When Mr. Buffett acquired Precision Cast Parts (NYSE:PCP), the world wasn't surprised as the acquisition made great sense. PCP was making very impressive margin growth year on year on the back of revenue growth through organic transformations and inorganic acquisitions. But the true rationale behind such a hefty price that Mr. Buffett paid is to be seen from some statistics from the Aerospace industry as Precision Cast Parts had 70% of its revenues from the aerospace industry. The aerospace industry is one that actually benefited the most from the low oil prices, which created the foundation for further investments for the future.
The three divisions of Precision Cast Parts are as follows as taken from the PCP website:
Investment Cast Products Division: This division deals with complex investment castings for aircraft engine, industrial gas turbine, airframe, and other applications, including the world's largest diameter investment cast components.
Forged Products: This division deals with complex forgings and high-performance alloys for aerospace application. It includes power generation and general industrial applications.
Airframe Products: This division deals with engineered fasteners, fastening systems, metal components, and assemblies for aerospace, transportation, power generation, and general industrial markets.
The connection with aerospace is strongly entrenched in every division.
If there was anyone who wanted to diversify the portfolio to fend off the impacts of high commoditization and needed a China-proofing strategy, it was the aerospace sector to lean into. It wasn't Mr. Buffett only who showed such an inclination; it was also Alcoa (NYSE:AA) that announced its spin-off almost at the same time with the naming of Arconic as its downstream value added company, which is also a similar attempt to make a move towards the value accretive aerospace sector as a major thrust area of the business.
But the first question is to clear all doubts that the aerospace sector as an industry is really the best bet to bank on.
I will begin by looking at the three most important indicators of the aerospace industry; the first one is the order backlog and how it has been growing as is shown in this series taken from the AIA website. The backlog number has grown from $219 Billion in 2004 to a formidable $732 Billion in 2015.
|Backlog of Orders in $ Billion||219|| |
The second is the capacity utilization of the important segments, of which the most important would be to look at the parts manufacturing segment as is provided in this series. If I take the period 2004 to 2015, the capacity utilization in the aircraft and parts segment has shown a capacity utilization improvement from 65% to 104%.
|Capacity Utilization (Aircraft & Parts)||65%|| |
The third and last is the trade imbalance in this segment, which is arguably the most export positive segment over imports amongst all the manufacturing industries in U.S. and this shows a whopping surplus in excess of $60.7 Billion (in constant dollars) as is evident in this series. More importantly the strength of the dollar is itself a huge value-add for this industry. If there was one very clear element of China-proofing to be seen, then this was it.
|Balance of Trade (Surplus)|
|In Constant Dollars ($ Billion)||42.8|| |
The Oregon-based Precision Castparts, which had a market capitalization of $26.7 billion before the deal, earned 70 percent of its revenue supplying the aerospace industry, including commercial, business and military, while the rest of its sales are split between power generation applications (17 percent) and industrial applications (13 percent). Mr. Buffett actually paid for $32 Billion in cash for the acquisition which was at 20% premium on the market cap, but it still carried about $5 Billion as debt on its books, taking the total to about $37 Billion for the buy.
Mr. Buffett saw an opportunity that Berkshire (NYSE:BRK.A) (NYSE:BRK.B) could hardly miss, when the stock took a tumble by 20% beginning January 2015 largely due to the beating in the energy sector slump, but Precision cast parts had just 17% of its revenues coming from that sector. So the 20% premium could well have been justified.
The real reason for the buy also needed some number crunching around the financials; it is the supremely successful model of business that the financials portray that triggered the buy. Let me first show the financials at a glance over a ten year horizon:
|Net Profit |
This roughly translates to a net margin improvement from 6% to 18.5%, something that very few companies in the metal parts manufacturing space can boast of. More than metal parts manufacturing, the company was actually pursuing a business model that differentiated itself into a supremely niche category of business which virtually created barriers to entry to its space of play.
The growth in revenues also cannot be lost sight of, although it involved a spate of acquisitions (Texas Honing, Synchronous Aerospace, Timet, Aerospace dynamics, to name a few) that Mark Donegan had been engaged in over one full decade; the CAGR growth had clocked an impressive 18%.
Now let me turn to Alcoa's rapid strides in aerospace and how this portfolio has grown in the last several decades; the story started in 1910 with the development of the alloy 2017-T4, which was used in the wings and propellers of aircrafts. The journey moved from casting of alloys in B-17 & B-24 in the 1920s to alloy 7085 used in the F-35 series in the 2000s. The current decade has seen all kind of forays in rockets and aircrafts with high strength alloys and precision parts in Titanium and aluminum including fasteners. The full journey can be seen here in this treatise taken from the Alcoa aerospace website.
The real might of the aerospace division can be seen in this presentation of Alcoa which shows the downstream in all its elements, where the aerospace section contributes to $6 Billion of revenues.
The Engineered Products Division, named as EPS, is a segment that represents Alcoa's downstream operations and includes titanium, aluminum, and super alloy investment castings; forgings and fasteners; aluminum wheels; integrated aluminum structural systems; and architectural extrusions used in the aerospace, automotive, building and construction, commercial transportation, and power generation markets.
EPS is a diversified portfolio of four businesses, with a core focus on solutions for the aerospace market:
- Power and Propulsion: Superalloy airfoil and titanium and aluminum structural investment castings for aerospace, defense, energy and industrial markets
- Fastening Systems & Rings: Multi-material fastening solutions and seamless rings for aerospace and industrial applications
- Forgings and Extrusions: Large and complex, multi-material fabricated parts and structures used across various end markets such as aerospace, automotive, defense and oil and gas.
- Titanium and Engineered Products: Advanced titanium and other specialty metals products and services to the commercial aerospace, defense, oil & gas and medical device markets.
The financial result of this division is noteworthy: $6.0B Revenue & $767M ATOI with an EBIDTA margin of 21.9% according to the Annual Report of Alcoa.
Thus the comparison of Engineered Products division, which is largely the Aerospace portfolio of Alcoa, with Precision Cast Parts, is very apt.
When Alcoa spins off into Arconic, which consists of EPS, the Global Rolled Products Division & Transportation and Construction Solutions, it is the Engineered Products Division, which will be the jewel in the crown, with the biggest prospects. It also holds the potential to China-proof itself as in aerospace industry, everything negative that keeps happening in China related to commodities actually helps to make this industry benefit in terms of cost while the order book is a clear indication of the strength of this industry going forward. These companies are completely insulated from the vagaries of commodity prices, while they benefit from technology differentiation.
PCP and Arconic shines on Aerospace strength, the spin-off of Arconic and the acquisition of PCP could not have been better timed.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.