Is Timken Steel one of the better NYSE stocks? (Part 1 of 2)

Value Investing Case Study 19-1: I first published Timken Steel in Seeking Alpha in Aug 2021 based on the results till Q1 2021. Since then, the company had released its results for Q2 2021. This is an updated post that incorporated the Q2 2021 financials.


Timken Steel Corporation (TMST or the Group) was listed on the NYSE in 2014. While it was profitable in 2014, the Group had since then incurred losses every year.

TMST is currently trading at USD 14.42 per share as of 27 Aug 2021. This is equal to a Price to Book of 1.1. 

TMST's performance is not because of industry problems as its competitors like Nucor and Steel Dynamics did not have 6 years of continuous losses.

For the first half of 2021, TMST managed to be profitable compared to a loss for the same period last year. It demonstrated that TMST is not a perpetually loss-making company.

Join me in a 2-part series as I analyzed TMST to find out:
  • Why it incurred such losses and the prospects for a turnaround.
  • Why despite its loss-making track record, TMST is currently trading at a premium to its Book Value.

For TMST to be one of the better NYSE stocks to invest in, it must enable you to make money. For this to happen a company must be trading below its intrinsic value. The intrinsic value in turn will depend on a better business outlook.  I would argue that this aptly describes TMST.

Should you go and buy it? Well, read my Disclaimer.

Contents

  • Is There Anything Special about the Group’s Expertise?
  • Is there Concern about how it Uses its Funds?
  • Is the Current Performance Outstanding?
  • Tracing the Group’s Rich and Unique History.
  • Is there a Great Future?
  • Pulling it all together.
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Is There Anything Special about the Group’s Expertise?

TMST had its roots in The Timken Company. In 1899 Henry Timken founded The Timken Roller Bearing Axle Company in St. Louis to manufacture roller bearings for horse carriages. 

When the automobile industry began to overtake the horse carriage industry, the company moved to Canton, Ohio to be near the centre of the new car industry. 

A strategic decision to gain greater control over its supply of steel led the company to pierce steel in 1915 and go on to melt steel in 1917. At that time, the business had one of the country’s largest electric-arc furnace facilities.

Through global expansion and acquisition, it grew to be the world's third-largest bearing company by 2003. The company changed its corporate structure in 2014.  
  • The roller bearing-producing part of the company was separated from the steel-producing part, resulting in two separate companies. 
  • The Timken Company continues to manufacture roller bearings, while Timken Steel produces steel.

TMST has an annual melt capacity of 2 million tons with almost all the steel raw materials coming from recycled materials such as scrap automobiles and appliances.

TMST's focus is on alloy steel products, although in total it manufactures more than 500 grades of steel, including high-performance carbon, micro-alloy, and alloy steel. These steel products can be custom-made in a variety of chemistries, lengths, and finishes. 

TMST's metallurgical expertise and unique operational capabilities drive high-value steel solutions for industrial, energy, and mobile customers when no other steel can do the job. 

The Group products portfolio included special bar quality (SBQ), seamless mechanical tubing, value-added solutions, and billets. 

TMST is the leading manufacturer of SBQ steel large bars and seamless mechanical tubing in North America. In 2020, about 90 % of its revenue was generated from the US. Its international operations included facilities in UK, Mexico, and China.

TMST delivers 100 % made-to-order steel and has the capability to produce hundreds of thousands of size configurations. While the industry order size is in hundreds of tons, TMST efficiently produces both large and small orders with an average order size of 35 tons.  

According to TMST, its cost structure enables this type of customization and positions it to deliver value in both upmarket and downmarket conditions. Unfortunately, the results from 2015 to 2020 did not support this contention. Why?


Is there Concern about how it Uses its Funds?

As of the end of Jun 2021, the Group had a Total Capital Employed (TCE) of USD 634 million. Shareholder’s fund accounted for 90 % of the TCE with the balance from debt (including leases).

This is equivalent to a book debt to TCE ratio of 10 % compared to the US steel industry average of 44 % (Industry source: Damodaran Jan 2021). 

TMST Sources and Uses of Funds
Chart 1: Sources and Uses of Funds

TMST Capital structure
Chart 2: Capital structure and its deployment

About 82 % of the TCE had been deployed for the operations with the balance tied up mainly in cash. TMST cash-to-firm value of 18 % is slightly higher compared to the steel sector average of 11% (Source: Damodaran Jan 2021).

The Group did not provide a breakdown of the TCE by its products or regions.  However, it did provide a breakdown of the Long-Lived Assets by region. In 2020, almost all of these are in the US.

In terms of borrowings, the Group has historically been conservative with Debt Equity levels varying between 0.20 to 0.31. 

TMST Debt Equity ratio
Chart 3: Debt to Equity

Is the Current Performance Outstanding?

For the 6 months ended June 2021, the Group achieved USD 601 million of revenue with USD 64 million PAT. For the same period last year, the Group achieved revenue of USD 414 million with USD 35 million net loss.

Revenue growth was due to higher volume and higher average net selling prices.  For the 6 months ended June 2021, the tonnage shipped was 27 % higher compared to the same period last year. At the same time, the average net selling price per ton was 15 % higher.

For the first 6 months of 2021, TMST achieved a gross profit margin of 16.3 % as compared to 0.9 % for the same period last year. The average gross profit margin from 2014 to 2020 was only 4.9 %.

The growth in the YTD revenue and net income is in contrast with the long-term declining trends as can be seen from the Performance Index chart below.
  • The drop in revenue in 2015 and 2016 was due to the prolonged weakness in the energy sector. The drop in demand affected production costs as the melt capacity utilization declined from 72 % in 2014 to 49 % and 46 % in 2015 and 2016 respectively.
  • The result in 2016 was also affected by a USD 75 million marked-to-market expenses relating to its post-retirement benefit plan.
  • The relatively poorer results in 2019 compared to 2018 were due to a drop in volume. This caused the melt capacity utilization to drop from 74 % in 2018 to 50 % in 2019. 

TMST Performance Index
Chart 4: Performance Index

One of the reasons for TMST's poor performance is its cost structure. It has resulted in a high breakeven level.

Breakeven analysis

The performance for TMST for 2014 to 2020 is tabulated below. 
  • It was profitable in 2014 with a USD 1,531 per ton average selling price and 72 % annual melt capacity utilization.
  • It almost broke even in 2018 with a USD 1,343 per ton average selling price and 74 % annual melt capacity utilization.
TMST 2014 to 2020 Performance
Chart 5: 2014 to 2020 Performance

I deduced that to be profitable, it required an average selling price greater than USD 1,343 per ton and at least 70 % annual melt capacity utilization. This is equal to about 1.1 million tons shipped per year. Note that historically, the shipped tonnage is about 80 % of the melt tonnage. 

From 2014 to 2019 excluding the pandemic year, an average of 1.0 million tons of products was shipped annually compared to its annual melt capacity of 2.0 million tons. The capacity had been under-utilized most of the time.

The steel industry is a high fixed cost one. To breakeven, capacity utilization generally needs to be above 70 %.

To confirm the breakeven picture, I charted the breakeven level for TMST under various tonnage and unit selling prices. You can see from the chart that the breakeven level depends on both the selling price and tonnage.

TMST breakeven analysis
Chart 6: Breakeven analysis

In deriving the above chart, I had assumed the following:
  • The fixed cost was based on the average cost for 2014 to 2019 ie excluding the pandemic year. The fixed cost = Interests + Depreciation and Amortization + Selling, General & Admin.
  • Variable cost = Cost of sales - Depreciation, and Amortization.
  • The unit cost and unit selling price was based on the actual tonnage shipped for the year.

The breakeven analysis indicated that to be profitable, there are 3 options for TMST - achieve a higher unit selling price, sell more tonnage or reduce its cost structure.


Case Notes

According to Investopedia, a breakeven analysis entails calculating and examining the margin of safety for an entity based on the revenues collected and associated costs. The breakeven point refers to the point in which total costs and total revenue are equal.

The analysis shows how many sales it takes to pay for the cost of doing business. Analyzing different price levels relating to various levels of demand, the break-even analysis determines what level of sales is necessary to cover the company's total fixed costs. In general, a company with lower fixed costs will have a lower break-even point of sale. 

Breakeven analysis should be one of the tools in your company analysis toolbox.

As you can see, fundamental analysis is more than just using some formula. There are choices to be made in terms of which approach to use.

So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.  

There are several financial advisers who provide such analyses. 

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.




Tracing the Group’s Rich and Unique History

Over the past 7 years, the revenue of the Group had declined from USD 1.7 billion in 2014 to USD 0.8 billion in 2020. The revenue was volatile as can be seen from the chart below. 

TMST revenue by segment
Chart 7: Revenue by segment

The US accounted for the majority of the revenue. In March 2021, TMST disposed of its investments in China leaving UK and Mexico as its international operations going forward.

TMST revenue by region
Chart 8: Revenue by region

The production performance of TMST post-IPO is not reflective of what it had achieved during the pre-IPO period as can be seen from the chart below.

TMST steel statistics
Chart 9: TMST steel statistics

Over the last 20 years, TMST had increased its annual melt capacity from 1.7 million in 2000 to 2.0 million tons in 2020. However, its shipped tonnage has not shown any significant growth.
  • For the 5 years from 2000 to 2004, the average annual shipment was 1.0 million tons. The average annual melt capacity utilization was 77 %.
  • For the 5 years from 2016 to 2020, the average annual shipment was 0.9 million tons with 56 % average annual melt capacity utilization.

Given the high manufacturing costs associated with low capacity utilization, you should not be surprised by the Group's decision to reduce the melt capacity. In Feb 2021, TMST announced its plans to indefinitely idle one of its melt and casting assets. This would reduce its annual melt capacity by 60% and reduce its fixed costs. In turn, this would reduce the breakeven level. 

Apart from reducing the fixed costs, it is possible that some of the variable costs eg manpower could be reduced if the remaining facilities operate at higher efficiencies.

TMST pride itself on having one of the lowest breakeven points in the industry and there is a constant focus on cost reduction and using its assets more efficiently.
  • In 2015, it implemented 2 cost reduction plans that resulted in headcount reduction.
  • In 2019, its restructuring efforts eliminated 15 % of its salaried workforce.
  • The organizational changes in 2020 resulted in the elimination of 55 positions.
  • In 2021 apart from the closure of one of its melt plants, TMST also completed the closure of its material services facility as well as discontinued the small diameter tubing products.

These are positive signs that steps are being taken to address the break-even levels thereby turning around the business.

Is there a Great Future?

TMST is in a commoditized cyclical sector. 

Steel consumption in the US decreased by 23 % from 107 million tons in 2014 to 82 million tons in 2020 because of the Covid-19 pandemic. In contrast, TMST external shipment decreased by 42 % from 1.1 million tons in 2014 to 0.6 million tons in 2020.

TMST sales and marketing results are not something to shout about. 

TMST US apparent steel consumption
Chart 10: US apparent steel consumption.   Source: Statista

Notwithstanding these statistics, I foresee the demand for steel in the US to increase. Growth will come from:
  • Increased consumption in the US. This is because the current level of steel consumption in the US is below the long-term average. With the Biden administration's focus on infrastructure development, the prospects of increased steel demand would be there.
  • Reduced imports.  There has been a decline in imports due to the various trade barriers instituted during the Trump administration. If the Biden administration continues with the trade protection measures and/or imposes additional ones, it would be positive for the US producers.

For further insights into the US steel industry, refer to my article "Is Steel Dynamics a reverse value trap?"

For the period 2014 to 2020, there is a 0.58 correlation between TMST shipment and US steel consumption. This implies that if the demand for steel in the US increases, we can expect a higher shipment volume from TMST. 

Steel prices

Steel products are commodities with cyclical prices.  The cyclical nature of the steel prices can be seen from the Producer Price Index chart below.  The Index was at 238 in Jan 2014. It declined by 26 % in 2016 and is currently about 48 % higher than that in Jan 2014.

Iron & steel producer price index
Chart 11: US Iron & Steel Produced price index      Source: FRED

You should not be surprised to see that TMST average product selling price also shows a similar cyclical pattern as can be seen from the chart below. 

TMST Price index c/w Producer Price index
Chart 12: TMST Price Index c/w US Producer Price Index

It would appear that steel prices are now in the upswing of the price cycle and this should result in higher selling prices for TMST in the immediate to mid-term. 

Pulling it all together

Given its poor profit track record since its IPO, you may be tempted to think that this is a company with poor fundamentals.

However, the Group is financially strong and the breakeven analysis showed that the poor performance is due to it operating below its breakeven levels.

The prospects of lower fixed costs, higher selling prices, and larger sales volume meant TMST would be able to be profitable.  Of course, what I have done is a back-of-envelope analysis but it does show that TMST is not a perpetual loss-making company. 

The opportunity to turn around TMST then rests on the following:
  • It would be able to continue to reduce its cost structure. While TMST claimed that it has the lowest breakeven in the industry, it must continue to lower this level. 
  • It would be able to ship more tonnage in line with the general growth in demand for steel. TMST is a specialized steel producer. Its growth would be driven by the general growth in the economy and this is not a sunset sector.
  • Prices, in the long run, would be at least be at their historical cyclical average. Any increase in price would be a bonus.

Given TMST's technical expertise and customer relationships, if it can get align its cost structure with the cyclical product prices, it would be able to turn around.

Of course, before we can confirm that it is one of the better NYSE companies to invest in, we also have to consider its valuation relative to its market price.

Join me in Part 2 of this series to answer this question.



End of Part 1 of 2

Part 2 of 2 will be published on 19 Sep 2021



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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.
















  


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