Company Reports

We make no change to our SEK 220 fair value estimate for narrow-moat SKF following delivery of first-quarter 2024 results, which tracked broadly in line with our full-year forecasts and company guidance. Organic sales declined by 7%, reflecting a broad-based weakening of demand for SKF’s industrial and automotive bearings amid challenging market conditions. Still, SKF delivered a pleasing 30 basis points of EBIT margin progression to 13.4% despite the easing of the top line in the first quarter. Lower raw material costs and easing labor cost inflation for the automotive segment largely accounted for the improvement in EBIT margin performance in early 2024.

Investors welcomed narrow-moat SKF’s fourth-quarter 2023 result, with SKF shares trading some 5% higher at the time of writing, ostensibly warming to strong operating margin progression for the industrial bearings segment, which edged out our and the market’s expectations. As we’d anticipated fourth-quarter sales weakened in industrial bearings—SKF’s largest segment, accounting for about 85% of group earnings—as slowing economic growth resulted in lower customer demand in all regions. Still, SKF’s efforts to focus on higher-profit margin bearings categories—and to exit more commoditized, lower-profit margin segments of the industrial bearings market—bore fruit, with the industrial segment EBIT margin rising to 15.4% in 2023, up 210 basis points year on year. Consequently, SKF delivered group full-year 2023 EBIT of about SEK 13.0 billion, beating consensus and our forecast by 2% and 3%, respectively.

SKF is the largest bearings manufacturer globally, with about 20% share of the global bearings market—about twice as much as its nearest rival. In perpetuating its industry-leading position, SKF leverages its expertise and reputation for bringing innovative, energy-efficient, and durable industrial and automotive bearings to market. SKF aims to work in partnership with its original equipment manufacturer, or OEM, customers—which include a highly diverse set of market industrial sectors and market verticals—during their product design process, offering its extensive engineering know-how in friction minimization. Specification of the correct and optimally customized bearing offers SKF’s customers greater energy efficiency and can also help to minimize machine downtime, which are both attractive attributes to users of industrial equipment. In this way, the relationship adds value for SKF’s OEM customers—which account for about 65% of group sales—while also creating demand for its bearings in the third-party distribution channel, where sales result from the need to replace existing SKF bearings and other products that have come to the end of their useful life.

A fresh look at SKF leads us to increase our fair value estimate by 5% to SEK 220. We maintain our narrow economic moat and Standard Capital Allocation ratings for the clear leader in the global bearings market. However, we raise our Morningstar Uncertainty Rating to High—from a prior rating of Medium—to reflect the group’s exposure to inherently volatile industrial sector capital expenditure and motor vehicle production cycles. In concert, we lift our cost of capital estimate for SKF to 9.8%, up from a prior 8%. However, SKF’s current capital investment program offers longer-term working capital benefits that we’d not previously credited and that offset the otherwise negative impact that our increased cost of capital assumption has upon our valuation. SKF shares screen as modestly undervalued, trading at a 7% discount to our revised fair value estimate.

SKF's core market is treading water from a growth perspective, and management's plan for faster top-line growth to double revenue by "2030" is fairly high level in its outline and therefore difficult for investors to assess. SKF has deep engineering expertise and a leading position in ball bearings; however, growth from new market opportunities will still take time and investment. Of the high level opportunities presented by the company, ceramic ball bearings for the electric vehicle market is one of the most promising. The market for EVs will expand over time, as the adoption is supported by regulators and consumers alike. Therefore, SKF's ceramic bearing solution should yield positive results as EV takeup accelerates.

Narrow-moat SKF’s second quarter outperformed our expectations with record net sales of SEK 27.1 billion and organic revenue growth of 8.0%. SKF’s EBIT margin also strengthened to 13.3% , up 280 basis points year over year, as price hikes and trimming less profitable products helped offset cost inflation more than anticipated. The ongoing re-positioning of the automotive segment continues to bear fruit with segment EBIT margin strengthening to 7.1%, up 560 basis points year over year. While organic sales growth was broad-based, demand from electric vehicle, railway, and renewable energy customer industries were the largest drivers growing 26%, 20%, and 18% respectively.

SKF's core market is treading water from a growth perspective, and management's plan for faster top-line growth to double revenue by "2030" is fairly high level in its outline and therefore difficult for investors to assess. SKF has deep engineering expertise and a leading position in ball bearings; however, growth from new market opportunities will still take time and investment. Of the high level opportunities presented by the company, ceramic ball bearings for the electric vehicle market is one of the most promising. The market for EVs will expand over time, as the adoption is supported by regulators and consumers alike. Therefore, SKF's ceramic bearing solution should yield positive results once EV takeup accelerates.

SKF's 2022 revenue growth and 2023 revenue growth guidance were both strong; however, the company's operating income margin was less impressive. Full-year 2022 organic revenue growth came in at 8%, driven by demand for both its industrial and automotive market bearings, right in line with our forecast. However, our 4% 2023 forecast for organic revenue looks conservative relative to management's mid-single-digit guidance. The more optimistic company outlook is predicated in part on pent-up demand in China coming through toward the second half of 2023, with the Chinese economy gathering steam again following lockdowns during 2022. Demand from electric vehicles has also been strong. Management also mentioned current strength in Europe as a source of optimism. We expect to make adjustments to our forecasts but not enough to materially affect our SEK 210 fair value estimate. We retain our narrow moat rating.

Higher energy prices put increased pressure on SKF's already underperforming margins in the third quarter. However, demand for both divisions was strong. Organic revenue grew 8% and 18% in the industrial and automotive divisions, respectively, although automotive growth was flattered by easy year-over-year comparisons. The group adjusted EBIT margin came in at just 8.5% before any restructuring charges and costs associated with exiting Russia. Inflation has been rising faster than the company's price/mix benefit for the last five quarters, pressuring margins. However, in the third quarter, a SEK 1 billion increase in energy costs pushed the gap wider to 110 basis points, with costs up 2.9% and not fully offset by the 1.8% increase from price/mix. While this year is challenging from a cost perspective, we expect some margin expansion next year from a combination of restructuring efforts and easing of some of the inflationary pressure, such as logistics costs. We are therefore maintaining our SEK 210 fair value estimate and narrow moat rating.

SKF’s second quarter proved more challenging than the prior quarter with moderately slower organic revenue of 5.4%, and a heftier toll on margins, down 450 basis points year over year, from supply chain bottlenecks and other disruptions. China is a material end market for SKF with 18% of revenue coming from the country and the coronavirus lockdowns muted the company’s revenue growth. That said, first-half revenue growth so far, is still tracking in line with our full-year forecasts of 5.5% organic and 11% reported growth, respectively. However, our 2022 adjusted EBIT margin forecast of 12.5% looks modestly optimistic given the 11.9% posted by the business in the first half. While we expect margin recovery in the second half with less pressure from supply chains and the reopening of China, we are not confident that the margin recovery will be strong enough to meet our 2022 current margin expectations. That said, we do not expect any margin forecast adjustments to materially affect our SEK 210 fair value estimate. We maintain our narrow moat rating.

SKF's core market is treading water from a growth perspective, and management's plan for faster top-line growth to double revenue by "2030" is fairly high level in its outline and therefore difficult for investors to assess. SKF has deep engineering expertise and a leading position in ball bearings; however, growth from new market opportunities will still take time and investment. Of the high level opportunities presented by the company, ceramic ball bearings for the electric vehicle market is one of the most promising. The market for EVs will expand over time, as the adoption is supported by regulators and consumers alike. Therefore, SKF's ceramic bearing solution should yield positive results once EV takeup accelerates.

Narrow-moat SKF's first-quarter results were mixed. The industrials division posted 11% growth while the automotive division saw a nearly 3% organic decline in revenue year over year due to supply chain constraints. The second quarter is likely to be more challenging due to the China lockdowns, as the country contributes 20% of group revenue. In April, volume growth declined as some China-based original equipment manufacturers have been forced to shut down manufacturing plants, preventing SKF from making product deliveries. Adding to that, current inflationary pressures increase the risk of slowing economic growth and lower demand for ball bearings. Nevertheless, we see value in the shares, now trading in 4-star territory, and maintain our narrow moat rating and SEK 210 fair value estimate.

SKF shares were down nearly 9% at the time of writing after reporting adjusted operating profits below the company's provided consensus. Relative to our forecasts, the SEK 81.7 billion in revenue and 13.3% adjusted operating profit margin was in line with our expectations. With the sell-off, shares are trading at a 9% discount to our SEK 210 fair value estimate. Near-term cost pressures from supply chain shortages are likely to persist, and management's strategy path to double revenue by 2030 remains elusive. We maintain our narrow moat rating.

SKF's smaller division, automotive, saw a dramatic drop in customer demand in the third quarter from car manufacturers suddenly starting production site shut-downs due to component shortages. Shares declined nearly 8% after the company said that the shortages are likely to continue for near term. We think the sell-off was an over-reaction as the extraordinary supply chain shortages wreaking havoc on the auto industry affect all of SKF's competitors as well and will eventually work themselves out. Moreover, the larger division, industrial (75% of revenue) margins, continue to impress with a 16.7% EBIT margin, reaping the benefits of years of footprint rationalization and automation to offset raw material and logistics cost inflation. Shares are trading moderately below our fair value estimate, which we maintain. Our narrow moat rating remains intact.

Similar to European industrial peers reporting results so far, SKF benefited in the second quarter from the postcoronavirus cycle bounce as well as easy year-over-year comparisons and continues to see strong demand going into the third quarter. Organic revenue was up 33% at the group level and the EBIT margin of 15% was at its highest levels since the first quarter of 2019. SKF is executing a multiyear cost-reduction program, which includes increased usage of automation. Pricing power along with cost flexibility, from the company's adoption of robotics and other automation, has enabled SKF to weather its mostly procyclical end markets, and we believe permanently lower its cost structure. Since 2019, it has closed six manufacturing sites with another 11 still to go. We do not expect to make any material changes to our fair value estimate on the back of the results and maintain our narrow moat rating. Shares look fairly valued.

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.

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's fourth-quarter results were in line with our expectations on revenue, down less than 1% organically year over year, but better on margins, expanding 290 basis points year over year. The full-year adjusted EBIT margin expanded by 50 basis points, and we expect the company to be able to retain these gains, due to cost savings achieved in 2020, with roughly half remaining permanent, and a continued recovery in demand. We are maintaining our SEK 175 fair value estimate. Our narrow moat rating remains intact.

SKF's third-quarter automotive division results beat our expectations on revenue and profitability, making a strong comeback from the second quarter, which was severely impaired by coronavirus-related restrictions. Third-quarter automotive demand increased particularly from trucks in Asia and light vehicles in North America, increasing utilization rates and partially reversing losses that the company booked in the division in the second quarter. The automotive revenue was down just under 1%, a positive result when considering divisional revenue was down 20% in the first nine months. The margin for automotive recovered quickly going from negative 19% in the second quarter to 5.5% in the third quarter. Outside automotive, demand from wind customers and in particular China was robust. However, general industry globally remains weak and the industrial division was more in line with our expectations. The industrial division's organic revenue was down 7% and the EBIT margin up 190 basis points year over year. We have made minor changes to our near-term forecasts and are maintaining our SEK 175 fair value estimate and narrow moat rating. Shares look fairly valued.

Not surprisingly, narrow-moat SKF's automotive division revenue and profits were hit by the coronavirus-related slowdown in the second quarter. The industrial division saw relatively less weakness. SKF's end markets are geared toward short-cycle swings in demand, with business proving resilient over time. Impressively, the company continues to invest in its business, where it sees the need for expanded capacity, namely in China. We maintain our SEK 175 fair value estimate, against which, the shares are fairly valued.