SKF vs FAG: Bearings biggies face off (Part I)

That India has emerged one of the fastest growing economies in recent times is a foregone conclusion. The same is likely to hold true atleast for the next decade as well. Not surprisingly then, sectors like auto and industry, which are a direct play on Indian economy, will also continue to do well. Infact, by virtue of their growth prospects, they have the capacity to leave even the Indian economic growth far behind. The bearings industry, which derives a lot of its demand from the auto and few of the other manufacturing sectors, is also likely to see good times ahead. Quite naturally then, investors would be keen to profit from this trend by buying shares in companies that manufacture bearings. But which bearings company can turn out to be a good investment from a long term perspective? We will make an attempt to answer the same through this series. Over the next few articles, we will compare SKF India and FAG Bearings, two of the biggest bearings companies in India and try and make it easy for you to bet on the horse most likely to win this long term race. An overview of the Indian bearings industry Every machine or product that moves or rotates more often than not has bearings in it. Bearings help in reducing friction between moving parts thereby facilitating movement with optimal use of energy. Ball bearings are the most commonly used bearings commanding around 60% of the total bearing market followed by taper roller bearing which accounts for 25% of the total industry size. The Indian Bearing market can primarily be divided into 2 sectors - Automotive and Industrial. Each of these segments may further be sub divided into OEM & End Users. Original Equipment Manufacturers (OEM) are the major users of bearings in India with about 60% market share while the end user segment contributes to the remaining. Within the OEMs, the Automobile segment consumes the largest share of bearings followed by the industrial sector. The supply structure within the bearing industry is dominated by the domestic bearings manufacturers who account for 75% of the total demand. Balance is met through imports. Imports constitute both supplies of niche products not manufactured in India as also cheap imports from neighbouring nations. As far as threats are concerned, steel and alloy steel constitutes the single largest component of the cost of bearings. Hence, margins of bearings manufacturers are susceptible to movement in steel prices.

Another threat is that of cheap low quality imports. It should be noted that many of these imported bearings are being sold in the market as spurious bearings. As per estimates, these account for 20%30% bearings sold in the replacement market. However, as technology improves and awareness increases, spurious bearings should see destruction of demand in the years to come.

Thus the fortune of bearings sector is a critical indicator of the direction in which the economy is moving. In the next article we will focus on how the topline growth of two of the biggest names in the sector viz. SKF and FAG Bearings has moved over the past few years and what factors have been responsible for the same. Let us consider operating performance first. As shown in the chart below, FAG's operating margins have remained consistently higher than that of SKF's over the past five years. Both the companies suffered a margin hit in 2009 but even then, FAG's margins came in higher than its counterpart. But the picture reverses if one considers the CAGR (compounded average annual growth rate) in operating profit. Between CY05 and CY10, SKF's operating profits have grown at a CAGR of 22%, slightly higher than FAG's 18%. This is because SKF has been able to keep its margins intact for both the years under consideration. FAG, on the other hand, has witnessed a slight contraction for the same time period. Both the players are also different in the way the operating margins are composed. For SKF, margin of traded goods is on the higher side than that of bearings manufactured in house (margins of traded goods take into account only purchase and sale of traded goods). But in the case of FAG, margins for in house products have been higher for most of the years under consideration. This perhaps points towards the fact that while SKF imports most of the high value add products; FAG manufactures some of it in house.

Source: Equitymaster

Let us now move on to net profit margins. While FAG had an edge over SKF on the operating margin front, the differential narrows down a bit by the time the net profit figures are reached. This could be attributed to slightly lower depreciation charges of SKF and absence of any extraordinary losses. However, on account of better performance at the operating level, FAG still noses ahead of SKF with an average net profit margin of around 12% between CY06 and CY10. The same for SKF came in the region of 8%. CAGR wise, SKF's profit growth at 22% between CY05 and CY10 comes in slightly better than FAG's 20% during the same period. To conclude, yet again, there was very little to choose between the two on the profitability parameters as only a few percentage points separated them.

In the previous article, we discussed the margin trend of the two largest bearing manufacturers viz. SKF India and FAG Bearings. We will now focus on how the two companies stack up on the capital efficiency front. Just as in the case of margins and growth, there isn't much to choose between the two when it comes to RONW (return on net worth) as well. For the five year period between CY06 and CY10, the average RONW for FAG stood at around 23% while the same for SKF stood at around 22%. This is a very good performance by both the companies as the returns are much higher than the cost of capital of these companies and indicate the wealth created for their respective shareholders. Furthermore, these returns have been achieved using practically no debt at all as both the companies are nearly debt free. It should be noted though that FAG has been hoarding more cash than its counterpart. Its average dividend payout of around 9% over the past five years is much lower than the 21% that SKF has averaged over the same period. Valuations

Source: Ace Equity

As far as valuations are concerned, SKF has had an edge over FAG Bearings if the data for the last five years is any indication. While SKF's P/E has averaged 15 times during the period, the same for FAG has come in at 11.5 times. With most of the parameters for both the companies being pretty much similar, the premium for SKF seems to have stemmed from its better dividend payout and superior brand equity that its products command in the market. However, only time will tell whether this premium will persist in the long term or not.