Precision Castparts’ (PCP) October 27th earnings report disappointed the market due to weaker than expected margins and subdued commentary about sales prospects in key markets such as fasteners and seamless pipe. This did not come as much surprise to us as we had warned about each of these issues in previous notes (see here, and here).
The bigger picture concern for us revolves around a lack of transparency, and we think this helped fuel the stock’s underperformance yesterday. PCP management repeatedly refused to give any quantification of the drivers of their business (see conference call transcript here). The company closed on four acquisitions of various sizes at various times during the quarter, and analysts were understandably trying to determine underlying trends. After numerous frustratingly elusive responses by management, an analyst finally asked a very simple question and got a very shocking answer:
And our next caller we'll hear from Ron Epstein with Bank of America Merrill Lynch.
<Q>: Good morning. It's Elizabeth in for Ron.
<A>: Hello, Elizabeth.
<Q>: Hello. Could you just give us the organic growth in revenue for the quarter and operating profit?
<Q>: All right.
In our experience, it is highly unusual for a company to refuse to give organic sales growth or profit numbers. Without these, analysis of the quarter becomes virtually meaningless. Why is PCP refusing this basic level of disclosure? We have two theories:
1) PCP doesn’t want people to know they are overpaying for acquisitions. PCP has historically said it pays around 8 times current period EBITDA for acquisitions. If PCP gave sales and profit numbers for its recent acquisitions, analysts could calculate that it has recently been paying multiples far higher than that. Take for example PCP’s recent $900 million purchase of Primus, PCP’s largest deal ever and one that analysts thought was terrific even though they didn’t know the EV/EBITDA multiple. PCP refuses to give financial information on Primus, but luckily one of Primus’ main competitors, LMI Aerospace (LMIA), was more forthcoming. From LMI’s Aug 8, 2011 conference call:
<Q>: Okay. My last question is the EBITDA; there was a take-out, a large take-out by Precision Cast. Can you just give us some details? I know we could go research it, as far as the take-out EBITDA and take-out PE that occurred in this acquisition by Precision of a company similar to yours. That would be helpful.
<A - Ronald S. Saks>: As best we can determine, the EBITDA multiple paid on next year's earnings - next year's cash flow was about 14 to 15 times and 12 times 2013. That is a multiple that is far in excess of what's typically paid in our industry. And although Primus and LMI are similar, we don't know what special events occurred that caused that type of pricing
Earlier in the same call, the CEO of LMI said that the price PCP paid was “a good 50% higher than we would have expected”. 14 to 15 times next year’s EBITDA is a far cry from 8 times the current period EBITDA - it’s no wonder PCP doesn’t want to disclose Primus’ profit contribution.
2) PCP doesn’t want people to see how poorly aspects of the business (including recent acquisitions) are performing. In both of our prior notes, we expressed skepticism about PCP’s ability to profitably grow in seamless pipe. Yesterday, the management team reported weaker than expected overall growth and backlog in seamless pipe, but pointed to strength in oil and gas as a positive. It boasted that oil and gas had risen from 2% of seamless pipe sales in the June quarter to 16% in the September quarter, but neglected to say how much of this was driven by its recent acquisitions.
We note that Rollmet and KLAD, two of the businesses it bought this quarter, had a significant presence in oil and gas. But without knowing its revenue contribution, we can only guess as to how much it helped the “step function” growth that PCP’s CEO trumpeted. The push into oil and gas has been mentioned repeatedly as a reason to own PCP, now it seems the growth is being bought.
It is also worth mentioning how poorly PCP’s other large acquisition of the past few years, Chengde, is doing. PCP bought its stake in Chengde mainly because the seamless pipe business was booming and Chengde had excess capacity that PCP needed. Yesterday on the call, PCP’s CEO admitted that the company badly misjudged this:
But it really was a situation that we needed the capacity and either we built a new forge complex or we bought and we bought Chengde. And unfortunately the markets imploded and the volume we needed we don't need right now.
One additional reason for buying Chengde was to get into the oil and gas market – PCP’s CEO talked about this at in a Jan 27, 2011 earnings call: And I think longer range, what continues to be the key is to utilize that new capacity at Chengde to penetrate these growing markets in oil and gas, and refining of petrochemical. Chengde is going to be an operation that we'll work, we'll qualify, we'll start delivering some product, we'll move it over.
And I think longer range, what continues to be the key is to utilize that new capacity at Chengde to penetrate these growing markets in oil and gas, and refining of petrochemical. Chengde is going to be an operation that we'll work, we'll qualify, we'll start delivering some product, we'll move it over.
Yesterday PCP’s CEO admitted this was mistaken as well - it couldn’t get Chengde qualified - and that it needed to buy Rollmet recently to do what Chengde was supposed to do: So we first had to qualify SMC, then we had to qualify Houston, then we had to qualify Chengde, which kind of didn't go through and then we had to get Rollmet and qualify that.
So we first had to qualify SMC, then we had to qualify Houston, then we had to qualify Chengde, which kind of didn't go through and then we had to get Rollmet and qualify that.
In this instance we can see why PCP doesn’t want to disclose full profit and revenue impacts from Chengde, it has been a $350 million mistake.
We conclude that PCP doesn’t want to provide information on its large acquisitions because they've been either wildly overpriced or complete mistakes. Yet PCP’s boosters continue to talk up PCP’s acquisition track record and its capacity to do even more deals. A further motivation for PCP to be opaque is so that it can suggest strong organic growth in oil and gas, something the PCP bulls are excited about.
On a separate note, PCP’s inventory levels continue to balloon. Here is an update of the chart we showed after the June 2011 quarter:
<Q - Sam J. Pearlstein>: Okay. And then I guess related, Shawn had mentioned on the inventory some safety stock kind of so you can continue to sell.
<A - Mark Donegan>: Sales don't go - sales don't - we have to supply our customers. So you know, we have to put the inventory on the ground. So what you'll see is, you'll see the sales do what they need to support the customer. You'll see the absorption go down and you'll see the inventory come down.
Yet inventory went up in the September quarter, this time because of “maintenance and strike contingencies” and “purchases to support Saudi Aramco order”. There was no mention of the expected drop from the June quarter’s purchases. In fact, yesterday PCP’s CFO even said on the call that they were building safety stock for “a significant project we have planned for this upcoming summer”! We believe that regardless of the excuses, this excess inventory build helped increase fixed cost absorption and lower raw material costs. September quarter margins got an artificial boost from this, just as margins did in the June quarter.
We continue to be mystified why investors accord PCP a premium multiple. The company’s recent large acquisitions have been overpriced or problematic, its disclosure is worst in class, it is constantly over-promising and under-delivering, and its recent weaker than expected operating margin performance is tainted by continued inventory increases.
 Jan 20, 2009 earnings call
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Disclosure: I am short PCP.