Greasing The Wheels Of Change: AB SKF’s Role In Sustainable Innovation (SKFRY)

In an effort to decarbonize the economy, a lot of attention is paid to renewable energy producers, and rightly so. However, a small group of companies is also trying to help by improving energy efficiency.

This group includes companies working on efficient LED lighting like Universal Display (OLED) and Signify (OTCPK:PHPPY), Accelleron (OTCPK:ACLLY) which makes internal combustion engines more efficient with its turbochargers, ABB (OTCPK:ABBNY) with energy-efficient motors and power distribution, and AB SKF (OTCPK:SKFRY) which is the global leader in bearings manufacturing and distribution.

In this article, we will focus on SKF, as it is a company that is not very well known by most investors, despite its global importance and contribution to fighting climate change. SKF likes to remind its investors that roughly 20% of all energy is used to overcome friction, and bearings are one key technology to help minimize this waste. Importantly, the company continues to innovate, just in the fourth quarter, the company introduced new robust bearings for railway gearboxes and precision bearings for lithium battery production. Most financial figures in the article are in Swedish Krona (SEK), and at the moment one dollar can purchase a little over 10 SEK.

Where Are Bearings Used?

Most people would be surprised by the long list of places where bearings are needed. This list goes far beyond the obvious example of roller skates. For example, one of the most important growth markets is electric vehicles, which use advanced ceramic bearings. Industrial automation equipment is another important segment, and in general, bearings enable more energy efficient industrial development. They are also a key component in some types of renewable energy production equipment, including wind turbines.

SKF holds a strong position in most of its markets, being either number one or number two in the most important ones.

While still a small market, electric vehicles are expected to grow in importance. The company has excellent relationships with several of them, including being a preferred supplier to NIO (NIO) and also working with Volvo Car (OTCPK:VLVOF), and several others.

SKF is increasingly getting involved in the design phase, adding sensors to monitor the chassis and powertrains, and developing simulation capabilities for virtual validation. As this end-market scales, the company is expecting not only revenues to increase, but the profit derived from it to improve as well.

Besides EVs, there are other emerging businesses in areas like marine, aerospace, and even hydrogen liquefaction. The company recently shared that it started collaborating with Atlas Copco (OTCPK:ATLKY) and Plug Power (PLUG), where their magnetic bearings are used in hydrogen liquefaction to enhance reliability, reduce risk of contamination, and enable greater production capacity. There is rapid growth of new magnetic bearing applications, which is good news for the company as one of the technology leaders.

Q4 And FY23 Earnings Results

Results for the whole year 2023 were stronger than results for the fourth quarter. For the year, the company reached record sales exceeding SEK100 billion, which was roughly 4% organic growth, in Q4 organic sales were -2%. Performance in the fourth quarter saw reduced demand across all regions.

Adjusted operating profit for the year was also a record high at SEK 13 billion, with the adjusted operating margin improving to 12.5%. The company reported certain segments saw strong growth for the year, mentioning in particular the railway and aerospace businesses. In general, demand was stronger in the first half of 2023, weakening in the second half.

Surprisingly, and in contrast with what many other global corporations have reported, the company actually saw more resilient demand in Europe compared to other markets like North America, where the agriculture and food businesses remained weak.

The company is getting closer to achieving its profitability and ROCE targets, as well as its decarbonization objectives. The one metric where it remains significantly below its target is revenue growth.

The company continues to see significant growth from its clean tech end-markets, which now represent about 10% of sales. At the same time, the company is investing in making its own operations more sustainable. It has allocated SEK 3 billion to invest over a six-year period to meet its 2030 clean energy and decarbonization goals.

This year, SKF is planning to invest SEK 0.5 billion to reduce energy consumption at its operations. These efforts have led to recognition by EcoVadis, which recently awarded them a sustainability Platinum Medal, putting the company in the top 1% of all companies that were evaluated.

Portfolio Management

For the last couple of years, the company has been aggressively managing its portfolio, working on repricing, cost reductions, and manufacturing footprint optimization that have contributed positively to its profitability. In particular, the company is moving towards a decentralized operating model that has helped improve productivity, agility, and efficiency.

Localizing their manufacturing footprint puts them closer to their customers, reducing delivery times and transportation costs. Examples of this strategy include the inauguration of their factory in Monterrey, Mexico, and the closure of their factories in Luton, UK, and Busan, Korea. They believe this will strengthen their supply chains, and make their regional operations more self-sufficient. Other initiatives include doing strategic reviews with respect to non-core businesses, which includes the aerospace business. During the most recent earnings call, CEO Rickard Gustafson announced the completion of this strategic review with the decision to look for a buyer for this business.

[…] aerospace and our conclusion of that strategic review, and that we now are embarking actually delivering on finding a home for some of those assets that was not deemed as core to us

During their last capital markets’ day in 2022, the company shared a very interesting slide, where they depicted their strategic intent with respect to each business segment, and it can be seen that in some businesses they are focused on improving growth, while in others they are working on improving profitability.

One strategy they are following to improve profitability is to “fire” bad customers. The company puts it more delicately as “walking away from unprofitable business”. They are also pricing more strategically based on the value they deliver to their customers, and they shared they have already walked away from roughly SEK 1.2 billion in unprofitable business. The company has a very large number of customers, and only a small fraction was in the low operating margin category.

Innovation

While the company has been in business for more than one hundred years and many of the company’s original patents have long expired, SKF continues to develop new innovations to improve bearings and adapt them to emerging applications. The company is putting especial effort into innovating toward a more intelligent and clean future. This includes monitoring the devices, in some cases, for preventive maintenance and better system integrations. It is also improving its designs so that they have a longer life.

Other innovations include selling “digital” bearings, which can be downloaded from a digital warehouse and 3D printed.

The company has developed a product line that it calls SKF Axios, which is specifically designed to monitor assets for data-driven decision making. This can reduce the risk of an unexpected failure, as well as determine when maintenance or replacement might be required. This improves reliability in a cost-efficient and simple way.

One particularly exciting technology is magnetic bearings, which have several advantages over traditional ones. They go from low friction, to basically no friction at all. They do not require lubricant and can be monitored with a high frequency.

These bearings are particularly important for applications where compression efficiency is critical. There are applications in semiconductor manufacturing, step-up grinding, and one particularly interesting one is hydrogen liquefaction. To further strengthen its position in this niche of magnetic bearings, SKF bought 2C Composites, a German high-performance fibre composite supplier. This company has a leading and unique technology of composite layers which are needed for magnetic bearings.

Another area of innovation for the company is improving the lubricants used in some of its bearings. One of its innovations is a lubrication technology that removes the need for oil changes, which improves equipment up-time, reliability, and has several other advantages.

Financials

The company appears on track to meet most of its financial targets shared on its 2022 capital markets day. Profitability has improved, and we believe their de-centralization strategy makes sense, in particular at a time when customers value supplier proximity and transportation costs have significantly increased.

Their efforts to further automate their production and make it more energy efficient should help reduce costs and improve margins. The company appears to have decent pricing power, and it has the advantage that it provides a low-cost but high-impact component, where it does not make sense for a customer to risk product failure to save a relatively small amount. The slide below was shared during their capital markets day in 2022, and they have made good progress on many of the initiatives mentioned. We believe the biggest disappointment has been relatively weak growth, but that could change as their growth end-markets become an increasingly larger part of the mix, and if the global economy improves.

Balance Sheet

SKF has been using part of its free cash flow to reduce outstanding debt, with net financial debt at SEK 7.6 billion at the end of the year, significantly lower compared to Q3 and compared to the same quarter one year earlier. This has led to very low leverage, with a net debt to EBITDA ratio of approximately 1.1x.

The company also continues to improve its net working capital management, mainly by reducing inventories, which has resulted in net working capital below 28% of sales in Q4, which contributed to the strong cash generation in the quarter.

Dividend Policy

SKF pays a meaningful dividend, with a policy to distribute around half of its net profit to shareholders. The company’s Board recently proposed a dividend of SEK 7.50 per share, which represents an increase of approximately 7% compared to a year ago. With the native shares trading at SEK226, the forward dividend yield is ~3.3%. Unfortunately, as many European companies do, SKF pays its dividend annually instead of quarterly.

Outlook

Management is guiding for a relatively weak first half in 2024, with expectations of a stronger second half. For Q1 2024, the company expects demand to experience a mid-single-digit decline and a negative currency impact on operating profits of approximately SEK 400 million.

For the full year it is guiding for a low single-digit organic sales decline year-over-year, and to invest in property, plant, and equipment roughly SEK 5.5 billion.

Valuation

We agree with Seeking Alpha’s valuation grade of “A-“, given that it is trading with a significant discount to its sector on the different valuation metrics. It is also trading at a slight valuation discount to its own historical 5-year average multiples for EV/EBITDA (TTM) and EV/EBITDA (FWD).

It looks particularly cheap when looking at its Price to Cash Flow from Operations multiple, which is currently several turns lower compared to its ten-year average.

Given that SKF is the global leader in its industry, continues to innovate and improve its operational efficiency, has a remarkably strong balance sheet, and has exposure to some attractive growth end-markets, we believe it deserves an above-average market multiple. We therefore believe the Price/Earnings ratio of ~15x to be a decent entry point, and we are starting coverage with a “Buy” rating.

Risks

One thing that is important to keep in mind, is that SKF is exposed to several cyclical sectors. It therefore can be disproportionately affected during economic recessions or industrial slowdowns. This risk is mitigated by the company’s strong balance sheet, customer and geographic diversification, and its industry-leading position.

Conclusion

SKF is a company that deserves more attention from investors, as it has some attractive financial characteristics and exposure to some growth end-markets. The company continues to innovate and improve its operations. The company is also helping fight climate change by reducing energy waste. We also believe the company’s strategy of optimizing its supply chain and footprint, automating its factories, and improving its energy efficiency will make it more resilient and profitable. We believe shares are currently only modestly undervalued, but the company is certainly worth following.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.