Equity Research Europe Capital Goods - Engineering (Europe) 06 November 2013 SKF (SKFb.ST) INDUSTRY OVERVIEW/ANALYSIS China becoming more of a threat than opportunity SKF market share in China (LHS) / Pricing in China (RHS) IDEAS ENGINE SERIES We are concerned about SKF's longer-term positioning and about the scope for a deterioration in returns in the medium term following our detailed proprietary study of the local bearings market in China. Our key concerns: 1) SKF's market share in China has declined by >100bps since 2009 The Ideas Engine and its revenues in China have declined slightly in 2011 and 2012 as local players have made meaningful progress over the period (now 5 sizeable local series showcases players and 2-3 focused specifically on the high-end applications). Credit Suisse’s unique 2) Profitability of the local players has been declining at the gross and insights and investment operating levels and is now below SKF's group level (SKF historically made ideas. higher margins in China vs group), giving potential downside on margins. Source: Company data, Credit Suisse research, Industry associations 3) Average domestic selling prices have been falling since 2010. SKF currently generates highest returns Please contact your 4) Local players' expansion supported by government into high-end 12 CFROI Sales person to market applications such as High-Speed Rail, Wind Turbine and Aero. 10 access the Reiterate Underperform, TP cut to SEK 150 (from SEK 155). China 8 accounts for c11% of SKF sales directly and we are concerned by new 6 supplemental 4 analysis behind this competition from Chinese players in other emerging markets (c30% of group 2 report. sales on top of China). We reduce our 2015E EPS by 8%. 0 -2 Valuation sensitivity. On Credit Suisse HOLT®, local Chinese players -4 ® currently generate CFROI 50% below that of SKF group and SKF is -6 currently priced to maintain its returns. Should SKF CFROI fall back to pre- SKF Timken Wanxiang Tianma NSK JTEKT NTN 2004 levels (when the industry was more fragmented and price-competitive), Qianchao Bearings it would imply >30% potential downside; a scenario of SKF emerging Source: Credit Suisse HOLT markets CFROI falling to industry average levels implies 25% downside. RESEARCH ANALYSTS Andre Kukhnin CFA Tiantian Li Simon Toennessen Max Yates Jonathan Hurn, CFA 44 20 7888 0350 44 20 7883 1552 44 20 7883 6893 44 20 7883 8501 44 20 7883 4532 [email protected] [email protected] [email protected] [email protected] [email protected] DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON US ANALYSTS. FOR OTHER IMPORTANT DISCLOSURES, visit https://rave.credit- suisse.com/disclosures or call +1 (877) 291-2683 US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.. ® CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access SKF (SKFb.ST) Price (05-Nov-13,Skr) 173.4 Market Cap (Skrmn) 78899.1 Previous Value Current Value Rating UNDERPERFORM Target Price (Skr) 155.0 150.0 EPS FY1E (Skr) 9.8 EPS FY2E (Skr) 12.8 12.8 EPS FY3E (Skr) 15.3 14.1 Source: Credit Suisse Estimates, IBES Income Statement 2012FYA 2013FYE 2014FYE 2015FYE Per Share 2012FYA 2013FYE 2014FYE 2015FYE Sales Revenue 64,575 63,399 70,109 73,832 No. of shares (wtd avg.) (mn) 456 456 456 456 EBITDA 9,163 9,304 12,048 12,773 EPS (CS Adj.) (Skr) 10.23 9.83 12.79 14.06 Depr. & Amort. -1,831 -1,887 -2,631 -2,517 Prev. EPS (Skr) 10.23 9.83 12.79 15.30 EBIT 7,332 7,418 9,416 10,256 DPS (Skr) 5.50 5.50 6.73 7.03 Net interest income (exp) -906 -906 -962 -850 Dividend yield (%) 3.17 3.17 3.88 4.05 Other adj. 0 0 0 0 Dividend Payout (%) 53.78 55.96 52.63 50.00 Profit before tax 6,426 6,512 8,455 9,406 Earnings 2012FYA 2013FYE 2014FYE 2015FYE Income tax -1,592 -1,894 -2,446 -2,792 Sales Growth (%) -2.48 -1.82 10.58 5.31 Profit after tax 4,834 4,618 6,008 6,614 EBIT Growth (%) -22.09 1.17 26.95 8.91 Minorities -154 -141 -183 -208 Net Income Growth (%) -20.36 -3.91 30.12 9.95 Associates & Other -21 0 0 0 EPS growth (%) -20.39 -3.91 30.12 9.95 Net profit (CS) 4,659 4,477 5,826 6,406 EBITDA Margin (%) 14.19 14.68 17.18 17.30 Other NPAT adjustments 7 -200 -300 -100 EBIT Margin (%) 11.35 11.70 13.43 13.89 Net profit (Reported) 4,666 4,277 5,526 6,306 Pretax Profit Margin (%) 9.95 10.27 12.06 12.74 Cash Flow 2012FYA 2013FYE 2014FYE 2015FYE Net Income Margin (%) 7.21 7.06 8.31 8.68 EBIT 7,332 7,418 9,416 10,256 Valuation 2012FYA 2013FYE 2014FYE 2015FYE Net Interest -650 -906 -962 -850 EV/Sales (x) 1.3 1.5 1.3 1.2 Cash taxes paid -2,839 -1,894 -2,446 -2,792 EV/EBITDA (x) 9.4 10.1 7.6 6.9 Change in Working capital 657 -596 -1,090 -306 EV/EBIT (x) 11.8 12.7 9.8 8.6 Other cash and non-cash items 1,688 1,558 2,202 2,288 P/E (x) 17.0 17.6 13.6 12.3 Cash flow from Operations 6,188 5,581 7,121 8,597 Price to book (x) 3.7 3.4 3.1 2.8 CAPEX -2,648 -1,700 -2,000 -2,000 Asset Turnover 1.1 1.0 1.1 1.1 Free cashflow to the firm 3,540 3,881 5,121 6,597 Returns 2012FYA 2013FYE 2014FYE 2015FYE Cash flow from Investments -2,856 -10,623 -2,000 -2,000 Return on equity stated (%) 21.8 19.3 22.9 23.5 Cashflow from financing activities -1,975 -2,505 -3,066 -3,203 ROIC (%) 18.4 13.4 16.9 18.3 Changes in Net Cash/Debt 1,357 -7,548 2,054 3,394 Interest burden (X) 0.9 0.9 0.9 0.9 Net debt at start 8,788 7,431 14,979 12,924 Tax rate (%) 24.8 30.0 30.0 30.0 Change in Net debt -1,357 7,548 -2,054 -3,394 Financial leverage 0.7 0.7 0.6 0.6 Net debt at end 7,431 14,979 12,924 9,530 Gearing 2012FYA 2013FYE 2014FYE 2015FYE Balance Sheet 2012FYA 2013FYE 2014FYE 2015FYE Net debt/equity (%) 33.1 61.8 48.3 31.8 Total Current Assets 34,848 27,881 32,184 36,526 Net Debt to EBITDA (x) 0.8 1.6 1.1 0.7 Total Fixed Assets 22,886 31,622 30,990 30,473 Interest coverage ratio (X) 8.1 8.2 9.8 12.1 Total liabilities 38,289 38,274 39,432 40,075 Source: Company data, Credit Suisse Estimates Shareholder equity 21,340 22,986 25,316 28,290 Minority interests 1,128 1,269 1,452 1,661 Total liabilities and equity 60,757 62,529 66,200 70,025 Net debt 7,431 14,979 12,924 9,530 IDEAS ENGINE 2 SKF (SKFb.ST) Figure 3: Chinese domestic players' profitability has been in decline Charting the story 30% Figure 1: SKF market share declined recently in China as its growth turned negative 25% 20% 15% 10% 5% 0% 2009 2010 2011 2012 Average bearing gross margin Average EBITDA margin Average EBIT margin Source: Company data, Credit Suisse research Figure 4: Average unit price per bearing in China fell consistently for domestic volumes Source: Company data, Credit Suisse research, Industry association data, Industry consultant data and started to decline for imports in 2012 Figure 2: Local listed competitors emerging in the market in addition to the two largest 2.50 11.00 state and private-owned players – export and local high-end markets targeted. Key state- or private-owned players are: C&U, Wafangdian (has a listed JV), Luoyang, Harbin 10.50 2.00 9,000 20% 10.00 8,000 15% 1.50 9.50 7,000 10% 6,000 9.00 1.00 5,000 5% 8.50 4,000 0% 0.50 3,000 8.00 -5% 2,000 -10% 0.00 7.50 1,000 2006 2007 2008 2009 2010 2011 2012 2013 3Q 0 -15% SKF Qianchao Wafangdian Tianma Longxi (LS) Xiangyang Zhouyan Keji Xibei (NXZ) Nanfang Zhonghang Import price, USD (LHS) Export price, USD (LHS) Domestic price, RMB (RHS) (QC) (ZWZ) (TMB) (ZXY) (ZYS) (NF) Hazhou (ZHHZ) Source: Industry association data, Credit Suisse research Total Revenue (RMB m) Bearing revenue (RMB m) Total EBIT margin Figure 5: China bearings market competitive landscape evolution – now (top) vs. 3 years NB. Rectangles indicate companies focused on export markets and ovals indicate those focused on high-end ago (bottom) – a visualisation based on company data, commentary and our estimates bearings applications. Source: Company data, Credit Suisse research IDEAS ENGINE 3 SKF (SKFb.ST) 25% Figure 6: Our China competitive threat assessment framework – degree of risk vs.