The Timken Company (TKR) Q3 2022 Earnings Report, Transcript and Summary

Good morning. My name is Emily, and I'll be your conference operator today. At this time, I would like to welcome everyone to Timken's Third Quarter Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Mr. Frohnapple, you may begin your conference.

Thanks, Emily, and welcome everyone to our third quarter 2022 earnings conference call. This is Neil Frohnapple, Director of Investor Relations for The Timken Company. We appreciate you joining us today. Before we begin our remarks this morning, I want to point out that we have posted presentation materials on the company's website that we will reference as part of today's review of the quarterly results. You can also access this material through the download feature on the earnings call webcast link. With me today are, The Timken Company's President and CEO, Rich Kyle; and Phil Fracassa, our Chief Financial Officer. We will have opening comments this morning from both Rich and Phil before we open up the call for your questions. During the Q&A, I would ask that you please limit your questions to one question and one follow-up at a time to allow everyone a chance to participate. During today's call, you may hear forward-looking statements related to our future financial results, plans and business operations. Our actual results may differ materially from those projected or implied due to a variety of factors, which we describe in greater detail in today's press release and in our reports filed with the SEC, which are available on the timken.com website. We have included reconciliations between non-GAAP financial information and its GAAP equivalent in the press release and presentation materials. Today's call is copyrighted by The Timken Company, and without expressed written consent, we prohibit any use, recording or transmission of any portion of the call. With that, I would like to thank you for your interest in The Timken Company, and I will now turn the call over to Rich.

Thanks, Neil. Good morning and thank you for joining our call. Timken delivered another excellent quarter with year-on-year revenue growth of 10%, earnings per share growth of 29% and margin expansion of 160 basis points. We continue to demonstrate Timken's ability to grow and deliver strong results through a variety of macroeconomic conditions. Our financial performance is driven by the successful execution of our strategy, the diversity and attractiveness of our portfolio and end-market mix and our disciplined approach to capital allocation. Demand continued to be strong across most markets and geographies, and when combined with our outgrowth initiatives and positive pricing resulted in organic growth of just under 14%. All regions except Europe were up double digits in the quarter. And as noted on Slide 8, revenue is forecast to be up for the year mid-single digits or higher for nearly all of our end markets. Supply chain issues continued to ease gradually, although they remain a challenge and the operating environment remains dynamic. We continued to face persistent inflation pressures, cost increased in the quarter and are well above prior year and pre-pandemic levels. Price realization was up significantly over prior year and up modestly sequentially. Price-cost was positive for the quarter and price realization has increased sequentially for eight consecutive quarters. Cash flow improved sequentially but conversion remains modest year-to-date due to the working capital required to support the organic growth and the supply chain challenges. From a capital allocation standpoint, we paid our 401st consecutive dividend and purchased about 1% of the outstanding shares. We're investing CapEx into the business for growth in margin, including investing in our footprint and capabilities. Examples include our state-of-the-art bearing facility in Mexico, which has ramped up through the course of the year and provides additional capacity at a very competitive cost position. We are also close to completing our plans to consolidate our chain operations into one facility in Illinois which will further improve our productivity and cost structure. We also continue to allocate capital to M&A. The first full quarter of Spinea has gone well and we remain excited about the growth potential of the business across the global automation space. We're also excited about our agreement to acquire GGB Bearings. GGB is a global supplier of highly engineered plain and metal-polymer bearings. The plain bearing category is highly complementary to Timken's roller and ball bearing offering and we expect significant synergies in the coming years as we integrate the businesses. We are on track to close the acquisition in the fourth quarter. We also recently reached an agreement to divest Aero Drive Systems. ADS is a supplier of flight critical components for rotorcraft applications. We're always reviewing our portfolio for strategic and financial fit and we determine that ADS will be better positioned to succeed in the market under other ownership. They represents just over 1% of Timken revenue and we expect to close in the fourth quarter. We do not expect any other sizable divestitures near term. We have an attractive and diverse portfolio and we're investing in it to win in the marketplace. I'd also like to point out that aerospace will continue to be an important end market for us. We also released our annual Corporate Social Responsibility report in the quarter. The report both highlights our accomplishments and outlines many of our forward-looking activities and goals. Overall, it was an excellent quarter in both delivering strong results in a dynamic environment, while also continuing to position the company for greater levels of performance in the years to come. Turning to the outlook, we are planning to achieve record revenue, record earnings and an improvement in year-over-year margins again in the fourth quarter. We've increased our full-year revenue outlook to 9% to reflect continued strong organic growth, acquisitions and price realization, partially offset by increased currency headwinds and the ADS divestiture. Through late October, our revenue and order run rate support our fourth quarter outlook. On the bottom line, we are expecting input costs to remain elevated and for the supply chain challenges to persist with only gradual improvements. We also expect the fourth quarter to be our ninth consecutive quarter of sequential price realization and for price-cost to be positive. We have increased our full-year earnings per share forecast to $5.80 to $5.95. At the midpoint, this would be a 25% increase over last year's performance. And finally, from a cash flow standpoint, we expect very strong cash flow in the fourth quarter from both seasonality and improving execution around inventory management. Turning to '23 in the longer term, we are always closely monitoring our global end markets and channels for signs of demand strength or softening and we are very aware of the concerns around global recession. However, as demonstrated in our recent results as well as our outlook for this quarter, demand for our products remains very strong and we expect the positive momentum to carry over to start 2023. We have a high backlog and orders continue to come in at a healthy pace. We typically see a seasonal step-up in demand end margins from the fourth quarter to the first. And our orders and backlog support a strong start to '23. We would also expect price to be up sequentially again from the fourth quarter the first. We're not expecting any relief from inflation in the near term, but we believe we are well positioned to keep price in line with costs as we move forward. And additionally, we have a lot of self-help heading into '23, including improving our operational performance as supply chain stabilize, delivering on our CapEx and margin enhancement initiatives, outgrowth, the GGB and Spinea acquisitions and the full year impact of share buyback. We will provide our full-year outlook for '23 early next year, but we have a lot of positive momentum as we end 2022. And finally, longer term, I'd like to take you back to Slide 11 in the deck, which summarizes our five-year financial performance. As we discussed in our recent Investor Day, Timken has delivered consistent and top quartile financial results through what has been a particularly volatile macroeconomic period. We will enter '23 a stronger company than we were entering 2018 and we are in excellent position to continue to profitably scale our business as a diversified industrial leader and deliver strong shareholder returns. I'll now turn it over to Phil for more color on the results and the outlook.

Okay. Thanks, Rich, and good morning, everyone. For the financial review, I'm going to start on Slide 13 of the presentation materials with a summary of our strong third quarter results. We posted revenue of $1.14 billion in the quarter, up 9.6% from last year. We delivered an adjusted EBITDA margin of 18.8% and we achieved record third quarter adjusted earnings per share of $1.52. We will dive deeper into each of these items as we move through the materials. Turning to Slide 14, let's take a closer look at our sales performance. Organically, third quarter sales were up nearly 14% from last year, as we generated double-digit growth in both of our segments. Our strong revenue reflects higher demand across most end-market sectors as well as the impact of continued positive pricing. I would also point out that our year-on-year organic growth rate stepped up from 11% organic growth we delivered in the first half this year. Our team continues to win in the marketplace and serve customers well in this dynamic environment. Looking at the rest of the revenue walk, foreign currency translation was a sizable headwind on the topline in the quarter as the U.S. dollar continued to strengthen against the euro and other key currencies. And the net impact of acquisitions, including Spinea, contributed modestly to the topline in the quarter. And while you don't see it on the slide, sequentially our sales were down about 1.5% from the second quarter driven mainly by currency. Organically, our sales were roughly flat sequentially, which is stronger than we would normally see when you consider our typical seasonality. On the right hand side of this slide, you can see organic growth by region, which excludes both currency and acquisitions. Most regions were up double digits in the quarter versus last year, with the Americas posting the strongest growth. Let me touch briefly on each region. We were up 25% in Latin America. All sectors were up in that region with industrial distribution posting the strongest growth. In North America, our largest region, we were up 20% with most sectors up led by distribution, off-highway and automotive. In Asia Pacific, we were up 12%, as most sectors were up there as well, led by distribution, renewable energy and rail. And notably, we delivered high single-digit growth in China in the quarter. And finally, in EMEA, we were flat overall as modest gains in distribution, off-highway and general industrial were offset by lower renewable energy and Russian rail revenue. Turning to Slide 15, adjusted EBITDA in the third quarter was $214 million or 18.8% of sales compared to $179 million or 17.2% of sales last year. Adjusted EBITDA was up $35 million or 20% from the year ago period, as we delivered an incremental margin of 35% on the higher sales, which enabled us to expand margins by 160 basis points. Looking at the change in adjusted EBITDA dollars, we benefited from strong price mix and higher volume in the quarter, which more than offset the impact of higher material and logistics costs, unfavorable net manufacturing performance and higher SG&A other expense. Let me comment a little further on a few of these items. Price/mix was a key driver once again to our strong quarterly results. Pricing was meaningfully higher in both mobile and process industries, reflecting our actions over the past 12 months. Mix was also a significant contributor, driven by our revenue growth and attractive sectors like industrial distribution. Moving to material and logistics, we continue to experience higher cost compared to the year-ago period. The increase was driven mainly by material and reflects the impact of supplier price increases across the globe. I would note that the year-on-year negative impact from material and logistics moderated compared to the second quarter headwind and we would expect further moderation again in the fourth quarter. On the manufacturing line, we were negatively impacted by higher energy, labor and other costs as well as continued supply chain and labor-related inefficiencies. Supply chain and labor issues are easing slowly and we have several self-help initiatives underway in our plants. So we would expect some improvement in the fourth quarter and even more in 2023. And finally, on the SG&A other line, costs in the third quarter were up in dollars, driven by higher compensation expense and other spending to support the increased sales levels, but SG&A was roughly flat with the second quarter and in line with our expectations. On Slide 16, you can see that we posted net income of $87 million or $1.18 per diluted share for the third quarter on a GAAP basis. This includes $0.34 of net expense from special items, which was driven mainly by a $29 million pre-tax impairment charge related to the planned divestiture of our Aerospace Drive Systems business or ADS for short. On an adjusted basis, we earned $1.52 per share in the quarter, up 29% from last year. With respect to ADS, the business is expected to post revenue of around $50 million in 2022 with EBITDA margins below our company average. You'll note that we had 4% fewer shares outstanding in the third quarter compared to last year, reflecting our significant buyback activity over the past 12 months. Interest expense was up slightly from last year as expected, and our third quarter adjusted tax rate of 25.5% was in line with our prior guidance. Now let's move to our business segment results, starting with Process Industries on Slide 17. For the third quarter, Process Industries' sales were $610 million, up 10.8% from last year. Organically, sales were up nearly 15% driven by growth across most sectors with distribution, general industrial and heavy industries posting the strongest gains. Marine and industrial services were also up, while renewable energy was modestly lower year-on-year. Pricing was positive, and net acquisitions contributed modestly, while currency translation was a headwind in the quarter. Process Industries' adjusted EBITDA in the third quarter was $167 million or 27.4% of sales compared to $131 million or 23.8% of sales last year. The increase in Process segment EBITDA margin reflects the benefits of positive price mix and higher volume, which more than offset the impact of higher operating costs in the quarter. Now let's turn to Mobile Industries on Slide 18. In the third quarter, Mobile Industries' sales were $527 million, up 8.1% from last year. Organically, sales increased more than 12% with off-highway and automotive posting the largest gains. We were also up in the heavy truck and aerospace sectors, while rail was relatively flat. Pricing was positive, while currency translation was a headwind in the quarter. Mobile Industries' adjusted EBITDA for the third quarter was $55 million or 10.5% of sales compared to $58 million or 11.9% of sales last year. The decrease in Mobile segment EBITDA margin was driven by the impact of higher operating costs, which more than offset the benefits of positive price mix and higher volume in the quarter. I would point out that Mobile Industries continues to be impacted by material inflation, labor inefficiencies and supply chain challenges to a greater degree than Process Industries. Turning to Slide 19, you can see that we generated operating cash flow of $145 million in the quarter. And after CapEx, free cash flow was $98 million. The higher free cash flow compared to last year was driven mainly by higher earnings. We expect working capital to come down seasonally as we approach year-end and we are taking other targeted steps to reduce inventory. So we would anticipate a further step up in free cash flow in the fourth quarter. Taking a closer look at our capital structure, we ended September with net debt to adjusted EBITDA at 1.8 times, which is an improvement from the end of June and well within our targeted range. After the planned closures of the GGB Bearings acquisition and the ADS divestiture in the fourth quarter, we would expect to finish the year with pro forma net leverage of around 2 times. With our strong balance sheet, we remain in great position to continue to drive our strategic priorities and we expect capital allocation to be accretive to earnings again in 2023. During the third quarter, Timken returned $72 million of cash to shareholders through dividends and the repurchase of 750,000 shares of company stock. Year-to-date, we've repurchased 3 million shares or about 4% of total shares outstanding as we continue to view buybacks as an attractive use of capital. Now let's turn to the outlook, with a summary on Slide 20. We are raising our full-year outlook for both the top and bottom line performance, based on our strong third quarter results and our expectations for the rest of the year. We now estimate adjusted earnings per share will be in the range of $580 to $595 per share, up from our prior guide of $550 to $580. The midpoint of our new outlook would represent a 25% increase in EPS from last year and a new all-time record for Timken. The midpoint of our earnings outlook also implies that our consolidated 2022 adjusted EBITDA margin will be up about 125 basis points versus last year, which is an improvement from our prior outlook. We expect strong year-on-year margin performance in the fourth quarter, driven by continued positive price cost dynamics, higher year-over-year volume and improving operational performance. Turning to the revenue outlook. We're now planning for revenue to be up around 9% in total at the midpoint versus 2021. Organically, we now expect sales to be up about 11.5% for the year, which is up from our prior outlook of 9%. This reflects our strong third quarter revenue performance and implies organic revenue growth of around 10% in the fourth quarter. Our backlog supports our increased outlook. We now expect currency to be roughly a 3.5% headwind to the topline for the full year, which is about 100 basis points worse than our prior outlook. And finally, we now expect M&A to contribute around 100 basis points to our revenue for the full year, up from 50 basis points prior. Note that we are including the net impact from the GGB Bearings acquisition and the ADS divestiture in our sales outlook, assuming a mid-quarter close for both transactions. Moving to free cash flow, we now expect to generate $250 million for the full year 2022. This is lower than our prior outlook and reflects higher working capital driven by increased sales and ongoing supply chain issues. As we highlighted at our recent Investor Day, we would expect free cash flow and conversion to step up significantly in 2023 under almost any scenario. We estimate CapEx will come in around 4% of sales for the year with the spend fueling our long-term growth and operational excellence initiatives. And finally, we anticipate full year net interest expense of roughly $70 million and we expect our adjusted tax rate will be around 25.5% both unchanged from our prior guide. So, to summarize, the Timken team delivered strong results in the third quarter and raised our full year outlook yet again. We're on pace to deliver all-time record earnings in 2022 and we're well positioned to continue to drive top quartile financial performance and scale our position as a diversified industrial leader going forward. This concludes our formal remarks and we'll now open the line for questions. Operator?

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question today comes from the line of Stephen Volkmann with Jefferies. Stephen, please go ahead. Your line is open.

Thank you so much. Nice to talk to everybody today. I wanted to start off talking a little bit about sort of the margin differential between the two segments if we could, because obviously Process is kind of crushing it, but as you know we on Wall Street are always going to look at the other one. So Mobile is a little bit below, I guess what we would have expected and I think at the low end of your sort of long-term ranges. And is cost just that much different between these two segments? Is there something going on with price that's also somewhat different? Is there perhaps some inventory reduction happening in Mobile? I don't know, there just seems like there's more to that story.

Yes. Thanks, Steve. Yes so, definitely Mobile margins are lower than we'd like them to be. We need to get them up. To the point you just made, Mobile does get hit disproportionately with steel, gets hit disproportionally with inflation and probably a little bit with currency as well. And then price recovery is slower. So, on the positive side, I think it will also benefit more from steel prices easing which, as Phil said in his comments, we did start to see in the third quarter and we expect more of that in the fourth quarter. So we have some natural help there. We also have the opportunity to -- another opportunity at January 1st to reset many of the annual pricing agreements there, and we'll take advantage of that. And then as I said -- I would say this year from a self-help standpoint, two of our bigger projects that will be positive next year that were negative this year, both the -- two that I referenced the new plant in Mexico, which started the year at a very low level, we'll finish the year and start next year at a much healthier level, and then closing the chain plant. Both of those are in Mobile and we'll see the benefit there. So I think we have probably a disproportionate amount of self-help coming in Mobile. We have been getting Mobile pricing. It's been improving sequentially, just not caught up probably with the -- with the cost, but we will -- we're focused on getting Mobile margins up. I think, we have a good line of sight to do so.

Okay, great. That's helpful. And maybe the follow-up, I don't know, if this is related. But Phil, based on your kind of bridge that you gave us for EBITDA, it's nice to see price/mix and material logistics kind of continues to get better, but manufacturing and SG&A actually continued to get worse as we go through the year here. So what's the outlook for that as we kind of get through year-end and into '23?

On the manufacturing piece, as Phil said, there is an element of that that is still supply chain inefficiencies and we need to do some things there and then also some of our self-help to improve that. Well, I would tell you, what we've seen in the last two quarters, is that number has gone up and material logistics gone down and we're seeing pretty broad-based inflation across the manufacturing space of everything else that we over our other input costs beyond steel and logistics, where it's a lubricant or grinding wheel or a pallet. We're seeing pretty broad-based inflation across that including labor. So I expect some self-help and some improvement on the one side, but I'm not sure the other side has topped out. So we are looking, as we look at next year that we think we need to look at that as largely a structural cost and offset that with pricing.

Yes, and on the SG&A, Steve -- go head.

No, sorry Phil, please.

Yes, I was just going to say on the SG&A, we were up in dollars as we pointed out with was higher compensation, some of that being incentive compensation, as well as higher spending, given the sales were so much higher year-on-year. But I mean you look sequentially from the second quarter when we exclude, you know, the special items were roughly flat on a dollar basis, running in that close to 14% of revenue. That's kind of what we ran last year. I think we'll run in that range for the full year this year, which sort of says, the SG&A did increase but kind of in line, in line with revenue, and coming out of COVID people traveling more and getting back to more normal activities, it was more or less in line with our expectations.

Super. Is there any way to ballpark what the productivity headwind has been kind of through all this, which may be unwind at some point in the future?

Well, I think it's been getting, I'll say, slightly better sequentially, and I would certainly say of that, of the bar on the EBITDA walk, it's well less than half of the manufacturing expense. I mean, there is certainly something there we need to get after and capture and get out of our cost structure, but I think as I said inflation is the bigger issue, right.

Super. Thank you, guys. I'll pass it on.

Thanks, Steve.

Thanks, Steve.

Our next question comes from David Raso with Evercore ISI. Please go ahead, David.

Hi, thank you. Your guidance implies organic sales growth in the fourth quarter at 10%, down from the third quarter, but it's still at a pretty healthy level. So, I guess, I'm just trying to calibrate how much of that is working often old backlog versus new orders that you're seeing? I know you're not a heavily backlog-oriented business, but just that kind of resiliency in the organic growth in the fourth quarter is interesting. And I'm just trying to calibrate, how much of that somewhat indicative of continued order strength or working off the old backlog? And then I have a follow-up.

I'd say, David, our backlog peaked in the May, June timeframe and did start to come down by the end of the second quarter. However, as we sit here today, in October, it's quite high, and orders are still coming in at a very healthy clip. So I'll give you one example, when I just looked at the data the other day through October, our distribution orders are up in October over last year, but they're up less than shipments. So we're still taking in orders at a faster clip than we were last year with price in there, but we are chewing a little bit into the backlog. So it is -- it's some above, but still positive.

And would you mind giving us a sense how large the backlog is right now, like I mean essentially the genesis of the questions here, I mean if you can really do 10% in the fourth quarter, and it's not just chewing through backlog, it obviously suggests at least as of now, unless you get cancellations, the first part of '23 also starts with pretty healthy organic. So, however you want to address that, you know, essentially, that's the question. Some sense as to how large is the backlog or maybe an overall book-to-bill on the quarter, whatever you can help us to get a sense of the pace of organic to start next year? Thank you.

Yes, I think, we don't give a lot of details on the backlog, because it's a lot of apples and oranges and other things added up in there, where we've got some businesses that run and product lines that run over a year of backlog and we've got some things that run a weak of backlog. So -- but I would tell you, we -- whenever we grow in the fourth quarter organically, we generally grow in the first quarter organically and a normal good market, a sequential Q4 to Q1 is 5-plus percent up organically. So as we said, as we sit here today, we think the orders are coming in at a pace. And again, the backlog is high enough that you could chew up quite a bit of it and it's still -- still going to end the year higher than it started the year. So I think it's setting up to finish the year strong which almost always means we start the year strong and after that we'll talk more about that as we get to the January, February call.

Yes, and the other comment I might make, David, too is on the fourth quarter is, we did -- the guidance does imply a pretty normal sequential step down in revenue, you know, call it, sort of the mid-single digit range, which is pretty normal, which kind of says some of that healthy growth obviously had to do with the comp from last year as well. But to Rich's point, the backlog we publish it annually in the K, it's up significantly from the end of last year. And as Rich said, our expectation is, we'll end the year up versus last year as well.

And one last little incremental, if you could, and I'll hop off. The organic, say, you hit your guidance 10% for the quarter. Between the two segments, right, obviously Mobile slowed a little bit, we had an acceleration in Process this quarter. For that step down from 13.6% for this quarter, down to 10%, do you have Mobile slowing notably and Process kind of holding? I'm just getting a sense of the momentum and just starting '23 and as we all know, the margins were a lot higher in Process. So I'm just trying to get a sense of where is the growth heading into...

Mobile typically slows a little bit more in the fourth quarter from the third, then Process more OEM and the holidays and shutdowns that sort of thing affected a little bit more as well as larger OEMs managing inventory a little bit at the end of the year. So more sequentially from Q3 to Q4 is the number that Phil just referenced. So I would expect it to do, probably a little bit heavier in Mobile -- which is obviously good for our mix on the flip side.

Thanks, David.

All right, thank you.

Our next question comes from Tim Thein with Citigroup. Please go ahead. Tim, your line is open.

Great. Thanks. Good morning. Yes, the first one is just on distribution. And Rich, you may have, I mean, covered a little bit on this earlier, but you noted strength, I think, in pretty much every geography in the quarter and it's certainly consistent with some of the growth reported by at least one of your larger public customers anyway in North America. But as we just think about the outlook, who knows where that growth trends in '23, but just how does Timken perform relative to that, i.e., is there -- and it basically means any element of restocking or helping this year that maybe goes against you for next year? Or I don't know just generically how do you think about that, your performance relative to kind of a sell-in versus sell-through question?

Yes, good question. And certainly, it's very strong around the world. I would say, Europe has slowed. So I would say that is the exception. The rest of the world though, everywhere except Europe very strong. And for where we have visibility to inventory levels and sales which would clearly be in Europe and the United States and maybe a couple of large global distributors. I would say, inventory is still more of a tailwind for us than a headwind and distributors are looking still to build more inventory. As I just quoted the October data, we are shipping at a higher rate than the orders October, but again both growing from prior year. So I think, certainly for the fourth quarter, I would say, it still is a tailwind and certainly don't see any headwind heading into next year. And then, I think, from there it probably depends on how the year plays out. But inventory levels, you know, really as you look even back to 2019 or/and '18 would be probably on the low side, particularly given the magnitude of growth that we've experienced, so turns through the channel are higher today.

Okay, got it. And then maybe just one of the end markets being renewables, you know the one in the red for the year. And certainly it's judged by some of the larger players in that market recently, I don't think a huge surprise at least on the wind side. But there is a notion that maybe some of that is on account of just customers waiting for a little bit more clarity regarding kind of the political, environment and subsidies, et cetera. How do you think about that for -- you know, the prospect for that maybe growing in '23 and presumably you've got a longer lead time there and little bit longer obviously sales cycles. So, I don't know, just how are you thinking about that specific piece of the portfolio in '23?

Yes, to the earlier question about backlog, it is an area where we would tend to have a higher visibility to the longer -- higher longer visibility of the backlog than other parts of the business. I start with, I mean, we remain very bullish on this space over the long-term and certainly continue to invest in it for growth and believe over the long-term it is going to be a high growth market for us and mix our growth rate up. And other reminder, we're heavily weighted to Asia and then Europe and underweighted to the Americas. So for us, the business slowed at the end of '21. So we started down a little bit to start '22. Thought it would come back later in the year. Still I think probably would have with the exception of -- the business in China has certainly been impacted by COVID issues and government lockdowns and various issues there probably more than it has been in the market. But even that we're looking at down mid-single digits of a -- was a really strong year in '21. So it's still -- it's still a strong year. I would tell you the -- for China and for Asia, the optimism is building for '23 that it will be a good year and we are getting the order flow for that. Europe, I think is much more uncertain and probably comes back to some of the issues that you just mentioned there in terms of stability of the economic situation there, et cetera. But coming back to my opening comment, Europe, U.S., et cetera, I mean, there is no doubt that the momentum for renewable energies investment and growth around the world is continuing to pick up momentum and is going to be a really good place to be for the next five plus years.

Got it. Understood. Thanks for your time.

Thanks, Tim.

Thanks, Tim.

Our next question today comes from Steve Barger with KeyBanc Capital Markets. Please go ahead, Steve.

Hi, thanks. Just to clarify the inventory comments, you're expecting solid growth, you said orders are still coming in and distributors still want to increase their own inventory, but yours came down sequentially for the first time in quite a while. Is that just working through higher priced items on the balance sheet or is that an actual unit reduction? Just trying to frame that up.

It's a unit reduction, and we are planning to produce less than we sell in the fourth quarter as well. We have built quite a bit of inventory in the last year and a half two years, quite a bit of it has not been as effective and as efficient as what it normally would be due to the supply chain issues. And again well those issues aren't -- are far from smooth and eliminated. We have seen things like transit times, improve and become more reliable, say, they doubled at one point, maybe they are up now 50% longer versus twice what they were and more consistent. So we're bringing our -- I would say, our inventory more on line of focus, more on the productivity of the inventory. So we aren't now looking at a big reduction in the fourth quarter, but we are looking at some correction there and that will help our cash flow in the fourth quarter as well.

Understood. And this -- this next one is going to be tough to predict, but obviously there was a lot of news as it relates to China and semiconductor manufacturing restrictions. Obviously impossible to say if or how they will retaliate, but does tension there make you rethink your manufacturing footprint strategy at all or -- and can you remind us how much product do you actually export from China?

Yes. We have a pretty balanced footprint. We are a small net exporter out of China, although not a lot of it comes back to the U.S., more of it would go into Europe, Australia, other -- other geographies. So I would say, we have had a balanced investment approach, largely probably between Europe and India, China -- Eastern Europe, India and China have been the bulk of our investment and then more recently Mexico. And I think you'll see us continue to take a pretty balanced approach to that. We don't -- we're not over-weighted or have too many eggs in one basket. And that, I would highlight there, as I mentioned, some of the economic volatility we dealt with in that five-year period on that chart, you know tariffs were a really big deal to a lot of our industry, if you will from steel customers and steel providers back three, four years ago. And again there was -- we took some short-term pain with that, but with the diversity of our footprint, we're able to navigate those things and deal with. And I think we're in a good position to handle whatever comes next.

Got it. Thank you.

Thanks, Steve.

Thanks, Steve.

Our next question comes from Bryan Blair with Oppenheimer. Please go ahead, Bryan. Your line is open.

Thank you. Good morning, guys.

Good morning.

Good morning, Bryan.

I noted solid backlog and that order trends are supportive of your implied Q4 guide through October. Just curious if across your major end markets, there are any you'd call out and order patterns diverging in any way from normal seasonality?

Yes, I think it's consistent with what Phil commented on, where the strength of the third quarter is probably still the strength of the fourth quarter, distribution looking strong and et cetera. I mean, as I said, Process is probably little bit more than Mobile. I think as you look to next year, you'd see some change there. Again, I think renewables will get off to a better start in '23 than they did in '22, but I wouldn't say there's anything significant happening in the fourth quarter different than what we just outlined happened in the third quarter.

Okay, understood. And any further color you can offer on the decision to divest ADS? I'm asking simply because I would assume that there's attractive cycle runway and with growth over the coming years that the margin profile would also benefit. And then another question, if you are willing to answer, looking at that divestiture and your 2022 acquisitions, what kind of net accretion carryover should we think about for 2023?

Yes. On Aero Drive Systems, I would say, it is slightly below the company average for margins this year, probably a little more lumpy margins, if you look year-over-year than the business in total. So probably help our predictability, cyclicality a little bit from that regard. The divestiture, we acquired that business over a decade ago and warfare has changed from helicopters to a lot more drones and the growth of that market, it's still a good market, it's still a good business, good cash generator. But it really needs some -- it needed to reposition itself on the next generation of equipment, et cetera. And we chose to not be the one to make that investment in consolidation and allow somebody else to do that. So that was really what led to divestiture. But I think it will have an immaterial impact on company margins, company cash flow, and as I said, it's a little over 1% of revenue.

Yes. And I would say a net accretion, Bryan. I mean, obviously we got this year with Spinea in the middle of the year, we got GGB at the end of the year, offset by the areas. It will still be net accretion flowing into a positive accretion, EPS flowing into 2023 from the carryover of Spinea, capturing synergies, driving growth as well as GGB.

Understood. Thanks, guys.

Thanks, Bryan.

Thanks, Bryan.

Our next question comes from Rob Wertheimer with Melius Research. Please go ahead, Rob.

Hi, thanks, and good morning.

Good morning, Rob.

Good morning.

My question is basically on Europe. Yes. So it's no surprise that Europe is slower, being flat there is no surprise, but there is some cross currents where some industrial end market still growing and some not. I wonder if you just provide any clarity of what you sell into, what's strong and what's weak and if there's any theme there?

Yes, I mean, I would say, Rob, as we talked about it in the quarter, the flat was really a combination of the industrial markets, in particular distribution and general industrial was modestly up. And then it was really offset by lower renewable energy, which obviously is big project spend over in Europe. And then also lower rail revenue with most of that rail revenue loss being because we idled our operations in Russia at the beginning of the year. So, you know, it's kind of the short story. Industrial still modestly up and then offset by the lower renewable and rail revenue. And then as we look ahead to the fourth quarter, we talked about expectations for being up organically. We are expecting Europe to continue to soften in the fourth quarter, slightly off the third. So we should post positive growth across most of the world, but Europe would be the one spot, which could tip to slightly negative in Q4.

Thank you. Sorry, if I missed something earlier. And then just one other one. You've touched on, gosh, supply chain in a few different ways, but just a general big picture sense, are things easing up, are they getting better, are they getting better in the 4Q or is it still back and forth?

I think they're getting better, they're getting better gradually more incrementally. I mean, we don't buy a lot of chips and aren't directly impacted by that, but we are indirectly impacted by that. For our customers that seems on their end to have gotten better. The labor situation in most of the world is significantly better from an absenteeism and coronavirus cases, et cetera, that it was. Still in third quarter, a fair amount of China issues with regional lockdowns that impacted some things there. As I mentioned earlier, transit times are still longer -- significantly longer than they were pre-pandemic. Ann then labor markets in much of the world obviously still remain tight and challenging -- more challenging than normal to add people. So I think it's still -- it's still choppier, bumpier, more surprises than what you would expect, but I do think it's getting better and we're expecting slightly better again in the fourth quarter.

Got it. Thank you.

Thanks.

Thanks, Rob.

Our next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.

Thanks. Good morning, everyone.

Good morning, Joe.

Hi, Joe.

Hi, I'm curious on like the -- just the inventory commentary specific to you, as you guys start to sell out of your inventory, obviously recognize like the positive cash flow effect that that's going to have. It's really in 2023. I'm curious, how does that impact your P&L, particularly, given that there might be some under-absorption also at the manufacturing facility that you are selling out? I just want to try to understand the margin impact.

It's a slight headwind and it's one of the reasons why we normally -- it's one of the reasons why our margins are usually lower in the fourth quarter than the rest of the year. We usually build some inventory in the first quarter, second quarter of the year and lowered a little bit in the third and fourth. So I wouldn't say it's anything abnormal. But when you look at a year-over-year basis, we built inventory last year in the fourth quarter, and we'd be looking to take a little bit out. So there would certainly be an impact from lower production in the absorption factor. But obviously, as we're guiding, we're guiding to more than offset that with margins up year-over-year in the fourth quarter from price/mix and other factors.

Yes. I guess, I think, the real question is, if you continue to sell a lot of inventories in, let's say, the first half of next year, like does that then like lead to is like a tougher comp, like I just want to make sure that I get it or are you guys going to be taking proactive cost actions to help offset some of that?

Yes. I mean, I think, as you look at this year, Joe, we certainly have, as Rich said, the inventory build, which helped from that standpoint. We also had higher costs and a lot of inefficiencies and we're expecting the higher cost to persist into next year. But as the -- if we build less inventory next year that will be a slight negative, as Rich said, but I think the inefficiencies -- our expectation would be the inefficiencies would sort of come down with it, because a lot of inefficiencies were caused by the significant ramp that we saw this year and the significant ramp up in production, et cetera. So as that -- as production moderate, if you will, I think we'll get a little bit of offset there, coupled with a lot of the self-help we talked about around new plants continuing to ramp, consolidating some of the facilities that we're working on as we speak. And so I think there'll be puts and takes as we look ahead into next year.

Got it. That makes a lot of sense. And maybe my one last one just on price-cost, I know we're not going to talk about anything like from a quantification perspective, but again kind of thinking through '23, as you reprice some contracts, do you think we're still in an environment where you can get pricing? Or have you started to see commodities and components come down enough where it might be a little bit more of a difficult conversation as we head into '23?

We would expect pricing to improve sequentially this quarter and again in the first quarter. And I think there's enough momentum there and there's enough need. We do, to your point, tough conversation. The drivers of the need for the price have moved from steel and logistics to other factors like labor and energy, but we will get positive price to start '23.

Okay. Thanks, guys.

Thanks, Joe.

Our next question comes from Dillon Cumming with Morgan Stanley. Please go ahead.

Great. Good morning, guys. Thanks for the question.

Good morning.

Just wondering if I can kind of build on Joe's last question there, just on pricing in the quarter. You were obviously clear about the kind of contribution from mix on the distribution side. But just wondering if you can kind of parse out how much of the actual price contribution in the quarter was from kind of what you considered to be normal annual price increases or kind of automatic indexing put through the start of the year versus any kind of more ad hoc pricing actions that you went out with during the quarter?

Yes. Within that price/mix, as we said, mix is certainly favorable year-on-year, so an element of that is mix. So it's not all price. And then there is a percentage of the price that is raw material indexed, and some cases, currency indexed, if we're selling things outside of -- in another currency. But I guess, a couple of things on that. It's well under half of the pricing, and it won't retreat unless the cost does. And generally, there's a lag on that. So like there was a lag in us recovering at last year, there's a -- which is negative for us. There was actually a positive lag. But with that and what we've seen with steel prices would still expect pricing to be up to start '23 net of any indexed factors that would play into it.

Okay. That's clear. Thank you. And then I realized it was kind of an unfair question since the consensus number are not yours, but you obviously had a pretty good quarter relative to the consensus number in 3Q, but the guidance raise didn't necessarily imply any upside into 4Q at the midpoint. Just curious if you can kind of talk through your assumptions in terms of what would have to go right in order for you to kind of hit the top end of your kind of full year guide that might imply a bit of upside kind of implied 4Q number for the fourth quarter?

Well, I think it would start with volume and being 1%, 2% over the revenue number would obviously drop through pretty well. I think on the second side, if we see further contraction on the material logistics sequentially that would certainly begin to help. And then we can even just stop the increase on the manufacturing side. And then there's also, as we said earlier, we are planning to produce slightly less than we sell during the quarter, but obviously anything that sales is higher helps that situation as well. I think the price is largely set. And then, I guess, the last one I'd say is the mix, which, again, we're largely counting on that to be positive again and all indications are with two months left, it will be.

Great. Thanks for the time.

Thanks.

Thanks, Dillon.

Our next question comes from Chris Dankert with Loop Capital. Please go ahead, Chris.

Hi, good morning, guys. Thanks for taking the question.

Good morning.

I guess starting off, just thinking about the Mexico facility, can you just kind of update us on what factory loading and utilization looks like there today? I mean, are we kind of -- is it 20%, 50%? Just a general ballpark of kind of how that's progressing would be great?

Yes, I probably wouldn't do a percent because there's machine capacity, man capacity, floor space, and we plan to be ramping the facility up for a couple of years. But it's gone from a year ago to -- at close to zero to if you went in it today, it would feel like a vibrant factory with well over 100 people working on in what's a fairly automated facility as well. And a year ago, you would have went in and saw a lot of construction equipment and idle machines being installed and/or running samples, et cetera. So it's come a long way in the last year, and it will be a nice year-on-year pickup for us on the cost side.

Got you. Yes, thanks so much for the color there, Rich. I guess, maybe to zoom out beyond just Mexico, I mean, Timken has done a really excellent job of kind of matching labor cost, the value of the product and getting on to -- into the market there. I guess, from a more holistic perspective, how are we thinking about footprint evaluation here today? I mean, are we talking about shortening supply chains? Are we talking about shifting facilities similar to -- are there other opportunities like chain? Any comments more holistically would be great as well.

You know, I don't think there's any major shift in our footprint strategy that we've been working on for better part of a decade. We invest our capital into -- overweight into specific facilities and specific regions and then flex other facilities with demand and over time take out some higher cost/smaller facilities. Some of our acquisitions done over the last few years have given us some more opportunity to probably do some of that in the coming years. We had two plant closures announced prior to the supply chain issues, et cetera. Those got drag out a little bit, but one of them in Italy, we completed earlier this year. And the other one, I mentioned, in Indianapolis is wrapping up kind of at the end of this year. So we don't have anything other -- anything else underway right now, but we do have, I'd say, a five-year plan that we march to and alter the timing of that plan based on market dynamics and the speed of it. But -- so we've got a pretty good balanced footprint. And I think you'll continue to see us march down, at no big imminent moves do we have in our plan for our footprint.

Got you. Thanks so much for the color there. And congrats to the entire team and really nice quarter.

Thanks.

Thank you.

Thanks, Chris.

Our next question comes from Michael Feniger with Bank of America. Please go ahead.

Hi, thanks everyone for squeezing me in. Hi, everyone. If we look at your EBITDA margin, which is up nicely this year, it's still below the pre-COVID level in '19, yet your sales are above pre-COVID, EPS above pre-COVID. So just broadly, anything structural preventing your margins from returning back to that pre-COVID peak and exceeding it as we look at '23, '24?

No. I think as we just outlaid at the Investor Day, we're targeting 20%, and we're committed to trying to do that. And obviously, the timing of acquisitions and various things play into -- and the cycle, the industrial cycle itself play into that. But we're marching towards the 20%. I think, we can get there.

Perfect. And just on, as you said, timing of the M&A, I mean your leverage is reasonable. I think you said you're going to end the year around 2 times. You expect a bigger free cash flow year next year. So just thinking about 2023, is 2023 more about integrating Spinea and the GGB acquisition is supposed to close in Q4, you know, and it's more about integration and maybe shifting more to buybacks or could we see more acquisitions outside year of M&A in 2023?

Well, I think, it will be a year of good cash flow and a year of -- that we will allocate more capital to one of those two. The M&A side remains opportunistic. I think the Spinea acquisition is certainly going to be -- been integrated to some degree with Cone, but they're more complementary than they are overlapping. So I would say it's a fairly light integration. And then GGB is a couple of hundred million dollar business being integrated into a $3 billion bearing business. So I think we could handle -- we have the management bandwidth to handle more of bearing, should that present itself, although as we talked before that's probably less likely because there's less targets that we're working on in that space. And then within the -- in the industrial motion product line, I think there's ample opportunities. And again, we have the management bandwidth and the organizational changes that we announced a few months ago were done specifically with the intention of making sure we did have the bandwidth to continue that. So biased to M&A next year as we've had and believe we'll be active in generating good cash and redeploying that cash.

Perfect. Thanks, everyone.

Thanks, Michael.

Thanks, Michael.

There are no remaining questions at this time. Sir, do you have any final comments or remarks?

Thanks, Emily, and thank you, everyone, for joining us today. If you have any further questions after today's call, please contact me. Thank you, and this concludes our call.

Thank you for participating in today's Timken's third quarter earnings release conference call. You may now disconnect.