On July 28, Precision Castparts (NYSE:PCP) reported yet another underwhelming quarter. Adjusting for a 3 cent benefit from a lower than expected tax rate, PCP’s first quarter earnings per share of $1.94 were a penny shy of the consensus estimate. This result was received well by Wall Street, particularly because of the 100bps sequential margin expansion, the first significant quarterly increase in two years despite a rebound in sales. However the margin beat was attained in our judgment thanks to one-time items and inventory increases. After adjusting for these factors, PCP margins continued to show the persistent weakness that we discussed in a Jan 25, 2011 report.
We estimate that the reported operating margin of 25.0% was inflated by 220 basis points due to metal speculation, overproduction, and internalization of sales. The first two points need to be considered in the context of a massive 11% sequential increase in inventories on flat sales. First, PCP admitted to making $108mm of “strategic” and other raw material purchases during the quarter. Given the declining trend in nickel prices throughout the quarter, we estimate this benefited margins by around 110bps.
Second, PCP revealed an additional $76mm sequential increase in work-in-process inventories. We estimate that the absorption of fixed overhead expenses into inventories benefited margins by approximately 50bps.
Finally, PCP disclosed that it internalized an extra $40mm of revenue in the Forged Products business (i.e. sold it internally rather than externally). While this did not affect earnings per share, it did boost margins by almost 60bps (while depressing reported sales by over 2%); this is important because investors have extrapolated this margin performance onto higher expected future sales. On top of all this, earnings benefited by 3cents from a lower than expected tax rate. Adjusting for just these issues, we estimate 1Q EPS would have been $1.81, 7% below consensus, and operating margin would have been 22.8% instead of 25.0%. We are including an Appendix showing how we arrive at these estimates.
It is worth looking again at the evolution in PCP’s inventory (the following chart uses calendar quarters):
Last year, in explaining why the inventory level was increasing in contrast to previous guidance, management said they were going to hold the level constant going forward as sales grew. They also added that PCP is “not a metal speculator.” But on the July 28, 2011, earnings call, PCP’s CFO said they bought the extra raw material “at good prices” and the CEO said: “I mean certainly we made some guesses on material. If we are right, good. If we are wrong it's a problem.” We are baffled that investors appear to have ignored this second about-face, especially given the peculiar timing and corresponding rise in margins.
Investors should also note that PCP’s LIFO reserve remains large at $142m, indicating that old high cost inventory remains on the balance sheet and has yet to flow through COGS. We think the avoidance of this hit on the income statement, and opportunistic purchases when its helps quarterly earnings, is the best explanation for PCP’s inventory changes. In other words, near-term reported results, not actual working capital needs, drive inventory.
We also look skeptically at PCP’s forecast of Oil and Gas revenue growing from at most 2% of Seamless Pipe in the June quarter to 25%-30% by calendar year end. We focus on Seamless Pipe because its collapse contributed to sharp margin declines at Forged Products. Bulls point to the margin upside as this business rebounds. PCP’s core Seamless Pipe business is in structural decline due to intense Chinese competition, and management has refused to acknowledge this. PCP has previously talked up the move to 1,000MW power plants as a sales driver that will lift the company out of the downturn in the Seamless Pipe business, and when that wasn’t realized they trumpeted the emergence of power plant orders from India. Now that also isn’t gaining traction, and Oil and Gas is the next flavor of the month. We don’t expect the push to Oil and Gas to meaningfully improve Forged Products profitability.
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Disclosure: I am short PCP.
Disclaimer: This report is intended for discussion purposes only. It is neither a recommendation nor a solicitation to purchase or sell any security or private fund offered by Temujin. The analysis and opinions of Temujin presented in this report are based on publicly available information sourced from SEC filings, earnings call transcripts, and other public sources that we believe to be reliable. Judgments have been made based on information sourced on or before the issuance of this report. There may be information concerning Precision Castparts that is not publicly available, which could lead the company to disagree with our analysis and opinions. Temujin expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this report.