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PCP - Precision Castparts Corp.


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Here's a Ted Weschler (I'm assuming it's him, sounds more like him than Combs) pick that is getting beaten up today because they released a lower guidance than expected:

 

http://www.nasdaq.com/press-release/precision-castparts-corp-provides-preliminary-third-quarter-fiscal-year-2015-results-20150115-01118

 

It's not one I own, though I looked at it back when I was first researching Transdigm (TDG). Seems like a quality business with an impressive track record. I thought it was worth creating a thread for it.

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Sequoia has a sizable position in this. If you look at their investor day transcripts, they outline the thesis pretty well.

 

Question:

Both Rolls and Precision Castparts are in the aerospace supply chain. I am curious how you think about the two. Which is a better business and which is a better long term investment?

 

Greg Steinmetz:

Which is better? We hope for greatness from both. Arman, you argue Rolls, I will argue PCP. Rolls and Precision are in the same industry, which is a fantastic one, commercial aerospace, because of an eight-year backlog we have now on jets. But unlike Rolls, which is making multi-billion-dollar bets when it sells an engine and has to wait for the cash, Precision gets hard money up front when it sells a part.

 

Precision Castparts, I really like the management there. Mark Donegan is first rate. He thinks about every penny and Mark is great at identifying adjacencies and interesting companies in those adjacencies to acquire. He has a great track record of taking these acquisitions and really milking them for all they are worth.

 

Why I think Precision can keep growing is that it generates — this year it will be close to $2 billion of cash, which management has shown it has been able to invest at a 15% return. The question is, can Precision keep finding acquisitions. The big one they did a couple years ago, Timet, a $3 billion acquisition — you could spot that one coming from a mile away, or in our case, 3,000 miles away, thank you very much. Precision closed on a $625 million one just last March, but I do not know what is out there now that has the kind of scale that Timet had.

 

Management says there are some and the team is always looking, but I would say my biggest concern is whether Precision can keep finding these

 

18

 

Ruane, Cunniff & Goldfarb Investor Day St. Regis Hotel, New York City – May 16, 2014

 

acquisitions. Once Precision gets them, I have no question that its managers can make them great. What Precision has done with Timet and most everything else it has bought since we have owned it gives me a lot of confidence. So my concern with Precision is just whether management can find the deals. If Precision does not, we still get organic growth because the 787 is going to go from seven or eight builds a month last year to ten this year, and maybe even higher. We have got these new narrow bodies coming on, and they are increasing the build rates of those. Because Precision is so good at improving efficiency, it has a better cost position than its competitors, and the company is able to pass that on to customers and win market share.

 

Arman Kline:

I would just add — they are in the same industry, but they are leveraged to two different parts of it. Over the long run, PCP has more leverage to the new build. Because of the unusually large number of engines that Rolls will deliver in the next few years, it is tied pretty tightly to the new build market for now, but once those engines are placed in service, Roll’s earnings should hold up better if and when demand for new planes slackens. Rolls’s service contracts run for ten to fifteen years. But the other thing with Rolls is that it is now buying Tognum, which puts the company more in energy systems, making it more diversified. It is not so civil-dominated a business anymore. And it is in marine whereas PCP is more levered to aerospace.

 

David Poppe:

I would just interject one thing. I agree with everything Greg said. But Mark Donegan is not milking the assets; he is sweating the assets. He is really good and he is driving these businesses harder than people thought they could be driven. Not to overuse the comparison, but I think these 3G guys running Budweiser would really appreciate Mark. He is a very good CEO.

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These guys are good operators, as Seq suggests.  It is almost purely aerospace business (85-90%), with 80% of that OEM, so obviously very tied to the aerospace build cycle that admittedly looks really strong right now, with mega backlogs (7-8 yrs+) at Airbus/Boeing. 

 

A few concerns (would love to hear others take on these)

 

1- Vulnerability to downcycle/blip in aero build rates.  This doesn't look too likely at the moment, but these order books are not exactly locked down. The problem stems from multiple airlines ordering capacity to cover a given route when only 1 will likely evnetually dominate.  Airbus reportedly admits that order book likely includes this "double" ordering but Boeing tends to play it down.  The end result is the order book is probably too optimistic.  A number of large orders have been cancelled recently for A/B and Bombardier just indefinitely paused the 85 program today.

 

2 - PCP has an enormous amount of operating leverage that has been purely built to serve this upcycle.  This is serious capital asset base with major required maintenance.  If/when cycle slows, margins will not hold up.

 

2- Lack of pricing power. Relatively concentrated customer base (GE is 15%, RR, Pratt) and even worse, eventual "sell through" to Boeing (via suppliers) is probably 35-40% of book (my estimate).  I believe PCP actually cedes 2-3% in pricing every year and accepts that.  If you follow Boeing, you know about "Partnering for Success", i.e. we take your margin.

 

4- CEO Donegan made comments in Jan'14 about "investing" in inventory.  He didn't say speculation but that's how I read it.  This is red flag in my book.

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I was told anecdotally that it is really difficult to qualify as a OEM supplier for critical components, helping to create a moat.  PCP then needs to ingratiate itself by adding value to the design process, etc. widening the moat by deepening relationship.

 

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These guys are good operators, as Seq suggests.  It is almost purely aerospace business (85-90%), with 80% of that OEM, so obviously very tied to the aerospace build cycle that admittedly looks really strong right now, with mega backlogs (7-8 yrs+) at Airbus/Boeing. 

 

A few concerns (would love to hear others take on these)

 

1- Vulnerability to downcycle/blip in aero build rates.  This doesn't look too likely at the moment, but these order books are not exactly locked down. The problem stems from multiple airlines ordering capacity to cover a given route when only 1 will likely evnetually dominate.  Airbus reportedly admits that order book likely includes this "double" ordering but Boeing tends to play it down.  The end result is the order book is probably too optimistic.  A number of large orders have been cancelled recently for A/B and Bombardier just indefinitely paused the 85 program today.

 

2 - PCP has an enormous amount of operating leverage that has been purely built to serve this upcycle.  This is serious capital asset base with major required maintenance.  If/when cycle slows, margins will not hold up.

 

2- Lack of pricing power. Relatively concentrated customer base (GE is 15%, RR, Pratt) and even worse, eventual "sell through" to Boeing (via suppliers) is probably 35-40% of book (my estimate).  I believe PCP actually cedes 2-3% in pricing every year and accepts that.  If you follow Boeing, you know about "Partnering for Success", i.e. we take your margin.

 

4- CEO Donegan made comments in Jan'14 about "investing" in inventory.  He didn't say speculation but that's how I read it.  This is red flag in my book.

 

1. Even if you handicap their current backlogs at 70% you're still looking at around 5-6 years of backlog.

 

2. This is correct and unfortunately a characteristic to many manufacturing businesses. They mention that maintenance is around 50% of the 450 mn of capex, so around 225 mn. Their cash flow generation in past years has been impressive.

 

3. Apparently this is not completely correct, for some products (god knows how much of their mix) it's PCP that "dictates" the prices as there really are no other alternatives. From my initial research I would suspect this to be in their very large casting products and the titanium single crystal products. Some of their fasteners also seem technologically advanced.. Forging, no clue..

 

4. Can you elaborate? There is not a lot of material to be found from Donegan but if you look at the company's operations I think he would fit in well with the 3G folks. He uses a "decrease your costs 2% every quarter" approach for all of the manufacturing plants. HQ corporate personnel is like 150 people compared to +29100 manufacturing employees. From glassdoor you can read "if you don't like in your face management this place is not for you". And one guy put as negative "too focused on profits"..

 

I think if you are supplying GE, RR, UTX, ... and others for 30-40 years in a business as regulated as airplanes you are definitely talking about switching costs. Imagine a chinese supplier offers the same products at a 20% discount, would you as GE/RR/UTX take the risk to use the product in one of your engines? Imagine if that engine fails, your gain is 20% in monetary value but your loss in terms of reputational risk is so enormous, there has to be stickiness there.

 

Where did you read about the inv management part?

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Oakmark has been buying PCP

3G capital has a position in it (disclosed in their 13 F holdings)

 

Oakmark Bill Nygren's commentary on their recent letter

 

"Precision Castparts Corp. is a manufacturer of complex metal components and products, including castings, forgings, fasteners and aerostructures for aerospace, power generation and general industrial applications. Precision Castparts enjoys what we believe is an outstanding corporate culture and is led by a long-tenured CEO who is known for aggressively pursuing operating efficiencies. For many years, the company’s stock traded at a significant premium to other aerospace and industrial peers, but recent weakness has brought the share price to attractive levels relative to these industry groups and the S&P 500. We believe the current valuation of less than 15x earnings is overly punitive, considering PCP’s organic growth prospects and the company’s ability to add value through acquisitions. PCP is providing more components on key new airplanes, which should allow the company to outgrow its end markets. In addition, management projects $4 billion-$6 billion of acquisition opportunities over the next couple of years with return characteristics similar to its existing business. Finally, the company’s unique technical and process capabilities, coupled with its efficiently run operations, should allow it to continue to generate above-average margins. We are pleased to have the opportunity to add shares of what we consider a best-in-class company at a price that implies it is only average."

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Mark Donegan is often referred to as "an outsider" type CEO. The success of his past several acquisitions certainly have me intrigued in PCP and their ability to continue to bolt on acquisitions and drive margin expansion. I have looked back at the success that they have had with Wyman Gordon, SPS and Special Metals and it certainly looks like they have done a tremendous job. Has anyone read any long write-ups on Mark Donegan that could help us all better understand his style? Has anyone done any work on the M&A opportunity in their target areas trying to judge the runway for growth? I am in the midst of my analysis but finding the industry a bit difficult to size up. Its clear that they have the ability to earn high returns and generate material amounts of free cash. Anything that can help judge the runway to invest this free cash would help us all.

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Mark Donegan is often referred to as "an outsider" type CEO. The success of his past several acquisitions certainly have me intrigued in PCP and their ability to continue to bolt on acquisitions and drive margin expansion. I have looked back at the success that they have had with Wyman Gordon, SPS and Special Metals and it certainly looks like they have done a tremendous job. Has anyone read any long write-ups on Mark Donegan that could help us all better understand his style? Has anyone done any work on the M&A opportunity in their target areas trying to judge the runway for growth? I am in the midst of my analysis but finding the industry a bit difficult to size up. Its clear that they have the ability to earn high returns and generate material amounts of free cash. Anything that can help judge the runway to invest this free cash would help us all.

 

From my research their success with Wyman Gordon is more rule than exception, as their last large acquisition (Timet) clearly shows. They're also not afraid to exit struggling businesses (Chinese businesses) so no sunk cost fallacies here. I have not yet come to the M&A opportunity set, but I would guess it will be more horizontal than vertical. They're planning on investing 3 - 5 bn in M&A (quite the amount) and 2 bn in share repurchases in coming years.

 

I think Rochon's case kind of boils it down to what it is, if PCP is able to increase content value per plane and its industrial markets turn around the stock will go considerably higher. Downside risk is significant downturn in commercial plane market combined with the operating leverage the company has built in. Place your bets guys.

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PCP strikes me as a company in a long term business that can think long term, which I like. 70% of their products eventually end up in an aircraft. The aerospace market is dominated by Airbus and Boeing. BA/AIR have backlogs of many years to come: a sizeable amount of the backlog is for new planes that yet have to come to full production. PCP provides the value that they deliver per type of Airbus and per type of Boeing (f.e. $10M per 787): anybody has forecasted delivery schedules for each type for AIR and BA for the coming years (per year, or even better per quarter)?

 

Everything about PCP looks and feels long term:

1. The aerospace market is projected to grow more than 3% per year over the next 20 years

2. PCP is consistently increasing their share of the pie and their aerospace business has a cagr of almost 15% since 2008

3. They have a roic of around 30% in the last 9 years.

4. Mark Donegan, the ceo, has worked for PCP since 1985, has been a ceo since 2001 and has a personal stake of $50M in PCP. And he is only 58 years old so has more time.

 

It is a long term investment: Mark Donegan states stable revenue for 2016, but inflection point in 2017 or maybe 2018. I am inclined to believe this. PCP is lined up to substantially supply parts for 737max and 320neo and for the new LEAP engine which are all only starting to really ramp up in 2-3 years. There is of course risk of delay of these programs.

 

I have patience.

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All is not unicorns and puppies at PCC just because Todd and Lou bought some.  I learned through discussions with industry contacts that PCC division Specialty Metals (SMC) is a huge cluster at the moment.  SMC is reportedly consistently late on product deliveries and all-around disorganized.

 

Perhaps this explains the "planned retirement" of Forged Head Ken Buck earlier this year:

http://www.precast.com/investors/press_release/?id=655

 

I think the harder long-term question it to predict how well PCC nails capacity in a high-volume aircraft upcycle (well-telegraphed and understood by all) where orders have possibly peaked.  The company has massive operating leverage, but this also works against it if OEM newbuild demand doesn't materialize as expected and obviously when the next downcycle occurs (it will).

 

 

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