Nice PCP piece - impressive story, definitely on my short list with BEAV:
Precision Castparts: Underlying Growth Prospects Are Overlooked
by: Jim Regan posted on: August 08, 2008
Chances are, when you think of Precision Castparts (PCP), you are reminded of the recent 8-month slide brought about by the fear of Boeing’s (BA) “Dreamliner” 787 delays, a gut-wrenching crude oil pricing environment and a supposed slow down in the aerospace cycle. Investors have been quick to lump Precision Castparts in with the fall and subsequent consolidation found across all major airlines, as well as problems among Industrials companies in handling higher oil costs. In reality, PCP cannot produce its product fast enough to meet order demand and is seeking further expansion.
Before I launch into an investment rationale for Precision Castparts, I want to discuss briefly what it actually does. Precision Castparts is best known for manufacturing metal components for large finished products like jet engines, industrial gas turbines, pumps, compressors and even artificial hips. Its revenues come primarily (50-55%) from the aerospace market with the sale of its forged products for plane engine components.
A quarter of its revenue is from the power generation markets with the production of industrial gas turbines (think jet engines used to power things). And its general industrial branch, making things for chemical, pollution control and medical business, represents the remainder (with a small 5% still devoted to automotive). In a nutshell, it provides OEM and aftermarket metal castings for many companies.
Precision Castparts - First Quarter 2008 Earnings Results
Precision Castparts announced earnings on July 22nd, 2008. I thoroughly enjoyed its results, but the shares still took a hit because of mixed results from Forged Products and some planned second quarter maintenance. After holding a net debt of $143 million on March 31st, it moved into a net cash position of $89 million on its balance sheets. The margin shortfall in Forged shouldn’t disturb very strong growth shown in PCP’s core growth story. It managed to beat earnings estimates despite the small margin contraction in the Forged unit, posting an EPS of $1.95 (22%+ YoY) to beat quarterly estimates by 2 cents.
With solid earnings booked, and organic sales growth of 11.2% YoY, PCP reported great earnings and a stellar outlook. Everything looks sustainable with a below-average oil risk, something investors haven’t picked up on. Precision Castparts' IGT business is soaring, with demand spiking to levels where it is seriously considering extending its operations to enhance its ability to provide turbines. Aerospace demand has held firm, and it is anticipating a large portion of its business to develop from Boeing’s new 787 plane, which hasn’t yet begun development. Its backlog of $900 million continues to expand, and margins are predicted to expand further despite an already impressive increase from 21.3% to 23.1% this year.
PCP Chairman and CEO Mark Donegan said:
The price demand we see right now remains strong and the backlog really supports two years of production. And on the non-aerospace alloy side we still see market share opportunities in our key areas. So, I think that overall Q1 was a good start. We have a lot to do. We have a lot of opportunities in all fronts in terms of growth, performance and margins. And certainly our goal is to stay focused, stick to the basics and drive through the results we have to drive through.
The Three Fears That Don’t Add Up
Because Precision Castparts is an industrial company that has ties to the aerospace cycle, investors have used rationale to dock a company that deserves to trade higher. Below are the three major false impressions that PCP has been falsely accused of:
1. Concerns in major carriers and the aerospace cycle
2. Problems in the Pipeline for Boeing
3. Rising Gasoline Costs
Concerns of a slowed aerospace cycle: There are essentially two sides of the equation here. The first, is that airlines cannot cope with unpredictable gas prices, so they need to cut the size of their fleets and cancel orders. But the other side of the coin is that since gas has become so expensive, major airlines will need to upgrade their fleets to more energy-efficient models. Here is where PCP comes into play, offering the best parts in the business to optimize energy usage. Not only do we have an American aircraft market flooded with models literally rushing away compared with the much newer European planes, but we see the need for energy-efficient parts… cheap forgings just aren’t flying anymore.
Problems in the Pipeline for Boeing: It would seem that every time Boeing’s stock took a dip on news of delays to the 787 Dreamliner, Precision Castparts was hurt in the same fashion. It’s amazing how quick people are to forget that PCP supplies parts to a huge array of company’s including General Electric Aerospace (GE), United Technologies’ Pratt & Whitney (UTX) and Rolls-Royce. None of these end markets represent more than 10% of PCP’s business, and it hasn't realized any gains from the 787 thus far. But don’t be totally thrown by this statistic; fuel-efficient models by Airbus and Boeing are going to be in excess demand by airlines like British Airways… which should give Precision a nice boost to aerospace sales.
Rising Gasoline Prices: We are currently seeing the major airlines swing violently on a daily basis as the price of crude oil trades up and down. Many investors like to include Precision Castparts as if it were an airline of sorts, feeling that there will be less demand with higher oil. However, the backlog is in fact so strong at this point in time that order cancellations would be a non-factor for the company. And orders canceled will be met wholeheartedly by the line around the corner to receive parts from PCP. This demand shouldn’t be slowing anytime soon. Though fuel costs will be an eventual problem if things persist, Precision Castparts has a golden future, and should be able to capitalize with a shift away from gas-guzzlers such as the Boeing 747.
An Acquisition-Ridden Future?
Short-term investors may not like to hear the word acquisition when they consider a company, but most of the deals that Precision Castparts would be pondering shouldn’t come until 2009/2010. Management is very confident in its ability to successfully acquire and merge businesses, and quite honestly further moves to expand business are needed as the demand is simply too strong to ignore.
In the past two years, PCP has doubled the margins of all major deals. Not only this, but now with an estimated cash flow of $2 billion by the third quarter of 2010, there is going to be about $5 billion in usable fire power for PCP. An example of the potential advantage? Cowen & Company, an equity research firm, estimated that a $1 billion acquisition at that point in time would add about $0.30 to overall EPS before intangibles and synergies.
Growth You Can't Ignore
There are many reasons to stay bullish on Precision Castparts' future through hard times. With a great earnings report and an outlook that backs up the ongoing enthusiasm coming from upper-management, here are my top three:
1. A Booming IGT Business Poised to Grow
2. Still-Solid Growth from Aerospace, Despite Worries
3. A Unique Process and Reputation Moat
Red Hot Growth from Global Power Generation Markets
Perhaps my favorite driver for Precision Castparts' growth into the future is its huge hand in global power markets, namely oil & gas infrastructure. Its main play on the infrastructure boom, which hasn’t slowed, but is being largely overlooked by the market, is the Industrial Gas Turbine [IGT] business. A quick recap: an IGT is simply a jet engine used to generate power for heavy duty work on everything from cargo ships to natural gas power plants. Estimates hold that the IGT business will grow from about $9 billion in 2007 to $15 billion in 2011.
The best use, and a major reason that the IGT business is booming, is in natural gas power plants. Since commodities like coal are too dirty, oil too sparse and solar & wind too unreliable, there have been a lot of bulls on natural gas as of late. If you want to play the natural gas market without subjecting yourself to a volatile commodity, hedge your bets with the energy of Industrial Gas Turbines and Precision Castparts.
Let’s make a quick observation. Perhaps the best “pure play” on the boom in industrial gas turbines is with Woodward Governor (WGOV). This stock has been off to the races in 2008 despite a rocky economic environment, climbing from $24.50 in January to a recent 52-week high at $47.50. Because it invests so heavily in IGTs, it wouldn’t be unfair to say that PCP’s 25% allocation of these power-generating cash cows will be profitable into the future, and gives reason enough that PCP should trend higher.
Growth from Aerospace Has Gone Unnoticed
Dragged down by the fates of major U.S. carriers and escalating oil, Precision Castparts clearly has a business that is a bit counter intuitive. Yes, the supplier for the same airlines that are struggling to exist is turning a profit and taking orders faster than it can fill them. Fears of cancellations are bloated, as people seem unaware of the queue out the door waiting for parts. I don’t want to recap my picking apart of the worries above, yet it is hard not to notice the value presented by the most recent sell-off.
A Unique Process and Reputation Moat
One of the big pulls that I have toward Precision Castparts’ business is the big business moat that it has built up around the company. Many mistake a “moat,” as defined by Warren Buffet, for a company that has a great reputation as a supplier. While PCP has this working in its favor as well, it has superior parts that come through a casting process more advanced than any competitor's. Higher barriers to entry always translate to higher costs at entering into profitable competition.
Precision Castparts is thought to be the leader in manufacturing large, complex structural investment castings. Casting, essentially the process of forging and shaping metals into unique shapes, can be done in a variety of ways. PCP has two unique and advanced processes called “directionally solidified” [DS] and “single crystal” [SX]. The basic idea that comes into play here is aligning the actual grains in the metal that it forges. Nobody else does this effectively, and having your castings with aligned fibers means that the parts are stronger, longer lasting and provide better fuel efficiency when used. This process gifts PCP with a reputation in the industry that will keep it profitable.
Precision Castparts - A Bargain Under $100
The bottom line here is that the strength in PCP’s business has been entirely thwarted, as it has been dumped into relationships with companies that it quite frankly doesn’t represent. Earnings seem to momentarily break the silence, but investors are still overlooking the strong end markets and demand that has stayed consistent in their business model. Being brought down with defense contractors and U.S. carriers alike fails to give Precision Castparts the value it deserves for healthy future prospects.
With an aerospace business leveraged to a global commercial airline demand that has continued to perform, and a defense exposure limited compared to the rest of its business, I believe that Precision Castparts holds a promising future. |
