SKF's Rally Into 2023 Seems Overdone

Industrials have certainly recovered of late. With investors feeling more confident that the impending downturn will be mild and that rate hikes are close to an end, the industrials have climbed about 20% over the last three months, and Sweden’s SKF (OTCPK:SKFRY) has gone along for the ride, though the shares are still down about 20% over the last year.

I think this rally may prove to be too much too soon. With global PMIs falling and the company likely to see weaker end-market demand coupled with price/cost pressures, 2023 isn’t going to be an easy year and if the market is wrong about a mild slowdown, there could still be meaningful downside to estimates. I don’t think SKF is particularly expensive now (and my near-term expectations are below sell-side averages), but I see a relatively unfavorable risk/reward balance going into the fourth quarter reporting season.

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SKF's Rally Into 2023 Seems Overdone

SKF Leveraging The Short-Cycle Recovery, But Short Cycle No Longer In Favor

 

In the year or so since my last write-up on Sweden’s SKF (OTCPK:SKFRY), the shares of this leading manufacturing of bearings, seals, and related products have had a mixed performance. While the shares have outperformed the S&P 500, the performance versus other industrials has been more mixed, with SKF outperforming the larger industrial group until late April, a time since when many shorter-cycle names have made less headway as investors have rotated to longer-cycle names.

Relative to my last update, I like the stronger guidance for long-term margins and I like the recovery we’ve seen in most industrial and auto end markets. I still don’t like the adjusted earnings shenanigans whereby SKF tries to pass off recurring manufacturing restructuring costs as “one-time” costs to ignore, but that’s an “is what it is” situation. I do still see some value in these shares, but I think beat-and-raise quarters are going to be harder to achieve and I think more bearish sentiment towards short-cycle names is likewise a headwind to consider.

 

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SKF Leveraging The Short-Cycle Recovery, But Short Cycle No Longer In Favor

SKF Beats, But The Downturn Could Still Turn Ugly

Credit where due, SKF (OTCPK:SKFRY) posted an impressive earnings beat for the first quarter, with stronger margin trends than investors have seen at other industrials like Atlas Copco (OTCPK:ATLKY). The question is how sustainable that will be; SKF is very sensitive to demand in auto and short-cycle industrials, and the second quarter is going to be brutal. On top of that, the company went into this downturn with high inventories and not many positive offsets.

I wasn’t wild about SKF when I last wrote about the stock, and the shares largely traced their peer group lower until this first quarter beat. The valuation actually isn’t bad here, but I think you need a relatively bullish outlook on the post-Covid-19 recession recovery scenario to support a bullish position here.

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SKF Beats, But The Downturn Could Still Turn Ugly

SKF Sees Industrial Revenue Contract On Broad Weakness

There are a lot of reports left for the second quarter reporting cycle, but so far it’s looking like my call for weakening industrial markets (particularly short-cycle markets) is playing out, as several high-quality industrial players are seeing weakness, including SKF (OTCPK:SKFRY). Although management tried to strike a positive tone, industrial organic sales slipped into contraction, the weakness is broad-based across its markets, and the company hasn’t been working down its inventory.

Even with the prospects of a U.S. rate cut increasing, I’m concerned about how industrial stocks like Atlas Copco (OTCPK:ATLKY), Illinois Tool Works (ITW), Parker-Hannifin (PH), Sandvik (OTCPK:SDVKY), and SKF will perform over the next 12 months given how past cycles have played out. A more meaningful decline in inventories would be a welcome sight (in the past, inventory corrections have usually predicted rebounds), but that could still be some distance away. As is, while SKF’s valuation is not demanding on a margin/returns basis, the high single-digit annualized return implied by discounted cash flow isn’t enough to coax me into taking the risk that things get worse before they get better.

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SKF Sees Industrial Revenue Contract On Broad Weakness

MinebeaMitsumi Looks Seriously Undervalued, But There Are Significant Upcoming Challenges

Japan’s MinebeaMitsumi (“Minebea”; also sometimes written as “Minebea Mitsumi”) (OTCPK:MNBEY) (6479.T) is certainly not a household name to most investors, but this odd mix of precision machined and electrical components is a strong leader in several attractive markets, and has uncommonly robust opportunities to drive improved operating and product synergies in the coming years. At the same time, though, the company is facing some significant product cycle risk and there are no guarantees that the synergy efforts will pan out.

Minebea looks undervalued on the basis of long-term revenue growth of just 3%, but revenue could be choppy over the next several years and the margin/FCF generation improvement I expect may prove to be beyond management’s capabilities. I’d also note that these ADRs are not very liquid at all, so investors should factor that into their evaluation process (the Tokyo-listed shares are quite liquid, for investors who wish to pursue that option).

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MinebeaMitsumi Looks Seriously Undervalued, But There Are Significant Upcoming Challenges

Rexnord Starting Its Cyclical Upswing

Improving end-markets across numerous industrial, consumer, and construction markets have largely mopped up most of the quality undervalued industrials stocks, and Rexnord (RXN) is no exception. The shares are up about 20% since my last update on the company, beating peers in its Process & Motion Control business like Regal Beloit (RBC) and Renold (OTC:RNOPF) and more or less matching its prime rival in Water (Watts (WTS)). Although the shares no longer appear fundamentally undervalued, the relative valuation is a little more appealing, and Rexnord's markets continue to improve, which could offer a little more appeal for less value-sensitive investors.

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Rexnord Starting Its Cyclical Upswing

Rexnord Should Be Seeing A Turn Now

I liked Rexnord (NYSE:RXN) back in mid-December, and I can't really complain with how the shares have performed since. Not only is the return about 10 points above that of the S&P 500, but Rexnord has done alright next to most of its process/motion control peers like ABB (NYSE:ABB), Altra (NASDAQ:AIMC), Regal Beloit (NYSE:RBC), and SKF (OTCPK:SKFRY), as well as peers in the water products sector. Better still, short-cycle industrial activity is picking up (including in the industrial MRO space) and process industries like mining seem to be past the worst, while core food/beverage continues to perform well. Add in a slowly improving institutional water market and some longer-term strategic growth opportunities and it's a relatively solid backdrop.

Valuation is no longer so compelling, but "meh" seems to be the new "bargain-priced" in the industry sector and shaving just half a point off of my 10% discount rate would give me a fair value slightly above today's price. Provided that Rexnord can show some healthy signs in its core revenue and margins later this week when it reports fiscal fourth quarter earnings, not to mention constructive guidance in line with what other industrial-leveraged companies have said, this could still be a name with some room left to advance.

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Rexnord Should Be Seeing A Turn Now

Timken Looking Forward To Leveraging A Big Transformation

Companies change over time, but Timken (NYSE:TKR) has actively sought to remake itself to a pretty significant degree over the past decade. In addition to spinning off Timken Steel (NYSE:TMST), this leader in bearings and power transmission components has jettisoned around $1 billion in lower-margin business over the past seven or eight years, while recommitting to long-term growth through collaborative product development.

Such has been the rally in the industrial space that I pause when I see a stock where the valuation looks interesting. While the stock already trades at a pretty healthy forward EBITDA multiple, mid-single-digit FCF growth should be able to support a total annual return of over 10% from this level. While I would be careful about buying any industrial stock at this point (for fear of a big correction when the earnings and guidance start rolling in in January), this is a name that definitely merits some consideration.

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Timken Looking Forward To Leveraging A Big Transformation

Seeking Alpha: SKF's Erosion Is Cause For Concern

Bearings are virtually ubiquitous in manufacturing and transportation, so I don't believe it is a stretch to say that Sweden's SKF (OTCPK:SKFRY) can be an invaluable barometer of early-cycle trends. That makes the company's ongoing erosion in organic growth worrisome, even allowing for the possibility of company-specific issues playing an increasing role.

SKF's new CEO seems to be taking the company in a disappointingly less-open direction, and the market really hasn't gotten much specificity regarding price/mix, the restructuring plans for the automotive segment, nor the ongoing cost reduction initiatives. That might not bother me as much if the shares were a bargain, but I don't see a lot of reason to lean toward giving a benefit of the doubt right now.

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SKF's Erosion Is Cause For Concern

Seeking Alpha: Atlas Copco's Frustrating Quality-Value Conundrum

I will grudgingly accept that it sometimes makes sense for investors to pay up for quality, but it is still a hard pill to swallow at times. In the case of Atlas Copco (OTCPK:ATLKY), I can't feel too bad about calling them a little pricey back in February, as the shares fell more than 10% from that point until a strong rebound after second quarter erased a chunk of that underperformance.

Atlas Copco remains a very good company, with leading positions in compressors (used throughout manufacturing and many other end markets), underground mining equipment, and certain segments of the industrial tool and construction equipment markets. What's more, margins are solid and the company has made a point of emphasizing its parts and aftermarket service businesses. The hang-up for me remains price, as Atlas Copco's quality has thus far kept the shares from selling off all that much.

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Atlas Copco's Frustrating Quality-Value Conundrum

Seeking Alpha: Two Valuable Lessons From Kaydon's Sale To SKF

I wrote on bearings and velocity control products company Kaydon (KDN) in early March of this year, and I didn't see a lot of value at the time. As the year went on, that call looked worse and worse, as the stock climbed about 18% - well above the S&P 500, and well above industry peers/competitors like Timken (TKR) and SKF (SKFRY.PK). To top it all off, Kaydon announced this morning (September 5) that it had received and accepted a buyout offer from SKF valuing the company at $35.50 - some 45% higher than the price when I thought it looked only about 10% undervalued. So what did I get wrong here, and what can investors do to avoid a similar mistake?

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Two Valuable Lessons From Kaydon's Sale To SKF

Seeking Alpha: Federal Mogul Could Still Have More Under The Hood

If you bought Federal-Mogul (FDML) shares in March or April of this year, then you certainly deserve to bask in the success of taking a major gamble that paid off handsomely. Shares of this heavily indebted auto parts company have nearly tripled from the April lows as a recovery in the auto parts business, the ongoing support of Carl Icahn, and a successful rights offering have all provided a little extra breathing room.

As crazy as its sounds, there could still be room for this stock to run. Both sides of the business are growing ahead of vehicle production rates, and a shift towards more emerging market sales and a focus on efficiency-improving/emissions-reducing products fits with what vehicle makers want these days. In addition, the company is already in the midst of transitioning production to lower cost regions, while further debt reduction should reduce both the company's interest burden and its cost of capital. Even with the huge move in the stock, a continuation into the high teens or even low $20s is not out of the realm of possibility, suggesting 20% to 40% potential even from here.

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Federal Mogul Could Still Have More Under The Hood

Seeking Alpha: Kaydon's Strong Niche Focus Doesn't Produce Quite Enough Value

I love somewhat obscure and under-followed industrial companies, particularly when they are leaders in their markets and have quality investors like Royce & Associates on board. That said, I find it hard to find a lot of value in Kaydon (KDN) shares today. Although the company has considerable market share and pretty solid margins, the bottom-line return on capital and free cash flow generation just aren't quite where they need to be relative to valuation to make this a must-own right now.

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Kaydon's Strong Niche Focus Doesn't Produce Quite Enough Value

Seeking Alpha: One Bad Quarter Doesn't Knock Out ABB

Wall Street institutional investors are paid overreactors, but individual investors have the luxury of taking a more patient outlook in response to a disappointing quarter - that's the benefit of not being judged (and/or fired) after every quarter. That's especially relevant as a host of industrial companies post difficult first quarter earnings.

In the case of ABB (ABB), a few things are clear. First, China has really slowed down, and parts of Europe are feeling the pinch as well. Second, North America is especially strong. Third, the basic equation of helping companies operate more efficiently with respect to energy and labor is still plenty popular out there.

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One Bad Quarter Doesn't Knock Out ABB

How To Double (Or Triple) Your Bets On Financials

Leverage can do remarkable things. With enough leverage, a 20% return can be transmuted into 100%. Of course, in the math world whatever is given can also be taken away. Plenty of investors (professional and amateur) have blown themselves up with leverage and that boost to returns in good times can turn around and bite ferociously when the play is wrong. Just ask the likes of Lehman Brothers what can happen when someone is highly leveraged and hits a rocky patch in the road.

Investors have always had some tools at hand to add leverage to their investment decisions. From buying on margin, to investing in options, to playing the commodity markets, these are all ways of making $1 of investment capital go a little further in exchange for higher risks. Relatively recently, though, financial services firms have come out with new products for investors - highly-leveraged ETFs that look to multiply the returns of underlying markets. 

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