Fitch Affirms The Timken Company at 'BBB'; Outlook Stable
KEY RATING DRIVERS
The affirmation takes into account Timken's currently weak operating results and higher but still moderate financial leverage. Timken's business weakened in 2015 and the first half of 2016 (1H16) due to soft end markets and the impact of the strong dollar. Timken's sales declined 6.4% in (1H16) reflecting its exposure to a broad array of depressed end markets such as general industrial, rail, energy, heavy-duty truck, agriculture and metals and mining, with the company's primary sources of growth being the automotive sector and its recent acquisitions.
In the face of these pressures, management has been successful in reducing the company's expense structure, thereby softening the impact of lower volumes on margins. The company's efforts include developing a more cost-effective manufacturing footprint and reducing SG&A, and these efforts are expected to be ongoing. The EBIT margin (before special items) declined by around 80 basis points (bps) to 10.4% in 1H16, with margin weakness concentrated in the Process Industries segment. EBITDA declined to $427 million in the 12 months ended June 2016 from $514 million in 2014, and Fitch expects it could drop further to around $400 million for full-year 2016.
Timken continues to pursue moderately-sized bolt-on acquisitions to expand its product portfolio and geographic presence. The company most recently acquired Lovejoy, Inc. in July 2016 for $66 million. Lovejoy, with sales of $56 million, makes industrial couplings and universal joints, and will extend the company's power transmission offerings.
Timken's leverage has increased over the past three years as EBITDA has contracted due to the steel spin-off and operating weakness in the company's remaining business, while debt levels trended higher in 2014-2015. Debt/EBITDA and adjusted debt/EBITDAR increased from 0.5X and 0.8x, respectively, at the end of 2012 to 1.5x and 2.0x, at June 30, 2016. Going forward, Fitch expects Timken will maintain adjusted debt/EBITDAR of 2.0x-2.5x, adjusting its share repurchases in the context of its acquisitions to maintain leverage within this range. If weakness in Timken's end markets persists, Fitch expects the company would adjust its spending on acquisitions and share repurchases in order to maintain its credit profile.
Timken's liquidity received a boost in 2016 with the receipt of $54 million of proceeds from the U. S. government arising from the U. S. Continued Dumping and Subsidy Offset Act (CDSOA). Fitch expects Timken will generate free cash flow (FCF) of around $150 million in 2016 including the $54 million CDSOA receipt, offset in part by restructuring costs, and that FCF will track at around $100 million annually thereafter.
Timken significantly reduced its pension obligation in 2015 by purchasing group annuity contracts from Prudential Insurance Company of America, requiring Prudential to pay and administer future pension benefits for two of its pension plans covering 8,400 retirees. The purchases were covered by existing pension assets and required no cash outlays by Timken. In total, the company transferred $1.1 billion of its pension obligations to Prudential, reducing its projected benefit obligation by around 50%. Timken's remaining pension plans are well-funded, with its domestic plans 94% funded and its international plans 90% funded as of the end of 2015. Pension contributions are estimated at $15 million in 2016 and should be modest going forward.
Rating strengths include Timken's well-established position in tapered roller bearings, its technological capabilities, broad customer base and well-funded pension plans. Significant aftermarket revenue generates attractive margins and reduces the impact of cyclical end markets. Rating concerns include weak operating results due to depressed demand in certain of Timken's industrial end markets, meaningful currency risk, and the risks associated with the company's acquisition strategy.
Fitch's key assumptions within the rating case include the following:
--Sales decline by 6% in 2016 (including the impact of the Carlstar and Lovejoy acquisitions), are flat in 2017 as end markets begin to stabilize, and increase by 4% thereafter.
--EBIT margins narrow from 11.1% in 2015 to 10% in 2016, and recover gradually thereafter.
--FCF of around $150 million in 2016, including the $54 million CDSOA (anti-dumping) receipt, and around $100 million annually thereafter.
--Adjusted debt/EBITDAR remains in the 2.1-2.2x range
Future developments that may, individually or collectively, lead to a negative rating action include:
--A decline in operating margins, or weak FCF including FCF/total adjusted debt below 5%;
--Aggressive cash deployment leading to higher-than-anticipated leverage, including total debt/EBITDA above 2.0x and total adjusted debt/EBITDAR above 2.5x;
--Significant loss of market share.
Fitch views an upgrade as unlikely over the medium-term. However, future developments that may, individually or collectively, lead to a positive rating action include:
--Increased product and geographic diversification through product development or acquisitions that reduce the company's reliance on industrial bearings;
--Strong FCF, including FCF/total adjusted debt consistently above 10%, that would reduce reliance on debt to fund acquisitions;
--Total debt/EBITDA and adjusted debt/EBITDAR are consistently below 1.5x and 2.0x, respectively.
As of June 30, 2016, total liquidity was $500 million, consisting of $25 million in readily available cash, $462 million available on a $500 million revolving credit facility that expires in June 2020, and $13 million available on a $100 million accounts receivable securitization facility that expires in November 2018. Approximately $131 million, or 84% of TKR's cash, was held outside of the United States.
FULL LIST OF RATING ACTIONS
Fitch affirms its ratings on The Timken Company as follows:
--IDR at 'BBB';
--Senior unsecured bank credit facility at 'BBB';
--Senior unsecured notes at 'BBB'.
The Rating Outlook is Stable.