TimkenSteel Spinoff May Create an Opportunity for Investors

The Timken Company announced earlier this year that it would split itself into two companies.

For years investors have advocated for spinning off Timken’s steel business to benefit shareholders and unlock value.  The steel business is different than its bearings and power transmission businesses.  It is also valued differently by investors and likely depressed the valuation of the rest of Timken’s business for many years.  Now that the company will split into two, investors may find value in the shares of parent Timken (NYSE: TKR) or The TimkenSteel Company after the breakup.

Overview of TimkenSteel Spinoff

TimkenSteel plans to break off from Timken on June 30, 2014 in a tax free spinoff that will create two publicly traded companies.  After the spinoff, Timken’s shareholders will hold 100% of TimkenSteel.  TimkenSteel and Timken have sales of $1.4 billion and $3 billion respectively.  TimkenSteel will trade on the NYSE under the ticker TMST.  Timken expects to incur a one-time cost of $105 million for the separation.

Management stated that following the spinoff, both companies will have strong balance sheets and fully funded pension obligations.  Financial policies will be aligned with investment grade metrics and there will be liquidity for growth and investment.  However, the primary focus is to return capital to shareholders through dividends and share repurchases.

TimkenSteel as a Standalone

In 2013, the steel business had sales of $1.381 billion, EBIT of $140 million (EBIT margin 10.2%).  It is a leader in high quality air-melted allow steel bars, seemless mechanical tubes, and precision components.  It produces bars in the 1” – 16” range and tubes that are 2” – 13”.  It also provides customized solutions for steel applications in high stress environments.  Its steel business has a high percentage of auto (26% of sales) and light truck (22% of sales) exposure.   While the auto business is stable, historically it is not know for a high margins.

On the other hand, the boom in oil & gas drillings has grown Timken’s tubular business which now accounts for 20% of sales.  This portion of the business has a positive outlook based on continued O&G development in North America.  The rest of sales are in other portions of the industrial economy and are in the below chart.

 

Some analysts see value in the steel business that is not reflected in the current share price of TKR.  The spinoff will unlock this.  It markets, energy and infrastructure, are rebounding in larger diameter SBQ which should improve sales and margins at TimkenSteel.  In addition, management invested $300 million in facility upgrades recently that should lead to better performance going forward.

The Timkin Company

The remaining business at Timkin (TKR) will consist of three businesses, mobile industries, aerospace, and process industries each of which have sales of $1.5 billion, $303 million, and $1.2 billion, respectively.

Mobile industries sells bearings and power transmission components to the car, truck, and rail market.  Management is pushing this business towards higher growth and higher margin business (segment EBIT margin is 11.2%).

Process industries is the Timken’s best business and manufacturers precision bearings and components for the industrial market.  It is more global than the rest of Timken that largely sell to the U.S. market.  Over 60% of the business is aftermarket.  Aftermarket sales are less economically sensitive and tend to carry higher margins.  The current EBIT margin is 16.3%.

Aerospace has a big aftermarket component but the margins are not strong at 8.1%.  It is the weakest business at Timken but also the smallest.  It manufactures components for fixed wing and rotorcraft applications.

Most Recent Quarter Beat Driven by Steel

Timken delivered earnings of $0.88 in 1Q14 and beat consensus EPS by $0.08.  Revenue was $1.1 billion, up just 1.3% y/y, and slightly below consensus.  Gross margins were ahead of forecasts and SG&A was slightly lower.  This led to EBIT ahead of expectations driven by the outperformance in Steel and some benefit from margins at the Process segment.  Steel margins improved to 14.8% from 11% in 1Q13 due to higher volumes, mix, surcharges and lower manufacturing costs.

New Valuation Targets

Steel companies trade currently trade at 7.3x FY14 EV/EBITDA and specialty steel at 8.5x FY14 EV/EBITDA.  Other companies similar to parent Timken in the process and mobile industries business trade at 9.3x FY14 EV/EBITDA.  The still combined Timken currently trades at around 8x FY14 EBITDA.  The value of the steel business using a multiple of around 8x FY14 EV/EBITDA and an estimate of $190-$200 million in FY14 EBITDA results in an enterprise value of around $1.5 – $1.6 billion.

Conclusion

A spinoff often creates an opportunity for investors.  The management teams of each organization in this case can better focus on driving growth and getting the most out of the businesses. For the share of Timken, the FCF yield is high and forecast at around 8% as capex wanes.  This will help drive more aggressive share repurchase at Timken.  In addition, investors often penalize one business for being paired with another.  The two separate companies have a broader appeal and should trade at pure play valuation.

What are thoughts on the Timken Spinoff?