I thought SKF (OTCPK:SKFRY) had some appeal as a contrarian idea back in April, and the outcome of that call is a little convoluted. The local shares had been beating the multi-industrial peer group, but a disappointing second quarter result hit the shares and the point-to-point performance has been a modest underperformance. If you look at the ADRs, though, even with the post-earnings disappointment, the shares have risen almost 25%, beating the peer group and S&P 500 by a wide margin as the Swedish krona has moved significantly in the interim.
While SKF has participated to a point in the short-cycle rebound anticipation rally, the company’s actual performance and guidance are worse than many peers and enough to cause some concern. On top of that, there are some earnings quality issues that I think need at least be discussed. On the other hand, management has been moving aggressively to cut costs and automate the business, the valuation is quite undemanding, and this is a very cyclical company leveraged to improvements in short-cycle manufacturing and automotive markets.
An Unimpressive Set Of Numbers
While SKF reported relatively early in the cycle, time has since shown that the results were not all that impressive on a relative basis. Certainly, there were industrials/multi-industrials that did worse, but SKF did miss revenue expectations in a quarter where most beat and the 34% operating earnings beat comes with a big asterisk.
Revenue fell 25% in organic terms, missing by about 1%, with industrial revenue down 17% and auto revenue down 45%. Gross margin declined almost seven points, while adjusted operating income declined 45%, with margin contracting 330bp. At the segment level, industrial earnings declined 27% (margin down 180bp), while auto earnings went into the red.
The 17% decline in industrial revenue actually wasn’t so bad relative to what most industrials have reported (down mid-to-high teens), though it’s worth noting that a lot of those companies have varying degrees of auto market exposure that would have weighed on their reported growth. On the auto side, the 45% decline seemed basically consistent with what auto and truck suppliers have reported for that industry.
Is Earnings Quality An Issue?
SKF’s self-reported “adjusted” operating income number excluded over SEK 650M in restructuring and cost reduction efforts, and that’s not so unusual – most companies try to claim that those are “one-time” costs that should be excluded to get a truer picture of the underlying health of the business.
There are a couple of problems with that, though. First, while management wants you to ignore the restructuring/cost reduction costs and costs related to customer settlements, it wants you to include almost SEK 200M in gains from a land sale. Unfortunately, this is a habit with SKF management – ignore the costs, but include the gains.
The other problem is that management’s history of taking these charges strains a credible sense of “one-time” or “unusual”, as there have been SEK 500M or more in such adjustments in three of the last four years. Moreover, as a lot of this restructuring is being done to repair or replace aging capacity, is it really not a typical operating expense?
To be fair, management has been cutting its workforce and introducing more automation into its manufacturing, and that can legitimately be thought of as restructuring. Still, I don’t like the inclusion of the land sale gain, and I get a sort of “heads I win, tails we flip again” vibe in how management handles these adjustments, and I’d note that based on how the shares trade, the Street largely ignores the adjustments and seems to treat the reported results as much closer to the “real” numbers.
A Challenging Near-Term Outlook, But Are The Vs Coming?
Unlike most of its peers, SKF management claimed that there was too much uncertainty in the markets to provide a third quarter outlook. Likewise, management said that June/July trends were only “slightly” better than the trends seen in April/May (down about 20%-25% versus down 25%). That’s not so unusual compared to Sandvik (OTCPK:SDVKY), but it is unusual against the wider peer group, where most companies saw a sharp decline in April and sequential improvements thereafter.
Listening to management’s market commentary, the strength in sales to marine markets (really the only area of consistent strength) does seem to fit with Alfa Laval’s (OTCPK:ALFVY) better-than-expected marine results, but there was broad-based weakness elsewhere that seems to fit the picture offered by other companies, as areas like aero, heavy machinery, and general manufacturing have been quite weak.
Although management’s tone was not particularly positive, I do believe SKF is leveraged for upcoming short-cycle recoveries. SKF has long been highly cyclical and sensitive to macro indicators like IP, and I believe that many customers have worked down their inventories, setting the stage for stronger results later in 2020 and into 2021. I will note, though, that management said most of the strength in China has been driven by government-related actions, which is a warning worth heeding that underlying demand may actually still be quite weak.
I likewise expect SKF to see better demand in auto, the third quarter will still be pretty weak on a yoy basis but should show sequential improvement and I believe this business can grow double digits in 2021. On a longer-term basis, though, I remain concerned about the company’s competitiveness in the auto market and its ability to differentiate and secure meaningfully better margins (automation and lower production costs would certainly help).
I previously wrote that SKF was going into this downturn with inventory levels that were too high, and management did manage to reduce inventories by about SEK 1,400M this quarter; that comes at the cost of gross margin, though, as the company has scaled down production and is under-absorbing overhead. I do expect this to correct relatively quickly, though, and I think Q2 will be the low point for gross margin.
While I’ve been raising my 2020 expectations for most industrials, I’m not doing that for SKF. I do still see a meaningful recovery in 2021/2022, but I’m still only looking for low-single-digit long-term revenue growth and mid-single-digit FCF growth.
The Bottom Line
I believe my modeling assumptions are relatively conservative, but SKF shares still end up looking cheap, with a high single-digit annualized prospective return on pretty lackluster revenue growth and modest long-term margin leverage. Likewise, I’d note the shares seem to trade meaningfully below normal multiples for the given level of margins and returns (even adjusting for the issues with “one-time” costs).
That leaves me in a weird spot with the stock. I have some concerns about management, and I don’t necessarily love the business (the ROIC is okay, but not great), but the valuation is pretty interesting, particularly for a company that should be looking at a significant and sharp turn in business around the turn of the year. I’d advise caution, but this looks like a name to consider for investors who still want a play on a short-cycle recovery.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.