Yesterday, Precision Castparts (NYSE:PCP) reported another quarter of negative sequential organic growth and multiple operational issues. Inventory continued its relentless and inexplicable climb despite numerous reasons why it should have dropped, and acquisition accounting likely continued to give PCP an artificial earnings boost. We believe that PCP is resorting to accounting related earnings boosts to offset their weak operational and sales performance, yet this earnings manipulation still isn't enough to help them meet estimates.
We think PCP is on a treadmill, where they need to continue to benefit from inventory and acquisition accounting profits just to maintain their current earnings level and not revert back to the true profit level of the business. We will focus on inventory in this article, first showing how management's explanations for the inventory increases don't make any sense, and then describing how profit can be boosted by both external and intercompany transactions that add to inventory. We end with a quick update on acquisition accounting and the SEC's recent correspondence questioning PCP's aggressive assumptions.
In the past four years, Inventory has risen by 89% while cost of goods sold (COGS) has remained flat:
Click to enlarge images.
Management's explanations for this increase don't make sense, with the most recent quarter being the most striking example. For the past year, PCP has been building finished goods inventory in anticipation of the 70- to 90-day shutdown of their 50,000 ton press. PCP's CEO Mark Donegan said in February of this year that the company was building $50 million of inventory so that there would be no sales impact from the 50,000 ton press outage in the September quarter:
Question:...You mentioned on the call the 50,000 ton press is going to be down.
Question: And you're going to build some buffer inventory ahead of those?
Donegan: About $50 million.
Question: $50 million. So, how should we think about kind of the sales and P&L impact of the downsize?
Donegan: Obviously, I have to ship when my customer wants it. So, I can't look them and say, 'Oh, my press is down…' We will make our sales, we'll lose the absorption across that asset for 70-ish days. So I think what you'll see out of that facility is, it's not going to be -- you'll see the sales going out, you'll see an inventory drop, and you'll see the lost absorption of that asset.
This quarter should have seen a finished goods inventory drop of even more than $50 million, as seasonal shutdowns in Europe also should have consumed finished goods inventory. Additionally, the operational issues with the 29,000 ton press and the Carlton Forge press meant that they couldn't produce finished goods on these presses -- they should have been aggressively selling down whatever finished goods existed at these plants. Yet somehow finished goods inventory rose $15 million excluding acquisitions (see slide 9 of this presentation). That same slide says that there was a $12 million reduction to inventory at the 50k ton press. What happened to the $50 million of finished goods that was supposed to be sold off? This is but one of many examples of PCP explaining away inventory increases as one-time in nature, but somehow never realizing lower inventory later when they theoretically should unwind. (See Appendix 1 below for a list of some of the more egregious examples.)
Why is it that PCP has to play this shell game? Because inventory has grown beyond any rational explanation over the past four years. On the March 2012 earnings call, Donegan was asked why inventory has risen so dramatically over the past four years and said "we are not even the same company we were in 2008" and then proceeded to talk about vertical integration and revert utilization.1 Bulls have picked up on this line of thought, pointing to a perceived vertical integration over that time period. Yet a look at intercompany sales doesn't support this notion: They are less vertically integrated today than they were back then. Appendix 2 below shows that intercompany sales as a percent of total sales (internal and external) has actually declined from 13.7% to 12.6% over this time period.
So we are left with the great mystery: Why have inventories risen so much as a percent of sales over the past four years? We've previously argued that PCP is likely using LIFO accounting to recognize low cost metal on their income statement while putting high cost metal on the balance sheet (see our note here). This analysis focused on external purchases, specifically of PCP's key raw material nickel. We also think it is possible that PCP is using intercompany purchases to boost earnings. Investors should be worried about this given management's demonstrated willingness to manage LIFO pools, the inexplicable inventory increases, and the increased ability to do intercompany transactions since the Caledonian purchase. Here's how it would work: One of PCP's downstream businesses could buy high priced product from an upstream business such as SMC. SMC books an abnormally high profit from the sale, and the offset is abnormally high inventory balances on the downstream business's books. Normally, this high cost inventory would be recognized when the downstream business actually sells off this inventory, and there would be no room to boost earnings over the life of the product.
But if the downstream business can label this inventory as a separate pool and use a different raw material source to build the product for the end customer, then PCP has managed to record a profit boost at SMC without recording a commensurate profit hit at the downstream business. A symptom of this would be an inexplicable inventory rise. Prior to the acquisition of Caledonian, this type of activity would be limited to the example we just gave -- SMC was by and large the only division that was selling to other PCP businesses. But the 2007 purchase of Caledonian vastly increased PCP's ability to do this. Caledonian buys scrap intercompany from all of PCP's divisions and resells it to SMC. This creates many more intercompany transactions, and more opportunity to boost profit at the expense of bloated inventory.
We recognize that we are hypothesizing here and have no direct evidence that this is happening. But we think it is as good an explanation as any for the radical inventory increase following the Caledonian purchase, especially in the absence of any rational reason given by the company. The key to this type of earnings boost would be the ability to know about and manage multiple LIFO inventory layers so as to avoid dipping into the artificially high pools created from the intercompany sales. And we know that PCP manages its LIFO layers; Donegan told us so on the March 2010 quarter call:
I think we understand our LIFO layers abundantly clear. So I think we know at what point we can liquidate material at a certain [price]... As long as I hold my total inventory dollars flat, I'm good. I can - so, again, deploying that same inventory level across a higher sales base lets me not take any negative LIFO hit, and at the same time lets me get better leverages of working capital as a percent of sales. And then to that, as [metal prices] may rise, we know the strike point so we may choose at some point in time when it crosses that threshold, when there's no impact, to make additional [inventory] reductions in that environment... So we have that type of clarity to it.
To recap, we think PCP's inexplicable inventory increases could be due to their use of numerous inventory pools/layers in order to boost earnings for both external and internal purchases, and PCP has shown that they are willing to do this. We remain surprised that analysts and investors are not questioning the company about their use of inventory to boost earnings.
Additionally, we continue to question PCP's acquisition accounting and are skeptical of the astonishing margin gains in their Airframe Products business (formerly Fasteners). We note that we aren't the only ones to have questions about the low net tangible book value of PCP's recent acquisitions, and their aggressive use of unamortizable intangibles. The SEC recently asked PCP questions (see here) about the exact same items we highlighted in our prior note on their accounting. We call on PCP to disclose whether they have dipped into any of the contract loss accounting cookie jar reserve they set up for Carlton Forge and Primus, and to what extent. We are fairly certain they have, given the deferred tax asset disclosures in their 10K (see Appendix 3 below). In their most recent earnings call, UTX admitted that changes in their loss contract accounting were the reason for better than expected guidance for their Goodrich acquisition in 2013 (see here). We think it is disingenuous of PCP to trumpet their Airframe Products margin performance without indicating how much it was boosted by the establishment, and possible amortization, of the loss contract reserve.
While bullish investors may view the current quarter as impacted by transient issues that are in the rear view mirror, we see it as emblematic of the way PCP runs their business. PCP focuses on short term profitability at all costs, which we believe has been a contributing factor to these operational problems and has caused them to resort to aggressive accounting and bloat their balance sheet.
Appendix 1: One-time inventory additions that should have reversed but never did:
- In the current September 2012 quarter, PCP blames $75 million of the inventory increase on acquisitions. But they don't disclose the $6 million benefit they received from divestitures (see page 366 of the proxy from the ARCW acquisition of PCP assets here).
- In the June 2011 quarter, they spent $64 million on "strategic material purchases." Yet in each quarter after that, when explaining the puts and takes in inventory, they never said that they dipped into that.
- In the June 2011 quarter, they said that $28 million of inventory increase was due to "summer shutdown/repair builds." Yet this $28 million was never listed as declining in the following September 2011 quarter.
- In the September 2011 quarter, not only did they not unwind the prior build, but they listed "Inventory build for maintenance and strike contingencies" as the reason for a $17 million inventory increase. The strike threat was resolved in the December 2011 quarter, yet they never listed the reversal of this inventory as a benefit.
Appendix 2: Intercompany sales (and therefore vertical integration) has declined:
For this table we need to look at the June quarter results, since they only disclose intercompany sales in their SEC filings:
Appendix 3: Why we think PCP dipped into their loss contract cookie jar in FY 2012:
Given the lack of transparency, we harbored little hope that we would be able to determine when the loss contract reserves were actually being used (i.e., when earnings are being boosted by it). But PCP's annual deferred tax asset disclosures actually give us a way to estimate when this is happening. When PCP books this loss contract liability, it needs to also book a deferred tax asset equal to the tax impact of the liability. For example, using the Carlton loss contract numbers, they booked a $35.7 million deferred tax asset when they recorded the $92 million liability, implying a tax rate of slightly less than 39%. In FY 2011, the deferred tax asset remained $35.7 million, which implies that they did not dip into the cookie jar.
However, in FY 2012, the deferred tax asset only rose by $11.4 million to $47.1 million, despite the addition of $85.3 million of new loss contract reserves from Primus. Assuming a normal 35% tax rate for Primus, the deferred tax asset should have risen by $30 million. This implies an earnings boost of $53 million ($18.6 million divided by the tax rate). It appears that just as PCP started recognizing artificial earnings boosts from the Carlton acquisition, they bought Primus and ensured that they would continue to be able to do this in the future.
1. Donegan claims in this call that they used to sell revert to the outside "within a day" and now they keep it, which has led to inventory bloat. If this were true, we would have seen it show up in a rise in intercompany sales. But more importantly, this characterization contradicts what he said at a conference in May of 2010:
We measure how long material revert sits. The whole goal is you don't want it to sit longer than a minute. So anytime revert's sitting there we move it somewhere else, and then we can replace it because people used to hoard it. I'm going to make sure six weeks from now I'm going to have a melt and I wanted that revert in hand, what we say is you can't have it, get it, move to Special Metals and we'll replenish it.
Disclosure: I am short PCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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