The Timken Company (NYSE: TKR) core product – engineered bearings – are essential for various applications in many industries, which is why investors should look to Timken. The company serves diverse end markets and generates revenue worldwide. He did extremely well in terms of revenue growth and profitability in 2022. But storm clouds are gathering over the global economy. Long-awaited economic data, such as the Consumer price index, will be released by the US federal government and could set the tone for future interest rate hikes. We are entering a critical earnings season this month, during which we will learn more about the state of the US and global economies. If you own Timken, it may be best to keep it for the long term. It may be best to wait if you are looking to buy or increase your existing holdings after company earnings and learning more about the direction of interest rate increases.
Timken has many long-term revenue generators
There are three long-term revenue drivers for this business. The first relates to ongoing relocation efforts around the world. Geopolitical tensions coupled with the supply chain disruption caused by the pandemic have forced countries and companies to rethink the location of their manufacturing plants. The second factor that could boost Timken’s revenue is greater adoption of robots in manufacturing and other industries. There is a labor shortage in many developed countries, and workers use this shortage to negotiate higher wages. This labor shortage is not going away anytime soon. Companies are looking to invest in robotics to replace some of the workforce in their factories.
Good Pricing Power Helps Boost Profits in 2022
The company performed well and delivered excellent revenue and earnings growth. Second quarter 2022 total sales [released on July 28] grew 8.5% from the same quarter in 2022 to a record $1.15 billion. The company achieved record adjusted EPS of $1.42, compared to $1.36 for the same period in 2021, an increase of 4.4%. Excluding exceptional items, diluted EPS increased by 21%. The company’s share buybacks of 750,000 shares during the quarter helped boost EPS. The company’s Process and Mobile Industries segments performed well. The Process Industries segment recorded sales growth of 7.3%, while the Mobile Industries segment saw sales increase by 10%.
Since 2012, the company has posted an average gross margin of 28.6% and an operating margin of 12.16%. For fiscal 2021, the company recorded a lower gross and operating margin of 26.8% and 13.2%. Since the end of 2021, the company has improved its margins. The company’s quarterly gross margins for the March and June 2022 quarters were above 29%, and its operating margins were above 15%. Improved profitability at Timken can be attributed to better pricing. Company CEO Richard Kyle said the following about the pricing during the second quarter 2022 earnings call:
Price realization improved sequentially from the first quarter, and we expect it to continue to improve modestly in the second half of the year.
This is good news for the stock if it can maintain its price. But the global economy is seeing storm clouds in the demand environment that could hurt Timken’s sales and profitability. The company generates revenue globally and is not immune to an economic downturn. For example, the company generates 45% of its revenue in North America, 6% in Latin America, 25% in Europe, the Middle East and Africa, and 24% in the Asia-Pacific region.
US GDP declined slightly in the first and second quarters of 2022, and consumption and consumer confidence could be hit further if interest rates continue to rise. Europe is grappling with an energy crisis as it tries to wean itself off Russian oil. Many Asian countries are grappling with the effects of a strong dollar, higher energy import bills and high inflation. Even though Asia continues to be the fastest growing region in the world, its economic growth rate is slowing. This global economic downturn could cause problems for Timken over the next year.
Timken Share Price Volatility
Timken stock has high volatility compared to the S&P 500 Index ETF. According to Yahoo Finance, the stock’s monthly volatility is 1.54. A linear regression of the monthly returns of Timken and the Vanguard S&P 500 Index ETF (VOO) gives a beta of 1.48. But, during this current market downturn, the stock has done well since I rated it as a buy in my Seeking Alpha article in March 2022. Timken has returned negative 1.03% since March, while the S&P 500 index lost 22% over the same period. period [as of October 3, 2022].
Small dividend yield and below-average financial returns in the current rate environment
The stock has a dividend yield of 1.95%, similar to the 1.74% offered by the Vanguard S&P 500 Index ETF. It’s not worth owning Timken for the dividend, but it’s worth owning for the various industries in which the company generates its revenue and the megatrends that can drive its growth. The company’s payout ratio is a reasonable 24%. Over the past decade, the company has grown its dividends at a compound annual growth rate [CAGR] 2.9%.
Over the past five years, the company has earned a 14% return and has continuously paid quarterly dividends for the past 100 years. [Exhibit 1]. In August, prices increased by 8.3% [Consumer Price Index] compared to the same period in 2021. As measured by personal consumption expenditure [PCE], the inflation rate increased by 6.3% in August 2022 compared to the same period in 2021. There is a difference of 200 basis points in the inflation rate measured by the two indices. Either way, inflation is high as measured by both indexes. If it doesn’t moderate in the coming months, Timken’s modest dividend growth may not offset investors’ loss of purchasing power, especially if the stock doesn’t appreciate enough to provide a good annual return. .
Exhibit 1: Timken exceptional dividend record
The company’s return on invested capital is 9.45% [Source: Seeking Alpha/YCharts]low relative to its weighted average cost of capital [WACC]. Based on a 10-year Treasury rate of 3.94% [October 11, 2022], I estimate the cost of capital at 10%. I calculated this capital cost based on the current interest payments of the loan. The company’s interest payments could increase in future years as it pays an interest rate below the current 10-year Treasury rate on some of its debt. For example, the company pays an interest rate of 2.02% on a $157 million note due in 2027. It pays an interest rate of 4.5% on $397 million in unsecured notes expiring in 2028. The company cannot obtain these same rates at current US Treasury rate levels.
It is safe to assume that the firm’s cost of capital is well above 10%. This is to ensure that the company’s return on capital does not exceed its cost of capital. In the short term, the company can focus on increasing its efficiency by reducing its cost structure to improve its financial returns. The company may also suspend or reorganize its acquisition strategy to ensure that it can derive good financial returns from its acquisitions.
Timken looks cheap
The company trades at a forward EV/EBITDA multiple of 7.7x and a forward price/sales multiple of 1.06x. Timken is trading at a cheap valuation for a company with a geographically diverse revenue stream with products serving many industries. The company generated 30% of its sales from what it defines as “new” markets, such as renewable energy, automation, passenger rail, and more. [Exhibit 2]. Automation continues to be a priority area for many manufacturing plants to increase efficiency and profits. These “new” markets have the potential to continue to grow for a long time.
Exhibit 2: Timken Revenue Generated by Renewable Energy, Automation, and Other Newer Markets
I own shares at an average cost of $63.70, but I would wait to add more stocks to my holdings. We are entering earnings season this month, which should offer some clues about the state of the economy. The consumer price index for September is expected to be released on October 13. It will provide clues on the direction of the Federal Reserve’s interest rate hikes. Timken is expected to report third quarter 2022 results in October. Considering all this upcoming market news and the company’s third quarter earnings, it may be best to wait before buying Timken.