Five months ago, SumZero member Rodrigo Lopez (Gerbera Capital) posted a long recommendation on Precision Castparts Corp (PCP:US) with a $332 price target. He presciently referred to the situation as, "Acquiring Buffett-like business at almost 2008 levels in EV/Inv. Capital driven by market overreaction to recent aerospace and O&G slowdown."
Mr. Lopez, who recently acquired his MBA from the University of Chicago's Booth School of Business and is now moving on to work for a multi-family office in Mexico City, heavily detailed the various attributes of the large aerospace business, and the situational opportunity presented by the deeply discounted shares.
We fast forward to this weekend's news of Warren Buffett's acquisition of the same company for $37B, a record-breaking figure for the Oracle. We happily acknowledge Mr. Lopez's great call, but also point to the fact that, according to Lopez's own work, Mr. Buffett is, once again, getting a tremendous deal at $235/share. This accounts for the 20% premium to recent prices that Berkshire is offering. Please enjoy the complete write-up with our compliments. Our sincere congrats go to Mr. Lopez on the excellent analytical work, as well as to WEB for his savvy deal making.
The March 2015 Investment Thesis
1. Aerospace (68% of revenues) segment is underestimated (revenue growth of 10% vs market consensus of 6%)
*Market overlooks PCP’s ability to increase its market share per new plane built: I assume conservative levels of $7.5M of Revenue/plane in 2020 (currently at $5.1M per plane). This ability is a result of producing differentiated products that make each airplane more fuel efficient and increase customer’s switching costs
*Plane penetration in emerging markets is 70% below that of the world average
*Sector is not as frothy as the market is pricing in: capacity utilization is currently at 77% which is far below pre-2008 crisis levels of 91%
2.Market overlooks PCP’s General Industrial segment (14% of revenues). This segment has the potential to become the fastest growing contributor to PCP’s top line as the company leverages its competitive advantage in this lagging segment
*The product segment most exposed to General Industrial is Forged products. PCP has increased its market share in Forged by 16% CAGR in the past 16 years and will continue to gain strength driven by segment margin convergence, TIMET and increased industrial CAPEX
3.Currently trading as if PCP’s free cash flow decreased by 5% in the next 5 years vs. historical CAGR 2005-2013 of 36%
*Acquiring high quality business for a 30% discount to its historical EV/Invested Capital multiple: close to 2008 levels
*Assuming my bear case, current price is at a 9% discount to PCP’s intrinsic value
*BA and AIR airplane orders – Aerospace sector
*New capital goods orders in the US – General industrial sector
*Lower Boeing and Airbus backlog; PCP is more exposed to OEMs – Management has expressed their effort to increase revenue per plane
*PCP is not able to successfully integrate acquired companies
*Client concentration: GE accounts for 13% of revenues
Precision Castparts is a supplier of complex metallic structural components and subassemblies for the General industrial, Power generation, and Aerospace end markets. The company’s exposure as of 2013 (fiscal year ending March 2014) to each sector as a percentage of sales is 68%, 18%, and 14% for Aerospace, Power (O&G) and General industrial, respectively. In terms of product segmentation, PCP reports 3 different segments: Forged, Investment cast, and Airframe products and as of 2013 accounted for 44%, 26%, and 30%, respectively, of total revenue. PCP is the leading supplier to both plane manufacturers and the two largest engine manufacturers for airplanes in the world (GE and Rolls Royce).
PCP’s stock price has fallen by almost 20% in the past 6 months due to three main reasons: 1) The market has overreacted to the effect the slump in oil prices will have to PCP’s results, 2) Lower earnings guidance driven by a single aerospace client that has been destocking for 2 years now, and 3) An expectation that aerospace demand will not catch up to supply.
However, I believe PCP does not deserve the current pricing due to 1) A good business that can be replicated across all product segments enhancing the General industrial segment and supported by overdue CAPEX plans in the economy, 2) Overstated slowdown in the Aerospace industry – client destocking is a short term blip. I recommend this as a long term investment
Mark Donegan has been CEO since 2002. As shown on the graph on the right, Mark is compensated mainly with option awards which attests to a long term commitment to the firm. Further, variable cash compensation has increased mainly due to the successful achievement of the company’s strategy.
Management’s variable comp is driven by EPS and RONA which implies that they may be incented to 1) use leverage, 2) generate enough FCF to have cash on balance. Mark currently has 0.2% ownership of PCP while all management has 0.3%.
I valued PCP with three different methodologies: Abnormal Operating Earnings (AOE), EV/Invested Capital, and P/E. First, the intrinsic value of PCP is estimated based on an AOE (ROIC –WACC) model. The key assumptions used are as follow (base case):
*Lower airplane deliveries than consensus is expecting (CAGR 3.5% vs. 4.2% consensus). My estimate is closer to GDP growth
*PCP’s long term ROIC (including intangible assets) to be 14% on the back of a slow convergence towards WACC. I prefer to remain conservative on my forecast of ROIC going forward and support my thesis that even with a lower ROIC, Precision Castparts is a good long term investment. To put it in context, ROIC:
*16.5% LT historical average
*11% lowest point in history: 2003
WACC of 8% includes PCP’s current capital structure of 11% debt (including value of operating leases and their net pension liability), Rf = 3%, Rm-Rf = 5.5% and a levered Beta of 1.03
Second, the graph on the right shows PCP historical EV/Invested Capital (EV/IC) ratio. At current prices, PCP is trading at 2.1x IC which is at a discount of 32% to its long term average of 3.1x and a 42% discount to where it was trading in 2013. Current levels are similar to 2008 ratios and therefore provides a large margin of safety on the investment.
Lastly, given PCP’s has high operating leverage and predictability, earnings deserve to be considered. PCP is currently trading at 12.2x 2016E (my estimates), vs. historical levels of 16x and vs. peers of 15.6x. According to my analysis, PCP is trading at a discount to peers given the company’s small exposure to the maintenance and repair market (only 10% of revenues). However, I believe that a 20% discount for a good business such as this one is a huge opportunity that the market is offering us. Refer to the valuation summary table to the right.
Why PCP is a good business
If we compare PCP’s historical operating performance relative to its peers we can clearly see that it has a competitive advantage that is sustainable and not easy to replicate. See below for a comparison of PCP (thick blue line) vs. peers in operating performance.
The source of PCP’s competitive advantage is its differentiated products and as a result benefits from pricing power and higher margins. Furthermore, PCP’s cost structure relative to its peers shows economies of scale that translates into more efficient operations. These economies of scale in addition to the high start-up costs to begin a business in this industry are important deterrents for new entrants.
PCP’s integration efforts have several benefits for the business. On the one hand, horizontal integration, mostly through acquisitions of complementary businesses, has given PCP the ability to offer more complete packages to each client. Today, PCP is able to not only offer structural castings on an engine but also turbine blades and other additions that increases PCP’s value content on each engine. PCP is taking advantage of one of the best methods of capturing value. They know that client’s demand for PCP’s joint products is less elastic than demand for its individual products giving them the ability to charge higher prices. On the other hand, vertical integration is also benefitting PCP’s business. Acquiring TIMET, for example, has assured PCP’s supply of titanium input and allowed more flexible coordination within the value chain. This also protects sensitive information that could be useful for PCP’s competitors. TIMET is not limited to selling titanium to produce PCP’s forged products: it is also supplying the investment cast parts and airframes segments and it even supplies external component manufacturers. This allows TIMET to achieve economies of scale.
Furthermore, PCP’s clients have high switching costs. The buyers need a big, resourceful supplier of parts that can provide more complex products that can withstand higher temperatures and pressures in order to improve their engine thrust and generate lower carbon emissions. Buyers’ main concern has been and will continue to be fuel efficiency. Although oil is at historically low prices and fuel may not be an issue for companies at the moment, in the long run, fuel efficiency will continue to be an important decision factor for any consumer who buys a machine. PCP’s has the technology and expertise to produce the essential parts in almost any type of machine and will continue to leverage their position.
PCP’s market share per plane will continue to be strong – and demand for aerospace as well
Given PCP’s complementary businesses, it has been able to vertically integrate into several steps of the value chain. For example, not only does it produce the Forging product but it also supplies the nickel to produce it. PCP also is able to cross-sell amongst its product segments with the same client: this is shown by the increased amount of intercompany sales. Ultimately, this results in acquiring more market share with each client and with each product sold improving PCP’s competitive position and pricing power. The revenue per plane delivered in 2007 was $4.3M and has steadily increased to $5.1M as of 2013. I expect these synergies to be a significant driver of PCP’s results in the Aerospace sector. Management has expressed that in some airplane platforms they have been able to achieve a Rev./plane of $10M. My base case assumes PCP’s Rev./ plane is below this upper limit reaching $7.8M until 2020, which can be a conservative assumption.
Industry reports signal significant expansion in aircraft fleets in emerging market in the next 20 years. To the right is a snapshot of how many people there are per plane in each region/country in 2013. I am not expecting the ratio to converge toward the US+Canada, which has the highest penetration of airplanes but rather notice the still large difference between the world’s regions. Over the long run, I expect the emerging markets to move closer to the overall average.
Within the US, the aerospace industry is not as frothy as the market is expecting. The 40-year average capacity utilization is approximately 74% and the industry closed at 77% at the beginning of 2015. Furthermore, current utilization rates are well below historical highs of 91% at the end of 2007, minimizing the risk of a reversion to the mean due to an unsustainable demand and supply economics.
General Industrial has the potential to become the fastest growing contributor to PCP’s top line as the company leverages its competitive advantage in this lagging segment
PCP’s “general industrial” segment has been lagging along with CAPEX in the overall US economy but has recently recovered ground. In the past 3 years both Aerospace and Power have decreased their growth while the General industrial segment has increased. In my forecasts, I assume a conservative assumption (under base case scenario) in terms of the growth of the Aerospace business (10% moving forward vs. 12% 2006-2013). I expect Power to be sluggish for the next few years (growing 1% moving forward vs. 5% historically) as a result of CAPEX cuts in many O&G companies. General industrial is where I believe growth will come from in the next 5-10 years, growing at a 15% clip from 2013-2020 compared to an average growth of 7% in the previous 4 years. This rational is on the back of PCP’s ability to offer differentiated, high margins products, leverage its recent vertical integration efforts and creating value through sharing its current assets across markets.
How will PCP increase its market share in General industrial?
This leads us to the product segments which PCP divides into three: Investment cast parts, Forged, and Airframe. See the sales evolution of PCP on the graph to the right.
The product segment most exposed to the general industrial sector is Forged products with 20% of Forged sales attributable to this sector. From a different perspective, sales to the General industrial sector attributable to Forged products has increased from 42% in 2006 to 62% in 2013. Clearly, an increase in Forged sales will translate into more market share in General industrial.
Further, PCP has positioned itself to be more exposed to the Forged segment and therefore to the General industrial sector. In the past two years the company has invested more than 60% of total CAPEX in their Forged product segment. In terms of profitability, Forged products’ ROA has the largest potential to converge toward PCP’s overall ROA (Forged: 7.3% vs. PCP: 11%) by using more of their internal assets to expand their Forged offerings. I analyzed PCP’s intercompany sales and the biggest contributor to them is Forged with almost 80% of the total. Although intercompany sales are netted out from total sales, it does reflect in higher market share within the product segment. The CEO has expressed this in his last earnings call: “…and general industrial was up in this segment (Forged) vs. last year, and again, that was driven to put the volume across our fixed assets.” The amount of assets dedicated to the Forged product segment (59% in 2013) is further proof of PCP’s ability and incentive to increase their market share in the segment. For a look at PCP’s market share per product refer to graph on the right.
There is an additional driver of Forged sales which will reflect in higher General industrial sales as well: TIMET (Titanium Metal Corporation, the largest titanium manufacturer in the US) which was acquired by PCP on Dec. 2012. The rationale behind this acquisition was to become independent of titanium suppliers and increase market share. TIMET is under the Forged product segment and has achieved significant cost synergies across PCP’s platform. Management’s comments on the last two earnings calls speak for themselves:
“We have a home right now obviously of self-feeding , feeding ourselves for titanium…the market share that we won early on is just now starting to come in into play. You'll see it as we move into the very end of fiscal year 2015, the year we're now, and then it continues to accelerate basically through 2016 and through 2017. There is additional market share that we are actively going after now. TIMET's cost position, back when these contracts were awarded, just wasn't remotely close where it is today.”
It is worth mentioning that Forged is the most competitive market of all. It is the largest market ($100B) but it currently has lower margins than the other segments (EBIT mg Forged 26% vs. 30% overall). However, given PCP’s competitive advantage it is well positioned to continue to gain market share and leverage its expertise in this segment.
Increased CAPEX spending from the General industrial sector
From the demand side of the General industrial sector, I expect more CAPEX spending from the industries that PCP serves including automotive, pulp and paper, chemical, farming, mining, and shipbuilding, among others. It is important to analyze the capacity utilization in this sector. Both Machinery and Durable Machinery are reaching levels of 80% as of mid-2014. Although there may still be room to use current capacity, companies will need to invest in PPE to expand their operations.
This is also supported by the meager top line growth and historically high levels of profit margins across companies in the US. Since the 2008 recession, firms have focused on reducing costs as much as possible and thus driving margins to the upside. Given that firms have exhausted most of the ways to reduce their costs, I expect profit margins to be more influenced by pricing moving forward. Margins can either continue to increase or revert to normal levels. If margins increase, companies will have to invest CAPEX to acquire better technologies or machines in order to charge a higher price to their customers. Current PPE is too old to have the ability to produce premium products. On the contrary, if margins revert to lower levels this will be driven by lower pricing as a result of more supply of capacity in the market. This is positive for PCP given that both scenarios require investment in CAPEX: to acquire new and better machines and charge a higher price or to expand capacity as a result of currently high margins.
Value investor by heart and a disciplined, hard-worker by conviction, Rodrigo is a recent MBA graduate from Chicago Booth where he earned a concentration in Analytic Finance and was actively involved in the IM / HF community. He was an Investment Banker before business school and worked as a summer equity analyst at Castle Union, a deep value hedge fund in Chicago. He recently accepted a position at a multi-family office called Gerbera Capital out of Mexico City where he will continue to span the globe looking for great investment ideas and outstanding asset managers.
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