Recently, analysts have been cheering as Precision Castparts (NYSE:PCP) has gone on a high-priced1 acquisition binge, having closed on eight companies in the twelve months ending March 2012 with at least six more slated to close by September 2012. Fueled by management commentary, bullish investors believe that PCP has an operational "toolkit" that enables them to significantly improve margins at acquired companies. We believe this "toolkit" involves aggressive acquisition accounting that creates illusory profits. The increased pace of acquisitions indicates to us that PCP needs even more of these fabricated profits in order to meet expectations. In this article, we detail how PCP uses "loss contract" reserves and other aggressive accounting to boost earnings without creating any real value. These accounting maneuvers, combined with the high prices paid for acquisitions, have bloated PCP's balance sheet and caused ROE to drop from 29% in FY 2008 to 16% in FY 2012. Free cash flow conversion has suffered as well. When it comes to acquisitions, PCP bulls should be careful what they wish for.
Primus' Loss Contract Reserves
PCP's August 2011 acquisition of Primus was a seminal moment for the company. PCP spent $900 million, more than they spent on any other acquisition in their history, to gain access to Primus' aerostructures capability and its 787 Dreamliner content. Management has called it a new growth platform, and has suggested that they will roll up the aerostructures market as successfully as they rolled up the fasteners market. They have since bought three more aerostructures companies amid much fanfare, with the latest example being the Heroux-Devtek asset purchases announced yesterday.
Given Primus' importance, we were surprised that PCP waited over 10 months before disclosing that the purchase involved an $85.3 million liability for "the fair value of loss contracts." PCP does not disclose any additional information on this item or its significance, but they should: Loss contract accounting can have a profound impact on a company's financials. It allows a company to estimate the cumulative losses from bad contracts and create a liability for them at the time of the acquisition. This liability serves as a "cookie jar" reserve that an acquiring company will dip into to avoid ever reporting losses on these bad contracts. It's a neat maneuver that divorces PCP's earnings from reality -- PCP gets to report earnings from the good contracts and avoids reporting earnings from the bad ones2.
The $85.3 million loss contract reserve is far more than Primus earns in a year. Given the size of this cookie jar, it has the potential to boost Primus operating profit for years to come. PCP management has said that Primus' margins are below the 22.5% level achieved by their Forged Product business, but that they eventually expect margins to be higher than the company average after they realize $20 million-plus of synergies. We question how PCP is calculating these margin targets and synergies: Is it before or after the artificial benefit from the loss contract reserve? We find any discussion of margin performance without mentioning the loss contracts reserve to be misleading.
Primus' Other Acquisition Accounting Issues
Loss contract reserves are not the only way that PCP could be boosting earnings through acquisition accounting. According to PCP's 10K, despite the $900 million price tag, Primus' net tangible assets3 were negative $27 million! It is highly unusual for a quality manufacturing company to have no net tangible assets -- as a producer of tangible goods it should have plants, equipment, inventory, etc., that overwhelm any liabilities. But acquisition accounting can allow a company to present an alternate reality. Upon completion of an acquisition, the acquiring company records a value for every asset and liability of the acquired company. This value doesn't have to be in line with the value the acquired company placed on the asset or liability -- effectively the whole balance sheet including tangible and intangible assets is "marked to market" at the discretion of the acquirer. The difference between the purchase price and this valuation is recorded as goodwill and never hits the income statement. As Tyco showed us during its accounting issues (see the fourth paragraph in the SEC settlement announcement), there is plenty of room for manipulation in this process. Indeed, one of the main red flags prior to Tyco's accounting scandal was the fact that it was valuing acquisitions at zero net tangible assets (see this New York Times article).
In our view there are only three possible reasons for Primus to have negative net tangible assets:
- It is a poorly performing, loss-making company
- Its assets such as PP&E and Inventory are being marked down by PCP and will eventually provide an artificial earnings boost. For example, lower PP&E leads to lower depreciation, and lower inventory leads to higher margins when that inventory is sold
- Its liabilities are being marked up, thereby creating "cookie jar" reserves that can be released to boost earnings. The aforementioned loss contracts are an example of this, but it could also be happening in environmental reserves, accrued expenses, etc.
Given the high price paid for Primus, as well as positive PCP management commentary about the quality of Primus' business, we conclude that the first reason doesn't apply. We are left with the conclusion that PCP has used aggressive acquisition accounting in order to artificially boost Primus' future earnings.
We'll close this discussion of Primus with one more example of PCP's dubious acquisition driven margin improvement. Analysts lauded PCP management for achieving strong margins in the March quarter at Primus after initially disappointing in the December 2011 quarter. We think we have shown enough evidence to suggest that this praise was misplaced. But it is particularly laughable since in the March quarter PCP lowered their estimate of net tangible assets arising from 2012 acquisitions by $39.9 million4. This means the company went back through their acquisition accounting assumptions and revalued their net tangible assets lower. Investors should question whether these further markdowns boosted earnings in a quarter where PCP management was under pressure to deliver improvement at Primus.
A Look at Carlton Forge Works Reveals Similar Issues
PCP also uses loss contract accounting in their acquisition of Carlton Forge Works, their second largest acquisition in terms of money spent. When accounting for the Carlton acquisition, PCP recorded a $92 million reserve for a "pre-existing revenue sharing agreement." It only became apparent in the 2012 10-K, the third 10-K since the acquisition, that this reserve was actually a loss contract reserve5.
Given PCP's abysmal transparency, it is difficult to determine when this reserve was actually used (i.e., when earnings are being boosted by it). Based on PCP's deferred tax asset disclosures, we believe that PCP dipped into this cookie jar sometime in FY 2012. We note that these two acquisitions were the only ones that PCP made in the past three years that were large enough to require the disclosure of this loss contract reserve. We suspect that their other acquisitions contained them but PCP does not disclose enough details to confirm this.
We also note that PCP valued Carlton at net tangible assets of only $110 million despite the $850 million price tag -- a multiple of 7.7 times. Aggressive net tangible asset acquisition accounting can be seen in large acquisitions prior to the Primus and Carlton acquisition as well (see earnings quality issue No. 3 in our prior note where we analyzed the SMC acquisition).
Intangible Asset Mix Also Sheds Light on PCP's Aggressive Acquisition Accounting
The mix of intangible assets also tells us how aggressive a company is with acquisition accounting. After all the tangible assets have been marked, an acquirer is supposed to value all intangible assets and determine how many are finite lived vs. indefinite. Those that are finite lived must be expensed over their estimated life of the asset. The rest of the purchase price is then allocated to indefinite lived intangibles, and never hit the income statement. Compared to peers, PCP has been quite aggressive in allocating nearly all their intangible assets to indefinite lived as opposed to finite lived. The table in the appendix shows that PCP has allocated over 90% of intangible assets to indefinite lived in FY 2012 and FY 2010 (their two recent years with meaningful acquisitions). That compares to the median 11% seen in the rest of their peer group -- no other company is higher than 44%. Once again, PCP's aggressive accounting is helping to boost earnings growth.
PCP trades at 19.5 times trailing earnings due to belief in the commercial aerospace cycle and PCP's ability to drive earnings growth through accretive acquisitions. We caution that the cycle has hit a negative inflection point, and that PCP's recent acquisitions show a pattern of value destruction and ROE dilution. We've written extensively about PCP's LIFO accounting fueled inventory binge (inventory up 83% in the past four years while sales are up 5%), and the parallels to its acquisition strategy are striking. In both cases, PCP is bloating its balance sheet in order to create short term earnings at the expense of the long term. And in both cases, PCP's disclosures and transparency have been remarkably poor. We expect continued fundamental disappointments, related to the cycle turning and competitive pressures (see the second half of this writeup), to cause analysts to view acquisitions with a more skeptical eye. When they do, they won't like what they see.
1. PCP's acquisition disclosure is quite poor, so we rely on quotes from competitors to confirm this. The CEO of LMI called the multiple PCP paid for Primus "far in excess of what's typically paid in our industry" and "a good 50% higher than we would have expected". (See our note here.)
2. Primus' much admired 787 content may actually be the loss making contracts. CEO Mark Donegan said at a Feb. 7, 2012 conference that Primus has "such a presence on the 787 that goes -- that's a huge piece of Primus' puzzle under contract."
3. After goodwill of $422 million and intangible assets of $505 million as disclosed in the 2012 10-K.
4. Goodwill rose $55 million from Q3 2012 to Q4 2012 without any meaningful acquisitions. Unamortizable intangibles dropped $20.5 million and amortizable intangibles rose $5.4 million, leaving a net impact on tangible assets of $39.9 million.
5. The deferred tax asset section of PCP's 2012 10-K shows "acquired loss contracts liabilities" of $35.7 million in FY 2011. The 2011 10-K calls this same $35.7 million "acquired revenue sharing agreement liabilities."
Click to enlarge image.
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.