2023-11-28 11:00:00 ET
Summary
- Timken Company is a long-term compounder with a history of predictable cash flows and strong customer networks.
- TKR has created immense wealth for its owners over the years by producing 15–20% returns on equity capital for the last decade.
- The company's sensible approach to capital allocation and attractive valuations make it a compelling investment opportunity.
Investment briefing
Long-term capital compounders are a rare bunch, but are more common on the global stock exchanges than one might first think. Take Timken Company ( TKR ), for example. Founded in 1899, the company provides the world with bearings + products for rotational motion/stability. These are products entrenched in industry and therefore have a near-infinite life cycle given their utility. The company's deep customer networks have been formed over 124 years of operations. Business is predictable in terms of cash flows and seasonality, and the company continues through the motions.
This is about as mature-phased company as it gets in the growth cycle. 10-years sales CAGR of 3.5%, 7.5% CAGR in earnings, 5% growth in FCF and a long history of dividends + buybacks. The " GARP" investing crowd ("growth at a reasonable price") would likely shy well away from TKR.
However, the capitalized value of TKR's earnings (its market cap) continues to advance over the long-term, compounding the wealth of its owners.
The two charts below show two trends (both log scale). The first is the yearly price returns for TKR since listing in 1968. The second is the weekly returns. As seen in Figure 1, the company's equity line has created immense wealth for its owners over the years. In Figure 2, note the mean reversion activity within the very long-term uptrend, and where we are currently situated.
Figure 1.
Figure 2.
Based on rigorous examination of the facts, there is reason to see compelling investment value in owning TKR in my opinion. Why? Three reasons:
- These are precisely the kind of economics that attract the intelligent, long-term investor:
- The company is a clear example of the benefits of our modern financial system, in the transfer of capital from spenders + corporations to savers + risk takers/investors and back again.
- Bearings, rotational control, and other fitted machinery products are essential components of our modern society. Their use is woven into the very fabric of our livelihoods. TKR's longevity is unsurprising.
- TKR first listed in 1968 at the price of ~$7.00/share. After riding through several markets, it has since expanded valuation by a factor of >10x. As noted here today, >65% of direct value created by TKR in the last decade was produced by its return of capital to shareholders (dividends/buybacks), as seen in Figure 3.
- Profits earned on the company's sales are then redistributed to shareholders after taxation, who then either reinvest the capital, pay their obligations (in the case of pension funds, insurance, annuities, etc.), or spend it on their lifestyle. Repeat. Because the company's creditworthiness is high, investors continue lifting the bid on its market value to participate in this.
- The company's sensible approach to capital allocation earns exceptional returns on investor equity:
- TKR routinely compounds earnings at a rate of 15-20%+ on equity capital every rolling TTM period.
- Business returns are produced on a combination of low-margin (10-11% post tax), high capital turnover (1x sales).
- Both returns on capital support TKR's continued growth and ability to throw off $8/share in FCF and $12.90/share in cash to shareholders inc. all dividends + buybacks in the last TTM.
- Valuations make sense and allow for constant entry point that magnifies forward 12 months return potential:
- The company still sells at 10.7x forward earnings , 9.8x forward EBIT and 2.1x P/B-below the company's 5-year averages, and the sector.
- The value for these prices is a talking point. A 12.5% cash flow yield buying TKR today, potential 19-20% forward ROE and $8/share in trailing FCF per share (11% FCF yield).
Collectively, my recommendations across all three investment horizons for TKR is a buy . This report will cover all of the moving parts in the investment debate.
Critical supportive data forming buy thesis
Joel Greenblatt, fund manager at Gotham Capital, when regarding securities selection, put it wisely in saying " Is this artist going to be the next Picasso?". Sometimes, it's better to find a "Picasso"-a high quality investment on sale. Greenblatt's reference to value investing encompasses the notion of paying a fair price, to receive something worth more in value.
Analysis of the facts in TKR's investment debate reveals a fantastic proposition in this regard. The company presents with terrific long-term economics which add up to "1 + 1 = shareholder value" over a multi-year horizon. The facts are best categorized into the following headings:
- Growth (sales/earnings, including market growth),
- Returns earned on investor equity,
- Economic value + FCF per share,
- Valuations
Regarding the growth outlook, the critical issues are:
As mentioned earlier, bearings (and similar) as a product aren't going anywhere:
- The market is poised to grow CAGR 9-10% into 2032, driven by solid fundamentals. New industry (including EVs + renewables) is spurring new demand for bearings in particular. It was valued at $117Bn in 2022, meaning TKR had 3.8-4% of the market on size of revenues and on market value.
- Being such a mature-phased company, with limited reinvestment opportunities other than dividends, sales + earnings growth are flat. Linear regression of analyst estimates projects 14% bottom-line growth in 2023, with 3% and 8-9% in '24 and '25 respectively. Wall Street is eyeing 3-5% sales growth in the same time.
- These aren't standout growth projections-but the company isn't valued for it either, at 10.7x forward earnings. At these figures, the average EPS forecast to '25 is 8.6%. Also, consider a 12% discount rate (long-term market averages). At these stipulations, the market's required rate of return to acquire TKR today is 8.8%, ranging from 6-15% depending on various stipulations. Still, the outlook from 1-3 years could be varied based on this.
This is of no issue whatsoever, in my opinion
Growth, in all its glory, is only worthwhile if it creates value. Value just creates value. Even companies who aren't growing cant therefore create immense value for shareholders. Such is the case with TKR.
The company routinely produces earnings at a rate of 15-20% on equity capital employed in the business. It therefore finances the majority of CapEx and growth spend with internal cash flows, whilst returning surplus cash to shareholders at various rates. If you were an owner of a private business, chances are you'd be happy with 20% TTM return on equity showing up regularly each period.
Figure 3.
The important point to note is that TKR is swimming in cash:
- It is earning high rates on investor capital, throwing off tidy FCF per share + dividends, compounding its intrinsic valuation in doing so. Since 2013, the company has spun off $63.00 in owner earnings (FCF per share + dividends) for its investors to enjoy. This, off just $11/share increase in net asset value since then. The trend from 2021-date is growing sharply, as seen in Figure 4.
- Since 2021, on a rolling TTM basis, FCF/share has averaged $10.06-excluding one negative print of $8.55 per share in 2022. Since this outflow-tied to CapEx + growth investment at the time, the path of owner earnings has increased dramatically, to $12.90/share in the TTM, the highest in the last decade. This bodes exceptionally well for the future investment outlook.
Figure 4.
Insights from Q3 earnings
The company booked its Q3 '23 numbers earlier this month, missing consensus estimates at the top and bottom lines. The breakdown on segments and outlook was mixed.
1. Engineered bearings segment:
The engineered bearings business put up sales of $775.6mm, a marginal 0.5% decline from last year. Lower volumes (demand) spurred the flat growth period, mitigated by the 7% net benefit from acquisitions and better pricing. Without the 700bps net effect from acquisitions and so forth, sales were down 7% YoY. It pulled this to pre-tax income of $148.2mm, or 19.1% of revenues. Stripping away one-off items, it clipped adj. EBITDA of $156.7mm, up ~$3mm YoY.
2. Industrial motion segment:
Industrial motion sales were up around 300bps YoY and tallied 367.1mm. Growth was again underscored by enhanced pricing, and offset by a decline in volumes (demand). It recognized ~100bps of pre-tax margin decompression, lifting to 20.5% of sales. This occurred due to better OpEx from lower material & logistics costs, because of the downturn in volume.
It also booked $194mm in operating cash flow, up ~$40mm YoY due to working capital investment outflows. Net leverage is at around 2x as I write. Regarding capital allocation (Figure 5):
- The company has invested roughly $900mm to various initiatives this YTD, with a heavy focus on acquisitions.
- Around 2/3 of this spend is in growth CapEx and acquisitions combined.
- The remainder ($300mm) has been returned to shareholders. This is a healthy profile of cash flow and returning capital to shareholders. In my view, TKR is on shareholders side.
3. 2023 revised outlook:
Management made a few critical changes to guidance. Importantly, it revised sales outlook lower to 5-5.5%. Without acquisitions, this is flat organically,
Earrings are now projected to fall within the range of $5.60-$5.70/share, or $6.95/share adjusted. This is 7% growth, and would be a record for the company.
Finally, it increased guidance for pre-tax earnings of 19.5% margins and the spinoff $425mm in FCF this year. Notably, this is 100% of guided earnings (unless any changes are made).
Figure 5.
Figure 6.
Valuation
The current shareholder equity is $35.12 per share at the time of writing, and you are asked to pay 2.1x this amount-around $5.2-$5.5Bn as I write. Linear regression of analyst estimates projects 2-14% annual earnings growth out to '25, as shown in Figure 6.
Owning $35.12/share of net asset value, or equity capital , in anything is meaningless without context. It is, for one, well below the current TKR share price of $72.71. It is also above the forward dividend of $1.32 per share.
More importantly, the rate of return investors receive on TKR's equity capital is highly valuable. This is illustrated in Figure 6, using long-term thinking:
- The FY'23 EPS estimates expects growth of 14% this year to ~$6.90. At the current equity value, it would produce the investor a 19.6% return on capital.
- Similarly, 2.7% YoY growth in earnings to $7.07 per share in 2024 might yield 20% return on equity. And so on, to 2026, as shown.
- Here you have a business returning 15-20% return on investor capital regardless of growth rates projected out to 2025-tremendously attractive.
- But paying 2.1x book value narrows the investor ROE to 9-10%, still very respectable for assets highly valued by the market.
- These returns are above the 8-9% required rate of return set out by the market to buy TKR today, discussed earlier.
Secondly, the stock sells at 10.5x forward earnings and 9.8x forward EBIT, 39% and 36% premiums to the sector, respectively. With growth priced in, the PEG ratio is 0.8x forward, implying these prices are more than fair in my opinion. We shan't forget the 12% FCF yield on offer either at $8/share.
My judgement is the company has a good shot at returning 15-20% on equity moving forward. At the multiple of 2.1x, and projected earnings growth rates, this warrants an implied intrinsic value of $85 by 2025, supporting a buy.
In short, for patient, long-term investors looking to compound capital over an extended duration, TKR fits the bill. The company's industry positioning in the bearings business is backed by terrific economic characteristics. In particular, investors are treated to satisfactory returns on equity capital they own, which, over the long-term may mirror stock returns as they have done to date. In my view, TKR is a long-term compounder with interesting economics tied into the mix. Net-net, rate buy.
For further details see:
Timken Company: Compounding Value Via Long-Term ROE And FCF Per Share