TimkenSteel: Probable Upside, But I'm Waiting On The Sidelines (NYSE:TMST) | Seeking Alpha

2022-04-01 03:27:11 By : Mr. Jianzhang Wang

fotolinchen/E+ via Getty Images

fotolinchen/E+ via Getty Images

This week when I was in a discussion on steel stocks, someone asked me what I think of the TimkenSteel Corporation (NYSE:TMST ). I didn't know as I haven't covered the stock since 2019! That needs to change, which is why I dedicate this article to one of America's smallest listed steel stocks. In this case, size is the only thing that's small as its performance is higher than that of its peers in the VanEck Steel ETF ( SLX), which used to be different prior to the pandemic. The company, which focuses on recycled steel is benefiting from high demand, strong prices, and significant improvements in profitability and balance sheet strength. In addition to that, the company is benefiting from the ongoing war in Ukraine as it lowers global output and shipments from that region. The biggest risk is slower economic growth, which the company was able to avoid thanks to the aforementioned reasons. In this article, I will give you the details!

The TimkenSteel Corporation entered the stock market in July of 2014 as it is a spin-off from the much larger Timken Company (TKR), which, like TimkenSteel, is based in Canton, Ohio. With a market cap of roughly $900 million, TimkenSteel is one of America's smallest stock-listed steel companies. United States Steel (X), for example, is more than 8x larger.

Founded in 1917, the company produces 100% of steel primarily from recycled scrap metal in electric arc furnaces ("EAF"). The company has an annual melt capacity of 1.2 million tons with 900 thousand tons of shipping capacity. The company's core product is bar steel and it is the largest producer of seamless mechanical tube products. It mainly sells to automotive, industrial, and energy customers.

Since its IPO, the company has become leaner. In 2020 and 2021, it reduced headcount by 38%, expanded its SW Ohio facility, reduced permanent costs by $100 million, repaid all of its outstanding borrowings on its credit facility, and generated $341 million in free cash flow, which I will discuss in this article in greater detail.

In its investor presentation released last month, the company mentions a positive outlook based on:

Steel production ended the 2021 year with close to 10% growth (see the graph below). I expect that steel production remains strong for the time being. At least for companies like TMST with significant auto exposure. Auto inventories are empty as the graph below shows. High demand and the ongoing semiconductor shortage have made it impossible for car companies to service demand. I expect that these issues will linger in the second half of this year, which will provide TMST will a steady stream of orders for its steel.

In this case, the company sees opportunities in higher infrastructure spending, automation, restoring, and supply chain re-risking. This would be a win for the company and for the entire Midwest. The company also expects that higher oil production in the US will boost its energy sales, which could happen sooner than later as there is no way around higher domestic production given the surge in prices, which I discussed in this article.

In its investor presentation, the company highlights two charts. One of them is the rig count in the US, which has been lagging behind the oil price as drillers were reluctant to increase production - they rather focus on free cash flow. The chart on the left side shows the purchasing managers index, which measures economic expectations. A reading above 50 indicates economic expansion.

The company used strong demand to boost its financials. For example, 2021 saw a record-breaking free cash flow ("FCF") result of $185 million. That's possible as the company had an average base selling price of $1,069 per ton. The company shipped 818.6 thousand tons, which is up from 640.4 thousand in 2020 but below pre-pandemic levels - because of lower car production related to supply chain issues.

Total revenue came in at $1.28 billion, which is down from $1.2 billion in 2019. Yet, the fact that free cash flow was so strong shows that cost-saving and efficiency measures are working.

The aforementioned FCF result of $185 million is a record in its short history as a stand-alone company. What's impressive as well given that sales were down is that FCF was 14.4% of total sales last year. During the post-2016 upswing, it didn't make it to 8.0%. So, congratulations to the company for being able to get this done.

This year, free cash flow is expected to end at $155 million based on $35 million in capital expenditures. Roughly half of this will be dedicated to "profitability improvement projects", which means close to $20 million in maintenance CapEx. In 2020, CapEx was $17 million. Going forward, I expect annual CapEx to remain close to $35-$40 million.

Based on that, the company has not only improved its margins, but also its balance sheet. In 2019, the company had close to $140 million in net debt (gross debt minus cash). This is expected to become $270 million in net cash in 2020 because the company does not pay a dividend, which means more cash is available for debt reduction. The company did authorize a share buyback program worth $50 million, which is a big deal given its small market cap (5.6% of shares outstanding).

The company also lowered gross debt. In 1Q22, Timken repurchased $5 million in convertible notes and it may repurchase additional convertible notes in the future depending on the repurchase price and holder interest. The company also has close to $240 million in pension and related liabilities. However, Timken has no required pension contributions until after 2031 based on its current assumptions.

This brings us to valuation.

This year, the company is expected to boost net cash to $270 million. To incorporate all of the company's pension liabilities ($240 million), I'm going to reduce this to $30 million. When adding the $900 million market cap, we get an enterprise value of $930 million. That's roughly 3.8x this year's EBITDA expectation of $248 million. Next year, EBITDA is expected to come in at $170 as prices are likely to normalize again. That still implies a 5.5x multiple.

I'm not going to show the company's historical EV/EBITDA multiple because the history is short (2014 spin-off) and because a lot of years saw negative EBITDA, making the graph useless.

Nonetheless, I believe that a 5.5x implied multiple is fair using the 2023 expected EBITDA result. This year, the valuation is too low, which is because steel prices are expected to come down. Hot-rolled coil prices have come down from $2,000 to currently $1,100. However, this is still well-above prior highs and a great basis to boost sales. I expect prices to remain high. One reason is the ongoing war in Ukraine. 15% of the country's exports come from steel products. Steel cannot leave the country right now. Moreover, as long as demand from construction and automotive remains high, I don't see a scenario where supply can easily catch up.

Right now, the stock is up 17% year-to-date and I believe it has room to run to $25-$30 depending on demand.

And, as the title suggests, the company has outperformed the steel ETF since the economic bottom in 2020. Prior to that, the return for TMST investors is lower than the SLX performance. TMST has changed in the past few years. Its measures to become more efficient have paid off and I don't think the stock will underperform SLX going forward - not even when economic growth starts to slow more significantly.

TimkenSteel did a tremendous job turning its company around in the past two years. Profitability has gone up, its net debt load has "evaporated", and free cash flow has skyrocketed. The company is now buying back shares and further reducing gross debt while focusing on high-tech steel for automotive and related customers.

For now, the company continues to benefits from high steel prices and solid demand as automotive producers need to ramp up production. The same goes for investments in infrastructure and related. Prices will likely benefit from the ongoing conflict in Ukraine and from the fact that demand is still much higher than supply in certain areas.

The valuation is attractive and I expect the stock to rise to $25. However, I'm not getting too excited as a decline in steel prices will quickly pressure EBITDA. That could happen in 2023. So, while I do see upside, I'm not that eager to jump into the stock at current prices. The risk/reward to invest in a steel stock needs to be better, which is why I will stick to a neutral rating. That may seem to contradict each other, but I want to avoid people jumping into steel at this stage of the cycle. There's definitely upside and people can exploit that, yet for me to be bullish, I want to see a better risk/reward first - especially when it comes to involving retail investors.

So, if you like the odds of it rising to $25, I think TMST is a good pick as it is likely to continue to outperform its peers. The post-pandemic TMST is different from the pre-pandemic company and it's exciting to watch!

(Dis)agree? Let me know in the comments!

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.