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Precision Castparts Corporation (NYSE:PCP)

F3Q10 Earnings Call

January 21, 2010 10:00 am ET

Executives

Mark Donegan – Chairman, Chief Executive Officer

Shawn Hagel – Chief Financial Officer

Analysts

Robert Stollard – Macquarie

Richard Safran – Buckingham Research

Robert Spingarm – Credit Suisse

Howard Rubel – Jefferies & Co.

Peter Arment – Broadpoint

Cai von Rumohr – Cowan & Company

JB Groh – D.A. Davidson

Ronald Epstein – Bank of America

Sam Pearlstein – Wells Fargo

Joseph Nadol – J.P. Morgan

Noah Poponak – Goldman Sachs

Eric Hugel – Stephens Inc.

David Strauss – UBS

Operator

Welcome to the Precision Castparts webcast and conference call to discuss its third quarter earnings for fiscal 2010. This event is being recorded and will be available on PCP’s company website at www.precast.com shortly after the conclusion of the presentation and discussion.

(Operator Instructions) I would now like to introduce Mark Donegan, Chairman and Chief Executive Officer from Precision Castparts.

Mark Donegan

I’m sure you’re all very familiar with the forward-looking statements and you can consider or analyze the following presentation.

Looking at the company in total I think Q3 continued to provide a number of challenges but in general even though Q3 from a comparison standpoint had a number of challenges I think sequentially from Q2 we saw no further erosion and we did see solidifying of our base. We’ll have detail on the following pages.

But looking at the overall company, year on year we saw sales drop by roughly 15% going from $1.6 million last year to $1.37 million this year. We saw operating income decrease by 5.3% going from $374 million last year to $354 million this year.

An area that we aggressively attack as most of you know every day saw operating margins improve year on year going from 23.2% last year to 25.8% this year. And all that took EPS from continuing operation going from $1.68 last year to $1.61 this year.

If you look at the overall drivers for the company, and begin with the business with a year on year comparison, put into apples to apples, currency had a benefit of $18 million on the sales line versus last year. On the flip side we saw lower effect from average nickel selling prices and material pass through by negatively impacting by $67 million.

If I go from there, and again I look on a year on year comparison, I think the story has remained pretty constant to where it was in Q1 and Q2 and kind of falls into the destocking across our base. If you look at the aerospace versus last year, we did have significant destocking across all of our business and I think it’s really again two fold as we were building above the rates last year at this time and as we come into this year and we’re taking out all that extra inventory we put in last year.

On top of that destocking I think we continue to see a significant over hit in the distribution side of our business and then on the IDT side we saw a year on year destocking but we’ve been able to find additional share in new customers as we’ve talked about that’s been able to offset that, but in Q3 we certainly saw some additional destocking from our European customer base. On the balance on the year on year industrial we saw destocking going on from there.

If I look at sequentially, I think that as we started last quarter we actually saw some growth in some of our base businesses, but I think Q3 was a kind of solidifying of the base we had and schedules remained very solid, much different than we’ve seen in previous quarters and in some cases we saw an uptick in Q2 versus Q2 ROM side and I’ll get into what some of those were as we go into the segments.

As we said last quarter in general industrial we did see some sequential growth. Not large, but again compared to where we’ve been we did see some growth.

On the EBIT side, again kind of comparing apples to apples we had a currency benefit of $3 million versus last year and then from there the key challenges remain the same; tackling the volume changes from last year that impacted all of our businesses.

In the quarter we also had some planned events. As we talked about we brought Carlton on. Carlton had planned outages and then as always we had some unplanned events that went to smaller forging outages in our base businesses that we had to deal with during the quarter.

Having said all that, I think I understand what our challenges have been and to be clear, we’ve identified those areas of opportunity and drive and attack with all the vim and vigor that we have. I think we saw solid gains in productivity again and revert yield, so again the same type of areas that we’ve been going after.

And if I kind of put some value to that, we did this last quarter and if I take that same math, if I take the sales decline we experienced in Q3 versus last year, we’ve talked a number of times about on the way up seeing 30% to 35% incremental margins. If I apply that same math on the downward pressure it would have generated a decrease in operating profit of roughly $57 million to $60 million.

And again by going after those models and going after those areas, instead of that number we saw roughly $23 million less in operating profit. So we kind of drove again a $35 million to $45 million out of our cost structure.

It’s not fancy. I think the way we go after it, a lot of you know it tends to be a very relentless, unyielding approach. It’s kind of a daily drumbeat but again, I think that that’s what we have to do in this environment and I think we got all of our team firmly engaged on staying focused on what we have sitting in front of us.

Moving on from there, if I look at sales by market segment, we saw Aerospace grow from 53% last year to 55% this year. Our Power went from 27% last year to 26% this year, and our General Industrial went from 20% last year to 19% this year.

Moving now onto each segment beginning with Investment Cast, year on year we saw sales decrease by roughly 15.4% going from $573 million last year to $454 million this year, but we saw an operating income increase by 1.6% going from $135.3 million last year to $137.5 million this year. As you’d expect with that we say margins expand from 25% last year to 30.2% this year.

If I look at the primary drivers in IGT and again beginning with the year on year sales, putting apples to apples we saw low material pass through of $8 million and from there, certainly the most key driver for us on a year on year comparison was the Aerospace destocking and again, we saw this across all of our operations in the Investment Cast.

Also in there year on year we saw weakness in the aftermarket, kind of impacting our air flows operations and the other area that is kind of driven by the balance of the market, we saw significant drop in our external alloy sales of roughly 40% which was lower demand from our outside customers, in most cases our competitors as they responded to destocking. You can kind of see the magnitude of what some of the other people are seeing in terms of the alloys we’ve been providing.

On the IGT side, again year on year we saw softness but we were able to offset a big piece of that with continuing market share and expanding base, but again as I said, in Q3 we kind of did see a new round with our new European customer base as they began to destock.

If I look sequentially now and obviously we had a few less manufacturing days in Q2, but there were some signs that we kind of see the base certainly solidifying and kind of moving up from there.

I think we saw OEM schedules all very solid through the quarter. We saw little to no push outs which was a significant change, and this is significantly different from where it was last two or three quarters.

If I look one of our particular operations, structural castings, as we entered this latest round of destocking or the kind of environment that we’ve been in, structural casting was kind of the leading indicator. Structural castings actually saw a small uptick so from that standpoint, they’re kind of the leader in and they seem to be at least from the OEM side gaining some small increases.

We saw no additional declines in our aftermarket demand but at the same time we saw no additional traction, and we really don’t see any real change in the aftermarket probably going through Q4 and Q1 and then Q2 it looks like it starts to pick up.

Again, we talked about this in the IGT, we did pick up some additional destocking in Q3 from our European customer base, but as we look forward that’s kind of the bottom and it moves from there.

If I moved into the EBIT side of the equation for Investment Cast, again the most significant challenge we face would be the year on year volume decreases but I think all the employees in this segment really did an extremely solid job of driving improvement from a cost structure. I think they continue to find areas.

But the big drivers for there were productivity, scrap and reworked materials. All of these are at or near record levels. At the same time, I think this group squarely focused on what is still there and what areas they can go get, but being able to go after some of these things, and we talked about this in the past, that there certainly are some expectations as we kind of enter a market like this and what opportunities we’re seeing in front. I think that this group has done a good job of executing on that.

I think they’ve also established a very solid position to move forward. In Investment Cast, whether it’s an aftermarket recovery, 787, the IGT coming back, all of these have potential benefit for us and it’s not a matter of we need one versus the other one. Any of these are good solid accelerators for us.

Moving on to Forgings, again looking at sales, on a year on year comparison they declined by 16.5% versus last year going from just under $703 million last year to $587 million this year. We saw operating income decline by just under 12% going from $155 million last year to $136.4 million this year.

The margins increased year on year going from 22% last year to 23.2% this year. And again I think it’s important to note that it includes the integration of Carlton which was not in last year’s comparison, was in this year and did have a planned outage that we’ve talked about and that occurred in the quarter.

If I look at the key drivers in Forged Products, again beginning with year on year sales and putting in an apples to apples comparison, the selling price at out three mills was lower by $23 million and we had $34 million less of contractual material pass through.

From there, as with Investment Cast, certainly going after the year on year sales decline was the big challenge coming in there. On the Aerospace side, again we had significant reduction in orders both from the OEM and the aftermarket. And the aftermarket is not nearly as strong as it is in the air flow side of the business, but there is about 20% of that forging disc market that does come from the aftermarket.

And as with castings, we also had significantly reduced external alloy sales to our customers in the same markets that responded to destocking, and then overall general industrial as we’ve talked about in the past was seeing destocking also.

If I look sequentially, again although there was no real uptick, I think that we saw a very stable, solid schedule, and again I would put this, this is the first time in the last three quarters we’ve seen something like this. So we certainly saw no further erosion.

On the Aerospace side, OEM schedules were solid and again, the aftermarkets saw no additional softening, but again we saw no upside on our disc aftermarket also.

On the balance of the business, sequentially pipe volume outstanding and we did see a slight recovery as we were over last quarter, just a slight recovery on general industrial. Not large, but again it was kind of a positive trend.

On the EBIT side, I’ve stated this numerous times and certainly this segment faces the largest challenge in a decreasing volume environment due to the magnitude of the fixed absorption, but again I think they continue to find areas of opportunity and it’s a very gut wrenching exercise to kind of go through and identify these but I think they continue to find material as their biggest piece, yields, blends. I think they’ve been very successful in maximizing those. And then even from productivity, even a small piece of the puzzle I think they’ve gotten good traction on variable costs.

In Q3 we saw the integration of Carlton and we did have substantial orders that were planned, but again we also in this segment had two unexpected outages in the quarter.

As I look forward, I think the key in this one is as the volume does recover is to hold onto that cost structure. I spent a lot of time talking about it. I think we’ve got a clear line of sight of what that looks and again, I think that we focus on that very clearly.

Look at the last segment, Fasteners, beginning with sales, sales declined by 10.6% versus last year going from $370 million to $331 million this year. We saw operating income decline by 3.5% versus last year going from $109 million to $105.6 this year. But again, as with the other ones, we saw operating margins expand from 29.5% last year to just under 32% this year.

Looking at the primary drivers in fasteners, and again year on year the major drivers clearly destocking at the OEM’s but more significantly the destocking at the distribution base. Year on year that’s a big, big nut that the fastener people had to be able to digest.

And again, year on year in Fasteners more so than any of the other businesses, they saw a significant hit from the regional and bizjet. It’s a more significant piece of their puzzle than it certainly is with the other two businesses.

But again I think the fact that they’ve seen the schedules year on year erode by kind of a small amount that the industry is doing, I think that they continue to find additional opportunities and market to mitigate that.

And then year on year general industrial actually saw sales flat so Q2 certainly was the change to that and Q3 was a flat.

If I look sequentially, I think they did see the OEM side of the business stabilize, with a slight improvement from Q2, but on the flip side, even though we saw no further erosion, we saw no increased demand at all off of Q2 levels from our distribution base and I think we don’t see any real change in that coming until late Q1 or Q2.

On the EBIT side, again I think they face the same challenge that all the businesses face on the reduced volume, but I think they really went after their cost model very aggressively. I think they’ve gotten good improvement in productivity across their assets and I think they’ve been very good at looking how to utilize excess assets or combining assets in the fastener side that kind of lets them maximize various sets of assets at a particular plant.

Then where we were outsourcing quite a bit of business, we’ve pulled that back in and they’ve been able to continue to stay focused on automation. So again, as with the other ones, I think finding that pipeline of projects, attacking it and making sure it is robust enough to continue on forward is what they did as well as the other ones.

If I look at Fasteners, they get some very key significant drivers here, and it doesn’t take a lot from that standpoint to drive to the bottom line, but any one of the three returning to the distribution base. The 787 moving into production is huge for this group. Half of our content on the 787 is residing in fasteners so for me it’s got a tremendous accelerator for us and I think they still have market share to go after as we go into next year.

So I think that’s looking at the businesses, there are a number of challenges. I think we get what we have to do. I think we’ve got to stay focused, aggressively clearly, concisely and with every ounce of energy we have on the opportunities that are there and not let that cross the road as these business and these drivers come back.

If I move on to cash, and again I want to say I’m not satisfied with where we are in our cash position yet, but having said that, after we paid for Carlton we had cash on hand of $218 million and we had debt of just under $290 million, so we generated roughly $300 million for the quarter.

Again, I think we still have opportunity there in cash and as I think as we move through Q4, Q1, Q2 certainly we can drive more cash as that volume starts to come back.

So in summary, I think fourth quarter beginning with Aerospace, I think on the OEM side we see gradual schedule recovery coming back. I think we get the bill rate more in Q1 of fiscal year ’11. On the flip side, I think we see no further erosion, but we’re seeing no significant pickup from our Q3 levels in the aftermarket or the distribution side of our business. And again, we’ve kind of talked as we went through this, that’s more of a late Q1, Q2 type of event.

I think we have Carlton going now on a full quarter. I’m extremely pleased with the integration process. I think the Carlton team has fully embraced what our expectations were in the way we run the business and I think that as we go into the next 12 months, I think there is quite a bit of upside coming out of Carlton from that standpoint.

On power, I think the IGT; I think Q3 is probably the base level. Again I think that has taken into account the new destocking from European, but again it doesn’t erode from there. It continues to migrate its way slowly back up.

I think the base pipe remains relatively flat and I think that we can begin to integrate the benefits of Chengde. I think that is a significant piece of the puzzle that we’ve been missing in Pipe and as we certainly look over the next 12 months, what we can do together as a combined company I think is substantial and it’s given our two businesses together and moving forward from there.

I think we continue to see slow growth in oil and gas consistent with what we said last quarter. And in general industrial again, I think we’re seeing that growth in the 1% to 2% range and that seems to be holding pretty solid.

In Q4 we also have a motor that went out on our steckel mill which is part of our process used in making flats. We are looking at probably at roughly a six week repair cycle. I think we have options similarly as what it was when 29 went down in Houston. We can outsource. We can realign products. But it’s just a matter of we have to manage our way through the press outage.

As I move onto to Q1, I think we’re looking at kind of using Q4 as a baseline, I think the OEM schedule closes the gap at that point in time. We kind of get back to where the bill rates were. I don’t think there’s any meaningful additional growth in the aftermarket or the distribution base.

I think the IGT finishes that destocking from the European and I think we continue to see slow growth in the general industrial. And as I go into Q2, I think Q2 is a quarter we begin to see some of these accelerators. I think the OEM schedules are certainly fuller rate. IGT orders should be behind us. The destocking is coming back.

I think we start to see gradual pickup in the ordering from the distribution customers in the aftermarket and the 787 should be moving into some sort of production at that point in time. Again, any combination of these to what degree they are all significant accelerators for us.

During this time this group, these employees, all of us have to stay aggressively focused on attacking our costs. You’ve heard me say over and over again for years and years, there are still numerous opportunities to go attack that cost model, so it’s not sitting there staring at the sky wondering what to do. I think we get it.

We know what we have to go after and then holding on to that leverage as we do come into that growth period, that is something we need to make sure we stay clearly focused on and I think all of our employees get it.

So with that, I know I covered a lot, and I’m done.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Robert Stollard – Macquarie.

Robert Stollard – Macquarie

On the Chengde acquisition, you didn’t give a lot of financial information in the release the other day. I was wondering if you could give us an idea of what sort of impact this could have on a 12 month basis and also what sort of control or influence you have as a JV and how much you’ll be able to contribute to the operations of this business.

Mark Donegan

I think that we will certainly, I know the next time we’re out there I think we’ll lay it out more like we did Carlton. It’s a business in size relative to what Carlton was today. It is a business with tremendous, tremendous upside.

They have a process and a capability and a cost structure that is very, very solid. I think what we’re able to do, and again we’ve kind of identified that market at potentially, we’ve said in the past, it’s about $1 billion of business we’re walking away from that we have had no answer to.

So I think over time Chengde has the answer to that and we can go to market now together side by side quoting packages. I think that we spent a lot of time through the process working with the management team and the Chairman over there.

I think we clearly understand what we’re doing together and I think together we will manage the business and I think that we’re looking forward to benefiting from both. I think they get some great skill sets and I think they clearly understand the skill sets we have. I feel very comfortable we’re going to be able to benefit from it the way we would any other acquisition. It’s a significant hole that we had.

Robert Stollard – Macquarie

On the metal front, you gave quite a lot of detail on how you expect the businesses to sequentially progress Q4, Q1, Q2. How do you think the metal pass through is likely to evolve because that could potentially dilute the margins as it goes the other way?

Mark Donegan

The way I look at it is actually I think you’re still looking at comparisons; it’s probably going to become flattening. It hasn’t moved a lot. It kind of jumps around but it’s been jumping around for quite awhile between 750 and 850 and it kind of bounces around there. So if you look at the hedge in there that we have in place, the orders we have in place, I think you start looking at Q4 and Q1 that starts to collapse and becomes almost a non common in the course of these. It’s kind of flat.

Richard Stollard – Macquarie

Also on the M&A front, you’ve made two acquisitions in the last six months. Should we expect things to go quieter in the next six months or are you still looking?

Mark Donegan

There’s still stuff we want. Again we’ve said in the past it’s not as though these things pop. They tend to group together. I think there are still businesses that we have been working on. I think there’s things we like.

So no, we’re not at a loss for ideas. These certainly were if you go back, I said I felt very confident I could deploy $1 billion, these certainly were that $1 billion piece of the puzzle that was in the back of my brain, so I think that we got the two pieces we want.

But we’re not at a loss of ideas for things to go after at all.

Operator

Your next question comes from Richard Safran – Buckingham Research.

Richard Safran – Buckingham Research

I think when you financed Carlton it was cash and commercial paper and I just wanted to know in reference to Chengde how you financed it. And also to your comment about further acquisitions, can you comment if you can on how you think you might finance future ones. In other words, do you think it would be primarily commercial paper? Do you think you’d be taking on some debt, that kind of thing?

Mark Donegan

See if I can answer your questions. If I miss anything you can come back and tell me. Chengde was cash and commercial paper. Certainly at this point in time with the type of cash we’re kicking off, our ability to pretty much pay that down will happen fairly quickly.

So as I look today at anything that would be in the hopper, I think we would still do it with cash on hand or commercial paper and again, with the amount of cash we’re generating, that creates quite a pool at this point in time.

Richard Safran – Buckingham Research

On Chengde, can you comment at all, did this deal give you any kind of exclusivity or any type of specific arrangement with respect to the Chinese power build infrastructure build over there?

Mark Donegan

No, the Chinese power build is still, you’ve got to be competitive and whether we’re competing out of the States or competing in China, you’ve got to be competitive. What I will say is I think Chengde has extremely, extremely cost competitive process.

It is a very modern facility. It is well capitalized. It’s got tremendous assets. It is a world class asset. Let there be no mistake. I think the staff want to be able to say we have a very, very solid competitive cost asset. That’s how you compete. But no, there’s no agreements around that.

Richard Safran – Buckingham Research

On your comments in the release on the aftermarket, you note that flight hours are increasing and I wonder if you could go over for us, explain for us why you’re not expecting a meaningful recovery until fiscal 2Q of ’11. Is this having to do pretty much with the lead time for aftermarket components, that kind of thing?

Mark Donegan

I think basically what you have if you go back to where we were in calendar year ’08, we as a company were building very, very heavily into additional growth, additional capacity. We were looking at probably an OEM bill rate at the time, we were probably billing into double digits.

So when that didn’t occur, I think in reality I think it’s all of that inventory in the system is able to come out whether it’s going to OEM schedule and aftermarket. And then I think on the flip side, I think the airlines, given where they were struggling over that same period were bleeding their inventories down.

If you look at it, that all works its way out and the best insight we’re getting from our customers in that Q2 timeframe, so its more of how much inventory is in the system that gets absorbed. And the fact that when that goes by the wayside, that’s really the primary catalyst for us.

Operator

Your next question comes from Robert Spingarm – Credit Suisse.

Robert Spingarm – Credit Suisse

When we talk about the quarterly progression from here, and I think back to the way you described it last time, so back in October, is it fair to say that you are moving the recovery to the September quarter that which you originally talked about happening in the transition way in June?

Mark Donegan

I think that the two big pieces that are still hanging out there is the aftermarket and the OEM distributor base. I think where we really thought that that Q1 would be the transition, I think that Q2 is now where pretty much, at least today is where our customers are saying that’s kind of when that transition occurs.

Robert Spingarm – Credit Suisse

Based on that answer, it looks like people are thinking about a fourth quarter, a March quarter revenue line that’s something in the neighborhood of down 4% or 5% year on year, and maybe about 12% better than this last quarter. Is that fair or should it be a little worse than that?

Mark Donegan

I’m not going to give you that much depth. If you go back and look, I think Q3 was the baseline. We obviously pick up more days, so we’ll get some benefit from there. We’re not seeing any additional growth from the aftermarket in the distribution base. We’re seeing that 1% to 2% growth in general and industrial. So I want to be somewhat a little careful, but I think directionally your intuitions are right.

Robert Spingarm – Credit Suisse

On the Chinese deal, how did that evolve? It seems that portion of the JV was on the market maybe a year, year and a half.

Mark Donegan

No, it wasn’t really on the market.

Robert Spingarm – Credit Suisse

Was it not officially on the market because it looks like the seller was out there in calendar ’08, at least to start.

Mark Donegan

I can’t give an exact date of when they made their acquisition, but they only made it two and a half, three years ago I think is about the period of time they made it. This was an asset that we kind of came across almost two years ago.

So the dialogue has been ongoing for quite awhile between us and the seller, and it had a number of starts and stops. It had a number of twists and turns and there were some very interesting twists and turns some of which probably would have derailed the job and the transaction under normal circumstances.

I don’t think there was an anxious seller at all. It took on a life of it’s own, I’ll tell you.

Robert Spingarm – Credit Suisse

What made them more willing? Was this a question of prices moving around? Did this business become more strategically valuable to you?

Mark Donegan

Probably all of the above. I think that the Chairman was a key piece of the puzzle. I think he clearly understood the value of the two businesses coming together and I think that he was very helpful and supportive. From that standpoint, I think it was some of the things in the marketplace that certainly may have made the future look a little less uncertain, kind of standing out by itself.

I think there was looking at what the valuations were. I think it was a combination of all those things. I wouldn’t say it was one thing, but it was a process. It was a very, very extensive drug out process.

Robert Spingarm – Credit Suisse

And just to close the topic, do you see prices on the M&A side inflecting back up at this point?

Mark Donegan

To date they’re holding. I think what you’re going to start seeing whether it’s six or eight, nine months, you’re going to start seeing the value you’re using, the multiple may not change, but you’re going to start seeing that base line go up again.

So I’m not seeing the multiples per se moving, but I think this six months we’re in right now is probably the opportunity to take a multiple against their earnings and try to get it at that point in time.

Operator

Your next question comes from Howard Rubel – Jefferies & Co.

Howard Rubel – Jefferies & Co.

I just want to ask a question about the subsequent event on the gain. The rules have changed a little bit there. Was the gain on the sale in the quarter or will we see it in the final quarter of the year?

Mark Donegan

The gain on the sale will come in the final quarter of the year. We got the tax benefit in Q3 but the substantial gain will come in Q4.

Howard Rubel – Jefferies & Co.

It looks like it’s a pretty impressive business you’re selling there because of the income when you do the math on the amount of business you’re selling.

Mark Donegan

It’s a very, very small business.

Shawn Hagel

What happened is that we were able to take some reserves; we were able to take the benefits, take some NOL’s off our books because of the sale of this business. And what happened under the tax rules is that it doesn’t always line up with when we actually complete the transaction. So the tax benefit associated with removing the NOL reserves came in Q3, but the gain will come in Q4.

Howard Rubel – Jefferies & Co.

It looks like when you talk about productivity and focus on costs, corporate expense looks like it trended down a little bit in the quarter and is that sort of where you want to target going forward for awhile?

Mark Donegan

I think we want to target that. There are a lot of moving pieces in the corporate expense, but yes. We certainly do not leave corporate untouched as we go after our cost mentality. There are no sacred cows.

Howard Rubel – Jefferies & Co.

You talk about productivity so was head count down, flat or at a point where you’re starting to see the need to now think about adding a few people?

Mark Donegan

We are looking at a couple of people. It will be small in comparison, but I wouldn’t be surprised if we add a couple hundred people this quarter.

Howard Rubel – Jefferies & Co.

That’s a big deal in a world where no one else is. If you look at your capacity, if we look at this outage that you had, you talked about it a little bit.

Mark Donegan

It’s not significant enough that we would call it material but it was a week in one of our melting operations which is a pretty important piece of our puzzle, and it was a three week in one of our processing materials. So it wasn’t small and it wasn’t material enough to call out.

Howard Rubel – Jefferies & Co.

On working capital, it is kind of neat that you’re able to generate some cash from the business, but as volumes start to go up, what are you going to do a little bit differently so that you don’t start drawing cash down as the volumes expand.

Mark Donegan

I think that’s a great question. I’ve had to make some hard calls and I think the biggest call I’ve made is if I kind of look at the way our schedules are, look at Q4, Q1, Q2, I’m going to have to balance our manufacturing across that period of time because I’m not going to be able to take step function.

I’m putting in and have in more inventory than I wanted in the system right now to make sure that I’m not out going through some great hiring curve. So what I want to do is, and everybody understands, by plan we’ve identified what they have added. And as the volume comes back, they have to keep their dollars flat and they can get more output out of that.

So that’s kind of the math. If I look out at the next three quarters, everybody pretty much has taken their dollar inventories and held them kind of flat and then that brings everything back in line.

Operator

Your next question comes from Peter Arment – Broadpoint.

Peter Arment – Broadpoint

Can you talk a little bit about how Caledonia is doing on the revert streams and if you’re seeing any changes in pricing there?

Mark Donegan

I think we saw the bottoming in our Q3. Q1 from Caledonia was kind of the bottom life. We’re seeing the price of revert go up. Having said that, we’re seeing Caledonia being in our business right now has been an enormous asset and getting the revert blends continuing to find where the material is, has been huge.

And then we’re also now finding other ways to take what traditionally for us would have been, that cost us as waste, we’re now finding ways to reintegrate, get the metallic’s back out and get back into Caledonia and back into Greenville metals.

So if I look over the next six months or so, we have some pretty substantial items that can continue to get that, but Caledonia has been huge for us.

Peter Arment – Broadpoint

You can see that in terms of your cost structure. I assume with the transition here that you’ve put out in terms of the next two quarters, we’re seeing the full brunt of the 777 cut, correct?

Mark Donegan

Yes.

Peter Arment – Broadpoint

And not much of an uptick in 787 volume.

Mark Donegan

No. Right now we have zero. I can’t say zero, but as close to zero as you can get. We have nothing right now in our system in 787. I mean any movement. That program for us across all of our businesses is just an enormous program for us.

Again, tools that have been developed are sitting on the shelf. We have the equipment. It’s just a huge program for us.

Operator

Your next question comes from Cai von Rumohr – Cowan & Company.

Cai von Rumohr – Cowan & Company

Normally you give what acquisitions are. How much did Carlton add to sales in the quarter and how much was the revenue loss from the two outages you mentioned?

Mark Donegan

I don’t have the revenue loss from the two outages. It was probably more of a loss absorption. Again, it had to something less material, so it’s something less than $5 million type of dollars.

Carlton was in that $55 million to $60 million range.

Cai von Rumohr – Cowan & Company

As you look at the fourth quarter, if I recall you have five more manufacturing days which would say essentially 8%. As we try to model where the volume is going to be, should we think we add the 8% and then we kind of tweak out or tweak down?

Mark Donegan

We have four more manufacturing days because we pick up another holiday in this quarter. but having said that, I think your math is reasonable.

Cai von Rumohr – Cowan & Company

Chengde, you said it’s about the same size as Carlton, but we don’t know how profitable it is both in terms of dollars and in terms of multiples.

Mark Donegan

Let me put the multiples; the multiples are very consistent with, it’s in the range of what we say we always pay.

Cai von Rumohr – Cowan & Company

But it doesn’t help us if we know the sales are the same. What sort of profitability?

Mark Donegan

You’ve got to back your way in. The one think I know, you’re already a very mathematic person, so if you know the sales, you kind of know the multiple. You can get to the profitability pretty quick.

Cai von Rumohr – Cowan & Company

Last quarter you gave us some color on the extent of the destock by narrow body and wide body. I recall it was 25% for the twins and 50% for the narrows. What was it this quarter if we look at it that way?

Mark Donegan

I don’t have it sitting in front of me, but destocking is still probably being driven mainly by that narrow body line. That’s where the bulk of the volume was sitting. That’s where the destocking is coming from.

I think a lot of the wide body I think is behind us but I think the narrow body, there was such an anticipation out there in the market that Boeing was going to go up, that Airbus was going to go up, and everybody was just putting inventory in there whereas the wide bodies, that rate was more stable.

Even as a forecast it wasn’t going to go through wild upticks, so I think certainly as we work through the balance of the inventory out there in the system, it’s going to keep coming out of that narrow body.

Cai von Rumohr – Cowan & Company

You’ve done these two acquisitions. What does the acquisition pipeline look like right now?

Mark Donegan

It’s always full. I think these are the two bigger pieces of the puzzle, but there are still numerous transactions we’d love to get our hands on. In our core competencies we have not had to find ourselves searching for ideas out of our base business. I think that Carlton will pass and will fill an enormous hole for us. We had no answer and I think Chengde sales and we had no answer for.

Operator

Your next question comes from JB Groh – D.A. Davidson.

JB Groh – D.A. Davidson

Considering the delays we’ve experienced on 787 and the investment that you’ve made related there in terms of CapEx, can you talk about what sort of margin drag underutilization in that particular segment of the business has caused? I guess it means pretty good things if you go out a couple of years for margins. Is that an appropriate way to look at it?

Mark Donegan

Yes. I’d say we probably put in, and these are rough numbers. We put in a new iso press for that and that ended up being roughly $40 million. We put in four or five casting furnaces, probably another $10 million. We put in roughly an $18 million to $20 million expansion in large parts.

So we’re probably in $100 million is what we put in. More of a volume, not necessarily a 787, so it’s not as though the assets are necessarily sitting waiting for 787, but if you look at the capacity we put in, that’s probably, $100 million to $120 million is probably the capacity we put in that’s not being fully utilized at all.

Now on the flip side, the fact that it is there and it’s not sitting necessarily idle, the 787 for us is just an accelerator. It’s such a huge accelerator.

JB Groh – D.A. Davidson

Is it because the contribution margin on those particular products is going to be better than legacy stuff?

Mark Donegan

It’s just that we’ve spent a lot of money on it. So if you look at our numbers that we’ve gotten, all of our engineering development was in there. All of our first part articles was in there. All of our redesigns were in there. All the capital was brought in place. All the employees were trained. So our numbers just have the cost.

So it’s not as though it’s out there with these massive margins. It’s just all the numbers that you’ve seen have absorbed all that cost. So when it comes through, it’s not going to have the cost that it had when we ran it last time.

JB Groh – D.A. Davidson

It seems like there’s a little bit of a disconnect between what a lot of suppliers are thinking on narrow body and what Boeing is saying. Could you give us your current thoughts without getting into trouble?

Mark Donegan

I guess the way I feel is, I’ve said this now for the last couple of quarters. Every month we fight through without a reduction is a month we get closer to not having one. I’d be lying if I told you that I would guarantee there wouldn’t be one. I can say that I think we are destocking and our schedules have been hit substantially enough that certainly some of our suppliers are counting when one is going to happen. If it doesn’t happen, I think it could be a catalyst for us.

On the flip side, we’re at the point that if it does happen, we’re going to be in the 787 build at that point in time and as you all know, that’s a three to four to one trade off for me.

For me, the way I look at it is, every month, I’m now in that time frame that if one comes, it may be that 787 and I’m okay.

JB Groh – D.A. Davidson

But it sounds like you customers seem to be planning for one.

Mark Donegan

I think our schedules certainly have, I think we’ve been getting schedules that would say that we’re destocking to handle a cut.

Operator

Your next question comes from Ronald Epstein – Bank of America.

Ronald Epstein – Bank of America

With the new business in China, your management style has been pretty hands on. How complicated is it having it so far away?

Mark Donegan

I actually plan a trip every four weeks. It’s the way it is. My management style is hands on. It’s not going to change. I think that we at various times with various acquisitions that the degree of hand holding changes, and not necessarily for the amount of time and attention it gets, just the way in which we approach it.

I think Carlton was a great example of that. I was honest enough with myself to know that the best person in the company we had to do that was Steve Hackett. Steve is by far the best at balancing that PCC hard driving intense mentality against a culture that is different. And it think Steve had done a great job of that.

I think the hands on approach won’t change and I just will be flying over to China every four to five weeks.

Ronald Epstein – Bank of America

Are there more opportunities for you in China?

Mark Donegan

Yes.

Ronald Epstein – Bank of America

And along that same path, in the past you did allude to the boiler pipe was an area that you were interested in and forging was. If you were to maybe lay out a portfolio there, that would be interesting to you, what could that be?

Mark Donegan

I think anything in the power world is of great interest to us. I think it’s a skill set we have. I think we’ve got a great presence. I think we have a great brand recognition. So I think power would be an area I still would go and there’s still fastener assets that I would love to have that are still out there as independents that I think make great sense, and I’ll continue to fill out our portfolio.

So those would probably be the two categories right now that I would continue focusing on.

Ronald Epstein – Bank of America

Would you ever think of anything non metallic, maybe something in the composite space?

Mark Donegan

Sure. I’ve kind of gone through what our five key core competencies are. If there was a non metallic and it was something else but it still had OEM interface and it was a component versus an engineer product, and if it had cost control, sure.

Ronald Epstein – Bank of America

If the geared fan really starts to get some momentum behind it, is there an opportunity there?

Mark Donegan

We have a great presence. For us, the gear turbo fan is the guts. So there’s not a whole lot in the gear portion of it but in terms of the core, we have a great presence on all that product.

Operator

Your next question comes from Sam Pearlstein – Wells Fargo.

Sam Pearlstein – Wells Fargo

Can you explain what you mean by seeing an uptick in large structural castings, because it would seem to me without production rate changes, how does that actually transpire on the OEM side? Does it mean you cut down below production rates to get rid of some of the inventory?

Mark Donegan

We were way below production rates.

Sam Pearlstein – Wells Fargo

So you’re just bringing them back up closer towards production.

Mark Donegan

Right, they were the leading indicator. So if I look back three quarters ago and looked across our businesses, they’re the ones that began leading where our schedules were a huge disconnect from the build rates. And again, it’s the easiest one for us to track because there are no spare parts. It’s one for one; one part, one engine, two engines per plane, so it’s very easy to track.

So they were leading indicators. Everybody else followed suit. They’re not a leading indicator on the way back but they are now going back to, and there was a 20% to 25% disconnect with them. So there is a significant, that opportunity is still there for them over time.

Sam Pearlstein – Wells Fargo

But it’s not an indication that the rates from the customers are changing, just you getting inventory back in line.

Mark Donegan

Right. If you look, that’s the biggest thing we’re getting whacked from. In our Aerospace world, there’s been except for the 777, there’s been no real changes yet in the bill rates, so all of our destocking and all of our disconnect to the bill rates is just getting inventory out of the system that had been put in for the huge growth that didn’t come.

Sam Pearlstein – Wells Fargo

Your inventories went up $68 million from September to December. You talked a little bit about building some inventory rather than taking a step function later but my expectation or thought was that you have customers who like to take advantage of the different fiscal years and so to what extend did that increase inventories and does that go back out in January/February and is Carlton a factor in there? Can you talk about that inventory increase?

Mark Donegan

You asked and answered quite a few of your own questions, but if I could try to put them into some, I think that certainly we always fight a year end battle, and there’s some of that in there. I think the base businesses X Carlton start working their way from Q3 forward to keep coming down, and Carlton certainly had an inventory position higher than most of our base businesses.

Sam Pearlstein – Wells Fargo

Can you talk about the financial reporting of that if you’ve got a 49% interest in the JV, what will we see on a go forward basis? Will we just see the equity income in an income line within the forging segment or will there be any revenue that flows through?

Mark Donegan

At this point in time there will not be any revenue recognition.

Sam Pearlstein – Wells Fargo

And it will fit within the forging segment?

Mark Donegan

I think it goes below.

Shawn Hagel

We’re still working on where it’s going to be presented but we’ll have a separate line so you’ll see it independently.

Sam Pearlstein – Wells Fargo

Have you determined the allocation of the purchase price within Carlton forge between goodwill or intangibles so that we can get a good sense of what it looks like on a going forward basis and the post amortization margins as they start to flow through?

Shawn Hagel

We have completed that, the allocation. There are some intangibles that were generated. You’ll see some indication of size when we get our 10-Q out to you.

Mark Donegan

We’ll probably wait until the 10-Q goes out to make sure everything is all said and done.

Operator

Your next question comes from Joseph Nadol – J.P. Morgan.

Joseph Nadol – J.P. Morgan

Just a quick question about margins; you laid out the progression on revenue over the next several quarters and a little bit of a delay in the recovery, and I wonder if you could do a similar thing with margins. We had margins flattish to down this quarter. Do we look now for margins to kind of stay in this range until we start to see more of a recovery?

Mark Donegan

I don’t think that we’re done, so even at these rates I think we still have opportunities available to us. Certainly they won’t be as significant as when the volume comes back, but I don’t think we’re at the end of improving our margins. Like I said there’s not a single operation I could look and say they’re doing outstanding, there’s no opportunity.

So I think there is opportunity to move slowly, but they aren’t going to take the jumps that they would take if the volume came back. But I don’t think this is the standard of excellent that I would say is good enough for now.

Joseph Nadol – J.P. Morgan

And then are the macros likewise for forge? We were flat sequentially and was that mainly due to the outage during the quarter?

Mark Donegan

Again, we brought in Carlton so that wasn’t in Q2, it’s in Q3, plus they had an outage, and then there were the other outages. So again I don’t think they’re at the end of their rope to improve.

Operator

Your next question comes from Noah Poponak – Goldman Sachs.

Noah Poponak – Goldman Sachs

What kind of organic revenue growth rate is reasonable to assume for fiscal 2011?

Mark Donegan

I would like to wait on that one. We’re in the process right now of putting our budgets in play so I don’t have everybody rolled up. What I’d like to do is hold that. Obviously I’ll do it in one of the conferences we have so I want to hold off on that one right now.

Noah Poponak – Goldman Sachs

Can you give us a little more color on what you saw on IGT in the quarter? The prepared remarks sound like it was sort of a surprise. What’s going on with the customers in Europe and how much of it is destocking versus you’ve taken as much share as you can and that’s dried up and just any additional color you can give.

Mark Donegan

I think that we certainly saw kind of the U.S. side destocking Q1 and Q2, but we had the new volume coming in. Through that process we didn’t see any real significant destocking from our European base.

Now there may be some reasons for it. As we were coming on line, I think there was probably some double ordering to make sure that we would be successful, and then on top of that I think that we were kind of as we were developing the new programs, I think that we had schedules that were inflated to some degree.

And besides that, I think they also saw they had too much inventory. It was a surprise in that it came in in about a two week period of time after Q3 started. Having said that, it really kind of bled out in lower Q3 and Q3 and Q4 kind of holds, so it’s about a six month event at the lower level and then they start to come back.

We’ve not lost or have not been successful in bringing any of the new jobs up. It’s just that their overall volume came down. It’s like they were kind of late to the party to destock.

Noah Poponak – Goldman Sachs

Why is it a sort of shorter process than the other side?

Mark Donegan

I just think it was a pretty aggressive whack.

Noah Poponak – Goldman Sachs

On 787 you’ve talked about a little. We’ve got a plane in the air and the second plane had a flight but then was grounded, but Boeing sort of says they’re okay with how everything is going. Is there any insight that you have as a supplier other than what we’re reading in the press?

Mark Donegan

Not really. What we’re hearing is that everything is going to plan, that everything is on schedule. So I’m not getting any new insight, but the type of comments we’re hearing and the type of schedules, they’re laying in thoughts of when they want to see schedules to come into play, but shy of that I think Boeing does a very good job on the flip side of holding any flow of information pretty close to the vest.

Operator

Your next question comes from Eric Hugel – Stephens Inc.

Eric Hugel – Stephens Inc.

On the IDT side most of the commentary you’ve given is on the OEM side of the business. Can you give some commentary on where things stand in the aftermarket?

Mark Donegan

We have not seen yet any real increase at all in the aftermarket. It’s been pretty flat, pretty benign so as the customers are out there saying that their turn is now opening up. I don’t think to date we’ve seen anything.

Now typically we don’t get any great foresight in that. Different from Aerospace where they’re kind of a pattern to it, the IDT we typically get starts and stops. So I’m not surprised that we haven’t seen anything yet and it’s not surprising on the flip side if we get a drop in or emergency or something like that. But typically that’s how a lot of stuff comes in when they open up and look at it.

Eric Hugel – Stephens Inc.

What gives you in terms of now you’re talking about a second quarter 2011 sort of recovery; I guess based on what your customers are telling you. I guess last quarter they were telling you first quarter, now it’s second quarter. Other than just that’s what your customers are saying, is there anything else that gives you comfort that that’s going to be the case especially if you’re going to be ramping up production in anticipation of that? Are your customers starting to see their end market demand actually and thus you have more confidence that they’re going to start ordering from you in the second quarter or is it still just keep your fingers crossed?

Mark Donegan

I don’t think it’s keep your fingers cross. I think there are areas that we can look at and we can clearly say here are the build rates. Here is where we get orders and here is the disconnect. So it’s not as though we’re looking for a rate increase.

What we’re looking for is for the customers to come back and order the rate that would support what the rates are which will probably be at somehow the last two of ’07, the first two of ’08. That’s probably that base rate and we can still see where we have a significant disconnect to that. That would be point number one.

We also are getting indications when we talk to our customers that they kind of say, the aftermarket they kind of see it coming in in that period of time. So putting those two together, today that’s what it looks like.

And again, if in fact the 77 stays anywhere near what they say, we’ve got to be building, that’s about the time we’ve got to start building, mid Q2, beginning of Q3, we’ve got to be building. So it’s three pieces of the puzzle today. That’s how we draw that.

So we still see a disconnect between where the bill rates are and what we’re being asked to produce.

Eric Hugel – Stephens Inc.

With regards to Carlton, you’ve owned them for a quarter now. Can you give us anything; are things better or worse than you thought, bigger opportunity? Can you give us some insights?

Mark Donegan

I think it’s a great asset. I think the people have been phenomenal. I think the leadership there is exceptional. So I think what we’re really going to do now is put in our model, go after the cost, go after the opportunity. I think we need to integrate with our capability of supplying material and then we need to take that and go after the market. But overall, I think it’s been equal or better than we had hoped.

Eric Hugel – Stephens Inc.

With regards Chengde, the 49% that you bought, was that Carlisle stake? Did you effectively buy it from them or how did that work?

Mark Donegan

Yes.

Operator

Your next question comes from David Strauss – UBS.

David Strauss – UBS

Similar to the question I asked last quarter, it looks like the Aerospace business was a $3.6 billion to $3.7 billion business at the peak but you now acknowledge relative to the build schedule that you were over producing at that point. This year it looks like the business is going to be around the $3 billion business. Is it fair without destocking to think about Aerospace as kind of $3.2 billion to $3.3 billion in that range before talking any 787 on top of that?

Mark Donegan

I think that’s probably a pretty reasonable number. I haven’t done an analysis, but that’s in the range.

David Strauss – UBS

You talked a lot about the aftermarket. How big as a percent of your total Aerospace business, I thought you had talked before that the aftermarket is like 20%. Is that right?

Mark Donegan

It is 60% of airfoils. You know the number better than I do? We assume about 50% of fasteners is aftermarkets 60% of airfoils and 20% of forgings aftermarket.

David Strauss – UBS

How big is auto now for you and what did you see there in the quarter?

Mark Donegan

We actually saw it up a little bit. It was about $50 million in the quarter.

Operator

On behalf of Precision Castparts, Mr. Donegan and PCC management I would like to thank you for joining the call today. As a reminder, the webcast and call has been recorded and will be available on Precision Castparts website at www.precast.com for approximately 30 days. This concludes today’s meeting.

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Source: Precision Castparts Corporation F3Q10 (Qtr End 12/31/09) Earnings Call Transcript
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