TimkenSteel (TMST, Financial) became an independent public company after being spun out of The Timken Company (TKR, Financial) on June 30, 2014. TimkenSteel, located in Ohio since October 24, 2013, is North America's leading manufacturer of special bar quality steel.
Operating segment
- Industrial and Mobile
TMST IM segment is a leading provider of high-quality air-melted alloy steel bars, tubes, precision components and value-added services.
Further IM is divided in to two segments:
- Industrial market sector –Â This segment includes Industrial application (8% of revenue), Machinery (7% of revenue) & Mining and construction account for 3% of revenue.
- Mobile market sector –Â This segment includes passenger car and light truck market (32% of total revenue).
Energy & Distribution: This segment accounts for 42% of sales and primarily sells to the Oil & Gas market, with specially attention on the exploration sector of O&G market.
The key drivers for the company's end markets include the U.S. light vehicle production SAAR, the Baker Hughes rig count, the amount of footage drilled in the U.S., industrial production for the agriculture and construction markets, distribution and mining and oil field machinery products.
Management
Lead members in management are:
- Ward J. Timken Jr., the chairman, CEO and president
- Randall Edward, president and COO
- Philip Cox, president and CEO
Inside ownership
In management the largest holder in inside ownership is of Ward J. Timken Jr. with 0.21% of total outstanding.
Outlook
The overall fall in steel and scrap prices, and even its heavy exposure to the exploration aspect of oil and drilling, leads to face the headwind to TimkenSteel, but investors' expectation from the corporation is too high that it would be difficult for the organization to reach at the consensus level. All the company’s issues will escalate in 2015 as management is strongly committed to repurchasing 2M shares (Total outstanding 46 million), of which it had already bought 100,000 during January at significantly higher prices than the stock is selling for today.
Looking at the company’s cash flow, it will be difficult to cover the company’s dividend of $0.14 per quarter, or $0.56 annually, as it only has $35 million in cash it will be forced to draw heavily on its revolver during 2015 and 2016, which will take its leverage from below 1x Net Debt/EBITDA last year to 2.5x by 2016, half a turn above management's target range of 1x-2x with the company’s goals of growing inorganically get limited, as acquisitions will be made available by increasing the debt load or issuing new equities.
There have been many rumors about the company being a potiential target by a financial or strategic buyer. After considering all the factors like synergies, cost cutting and company growth capex budget, it doesn’t make any sense to acquire this as the organization is roughly already trading at 17x 2015E EBITDA versus peers which are trading at 8x. We believe that TMST has 50% downside to $12-$15 from its current price of $27.40.
Steel prices have been, and will continue to be, one of the primary victims of the boom-and-bust cycle created by the historic level of infrastructure spending by China from 2005-2012. To represent this there is no other better metric than to look at the price of iron ore, the primary raw material of steel products. Until 2004 the price of iron ore was $20 per metric, but by 2007 the price had skyrocketed to $61 which is when the real bubble began. Between 2008 and the beginning of 2010, iron ore prices shot up to $187 per metric ton, threefold from where it had been in 2007 and more than tenfold from where it traded for the better part of a century.
Looking at the above demand-supply analysis of the iron ore, we believe that bull, base and bear cases the iron ore market will be oversupplied for at least the next three years. Supply estimates are something to keep in mind while they are only estimates; they consist of projects that are either in construction or fully financed. There are actually incremental projects to those in the numbers above which are not financed; however, I have not included those in these estimates. Another important factor is that the majority of these new projects carry very low cash costs with respect to extracting the ore. Most of the projects have cash costs in the neighborhood of $40-$50. On the demand side of the equation we use 4% growth per year for the bull case, 2.2% growth for the base case, and 1% contraction in the bear case. These estimates were derived by examining the percentage of iron ore consumed by each country/region, analyzing what the growth rate of steel demand has been recently, and then putting it all together to arrive at a total world iron ore demand growth.
What is also interesting is that, while many sell-side analysts and economists have taken down their assumptions for the future price of iron ore, their estimates do not yet reflect a realistic depiction of the supply/demand environment detailed above. In fact, there is not one sell-side estimate that is lower than the current price of iron ore.
There is very little evidence that it can be believed that iron ore will spiral in the next 12-24 months. The main threat to the entire prospect is if China starts to restock its inventories even though having such a scenario is quite difficult as the overall economy is running slow and the government is attempting to change its infrastructure-based economy to a consumer-based one. By all accounts Chinese steel mills have been running their iron ore inventory significantly lower than they had in the past, and many economists believed that this will continue to be the case going forward.
Looking at the above chart and reported in the Wall Street Journal on March 15, China's steel exports rose 63% year over year in January, including a rise of 40% year over year to the United States. This flood of supply is pressuring domestic steel prices even further. The combination of these factors has pushed down hot rolled and cold rolled steel 25% since the first quarter of 2014. Considering the two catalysts, iron ore and Chinese exports, it is my belief that steel prices are going to be pressured even further over the next few years.
If we make an assumption that, if the price of steel declines, one thing is sure –Â that the company's price per unit is going to come under pressure. However, what hasn't been discussed yet is that the company derives 35% of its total revenue from the oil and gas industry, 66% of which is directly tied to exploration and is therefore influenced dramatically by the active North American rig count. While most people are aware of the rig count decline, here's a visual of the five-week average North American rig count since 2011.
Looking at the decline in the current rig count, it means that TMST experienced a massive slowdown in shipments and utilization. In the company's energy segment shipments were down 17% in 2012 and 20% in 2013, year over year. More importantly, as the company's utilization rate fell, its detrimental margins (the percentage EBITDA fell per dollar of revenue) were 11.5% in 2012 and 66.1% in 2013. During that time capacity utilization fell from 85% in 2011, to 65% in 2012, and to 58% in 2013. This occurred during a time when the rig count was "only" down roughly 10% each year. As it currently stands, the rig count is down 45% year over, typically at a time when the figure is at its high for the year. This is going to have a profound impact on the company's energy segment during 2015, and only compounds the issues of plummeting iron ore prices and Chinese steel exports.
Valuation
Going in 2015 it would not be like 2014. The important thing to keep in mind is the deleveraging effect in the company's energy and distribution segment. Adjusted EBITDA is going to fall from $230M to only $80M in 2015. This could be more of the estimation as in this theory we are making an assumption that it will fall near around at 40% as considering the last 10% fall of rigs in this segment which brought 66% lower side margins. Right now the rig count year over year basis falls to 45%.
Considering the above factors and investors' expectation, the TMST will bring worth only after some fall, as it is quite difficult for the TMST to meet the consensus estimation, as the estimation are quite high and in this work Bloomberg consensus estimates for Timken Steel 2015 are consider they are as below:
Revenue $1.47B
EBITDA $153M
EPS $1.06
Not only are those, but estimates for 2016 and 2017 assuming significant growth off 2015's base estimates. 2015 consensus EPS is expected to double from $1.06 to $2.11 in 2017, and EBITDA is expected to rise by $79M from $153M to $232M over the same time period. Looking at the current market dynamics there is no door available with the help of which the company is able to hit those targets. In addition, TMST is very expensive relative to peers.
Another factor yet to be discussed is capital allocation. Based on our assumptions the company is going to have $18M of leveraged discretionary free cash flow in 2015. Entering the year the company has $35M of cash and $185M of debt, as well as $145M available on its revolver and a $150M accordion feature. The free cash flow looks fine, albeit not great for a $1.25B company, but that's before subtracting $40M of growth capital expenditures, $25M for dividend payments and $45M of share repurchases. Given those figures the company is going to run at a cash use of $92M during 2015, and will have to tap its revolver in order to cover its share repurchases and dividend payment. This cash usage will take net debt from $150M to $242M entering 2016. Using assumption estimates for 2015E EBITDA of $80, this means the company will enter 2016 with a TTM leverage ratio of 3.0x, and a forward ratio of 2.5x, well above not only the company's target range of 1x-2x, but also far above its peer average of 2.2x. The other important effect this will have is on the company's inorganic growth profile, which management has indicated is a high priority. If the company is going to make acquisitions, it will either have to take on more debt, thereby increasing its leverage ratio, or issue new equity. When you step back and look at the whole picture, I think it's more likely that the company decides not to execute the full 2M buyback during 2015 (although management was very strident on the most recent conference call about it), pulls the dividend, or pulls back on its growth capital expenditures. The point being that, if management pulls back on any of those items, I do not think it will be received well by the market. Pulling the buyback and/or dividend shows a lack of confidence, and pulling growth capital expenditures lowers future growth expectations, of which the market has plenty (consensus revenue estimates go from $1.47B in 2015 to $1.61B in 2017, while EBITDA and EPS estimates go from $153M to $232M and $1.06 to $2.11, respectively, during the same time period).
TimkenSteel is facing very serious and prolonged macroeconomic factors that will pressure pricing and have a profound negative impact on its margins. These impacts are not just being felt by TMST, but also by other domestic companies who have recently missed or lowered guidance such as AK Steel (AKS, Financial), Nucor (NUE, Financial) and Steel Dynamics (STLD, Financial), to name a few. In addition TimkenSteel dividend and stock buyback will not be covered by cash flow, forcing the company to draw down on its revolver, thereby significantly increasing its leverage. Moreover the company is trading at a 100% premium to its peers. To keep a faith on the thing that someone will try to acquire company at this is not so easy it do not attract any buyers at this price. Considering all the above assumptions, it’s believed that, once these factors are better understood by the market, TMST's stock will trade in line with peers, indicating downside to $12-$15 per share from its current price of $27.40.
Disclosure:
1) As an author I declare that I don’t have any investment in the aforementioned stock, nor do I get paid from the aforementioned stock company to write, and I have no plans to invest in the stock for the next 72 hours.
2) The above details are taken from the company filings 10K, transcript from seeking alpha & one of their author westpark report is consider while drafting the above article
3) The price of TMST is taken from Yahoo! (YHOO, Financial) Finance.
4) And all the above diagrams showing are taken from westpark report.
5) The Top director holding image includes all the insider holding is subject to copyright of Gurufocus.com
