Precision Castparts (PCP) reported another underwhelming quarter yesterday, with the highlights being a sequential drop in organic revenues, continued management obfuscation over the impact of acquisitions, and further bloating of the balance sheet through inexplicable inventory increases. The conference call and presentation were littered with references to strong organic growth - the first slide talks about double digit year on year organic growth in all of PCP's main markets - Aerospace, IGT, and Oil and Gas. The overall impression is one of a company firing on all cylinders and growing strongly. Yet when PCP's CEO Mark Donegan was asked to disclose organic growth for the company, he refused. From the call:
I don't look at the organic standpoint of the whole company. What we try to call out is the things that I thought were valid to you in terms of the organic growth by segment and by market. So at this point in time that's kind of where I want to keep that organic growth conversation.
Why has Donegan decided not to look at overall organic revenue growth of the company, despite it being perhaps the most relevant metric for managers and investors? Because he wouldn't like what he would see. In what should be a seasonally strong quarter for growth, PCP's organic sales dropped approximately 2.8% sequentially. This drop cannot be explained by the unplanned outage at the Houston forging press, which impacted sales by 80bps at most (see appendix for a breakdown of sequential organic growth).
In the call Donegan also talked up the "strong operational improvements" seen at Primus and said that it is "exceeding initial operational synergies". Analysts seemed pleased and didn't question how Primus margins have improved so quickly, despite ample evidence that it is due to aggressive acquisition assumptions. Our note last week focused on Primus' $85mil loss contract reserve, which allows PCP to report earnings from good contracts and avoid reporting earnings from bad ones. We continue to find any discussion of margin performance without mentioning the loss contracts reserve to be highly misleading. The company should disclose how much of the loss contract reserve or other accruals were released since they help earnings without providing any real economic or cash benefits.
In light of the decline in organic sales, investors should be very concerned that PCP added another $106mil of non-acquisition related inventory. The performance continues the trend of the last several years: inventory has roughly doubled since FY2008, and yet the sales run rate is only 10-20% higher.
As we have argued before, it is our belief that PCP is afraid of drawing down their inventory because it contains old high cost items created more than four years ago when metal prices were much higher. By adding to their inventory, they avoid the old high cost items flowing through their income statement and hurting earnings. When metal prices are declining, as they were in the latest quarter, PCP's incentive to binge on metal is greatest: in addition to avoiding an earnings hit, they can boost margins sequentially by lowering their COGS via cheaper metal purchases. This happened in the latest quarter, and helps explain the slight sequential margin improvement in the face of organic sales declines. This is artificial of course, and comes at the expense of cash flows and a bloated balance sheet.
PCP's most recent quarter shows a company trying to offset the impact of organic sales declines through aggressive inventory building and acquisitions. The drop in the stock indicates that investors are indeed worried about these issues, even if management would prefer to focus the conversation elsewhere.
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