Reduce friction in your portfolio with Timken (NYSE: TKR)
Timken (NYSE: TKR) is trading at a discount to its industry peers. It has good long-term growth prospects and serves desirable end markets. I own stocks and am eager to increase my holdings at or below $60 per share. I would also consider selling a cash guaranteed put to generate income if it falls below $60.
Timken Serving Attractive End Markets
Timken manufactures essential products that reduce friction and help transmit power across a wide range of products and applications. Timken sells products to two major industries – the mobile and process industries. Its Mobile Industries segment’s products target off-road equipment (agricultural, mining and construction markets) and on-road vehicles (passenger cars, light trucks, wagons, locomotives and others). Both segments have shown growth over the past few years after excluding revenue from acquisitions, with the exception of COVID-hit 2020. For example, the process industries segment saw year-on-year sales growth. the other by 15.3% in 2021, and it increased by 3.5% in 2019 after excluding revenue from acquisitions. Process Industries has a higher EBITDA margin – 23.4% in fiscal 2021 – than its Mobile segment, which had an EBITDA margin of 12.2% in 2021.
Timken reported revenue growth of 13% in fiscal 2021 compared to fiscal 2020. Its revenue grew 10% year-over-year in the fourth quarter and recorded record sales of $4.1 billion in 2021, surpassing the previous record set in 2019. Its renewable energy segment saw a fourth consecutive year of double-digit revenue growth. The company expects revenue growth of 10% in 2022. Product volume will account for 7% and price will account for about 4% of the revenue increase. The company sees currency headwinds contributing to a 1% revenue decline.
Inflation continues to eat into margins
Prices lagged cost increases in 2021, resulting in a 280 basis point decline in margin and a 7% drop in earnings per share. Inflation is hurting Timken’s business and may continue to do so for the foreseeable future. But, the company has started raising prices and expects the price increases to significantly reduce the impact of inflation in 2022. Timken made diluted earnings per share [EPS] of $4.79 in 2021 and diluted EPS of $3.72 in 2020. This represents a diluted EPS increase of 28.7%. It projects EPS of between $5.00 and $5.40 for fiscal 2022.
End of globalization and acceleration of green investments
Recently, Larry Fink said that Russia’s invasion of Ukraine ended the era of globalization. The Economist had argued that long before the war and COVID, global trade had entered a “slowdown”, where trade slowed between countries. We have entered a new era where governments are beginning to invest more in infrastructure and manufacturing capabilities to increase their self-reliance. No one wants to be the next Germany, which has been caught off guard due to its overreliance on Russian energy supplies. The Economist argues that countries should try to diversify their supplier base rather than aiming for a complete blockade of trade with authoritarian regimes.
The end of globalization and increased investment in localized manufacturing should benefit Timken. Countries may also wish to develop local product suppliers, which could increase competition for Timken. But expanding local manufacturing and competition is an expensive proposition that could drive up costs, reduce economies of scale and increase inflation.
The trend towards renewable energy should also benefit Timken and provide good revenue growth for years to come. Arthur Chiao Yu-cheng, CEO of Taiwan-based semiconductor company – Winbond ($3.5 billion in revenue), said his company is investing in electric vehicles and smart agricultural products. I can’t agree more; both of these industries have long-term growth prospects due to the urgent need to combat global warming. There may be turbulence in renewable energy investments in the short term, but the long-term outlook is strong. Watch this video on the use of Timken bearings in wind turbines.
Finally, businesses are facing persistent labor shortages. Many companies have turned to increased automation to reduce their reliance on human labor. Timken should benefit from this trend for years to come.
Debt, dividend and share buyback
The company has a net debt to adjusted EBITDA ratio of 1.7x. This low debt ratio gives the company options to deploy capital in the future for more acquisitions or more return of capital to shareholders. The company spent $93 million, $49.3 million on stock buybacks, and paid cash dividends of $92.2 million and $87 million in fiscal 2021 and 2020. Even after spending millions of dollars in stock buybacks, the company’s outstanding shares fell from 76.4 million in fiscal 2020 to 77 million in fiscal 2021. The stock currently earns just $1 .95%, more than the 1.32% return offered by the S&P 500 Index. Right now, even the Vanguard Total Bond Market ETF is outperforming the 2.28% return of Timken and the S&P 500 index. Timken’s payout ratio is only 24%. The company may increase its dividend, but it tries to avoid further dilution of outstanding shares by doing stock buybacks. Seeking Alpha Gives Company Good Dividend Ratings for Safety, Growth, Yield and Consistency (See Exhibit 1).
Exhibit 1: In search of an alpha dividend rating for Timken
Financial performance, valuation and technical indicators
Timken has good returns on invested capital [ROIC] and fairness [ROE]. Timken’s return on invested capital is close to 10% and its return on equity is close to 16.5%. These yields are far superior to other industry players like Kennametal (KMT) and Flowserve (FLS) (See exhibit 2).
Exhibit 2: Return on invested capital for Timken, Flowserve and Kennametal
The company is trading near its 52-week low of $59.20. I hold shares at an average unit cost of $66.73. I look forward to adding to my position if the stock drops below $60. The RSI and MFI technical indicators are close to 40, and it has been between 30 and 40 for the past few weeks (See exhibit 3). Timken trades at a GAAP PE of 11x compared to the industry median of 19x. Timken has achieved an average PE of 13.9x over the past five years. Looking for Alpha Factor Notes (See exhibit 4) gives the company an undervalued “B” rating. Wall Street analysts have an average price target of $84.30, implying a 33% return from its current price of $63.28.
Exhibit 3: RSI and MFI technical indicators for Timken
Exhibit 4: Search for alpha factor ratings for Timken
Selling Cash Secured Put Options
I would sell a cash guaranteed put to generate income from time to time. In Timken’s case, I was looking to sell a guaranteed cash put on May 20 at a strike price of $55. At $55, the stock would yield 2.18% and trade at around 10 times earnings. I would love to own 100 shares of Timken long term at $55. But, put options do not pay a good premium, the bid-ask spread is too wide, and these contracts are not actively traded.
I plan to hold Timken for the long term, and would add to my position if the price drops below $60. I will also consider selling a cash safe put option to generate additional income if the price drops below $60. The company’s financial returns and growth prospects are good. Its buyback program appears to serve management more than shareholders. This is negative for the company and the stock. But, there are no perfect companies in this world. Timken’s products cover many sectors and offer good growth prospects for the years to come.