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

Value Investing Case Study 19-2: I first published Timken Steel in Seeking Alpha in Aug 2021 based on the results from 2010 until Q1 2021. The company has since then released its results for Q2 2021. This is Part 2 of the updated post that incorporated the Q2 2021 financials.

 

Except for its IPO year of 2014, Timken Steel Corporation (TMST or the Group) has been incurring losses every year since then.

However, for YTD June 2021, it achieved a net income of USD 64 million. Is this a lucky performance, or does the Group has the fundamentals to be profitable?

I have shown in Part 1 that the losses were because it was operating below the breakeven levels. The breakeven level is dependent on its capacity utilization and/or its product selling prices. The past 6 years’ losses were due to either of these or a combination of them.

To turn around the business, TMST has to address its cost structure, the sale volume, and/or the selling price. 

In Q1 2021, TMST had taken steps to reduce its annual melt capacity by 60%. I have shown that the demand for steel in the US is expected to increase. Furthermore, steel prices seemed to be in the uptrend part of the price cycle.

All these points to improved prospects. I had shown that TMST is not a perpetual loss-making company. 

But whether it is one of the better stocks in the NYSE to invest in also depends on whether it is trading at a discount to its intrinsic value. I will pursue such an analysis here under Part 2 of this series.

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

Contents

• Did Top Management Seize Opportunities?

• Is there an Awesome Buying Opportunity?

• Will there be Spectacular Growth in Shareholders’ Value?

• How to Secure Your Investment by Minimizing Risk

• Pulling it all together

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Did Top Management Seize Opportunities

There are 10 members on the TMST Board of Directors. 

• 8 of them are Independent Non-Executive Directors. The 2 Executive Directors were the interim CEO/President and the newly appointed CEO/President. 

• 2 of the Independent Non-Executive Directors will not stand for re-election to the Board when their current terms end in 2021.

Note that the interim CEO/President was a Board member since 2015. He took on the role of interim CEO/President in the 4th quarter of 2019 when the then Chairman, CEO, and President stepped down.

The Board members are on average 65 years old with an average of 5 years tenure with the Group. A profile of the Board can be seen from the following extracts from the 2021 Proxy Statements.

Chart 1: Board profile

A new CEO/President was appointed in 2021 to take over from the interim CEO/President. Together with this new CEO, 4 other executives were profiled in the TMST 2020 Form 10k.

• They are on average 55 years old.

• 3 of them including the CEO have been with the company for less than 3 years. The other 2 were long-serving staff having been with the company for 3 to 4 decades.

The Directors and Executives collectively hold 1.8 % of the common stocks of TMST. As such I would not consider this an owner-managed group.

There are 4 institutional shareholders - BlackRock, Ellwood, Dimensional Fund, and Vanguard. They held 35.6 % of TMST.

To align the management interests with those of the shareholders, the company has an incentive plan.  This comprises annual incentives, restricted stock units, and performance shares. 

TMST uses the adjusted EBITDA as the primary performance measure under the annual incentive plan.  This is because it believes that this metric is closely connected to the creation of shareholders' value. During the past 3 years, the total incentives awarded averaged USD 2.7 million per year compared to the average annual EBITDA of USD 60.3 million. 

Given these incentives how did management perform? I compared TMST performance with the following peers:

• Cleveland Cliff (CLF) - as it had acquired ArcelorMittal USA.

• Nucor (NUE) - identified as a competitor by TMST.

• Steel Dynamics (STLD)- identified as a competitor by TMST.

• United States Steel (X) - as it competed with NUE and STLD.

Chart 2: Peer Revenue Index

In terms of revenue growth, while TMST generally followed the industry direction, its growth from 2014 to 2020 was among the worst. Note that CLF's growth was because of its acquisitions.

In terms of returns as measured by EBITDA / TEV, TMST did not perform well. 

The incentives for the past 3 years were awarded when TMST was not profitable. There is thus a need to relook at using EBITDA to assess management performance.

Chart 3: Peer Return

Case Notes EBITDA is used as an alternative to the net income in some circumstances.  According to the Corporate Finance Institute, EBITDA is a variation of operating income (EBIT). The metric excludes non-operating expenses and certain non-cash expenses.  The purpose of these deductions is to remove the factors that business owners have discretion over. Examples of such factors are debt financing, capital structure, methods of depreciation, and taxes.  EBITDA can be used to showcase a firm’s financial performance without accounting for its capital structure. But EBITDA can be misleading because it strips out the cost of capital investments like property, plant, and equipment. Nonetheless, some consider it a more precise measure of corporate performance.  This is because it is able to show earnings before the influence of accounting and financial deductions. It can be considered as a proxy for cash flow from the entire company’s operations. According to Investopedia, EBITDA first came to prominence in the mid-1980s. This was when leveraged buyout investors examined distressed companies that needed financial restructuring.  Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. The EBITDA-to-interest coverage ratio would give a sense of whether a company could meet the heavier interest payments it would face after restructuring.  EBITDA was popularized further during the "dot com" bubble. This was when companies had very expensive assets and debt loads that obscured legitimate growth numbers. An important red flag for investors to watch is when a company starts to report EBITDA when it hasn't done so in the past. This can happen when companies have borrowed heavily or have rising capital and development costs. In this circumstance, EBITDA can serve as a distraction for investors and may be misleading. As you can see fundamental analysis does require some basic accounting knowledge. As a newbie, you may find this a bit challenging. If you face such a situation, one way is to rely on third-party analysis 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.

Case Notes

EBITDA is used as an alternative to the net income in some circumstances. 

According to the Corporate Finance Institute, EBITDA is a variation of operating income (EBIT). The metric excludes non-operating expenses and certain non-cash expenses. 

The purpose of these deductions is to remove the factors that business owners have discretion over. Examples of such factors are debt financing, capital structure, methods of depreciation, and taxes. 

EBITDA can be used to showcase a firm’s financial performance without accounting for its capital structure. But EBITDA can be misleading because it strips out the cost of capital investments like property, plant, and equipment.

Nonetheless, some consider it a more precise measure of corporate performance.  This is because it is able to show earnings before the influence of accounting and financial deductions. It can be considered as a proxy for cash flow from the entire company’s operations.

According to Investopedia, EBITDA first came to prominence in the mid-1980s. This was when leveraged buyout investors examined distressed companies that needed financial restructuring. 

Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. The EBITDA-to-interest coverage ratio would give a sense of whether a company could meet the heavier interest payments it would face after restructuring. 

EBITDA was popularized further during the "dot com" bubble. This was when companies had very expensive assets and debt loads that obscured legitimate growth numbers.

An important red flag for investors to watch is when a company starts to report EBITDA when it hasn't done so in the past. This can happen when companies have borrowed heavily or have rising capital and development costs. In this circumstance, EBITDA can serve as a distraction for investors and may be misleading.

As you can see fundamental analysis does require some basic accounting knowledge. As a newbie, you may find this a bit challenging. If you face such a situation, one way is to rely on third-party analysis 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.

Capital allocation

From 2014 to 2020, the Group generated USD 546 cash from operations. Of these:

• USD 31 million was spent on dividends. These dividends were declared in 2014 and 2015 when the total net income was USD 0.6 million. In hindsight, it was not a good capital allocation plan.

• USD 56 million was spent on share repurchases. These were undertaken in 2014 and 2015.

• USD 366 million was spent on CAPEX. 

• USD 50 million was paid to Timken for a spinoff

• There was an increase in cash of USD 68 million. 

Note that the total payments exceeded the Cash from Operations. This was funded by debt.

The dividend and share buyback were taken at the time when the company was profitable. As such I would rate the capital allocation plan as OK as the bulk of the cash was channeled to improve the production capabilities. 

Chart 4: Capital Allocation

How would I asses management?

• From an operations perspective, I would rate its performance as below average.

• In terms of capital allocation, I would rate it as average.

On an overall basis, I would say that the management team did not perform. But there are two points to note:

• The current CEO/President joined in Jan 2021.

• The service of the Executive Vice President cum General Counsel and Secretary was terminated. There was a severance payment of about USD 0.8 million. The company did not provide any information on the reasons for the separation. But the severance payment suggests that it is due to some unusual circumstances.  

I would like to think that TMST has a different management team starting from 2021.

Is there an Awesome Buying Opportunity?

I generally use two approaches in assessing the intrinsic value.

• Asset Value (AV). 

• Earning Value (EV).

I normally assumed that for a cyclical company, the future is equal to the historical performance. The challenge with TMST is that it is undergoing a turnaround. You would expect the future to be better than the past.

I such cases, I would consider the Asset Value as the base. The Earning Value would then be based on the projected turnaround performance. 

TMST market price as of 27 Aug 2021 is USD 14.42 per share compared to its Book Value of USD 12.64 per share as of the end of June 2021.  This is equal to a Price Book ratio of 1.1.  Note that the Book Value has already accounted for the impairment charges for the various closures.

To get a sense of what is possible after the turnaround, during the period 2010 to 2014, TMST achieved the following:

• An average melt utilization of 70% with an average of 1.1 million tons of shipment per year. The average selling price was USD 1,499 per ton.

• An average net income of USD 108 million per year. The average EBIT was USD 162 million per year and the average EBITDA was USD 159 million per year.

Based on USD 162 million EBIT and the Free Cash Flow to the Firm model, the Earnings Power Value (EPV) comes to USD 34 per share.

In computing the EPV, I have derived the WACC to be 7.9 % based on the following assumptions (Source: Damodaran Jan 2021 dataset).

• Risk-free rate - 1.9 % 

• 26 % tax rate.

• Unlevered Beta = 0.78 based on the US steel sector.

Chart 5: Valuation

It is instructive to note that for the half-year ended June 2021, TMST shipped about 407,600 tons of steel with an average selling price of USD 1,474 per ton. It achieved USD 64 million of net income.

If you extrapolate for the year based on this, the annual shipment would be about 800,000 tons with a net income of USD 128 million.

The projected annual shipment is not significantly different from 2014 to 2020 annual average of 940,000 tons. However, the average selling price is higher than the average selling price of USD 1,308 per ton for the period 2014 to 2020.

It does show that a turnaround is possible with a higher selling price. It may also reflect the profit potential with a lower cost structure.

Chart 6: Valuation metrics

To get another perspective of TMST valuation, I compared it with its peers based on 2 valuation multiples as shown in the table below.

TMST's Price Book ratio is very much lower than those of its peers. It suggests the potential for re-rating if TMST can sustain its profits.

Chart 7: Peer Multiples        Source: TIKR.com as of 27 Aug 2021

TMST's EV / EBITDA multiple is also lower than those of its peers.

Assuming an EBITDA of USD 159 million, Debt of USD 64 million, and cash of USD 115 million, the TMST share price would be about USD 19 per share.  This is based on the current EV / EBITDA multiple of 5.07

In his book, Deep Value, Tobias E. Carlisle defined the enterprise multiple or the Acquirer’s Multiple as EV / EBITDA.

Carlisle compared the returns using valuation multiples.  He found that the Acquirer’s Multiple had the most success in identifying undervalued stocks. Wall Street’s favourite metric— price-to-forward earnings estimate—was by far the worst-performing ratio.  

An Acquirer’s Multiple below 6 is considered cheap. TMST Acquirer’s Multiple of 5.07 falls into this category.

This is not even considering a re-rating of the multiple to be in line with those of its peers. 

Looking at both the potential EPV and the Acquirer’s Multiple there is a sufficient margin of safety at the current price. 

Will there be Spectacular Growth in Shareholders’ Value?

If you have been following my blog, you will know that a high-quality company is one that has a good chance of increasing shareholders’ value. 

I looked at the following metrics to assess shareholders' value creation. 

• From 2014 to 2020, assuming that no dividend was distributed, the shareholders’ funds would decrease by a compounded annual rate of 8.8 %.  This is below the cost of equity of 6.3 %.

• Over the past 7 years, the Group achieved an average negative return.  This return was computed as EBIT(1-t)/TCE assuming a 26 % tax rate. The return is very much below the Group’s cost of funds of 7.9 %.

• If a shareholder had bought a share at the end of June 2014 and held onto it till the end of 2020, he would have made a loss. Compare this with the 3.3 % cost of equity.

Chart 8: Shareholders' gain

Based on these 3 metrics, the conclusion is that TMST did not create shareholders' value.  Given this conclusion, I would again question the company incentive plan. 

How to Secure Your Investment by Minimizing Risk

The main business risk for the Group relates to the prospects of a turnaround. There are 2 related issues here:

• Can the Group reduce its cost structure so that the breakeven level is around 1 million tons of shipment? This is assuming its average 2010 to 2020 selling price of USD 1,375 per ton.

• From 2014 to 2020, TMST's market share declined from 1.0 % of the US apparent steel consumption to 0.8 %. Would TSMT turn this around and grew the sales volume at a rate higher than the US steel consumption?

TMST revenue will depend on both the sales volume and selling price. Steel is a commodity and the selling price is cyclical depending on the global supply and demand. As such, I would not expect TMST prices to follow a different trajectory than that of global prices.

The 2 controllable factors are costs and volume. The business risk comes to whether TMST can address these 2 and operate above the breakeven level.

In Part 1, I have developed a breakeven model for TMST. Based on this model, I have plotted the variable costs and fixed costs from 2010 to 2020 as shown below. As can be seen, TMST did manage to bring down the variable cost during the period from 2015 to 2017. The fixed cost track record was not as good.

However, there are prospects for reducing the fixed cost with the closure of the excess melt capacity. I would like to think that these are signs that the Group is able to address the cost issue.

Chart 9: Cost model

As for the sales volume, TMST would have to rely on its order size capability and its customer relationship. If there was any risk, this would be the one I would be concerned about.

The positive picture is that there are tailwinds for steel consumption in the US. This is because of the Biden administration's infrastructure and other economic plans. This should help TMST grow its sales volume even if you assumed that TMST would not be able to increase its market share.

Pulling it all together

There is a new CEO/President starting work in Jan 2021.  During 2020, there was only an interim CEO following the departure of the previous CEO.

This could be a catalyst to turn the Group around. I would like to think that the plans to reduce the melt capacity by 60% were initiated by the CEO. This over-capacity was there long before its IPO and could have been a legacy issue that could only be tackled by a new CEO.

If I am right, then the prospects for a turnaround are good. The only concern I have is the current incentive plan. The Board stated that it chose EBITDA as this best measures shareholders’ value creation. However, as I have shown, shareholders’ value was not created. I would have thought that it was evidence that the performance measure needs to be relooked.

The Investment Thesis is that TMST would be able to turn the Group around. If this is achieved there is a sufficient margin of safety at the current market price.

If it failed, the current market price is 1.1 times the Book Value. This would limit the downside if the turnaround is not successful. 

End of Part 2 of 2

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If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play.

PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play. 

Disclaimer & Disclosure

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.

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