The Timken Company (NYSE:TKR ) Q2 Results Conference Call July 28, 2022 11:00 AM ET

Neil Frohnapple - Director of IR

Richard Kyle - President and CEO

Chris Dankert - Loop Capital

Good morning. My name is Jennifer, and I will be your conference operator today. As a reminder, this call is being recorded. At this time, I'd like to welcome everyone to The Timken Second Quarter Earnings Release Conference Call. [Operator Instructions] Mr. Frohnapple, you may begin your conference.

Thanks, Jennifer, and welcome, everyone, to our second quarter 2022 earnings conference call. This is Neil Frohnapple, Director of Investor Relations for The Timken Company. We appreciate you joining us today.

Before we begin our remarks this morning, I want to point out that we have posted presentation materials on the company's website that we will reference as part of today's review of the quarterly results. You can also access this material through the download feature on the earnings call webcast link.

With me today are The Timken Company's President and CEO, Rich Kyle; and Phil Fracassa, our Chief Financial Officer. We will have opening comments this morning from both Rich and Phil before we open up the call for your questions. During the Q&A, I would ask that you please limit your questions to one question and one follow-up at a time to allow everyone a chance to participate.

During today's call, you may hear forward-looking statements related to our future financial results, plans and business operations. Our actual results may differ materially from those projected or implied due to a variety of factors, which we describe in greater detail in today's press release and in our reports filed with the SEC, which are available on the timken.com website.

We have included reconciliations between non-GAAP financial information and its GAAP equivalent in the press release and presentation materials. Today's call is copyrighted by The Timken Company and without expressed written consent, we prohibit any use, recording or transmission of any portion of the call.

Finally, I would like to remind you that we are planning to host an Investor Day on Wednesday, September 28 in New York City. So we hope that you will join us either virtually or in person.

With that, I would like to thank you for your interest in The Timken Company, and I will now turn the call over to Rich.

Thanks, Neil. Good morning, and thank you for joining us today. Timken delivered another excellent quarter with record revenue, record earnings per share and 20% EBITDA margins. Our strong results further demonstrate the ability of the business to perform at a high level through a variety of macroeconomic conditions. Demand continues to be very strong across most markets and geographies.

Organically, we increased revenue more than 11% over last year and by almost 4% from the first quarter. That was despite significant COVID disruptions in China, continued supply chain challenges and our exit from Russia.

Incoming orders also continued at a strong pace and backlog grew slightly in the quarter. Our mix and price costs were favorable in the quarter and were the primary drivers of the year-on-year margin improvement of 120 basis points. Price realization improved sequentially from the first quarter and we expect it to continue to improve modestly through the second half of the year.

Costs were up significantly over prior year and up slightly from the first quarter. These include external costs as well as internal inefficiencies. We saw some costs like steel pullback from peak levels, but others such as energy hit new peaks in the quarter. While costs in total did not recede in the quarter, the trend line appears to be leveling off. We are expecting costs to roughly stay at the second quarter levels in the second half and for the year-on-year price cost to get more positive from both easier comps as well as more price realization.

We responded to a variety of challenges in the quarter, including the impact from Russia, China COVID shutdowns, elevated absenteeism around the world from COVID and continued supply chain disruptions. We continue to navigate these issues and deliver for our customers while performing well financially.

From a capital allocation standpoint, we purchased approximately 1% of the outstanding shares in the quarter, which brought the year-to-date total to about 3% of outstanding shares. We also completed the Spinea acquisition. And while we have only owned the business for about 2 months, it is off to a great start. Spinea Engineers precision robotic drives. It has great product technology, and we see significant opportunities to profitably grow Timken's presence in the factory automation space, with Spinea playing a key part of our expanding portfolio.

Our cash flow year-to-date has been modest and impacted by both seasonality and supply chain challenges, but we expect to generate significant cash in the second half of the year. Receivables will decline with seasonality, and we are focused on improving inventory management as the supply chain stabilizes. The balance sheet remains strong and combined with the cash flow we expect capital allocation to contribute meaningfully to next year's results.

Turning to the outlook. Short-term uncertainty remains elevated. I won't run through all of the macros that have moved significantly this year, but there are clearly a lot of them and many of them are concerning. Despite the concerns, I would say that we have not seen any meaningful change in customer sentiment or behavior since last quarter.

In total, demand for Timken products and technology remain strong, and we are innovating and winning in the marketplace.

Orders in the second quarter continue to come in at a pace slightly ahead of revenue levels and customers are generally preparing for growth, both in the second half and next year.

At the midpoint of our outlook, we will grow revenue 9% organically for the full year and 7% are netting off the impact of currency and acquisitions. From an EBITDA perspective, we feel good about the price cost dynamic for the rest of the year and mix is also trending favorably. A step-down of 200 to 400 basis points in EBITDA margin from the first to the second half is normal for us, and the midpoint of our guide implies around 300 basis points.

Revenue, inventory and costs all play a role in its margin seasonality. And as you've seen from the last few years, it does not imply that margins won't bounce right back up in early '23. The midpoint of our guide would result in earnings per share of about 20% greater than last year's record.

In summary, we remain on track to deliver record sales and earnings for the year in this dynamic environment. And when you look at Timken's financial performance over the longer term, you can see the strength and consistency in our results.

I'd like to point out Slide 9 in our earnings material, where we've summarized our performance over the last four years, plus estimates for 2022 at the midpoint of guidance. As you know, through this five year period, we've been faced with a wide variety of macroeconomic conditions. Many of those conditions were favorable and many were unfavorable.

In the last five years, we've had industrial market conditions that have ranged from bad to excellent, a pandemic or in Europe, tariffs, tax policy changes, labor shortages, inflation, supply chain challenges and more. Through all the good and bad market conditions over the last five years, Timken has consistently performed at a high level.

We've won in the marketplace with our products, our technical sales model and our excellent service, and we have steadily deployed capital back into the business and directly to shareholders. 2018 was a strong industrial market globally, and Timken delivered a breakout year with earnings over 30% higher than our prior record. And off that challenging comp, we are on track over this five years period to grow revenue 24%, grow earnings 35% and operate between 17.4% and 19.2% EBITDA margins.

Five years of extremely dynamic market conditions and only 180 basis points of margin variation and four years of record revenue and earnings. As we look forward to the next five years, Timken is a stronger company in 2022 than when we entered 2018. We are better positioned to win with a more diverse and attractive end market mix and a broader product portfolio.

And financially, we are a larger company generating more EBITDA and more cash flow, and we have ample opportunities to continue to deploy that capital into value-creating opportunities.

As Neil just mentioned, we recently announced that we'll be holding an Investor Day virtually and in New York in September, and we look forward to that event and sharing more with you on what the next five years could look like for Timken.

We have proven our ability to consistently create value through industrial cycles, through evolving technologies and a variety of macroeconomic conditions. We've put ourselves in a great position to accelerate that performance and we're excited about the opportunities in front of us and confident in our abilities to capitalize on them.

That concludes my remarks, and I'll now turn it over to Phil.

Okay. Thanks, Rich, and good morning, everyone. For the financial review, I'm going to start on Slide 11 of the presentation materials with a summary of our strong second quarter results. Revenue in the quarter was $1.2 billion, up 8.5% from last year and an all time quarterly record for the company. We delivered an adjusted EBITDA margin of 20% for the second quarter in a row, and we achieved all-time record adjusted earnings per share of $1.67, an outstanding quarter all the way around, especially considering the choppy environment we faced during the quarter.

Turning to Slide 12. Let's take a closer look at our second quarter sales performance. Organically, sales were up over 11% from last year, reflecting solid growth across both segments and most end market sectors as well as the impact of net positive pricing. Currency was a notable headwind on the top line in the quarter, all acquisitions, including the Spinea acquisition, which closed at the end of May, contributed modestly.

On the right-hand side of the slide, you can see organic growth by region, so excluding both currency and acquisitions. All regions were up in the quarter versus last year, with the Americas leading the way. Let me provide a little color on each region.

We were up 29% in Latin America, driven by strong growth broadly across most sectors, led by industrial distribution. In North America, our largest region, we were up 14%, with most sectors up, led by distribution, off-highway and automotive. In EMEA, we were up 8%, as we saw strong growth in distribution, off-highway and general industrial, offset partially by lower renewable energy and rail revenue. And finally, in Asia Pacific, we were up 5% and as sales were down in China due to the impact of COVID lockdowns, but up significantly across the rest of the region. From a market standpoint, the rail and industrial sectors were notably up while renewable energy was lower.

Turning to Slide 13. Adjusted EBITDA was $231 million or 20% of sales in the second quarter compared to $200 million or 18.8% of sales last year. Adjusted EBITDA was up $31 million and margins were up 120 basis points as we delivered an incremental margin of 34% on the higher sales in the quarter.

Looking at the change in adjusted EBITDA, we benefited from higher volume and favorable price mix which more than offset the unfavorable impact from material and logistics costs, net manufacturing performance and higher SG&A other expense.

Let me comment a little further on a few items. As I mentioned, price/mix was positive and a key driver to the strong results for the quarter. Pricing was meaningfully higher in both mobile and process industries, reflecting our pricing actions over the past 12 months. Mix was also positive, driven mainly by strong distribution sales.

Moving to Material & Logistics. As expected, we saw a significantly higher cost in the second quarter compared to last year. Driven by inflationary pressures and ongoing supply chain challenges. On the manufacturing line, we were negatively impacted by higher energy, labor and other costs as well as continued operating inefficiencies, which more than offset the benefit from higher production volume in the quarter.

And finally, on the SG&A other line, costs in the second quarter were up in dollars driven by higher compensation expense and other spending to support increased sales levels. But SG&A was down slightly as a percentage of sales as we continue to leverage our cost structure.

On Slide 14, you can see that we posted net income of $105 million or $1.42 per diluted share for the quarter on a GAAP basis. This includes $0.25 of net expense from special items driven mainly by pension remeasurement and Russia related charges.

On an adjusted basis, we earned $1.67 per share in the quarter, up 22% from last year and a new Timken record for any quarter. You'll note that we had 4% fewer shares outstanding in the second quarter compared to last year, reflecting our buyback activity over the past 12 months.

Interest expense was up slightly from last year due mainly to our recent bond issuance and a portion of which was used to fund the Spinea acquisition. And finally, our second quarter adjusted tax rate of 25.5% was in line with expectations.

Now let's move to our Business segment results, starting with Process Industries on Slide 15. For the second quarter, Process Industries sales were $610 million, up more than 7% from last year. Organically, sales were up about 10%, driven by growth across most sectors, with distribution and general industrial, posting the strongest gains. Heavy industries and industrial services were also up. Marine was down modestly due to supply chain constraints affecting the timing of revenue recognition. And renewable energy was also lower year-on-year, although sales were up sequentially from the first quarter. Pricing was positive, while currency translation was a headwind in the quarter.

Process Industries adjusted EBITDA in the second quarter was $165 million or 27% of sales compared to $142 million or 25% of sales last year. The increase in segment EBITDA margins was driven mainly by positive price mix, and the impact of higher volume, which more than offset higher operating costs in the quarter.

Now let's turn to Mobile Industries on Slide 16. In the second quarter, Mobile Industries sales were $544 million, up 10% from last year. Organically, sales increased 13% with off-highway posting the strongest gains. We were also up double digits in the rail, heavy truck and automotive sectors, while aerospace was down modestly due to lower defense revenue. Pricing was positive, while currency translation was a headwind in the quarter.

Mobile Industries adjusted EBITDA for the second quarter was $80 million or 14.6% of sales compared to $69 million or 13.9% of sales last year. The increase in segment margins was driven mainly by positive price/mix and the benefit of higher volume, which more than offset the impact of higher operating costs. While mobile continues to be more negatively impacted by cost headwinds and process, I would point out that price cost was positive in mobile this past quarter for the first time since 2020.

Turning to Slide 17. You can see we generated operating cash flow of $78 million in the quarter. And after CapEx, free cash flow was $37 million. The decline in free cash flow from last year was expected and reflects higher working capital to support the strong sales growth. We expect a significant step up in free cash flow over the course of the rest of the year.

Taking a closer look at our capital structure. We ended June with net debt to adjusted EBITDA at 2x, which is up slightly from the end of March and reflects the Spinea acquisition. Our leverage is well within our targeted range, and we remain in great position to continue to drive our strategic priorities going forward.

From a Capital Allocation standpoint, during the second quarter, we raised our quarterly dividend by 3% to $0.31 per share, paid our 400th consecutive quarterly dividend and repurchased 750,000 shares of company stock. Year-to-date, we've repurchased almost 2.3 million shares or about 3% of total shares outstanding. Our share buyback activity demonstrates our confidence in the long-term earnings power of the business and our commitment to consistent and accretive capital allocation.

Now let's turn to the outlook with a summary on Slide 18. We're raising our full year earnings estimate based on our strong first half performance and our outlook for the rest of the year. As you can see on the slide, we're now expecting adjusted earnings per share in the range of $5.50 to $5.80, which would be up 20% from last year at the midpoint and a new record for Timken.

The midpoint of the earnings outlook implies that full year adjusted EBITDA margins will be up just over 100 basis points from last year, which is an improvement from our prior guide. We expect strong year-on-year margin performance in the back half of the year, driven by positive price cost dynamics and continued strong execution. And our outlook implies full year incremental margins in the mid 30s.

Turning to revenue. We're now planning for revenue to be up around 7% in total at the midpoint versus last year compared to 8% in our prior guide. Organically, we now expect sales to be up 9%. Customer demand and sentiment remain robust across most sectors and our strong backlog supports our outlook.

We now expect currency to be a 2.5% headwind to the top line for the full year, which is based on June 30 spot rates and reflects the strengthening of the U.S. dollar versus key currencies since the beginning of the year. And finally, we added seven months of Spinea sales to the outlook, which now has acquisitions contributing around 50 basis points to our top line growth.

Moving to free cash flow. For the full year, we estimate conversion of around 65% of net income. This percentage is consistent with our prior outlook, but it would imply modestly higher free cash flow dollars for the year on the increased earnings. We continue to expect CapEx in the range of 4% to 4.5% of sales with the spend fueling our long-term growth and operational excellence initiatives.

Finally, for the full year, we anticipate net interest expense to be roughly $70 million, which reflects the expectation for higher short-term variable interest rates. And we estimate that our adjusted tax rate will be around 25.5%, unchanged from our prior guide.

So to summarize, the Timken team delivered truly outstanding results in the second quarter and first half of the year. We achieved 20% EBITDA margins and continue to win new business in this dynamic market environment. We raised our full year earnings outlook, and we remain in great position to continue to drive profitable growth and advance our strategic initiatives, over the rest of 2022 and beyond.

This concludes our formal remarks, and we'll now open the line for questions. Operator?

[Operator Instructions] We'll go first to Stephen Volkmann with [Jefferies].

Hi, good morning guys. So maybe I'll -- maybe I'll just lead off. Everything seems to be kind of moving in the right direction, but obviously, the market is kind of on pins and needles about the big R word. And the one thing, I guess, that sort of went the other way was your outlook for organic growth is down slightly, and I guess I'm splitting hairs a little bit, but just anything to see there. Is there any sort of demand destruction that's starting to pop up?

Well, I'd say one, it was a pretty small adjustment. Currency played a role in the total number. I would all say China was significantly lower in the second quarter than what we would have hoped, and we're not expecting to be able to make that up as you look at the rest of the year. So I think that's certainly a factor.

And then we're getting a little more cautious on Europe in the outlook. I would say our business in Europe, to your point, continues to be quite good. And we're not forecasting the R word to use your term, but we are a little more cautious as the year goes on in Europe. But I would say it's a pretty small adjustment in total.

Okay. Fair enough. And then maybe I can just take you back to your Slide nine since you sort of pointed it out there. And I guess I'm trying to just think through -- I'm guessing you don't want to say much about '23 yet, but if you have anything, I'll take it. But how should we think about the potential if we were to have some sort of a modest slowdown? I can see a scenario where decremental margins might be pretty minimal given what's going on with price cost normalization and so forth. But I don't want to put words in your mouth. Just how should we think about kind of what the risk of some sort of modest R word might look like? Let's not say it that loud?

So well, I think one of the reasons for putting that in and obviously teasing out the Investor Day here in a couple of months. But obviously, we're not hoping for the recession and hoping and really planning for '23 to be up. And as I said in my comments, I think certainly not ready to say directionally but the customer sentiment planning, et cetera, still would be up for and we do a lot of fully engaging of that.

And I think whether it's -- whether that happens or the other scenario happens, obviously, we've been pulling for the other one, but we'll do fine in the other scenario as well. And over a two or three year period, it will bounce back, and we'll be able to peak, trough to trough of an industrial cycle, grow the earnings and grow the revenue. I also think as you look at next year, obviously, we've been reasonably active year-to-date in share buyback and modest M&A. And I think that will be an offset contributor or an adder depending on which economic scenario that we're in.

And beyond that, probably not ready to -- certainly not ready to talk about decrementals after coming off an 11% organic growth number.

Okay. Fair enough. I'll wait for September, we'll see you there.

We'll go next to Bryan Blair with Oppenheimer.

Thank you. Good morning guys.

Solid quarter all around and obviously encouraging to see the transition to favorable price cost, especially in Mobile. It sounds like you will have some acceleration and contribution in the back half. Just wondering, given your price traction and current visibility on costs, how we should think of the order of magnitude, cadence in terms of Q3 and Q4 impact, certainly on a year-on-year basis, the optics should be quite favorable?

Yes. Certainly, the year-on-year is a much easier comp. We went price/cost negative in the fourth quarter of '20, but it was reasonably modest in first couple of quarters of it and then a little bit bigger in Q2 last year and then Q3 and Q4 are pretty significant.

So as you look back a year ago at this time, Q2 was pretty significant price cost -- thought we overestimated the amount of transitory part of that cost and projected at that time that cost would ease in the second half. Not only did they not ease, they went up a lot. So our price cost went pretty negative. I think as you just mentioned, we went positive this quarter in both segments and in total.

Also, as I said, we definitely see the costs leveling off. I think in general, the projections will probably be they're going to ease in the second half, but we're projecting they're going to largely hold and there's certainly some puts and takes within that. As I said, we've seen some easing. We've seen some other things go up.

And then we will have more price realization sequentially from Q2 to Q3 and Q3 to Q4. It will certainly be more modest than the Q4 to Q1 step up that we had in price realization, but we implemented pricing in the second quarter that really isn't in the second quarter results yet. It will start showing up in the third quarter, and we'll implement some more in the third quarter. So I would expect the price cost to look quite favorable with the price feel very good about and probably the bigger variable is do costs level off. Do they receive or -- is there another tick up in cost.

Okay. Understandable. Appreciate the detail there. I was hoping you could offer a little more color on early-stage Spinea integration. On the risk side, curious whether European macro is meaningful headwind or potential headwind for near term contribution? And then in terms of catalysts and the strategic upside of the deal, how quickly can your team drive geographic expansion? You understandably called out Asia as a major opportunity last quarter.

Well, it's -- the team is already all over it. All the diligence you can in the -- and obviously, you're familiar somewhat with the product and reputation in the marketplace. I would say, again, a couple of months in, very pleased with what we've seen now that we're getting a look under the hood.

The reality though is this is sold to OEMs designed in. So the sales synergies take time, but we're already working on who they sold to, who we sold to and making introductions and bringing the technology together as a platform.

So and then on the market itself, I think certainly, all the supply chain challenges we're seeing to the degree there's on-shoring, all these things fit very favorably into the warehouse automation, factory automation, markets and long-term trends there. And we're making investments in those. Our customers are making investments in those capabilities and in our own factories, I mean. So I think very confident in the long term outlook of that.

Coming back to your short-term question, I think the -- it's a business that's overweighted to Europe, certainly as a customer base. And definitely, there's some risk there depending on how Europe goes in the next 6 to 12 months. And then it's also -- it is -- it's -- again, it's an OEM capital good, so not just Europe but also credit markets tightening and the cost of capital going up but feel very good about the long term growth prospects and the business got off to a great start financially in the first couple of months.

Yes. The one thing I was going to add, Bryan, is to that point, I mean, we've only owned it a month. And typically, month one, you're always keeping your fingers cost because of disruption and things of that nature. But month one was very strong from a financial standpoint ahead of our expectations. And so the team there continues to operate very well and integrating into our results quite nicely.

[Operator Instructions] We'll go next to Chris Dankert with Loop Capital.

Hey, good morning guys. Thanks for taking the questions.

I guess, to pull a thread on Europe, just a little bit here. As you're talking with the team in Romania and elsewhere, how are we planning for winter and kind of what's in Timken's control in terms of insulating yourself from energy bottlenecks versus things just -- there's really no control here?

Well, we're working on as I think everybody is contingent to see planned risk profiles, et cetera. We do have probably some better capabilities than some and that we have some redundant capacities around the world that should our Romanian plant or Poland plant get limited on its gas, electric supply, et cetera, that we could do some things in other parts of the world.

I think if it is -- if it becomes a worst case type scenario, we're probably going to see it in a demand reduction because our customers in Europe would be facing some of the same issues. It's -- I don't think it's dampening demand today. And I don't think it's going to in the near term, but certainly a lot of uncertainty out there six months from now, nine months from now. And we're actively working those contingency plans, but I'm more concerned about what the risk to the demand profile than I am our ability to supply profile.

Got you. That makes sense. And then switching gears. On the Mobile side, I think stronger than I expected, just kind of given that off-highway strength. Any comment kind of specifically on automotive, I guess, F-150 production was less of a headwind than [indiscernible] just any comments on auto specifically and kind of what you're seeing in that market would be great?

Yes. I think we're still seeing some chip problems, both there and the truck market. I think we're seeing some of the supply chain issues smooth and the planning around chip problems get a little better. But I think it's still -- between that and China, the China COVID situation still constraining our customers' ability to produce as much as they want and therefore, buy as much as they want.

With our product mix, I think our customers are generally trying to wait -- push their chip capacity into the places where we are again, are in premium cars and light trucks. So we've got a -- I'd say we've got -- in our [7%] for the second half, it's a little easier comp next year because the chip problems were pretty significant. I'd say it's in line -- roughly in line with that kind of number is what we're looking at for the second half.

Yes. The only thing I would add there, Chris, is really what you're seeing in the automotive is really the choppiness on the customer side relative to the chip situation. So yes, we were up -- we were up double digits in Q2 year-on-year. But if you remember, we were off in the first quarter. So year-to-date, we're up more, kind of, call it, low to mid-single digits. And then but we still feel good about the our full year outlook of mid single digit growth in that market. So we'll do a little bit better than that in the second half on easier comps. But it's really a lot of that's just sort of the choppiness quarter-to-quarter.

Got you. Got you. Thank you both so much to put some color. And [indiscernible] some optimism in the back half here.

And at this time, there are no further questions.

Okay. Thanks, Jennifer, and thank you, everyone for joining us today. If you have any further questions after today's call, please contact me. Thank you, and this concludes our call.

This does conclude today's conference. We thank you for your participation.