Earnings Call Transcript - TKR Q2 2022

Operator, Operator

Good morning. My name is Jennifer, and I will be your conference operator today. This call is being recorded. I’d like to welcome everyone to The Timken Second Quarter Earnings Release Conference Call. Mr. Frohnapple, you may begin your conference.

Neil Frohnapple, Director of Investor Relations

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.

Richard Kyle, CEO

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 the prior year and up slightly from the first quarter. These include external costs and internal inefficiencies. We saw some costs like steel pull back 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 become more positive from both easier comps and more price realization. We responded to various 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 in 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 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 remains 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% 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 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-year 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.

Philip Fracassa, CFO

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, but 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. 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. The 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. 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. 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. 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 than 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 a 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. Our outlook implies full year incremental margins in the mid-30s. Turning to revenue, we're 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. 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

We'll go first to Stephen Volkmann with Jefferies.

Stephen Volkmann, Analyst

Hi, good morning everyone. I'll start off by saying that everything appears to be progressing positively, but of course, the market is apprehensive about the potential recession. However, I noticed that your outlook for organic growth has dipped slightly. I might be nitpicking here, but I wanted to ask if there are any signs of reduced demand starting to emerge.

Richard Kyle, CEO

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.

Stephen Volkmann, Analyst

Okay. Fair enough. I’d like to refer back to Slide nine, which you mentioned. I'm assuming you might not want to share much about 2023 yet, but if there’s anything you can share, I would appreciate it. How should we consider the potential impact if there were to be a modest slowdown? I can envision a situation where decremental margins could be quite limited due to price cost normalization and other factors. However, I don't want to put words in your mouth. How should we view the risks associated with a possible modest downturn? Let's keep that on the down low.

Richard Kyle, CEO

I believe one reason for addressing this now is to hint at our upcoming Investor Day in a few months. We are not anticipating a recession and are actively planning for growth in 2023. While I'm hesitant to provide specific projections, customer sentiment and planning indicate a positive outlook. Regardless of whether we face a downturn or not, we are prepared for either outcome, and we expect to bounce back over the next two to three years, allowing us to grow our earnings and revenue through the industrial cycle. Looking ahead to next year, we've been fairly proactive with share buybacks and some modest mergers and acquisitions, which should help depending on the economic conditions. That said, I am not ready to discuss potential declines, especially after achieving an 11% organic growth rate.

Stephen Volkmann, Analyst

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

Operator, Operator

We'll go next to Bryan Blair with Oppenheimer.

Bryan Blair, Analyst

Thank you. Good morning guys.

Richard Kyle, CEO

Good morning.

Philip Fracassa, CFO

Good morning.

Bryan Blair, Analyst

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?

Richard Kyle, CEO

Yes, the year-on-year comparison is much easier. We experienced a negative price/cost situation in the fourth quarter of 2020, but it was fairly modest initially and increased a bit in Q2 of last year, with Q3 and Q4 seeing significant impacts. Looking back to a year ago, Q2 had a notable price cost issue. We had projected that the transitory costs would ease in the second half, but instead, they increased significantly, which resulted in a negative price cost for us. However, we achieved positive results this quarter in both segments overall. We see costs beginning to level off, and while we expect them to ease in the second half, we anticipate they will largely remain stable, with some fluctuations. We have noticed some easing alongside some increases. We will experience more sequential price realization from Q2 to Q3 and from Q3 to Q4. This will be more modest than the significant jump we saw from Q4 to Q1, but we initiated price adjustments in Q2 that haven't fully reflected in the results yet, and those will start to appear in Q3, along with additional adjustments. I expect the price cost dynamics to be quite favorable, and the bigger question remains whether costs will level off, decrease, or rise again.

Bryan Blair, Analyst

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 a 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.

Richard Kyle, CEO

The team is actively addressing the situation. As you're somewhat familiar with the product and its reputation in the market, I can say that a couple of months in, we are very pleased with our observations now that we are getting a deeper understanding. However, since this product is sold to OEMs and designed into their systems, it takes time to realize the sales synergies. We are already connecting with who they sell to and who we sell to, facilitating introductions and integrating the technology into a cohesive platform. Regarding the market, the supply chain challenges and any on-shoring efforts are positively impacting warehouse and factory automation, which aligns with long-term trends. We are investing in these areas, as are our customers. We feel very confident about the long-term outlook. In terms of the short-term, the business is predominantly focused on Europe as a customer base, which brings some risk depending on the economic situation in Europe over the next six to twelve months. Additionally, as an OEM capital good, it's affected by tightening credit markets and rising capital costs. Still, we are optimistic about the long-term growth potential, and the business had a strong financial start in the initial months.

Philip Fracassa, CFO

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 crossed 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.

Bryan Blair, Analyst

Helpful color. Thanks guys.

Operator, Operator

We'll go next to Chris Dankert with Loop Capital.

Chris Dankert, Analyst

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

Richard Kyle, CEO

Good morning Chris.

Chris Dankert, Analyst

I would like to follow up on Europe. As you engage with the team in Romania and other locations, how are we preparing for winter, and what measures can Timken take to protect itself from energy supply issues versus factors beyond our control?

Richard Kyle, CEO

We're focused on understanding the planned risk profiles. We have better capabilities than some companies because we have redundant capacities globally. If our Romanian or Polish plants face limitations with gas or electric supply, we can manage operations in other regions. In a worst-case scenario, we might see reduced demand, as our European customers will likely encounter similar challenges. While current demand isn't being affected, and I don't expect it to change in the short term, there is significant uncertainty looking ahead six to nine months. We are actively preparing our contingency plans, but I'm more concerned about the potential risks to demand than to our supply capabilities.

Chris Dankert, Analyst

Got it. That makes sense. Now, shifting focus to the Mobile sector, it appears to be performing better than I anticipated, especially considering the strength off-highway. Can you provide any specific insights on the automotive market? I assume that F-150 production has been less of an obstacle than expected. Any comments on the automotive sector and what trends you're observing would be appreciated.

Richard Kyle, CEO

Yes, we are still encountering some chip issues in both the truck market and other areas. While we have noticed some improvement in supply chain challenges and better planning for chip shortages, factors like the ongoing COVID situation in China continue to limit our customers' production capacity and their purchasing power. Our customers are primarily focused on channeling their chip capacity towards higher-end vehicles like premium cars and light trucks. As we look to the second half of the year, our forecast indicates a slightly easier comparison for next year due to the previously significant chip issues. We expect our performance for the second half to align with those considerations.

Philip Fracassa, CFO

Yes. I would just like to add that the fluctuations we're seeing in the automotive sector are primarily due to customer reactions to the chip supply situation. We experienced a year-over-year increase in the second quarter, but we did see a decline in the first quarter. For the year so far, we are up in the low to mid-single digits. Nevertheless, we remain optimistic about achieving mid-single-digit growth for the full year in that market. We expect to perform better in the second half due to easier comparisons. However, much of this variation is simply the result of quarter-to-quarter fluctuations.

Chris Dankert, Analyst

Thank you both for providing some insights and optimism for the second half.

Richard Kyle, CEO

Thanks Chris.

Philip Fracassa, CFO

Thanks Chris.

Operator, Operator

And at this time, there are no further questions.

Neil Frohnapple, Director of Investor Relations

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.

Operator, Operator

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