April 18, 2011 - 11:33am EST by
2011 2012
Price: 47.40 EPS $3.00 $3.85
Shares Out. (in M): 99 P/E 14.6x 11.3x
Market Cap (in $M): 4,669 P/FCF 11.7x 12.3x
Net Debt (in $M): -363 EBIT 466 610
TEV ($): 4,322 TEV/EBIT 9.3x 7.1x

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 I am recommending Timken (ticker TKR) as a long investment. The company has two business groups - Bearings & Power Transmission and Steel. They are the largest manufacturer of tapered roller bearings in the US. Trading at 10x 2012 earnings and 8.5x 2013 earnings (and even lower on free cash flow), the stock is way too cheap for a company which will benefit from the industrial upturn in both early cycle and late cycle end markets. It is my opinion that the market valuation does not fully capture the structural improvements management has made over the last few years operating the business.
The Bearings & Power Transmission Group is divided into 3 distinct groups - Mobile, Process, and Aero & Defense. The Mobile segment sells bearings into end markets such as agricultural equipment, construction and mining equipment, passenger cars, light/medium/heavy duty trucks, rail cars and locomotives. The Process division sells bearings into heavier capital equipment such as rolling mills, cement and aggregate processing equipment, wind turbines, conveyors/crushers etc. Process is a more international business than Mobile (60% outside North America) and also has higher aftermarket exposure (65% of sales). Lastly, the Aero & Defense division sells bearings, helicopter transmission systems, turbine engine components and precision components for commercial and military aviation.
Timken also operates a Steel business, where they produce more than 450 grades of carbon and alloy steel which are sold in solid and tube sections, and sell into similar end markets as their bearings business - auto, truck, agriculture, oil/gas, mining, etc. They do not participate in commercial construction. This business is a highly engineered steel business, whereby they buy scrap and convert it into a high margin/high tech steel. 90% of their steel capacity is sold externally, the remaining 10% is used internally for making bearings.
The company has drastically transformed itself in the last 10 years, taking the business from a low/mid single digit margin business into the mid teens, with similar results for returns on invested capital. Historically, the Mobile segment sold commoditized bearings, and they did not earn decent returns. In the last 5 years, however, they've transformed the business to focus on highly technical, larger, more differentiated bearings where they could raise prices, earn a high margin, and thus a high return. They've reduced the segment's exposure to light vehicle commoditized bearings and increased its business in the mining space. The business that Timken did keep in passenger cars was drastically repriced, and while they did lose some business as a result, they actually lost less than expected. Timken's competitors are not making as high quality bearings, so even the customers who left Timken have often subsequently returned. For example, Maserati and Ferrari have Timken products in their vehicles, Prius does not. Timken has 100% market share on Nascar race car bearings. It's a price vs. quality issue. This is evident in Mobile's operating margins going from 2% in 2007 to 14% in 2010. In the next few years, I think they can raise margins even further, toward a 15-16% range, as the company leverages incremental volume in strengthening end markets such as heavy duty truck (where production can quite possibly be up 50% in 2011), agriculture equipment demand as farmer economics don't appear to be dwindling any time soon, and increasing exposure to high margin aftermarket business (currently only 15-20% of Mobile sales). Capacity utilization is currently about 70%. In addition, they have surcharges in about 80% of their contracts to pass on raw material price increases to customers. Roughly 60% of Mobile sales are in North America, 20% Europe, 10% Asia, and 10% ROW.
The Process segment within bearings is also a very exciting business. Its exposure to oil and gas markets, late cycle construction markets, in addition to its international exposure (40% North America, 30% Asia, 20% Europe) and high margin aftermarket business (65% of Process segment sales) make this segment very attractive. This can be seen in the consistently high operating margins, in the mid to high teens, even in the very depressed market conditions of 2009. As the Process segment is currently operating in the 60% utilization range, incremental volume should leverage at a very high profit rate as some of these late cycle end markets pick up steam. Management is extremely bullish on the company's prospects in China, Southeast Asia, and Indonesia. In addition, raw material input exposure is minimal due to automatic surcharges to customers, it's easier to pass along price increases in the Process segment than in Mobile. I expect this business to achieve 20% operating margins within the next 3 years.
Lastly, within Bearings, the Aero/Defense segment is currently extremely depressed, as the aerospace end markets were severely hurt during the recession and have not yet recovered. We are currently at the trough of aero capex, however, and revenues should sequentially start to uptick from here. To speak of the quality of Timken's bearings once again, the company has 98% market share on airplane landing gear. Capacity utilization is very low today in this business, thus revenues from incremental volume should fall pretty meaningfully to the bottom line, in fact incremental operating margins can be close to 50% in 2011, putting the company in a position to end the year for the Aero & Defense segment with a double digit margin run rate. Longer term, management has stated they expect to get back to 20% operating margins for this business.
Bearings are currently in very short supply, the machinery/equipment companies all have vocally expressed concern over their ability to obtain sourcing, which should only further Timken's ability to raise prices.
The Steel business is probably the least understood of Timken's business lines. 90% of the world's steel is used in static structural components like buildings and bridges, this is not where Timken plays. TKR steel is used in rotating machinery where severe stress conditions are tested. It is a highly engineered niche steel business, with revenues forecasted to grow north of 25% this year (sales were down 60% in 2009, and up 87% in 2010) with margins in the mid teens. Strength in 2010 was due to energy and mining end markets. 80-85% of this business is booked on annual contracts, therefore only 15-20% has spot exposure. However, the annual contracts do allow for surcharges where the company automatically increases pricing based on the price of steel in North America (an average of Chicago/Pittsburgh/Cleveland scrap prices), thus limiting their raw material input exposure. This business is currently booked up for the entire year, they literally cannot produce enough to meet demand, thus the company is focused on adding additional capacity. Management is targeting margins in the 12-15% range for the Steel business.
Longer term, the company hopes to achieve annual revenue growth around 10-15% based on 4% global GDP growth, and $4.75-$5.25 of EPS by 2013, a target which I think is very achievable on the high end. In fact, I project 2013 earnings to be closer to $5.50.
Timken has been a major turnaround story, with very attractive growth prospects in end markets such as mining, oil and gas, aerospace, and more. It also has strong market positioning in both North America and the emerging markets. The company trades at 10x 2012 earnings, while its competitors and the rest of the industrial space trade anywhere from 12-20x earnings. On a free cash flow basis, the company is even cheaper, as maintenance capex is only $80m/year while D&A runs close to $200m per year. Even after incorporating an additional approximate $150m/year of growth capex, the company throws off meaningful cash flow, which they will use to make accretive acquisitions, pay down pension liabilities (they are almost through with that), and return cash to shareholders via dividends and share repurchases.
Using a 12x multiple on my 2012e EPS forecast of roughly $4.60, plus the $3.70 of net cash, my price target on TKR is $59, a 25% premium to where the stock trades today. Using a 14x multiple (which I don't think is unreasonable given many of their later cycle end markets and growth rates), my price target would be $68, a 44% premium.


Continued earnings beats and margin improvement ahead of street expectations.
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