2) The diversification benefits you cite are not worth the cost.
The Company’s November 29
press release argued that the current diversification benefits will be lost if the businesses are separated. The reality is the diversification benefits you cited in defending Timken’s current structure, in our opinion, cause Timken’s trading discount by confusing investors and obscuring the dramatic operating improvements in the underlying businesses. Investors do not need you to diversify for them. The significant discount investors are applying to Timken’s stock shows the market’s clear preference for pure-play steel or bearings alternatives.
3) Both companies will have substantial financial flexibility and the pension liability has been mitigated to the point that it is no longer an issue following a separation.
The same November 29
press release cites a decrease in the Company’s financial flexibility following a separation as a reason to maintain the current structure and on the January 24
earnings call management pointed to the Company’s pension as a reason the businesses needed to stay together. As you should know, the two issues are linked, and neither presents a real obstacle to separating the businesses. With net cash of over $100M and available liquidity of $1.4B
, Timken has significant financial resources and flexibility to ensure that both the Steel and Bearings Businesses are well-capitalized following the separation. Both businesses would have ample funding for their pension and capital expenditure needs while maintaining credit metrics superior to their peers’. The Company has invested over $1.3B into its pension plan over the last 4 years to bring the unfunded liability down to $398M at the end of 2012. CFO Glenn Eisenberg has stated that the pension plan will be nearly fully funded by the end of 2013 and that the Company will annuitize a significant portion of the gross liability, removing it from the balance sheet. The Company’s $1.4B of liquidity could easily be used to fund that pension liability. While the pension may have hindered the Company’s strategic options in the past, we do not find the Company’s assertion that it lacks the ability to sufficiently fund its pension to be credible. The reduced size of the underfunded pension liability also makes it unlikely to be a driver behind Timken’s trading discount.
4) Timken does not trade at a premium to peers on cash flow. It trades at a substantial discount on any cash flow measure that is relevant to investors.
On the January 24
call, management asserted that Timken trades at a premium to peers on cash flow metrics. Management relies on a non-standard calculation of cash flow that we believe is severely flawed. Investors will normally adjust GAAP cash flows for voluntary cash outflows related to pension obligations accrued over previous decades that will not be repeated in future years (since the pension will be fully funded at the end of this year). These voluntary, temporary contributions should not be included as a recurring cash flow. Additionally investors can see that a temporary spike in capital expenditures (before returning to Company guided 4% of sales in 2H14) and the corresponding build-up of working capital should not be seen as permanently impairing free cash generation and should be backed out of the multiple. Once cash flows are normalized, Timken trades at a substantial discount to peers on pension-adjusted EV/FCF, just as it does on pension-adjusted EV/EBITDA.
5) Growth and earnings volatility are a reason to separate the businesses, not keep them together.
On the January 24
call, management proposed Timken’s earnings volatility as a reason the businesses should remain combined. The high earnings volatility and capital intensity of the Steel Business have masked the continually improving margin performance of the Bearings Business over the last five years. The combination of these businesses is driving the discount in Timken’s share price. The only way to eliminate that discount is by separating the businesses.
Spin-off Transactions have Created Substantial Value for Shareholder’s in the Past
As noted above, in 2005 Timken’s closest bearings peer, SKF separated its steel business, Ovako, into a separate company. SKF concluded that the separation offered a structural solution, allowing shareholders to focus on the bearings business and SKF to move to a more variable cost structure.