Summary
- TimkenSteel Corporation is in a cyclical sector. Any analysis and valuation should be based on its performance over the cycle.
- There was no revenue or shipment tonnage growth from 2014 to 2022. Any valuation of TMST should be based on Earnings Power Value (EPV).
- There have been major changes to the TMST's set-up since 2020. Deriving the cyclical values based on historical data has to take this into account.
- TMST is financially sound. Based on its cyclical performance, it would be able to create shareholders’ value. There is also a margin of safety at the current price.
Investment Thesis
TimkenSteel Corporation's (TMST) 2021 and 2022 results suggest that it has turned around from its historical losses. This was due to a combination of high steel prices and operating improvements. But steel prices are cyclical and any analysis of TMST should be based on its performance over the cycle.
TMST is not a growth stock as its revenue and shipment tonnage did not grow since its 2014 IPO. EPV or Earnings Power Value would be an appropriate valuation metric.
There have been major changes to TMST's set-up since 2020. The values of any metrics over the future price cycle will have to account for this. On such a basis, I found that TMST would be able to create shareholders' value.
I recommend buying TMST as it is financially sound. At the same time, there is a margin of safety based on the EPV. This is a complete contrast to it 2014 to 2021 cyclical performance where it incurred a cumulative loss of USD 147 million.
Analytical Approach
There are 3 key questions for TMST:
- Is it financially strong so that it can outlast any price downtrend during the cycle?
- Can its cyclical performance create shareholders’ value?
- Is there a margin of safety at the current price?
In Aug 2021, I opined that TMST historical losses were because it was operating below its break-even level. But there were prospects for TMST to turn around. Firstly, it had taken steps to improve its cost structure that will reduce the breakeven level. Secondly, there were good prospects for an increase in the demand for steel in the US. Finally, steel prices then were in the trending-up part of the price cycle.
Refer to ” Timken Steel - Time To Go In As The Worst Is Behind It ”
TMST achieved exceptional profits in 2021. 2022 looks like another bumper year. But we know that 2021 and 2022 were extraordinary periods for steel prices. How much of TMST’s performance was due to strong steel price tailwinds and how much was due to operating improvements?
Steel is a cyclical sector and prices will eventually come down. Any valuation of TMST should then be viewed through the cyclical lens. This will take care of the strong price tailwinds.
Steel Cycles
The cyclical nature of the sector can be seen in Chart 1. You can see that TMST revenue follows the steel prices. Since its IPO in 2014, there have been at least 2 price cycles.
The key point from Chart 1 was that there was no growth in TMST revenue from 2014 to 2022. An analysis of the shipments in tons shows the same results. It suggests that TMST should be valued based on its EPV.
Chart 1: Cyclical performance (Author)
Notes to Chart 1:
1) The indices were computed by dividing the values of the various years by the respective values in 2014.
2) The US Iron and Steel Prices were from FRED Producer Price Index and based on the Jul prices of each year.
3) TMST 2022 value was based on the 202 first half revenue X 2
Representing The Cycle Values
Normally, I take the average values of a metric over the past decade to represent the performance over the cycle. There are several challenges with this approach in the case of TMST:
- Its data were only available from 2014; i.e., its IPO year. Nevertheless, looking at Chart 1, there seems to cover 2 price cycles from 2014 to 2022.
- 2021 and 2022 seemed to be exceptional periods concerning steel prices. These periods should be considered outliers when estimating the cyclical performance.
- The pre-2020 performances for some of the parameters may not represent the future given the various changes undertaken in 2020/21.
As such, I determined the cyclical value based on the 2021 values.
The key premise is that the value in a particular year comprises a base value (cyclical average) and a variable element. If we take the average values over a long enough period, the variable element would cancel each other. What is left is the base or cyclical average.
I used this approach to determine the raw material spread component of the gross profit.
The key parameter for my analysis and valuation is EBIT. I estimated the EBIT as = Gross profit – Selling, General, and Admin expenses ((SGA)).
The challenge then boils down to determining the cyclical values for these parameters. The cyclical Gross Profit was built-up from several components as shown in Table 1.
Table 1. Computation of cyclical gross profit (Author)
Notes to Table 1.
a) I assumed that the USD 75 m gross profit variance as per Chart 2 was the result of the various operational improvements and is sustainable.
b) The 2021 shipment tonnage was 91% of the restructured shipment capacity of 0.9 m tons. I took this as a conservative estimate of the cycle shipment. Note that the average 2014 to 2022 shipment was 0.91 m tons.
c) I needed a base as all the components were variances. Referring to Chart 1, 2020 was the year with the lowest revenue and shipment tonnage. I took this as the base from a conservative perspective.
d) The various 2022 values were derived based on 1H 2022 values X 2.
Gross Profit Analysis
TMST’s gross profit is a function of its raw material spread and other non-raw material costs. Unfortunately, TMST did not provide a breakdown of its production costs. The only available information was the gross profit variance analysis as reproduced in Chart 2.
It analyses how the gross profit in 2021 differed from that in 2020. It is broken down into several components that can be used to estimate the cyclical values as follows:
- Raw material spread. This is the difference between the selling price and raw material costs (steel scrap in the TMST case). I assumed that this is independent of the operating improvements or tonnage.
- Manufacturing. This is probably the result of the various operating improvements. I assumed that this will be independent of the price cycle.
- Volume. This will vary with the volume rather than steel price changes.
- Inventory, price mix, and others. I ignored these in my estimates of the gross profit over the cycle.
Chart 2: Drivers of Gross Profit Variance between 2021 and 2020 (TMST Form 10l)
Raw Material Spread
TMST only provided details on the gross profit variances from 2015 onwards. Refer to Table 2. Assuming the 2015 to 2021 average as the cyclical value, the raw material component = USD 28.6 m.
Table 2: Gross Profit Variances (Author from TMST Form 10k)
Financially Strong
I would consider TMST to be financially sound based on the following:
- As of the end of Jun 2022, it has USD 238.5 m cash. This is about 20% of the total assets.
- It has been able to generate positive Cash Flow from Operations every year since its IPO in 2014. This was despite incurring 6 years of losses from 2014 to 2021.
- As of the end of Jun 2022, its Debt to Equity ratio was 0.04
These are good signs that TMST has the resources to withstand the financial impact of any price cycle.
Shareholders’ Value Creation
I assessed whether TMST would be able to create shareholders’ value by comparing its cyclical return with its cost of funds.
I estimated the cyclical return = cyclical EBIT(1-t) / Total Capital Employed. As shown in Table 3, this was estimated to be 13.1%.
TMST’s WACC was estimated to be 6.8%. You can see that the cyclical return exceeds the cost of fund. In other words, TMST performance over the cycle would create shareholders’ value.
Table 3: Computation of cyclical return (Author)
Margin Of Safety
I use the Free Cash Flow to the Firm model to derive the EPV of TMST as follows:
EPV to the Firm = FCFF / WACC = EBIT(1-t) / WACC
I have shown that the cyclical EBIT(1-t) = USD 60.6 m.
I estimated the WACC = 6.8% based on the CAPM with the following assumptions:
Risk-free rate = 2.5% based on the 2007 to 2022 average 10 years treasury rate.
Equity risk premium = 4.3% based on a weighted average for the 2021 US and Western Europe revenues as per Damodaran Jan 2022 datasets.
Beta = 0.98 as per Damodaran Jan 2022 datasets.
EPV to the Firm = USD 60.6 m / 0.068 = USD 891.2 m
Equity EPV = USD 891.2 m + Cash – Debt. The Cash and Debt are based on the Jun 2022 positions.
Equity EPV = USD (891.2 + 238.5 – 33.6) m = USD 1,096.1 m
EPV per share = USD 23.78
The market price of TMST as of 30 Aug 2022 was USD 15.61 per share. There is a 52% margin of safety.
Risks
The largest risk in my analysis is the computation risk. There are 2 concerns here.
I have assumed that the average would be equal to the cyclical value for the raw material variance. The concern here is that there were only 9 years of data including one outlier.
Secondly, the manufacturing component of the gross profit accounted for about half of the cyclical gross profit. I have assumed that the 2021 variance is the result of all the operational improvements and represents the future cyclical value.
If you ignore the 2021 raw material spread, and took the manufacturing component as the 2020 and 2021 average, the EPV = USD 15.56 per share. There is no margin of safety.
However, there are other factors that could mitigate the risks:
- The Book Value at USD 16.68 per share provides a floor value as I do not see any further impairment of assets.
- As part of its 2030 ESG targets, TMST is committed to a 30% reduction in total energy consumption and a 35% reduction in freshwater withdrawn. This will reduce its operating costs further.
Conclusion
There are 3 key questions for TMST:
- Is it financially strong?
- Can its cyclical performance create shareholders’ value?
- Is there a margin of safety at the current price?
The answers to these 3 questions are a resounding yes.
I estimated that over the future price cycles, TMST would be able to achieve a return of 13.1%. This is a complete contract to the past 2014 to 2021 cycle where it incurred a cumulative loss of USD 147 m.
The value creation and margin of safety analyses were based on looking at the cyclical performance. I don’t think anyone would challenge that the idea of looking at the performance over the cycle. Neither would they challenge the EPV perspective.
The challenge would be how I derived the cyclical values. In a sense the investment thesis hinges on whether my approach to estimating the cyclical values is appropriate.
The best approach is for TMST to provide a breakdown of the production costs into the raw material spread, labor costs, utilities, and others. Then we don’t have to guess them. In the absence of this I offer my approach. I would welcome feedback on alternative ways to estimate the cyclical values.
For further details see:
TimkenSteel: Under-Priced Even Through A Cyclical Lens