Analyst Note | May 14, 2021
We increase our fair value estimate for narrow moat SKF to SEK 210 per share from SEK 175 per share, factoring in a sharper than previously expected recovery in SKF's markets, the beginning of which was demonstrated with first-quarter results. We also bring our midcycle operating income margin assumption to 14%. We assume a permanently lower cost structure going forward by 200 basis points from our previous assumption and in line with management's long-term goal. SKF is executing a multi-year cost reduction program, which includes increased usage of automation. As a result, the number of employees is down more than 6% since 2015. This has supported an increasing annual revenue per employee. By 2022, when we expect a full recovery to the company's prepandemic revenue levels, we forecast revenue/employee to be 20% above 2015 levels.
Our narrow moat rating for SKF is predicated on pricing power, due to the engineering behind its often customized ball bearings. Advanced ball bearing engineering can increase productivity and lower energy costs for customers. Pricing power along with cost flexibility, from the company's adoption of robotics and other automation, has enabled to SKF to weather its mostly procyclical end markets. However, we estimate around 10% of its revenue is favoured by structural tailwinds. First, its exposure to renewables through wind turbines and other "clean tech," end markets, which currently contribute around 9% of revenue. Second, it has an emerging connected service business, with contracts at less than 1% of revenue. However, the services offer a promising growth outlook and also welcome recurring revenue for SKF. Across capital goods companies, connected services have seen good customer take-up rights, due to the productivity gains from preventative maintenance, and we expect the same for SKF's connected service.
Business Strategy and Outlook | May 14, 2021
Pricing power along with cost flexibility thanks to the adoption of robotics and other automation has enabled to SKF to weather its mostly procyclical end markets. However, we estimate around 10% of its revenue is favoured by structural tailwinds. First, it has exposure to renewables through wind turbines and other "clean tech" end markets, which currently contribute around 9% of revenue. Second, it has an emerging connected services business, with contracts at less than 1% of revenue. However, the services offer a promising growth outlook and also welcome recurring revenue for SKF. Across capital goods companies, connected services have seen good customer takeup rights due to the productivity gains from preventative maintenance, and we expect the same for SKF's connected services.
SKF provides its customers with measurable operational cost savings versus competitor bearings, which it can accomplish by designing its ball bearings on an application-specific basis. As one of the two largest industrial bearings suppliers, along with Schaeffler, it draws on its more than 100 years of experience in industrial application design to lower energy costs and extend the length of time between maintenance breaks. Customers are willing to pay a premium for this engineering and often sign supply contracts, as work stoppages are very costly for customers running processes for hours at a time or even on a continuous basis.
Economic Moat | May 14, 2021
We believe SKF possesses a narrow moat based on its brand and reputation, intangible assets that are built on a long history of engineering expertise, patents, and a larger global spare parts distribution network than its competitors, maintaining its customer service reputation.
On a very simple level, bearings protect other components by being placed in between moving parts that would otherwise be damaged through direct contact, friction wearing down, and/or heating and melting surfaces. In industrial applications, they are used for rotating objects like automotive wheels, wind turbines, centrifuges, or compressors. Because bearings are so widely used across many industries, they are engineered with hundreds of variations to meet the optimal needs of the piece of equipment that they service. For this reason, we do not see them as a commoditised product. We believe SKF’s position in the industry, with over 100 years of experience, is one well known to major industrial customers for the quality of its products, as well as the efficiency and productivity savings that it can boast when it replaces competitor bearings. SKF has generated positive economic profits through our 10-year model history, including the Great Recession.
Temperature, force, speed, equipment size, and chemical exposure are just some of the factors that influence a customer’s choice of bearing. Most of SKF’s revenue comes from its industrial division, and 60% of those sales are completed by its direct salesforce, who use the companies modelling software and engineering expertise to help customers choose the right bearings, including type, size, and material. Bearings come in several different physical designs--radial, needle, or tapered, to name a few--and can be built with different materials, all of which affects their behavior once in play.
Industrial ball bearings have a varied life span depending on construction and use. A ball bearing in a wind turbine can last up to 20 years. Choosing the right bearing can influence the size, cost, and productivity of the equipment that it services--in that sense, it is a small part that plays an important role. For example, SKF’s ball bearings go into cement plants that have large rotating kilns running at extreme temperatures and churning out concrete. Here, they offer a solution that can reduce plant energy consumption by 8%. In wind turbines, ball bearings are a large component of the rotor hub (the head on which the blades turn). They can also lead to customer savings--SKF designed a reduced-size ball bearing that shrank the size of the rotor hub for one of its clients, reducing the turbine’s cost and maintenance.
Forty percent of SKF's industrial sales come from its third-party distributors, some of which are exclusive (though most, we suspect, are not). Through software, customers from this channel can still choose from hundreds of options for a made-to-order solution, but sales through this channel also include a mix of standardised products and bearings with less complex engineering.
The company has 17,000 distribution points. We believe its closest competitor, Schaeffler, has less than 10,000. The reason behind the gap is likely Schaeffler’s larger exposure to the auto industry, which represents just over three fourths of the company’s revenue and has a more concentrated customer base.
The automotive division, which contributes 30% of group revenue, specialises in ball bearings on wheel hubs. We see this as a sticky but low-margin business. While a trusted supplier and part of high-profile programs like Tesla, it is more price-competitive than SKF’s industrial business.
Fair Value and Profit Drivers | May 14, 2021
We increase our fair value estimate to SEK 210 per share from SEK 175, factoring in a sharper-than-expected recovery in SKF's markets, the beginning of which was demonstrated with first-quarter results. We also bring our midcycle operating income margin assumption to 14%. We assume a permanently lower cost structure by 200 basis points from our previous assumption and in line with management's long-term goal. SKF is executing a multiyear cost-reduction program, which includes increased usage of automation. As a result, the number of employees is down more than 6% since 2015. This has supported increasing annual revenue per employee. By 2022, when we expect a full recovery to the company's prepandemic revenue levels, we forecast revenue/employee to be 20% above 2015 levels.
The company operates under two divisions, industrial and automotive, with a roughly 70%/30% split between the two, industrial being the larger division. Our explicit forecast period runs to 2025; during this time, we expect both divisions to grow at roughly 3% after 2022, when we expect a full revenue recovery to pre-COVID 2019 levels.
Risk and Uncertainty | May 14, 2021
We give SKF a medium uncertainty rating. The company's revenue growth is highly correlated to the business cycle, which has previously caused periods of revenue decline and EBIT margin dips. While the company is trying to tilt its customer portfolio to segments with more structural drivers, cyclicality is likely to remain a force increasing volatility in the revenue line and operating EBIT margin. However, the company's product process is highly automated with heavy investments in robotics and other automation over the past few years, and improving cost management through the cycle.
While some of the company's ball bearings can last as long as 20 years, a portion of its portfolio has a short life span of less than five years, which can provide more frequent opportunities for customers to switch or exact pricing pressure, particularly in declining phases of the business cycle. Nonethelesss, ball bearings are essential but small components and SKF has seen only modest levels of pricing declines even in deep economic downturns like the global financial crisis.
In SKF's automotive segment, where the customer base is highly concentrated, short-term gains in restructuring efforts could be eroded by longer-term customer bargaining power. Once in an automotive model program, the company has a long-term recurring revenue stream, but usually with regular price discounts over the life of the contract.
SKF's key ESG risk stems from product governance, with any defects in its ball bearings having the potential to cause a customer work stoppage. However, we view this a low-probability event, given the company's internal quality-control processes. Employee safety across the company's manufacturing and assembly footprint is also a risk, but we believe a low probability one, given SKF's focus on automation as well as working safety measures, which have led to steadily decreasing accident rates.
Capital Allocation | May 14, 2021
We assign SKF a standard capital allocation rating. With a high degree of cyclical exposure, the company manages its balance sheet on a appropriately conservative basis. SKF's acquisition strategy has been modest and targeted to growth markets, including clean tech, which could enhance growth prospects. Shareholder returns are moderate, allowing the company to maintain a strong balance sheet and liquidity position through the cycle while providing room for acquisitions.
