether it would be a good long-term investment. From the financial perspective, the company seems to be trading close to its fair value, however, I am assigning a hold rating for now due to the lack of revenue catalysts that could propel the growth further. I would like to see further margin improvements before starting a position.
Briefly on the Company
TKR manufactures engineered bearings and industrial motion products, such as bearings, seals, lubrication devices, engineered chains, belts and augers, couplings, clutches, etc. All these products are used in agriculture, construction, mining, power sports markets, passenger cars, and light trucks. Basically, it has a lot of products for many different applications and sectors.
Outlook
Unfortunately, there isn't much growth in the metal fabrication industry. Since the pandemic, we saw high freight costs and raw materials added pressures to margins. These have started to come down over the last year, however, revenues are still projected to grow at around 2% CAGR until '27, which is rather slow. According to the earnings call , China's COVID recovery has been disappointing, which dampens the revenue assumptions further. Everyone indeed expected China to pop off after the zero COVID policy was lifted, and it looked like it would be that way, however, the euphoria didn't last long, and the GDP growth of China has been below estimates.
I believe the best bet for the company is to try to become more efficient and profitable through technological advancements or cost-cutting measures that would help improve its EPS growth over the next couple of years.
Financials
All the graphs below will be as of FY22 because I would like to look at the company's long-term trend. Q/q numbers tend to fluctuate more due to the seasonality of businesses, however, I will include some numbers from the most recent quarterly report for extra color if needed.
As of Q2 '23 , the company had around $344m in cash against $2B in long-term debt. This is quite a substantial debt for a company like Timken, however, I don't think it's of concern. Debt is only bad if the management isn't able to use it smartly, and by that, I mean it's not manageable. The company's interest coverage ratio historically has been very healthy, sitting at around 9x over the last 5 years, which means that the company's EBIT can cover the interest expense on debt 9 times over. For reference, a healthy ratio is as low as 2x, but I look for at least 5x to be on the conservative side. I think it's safe to say the company is at no risk of insolvency.
The company's current ratio is very healthy but a bit on the side of inefficient in my opinion. I consider an efficient ratio to be in the range of 1.5-2.0, which to me seems like the perfect balance between being able to pay off short-term obligations and using cash for further growth of the company. TKR's current ratio is right over my top end of the range at around 2.4, which is not too inefficient. As of Q2 '23, the ratio went up to 2.6, which is not what I wanted to see. I would like it to come down to around 2. It is also safe to say the company has no liquidity issues.
Speaking of efficiency, the company's ROA and ROE are decent and are above my minimums of 5% for ROA and 10% for ROE. A few years ago, these were slightly higher, however, I can see that these have been improving since the lows of FY20. This tells us that the management is doing a decent job of utilizing the company's assets and shareholder capital.
TKR also has a decent return on invested capital, which has recovered the same way as ROE and ROA did since FY20. I would like to see ROIC stabilizing above 10% going forward as that is the minimum I would like to see companies achieve. This tells me that the company has some sort of competitive advantage and a decent moat.
The company's revenue growth hasn't been the best over the last decade, which could explain why it is trading at such a low PE ratio right now. It achieved 4.5% CAGR over the last decade, and I don't see how it could achieve a much higher growth without any catalyst in play.
In terms of margins, the company has been keeping consistent margins over the last while, with improvements since FY20 also, but not by much. With time, companies do tend to find some further efficiencies to improve profitability whether that is through cost-cutting measures or advanced technology, so for my model, I will consider that.
The company has also been steadily reducing shares outstanding over the last decade, which is good if the money cannot be used for the further growth of the company and if the shares are cheap or have been cheap over the last decade. Right now, at around 12x earnings, it seems cheap and is below what the company usually trades at, which is 15x-16x recently.
Overall, it seems like the company is chugging along nicely. The operations seem to be running smoothly, with no potential red flags in the balance sheet that would warrant a higher margin of safety than usual. It seems like the company has a decent moat and competitive advantage and also creates value for its shareholders.
Valuation
So, I have no reason to believe that the company would be able to grow its revenues at a higher level than the average it saw over the last decade. For my base case, I decided to grow revenues by around 4.4% CAGR. For the optimistic case, I went with around 8% CAGR, and for the conservative case, I went with 2.5% CAGR to give myself a range of possible outcomes.
In terms of margins, as I mentioned earlier, the company is keeping it steady, however, I will assume with the advancements in technology and other cost-cutting measures, I could see gross margins improving slightly over the next decade, so I decided to improve these by around 400bps or 4% from FY22 numbers by FY32. I also decided to improve operating margins by around 100bps over the next decade.
On top of these estimates, I added a 25% margin of safety to be extra cautious. The company's financials seemed to be decent enough to warrant 25% MoS but not lower because the company isn't very well covered by the media, and it may not reach its full potential. With that said, The Timken Co.'s intrinsic value is around $71 a share, which means the company is trading at a 2% premium to its fair value.
Closing Comments
It seems to me that the company's low PE ratio is justified. The lack of growth catalysts will keep the multiple at the lower level until it can see something changing in that area or it can reduce its costs further and improve margins by considerably more than what I have modeled. I did not see any indication that it's going to happen, so I believe that the company may come down further and if it does come down to around 10x PE ratio, I would consider starting a position but right now, I'll wait for the upcoming earning reports to see how the company has been performing and what the outlook next year looks like.
For further details see:
The Timken Company: Low P/E Seems To Fit The Growth Prospects, A Hold For Now