PRECISION CASTPARTS CORP PCP
August 10, 2015 - 6:02am EST by
Pluto
2015 2016
Price: 220.00 EPS 13 0
Shares Out. (in M): 138 P/E 17 0
Market Cap (in $M): 30,500 P/FCF 16.5 0
Net Debt (in $M): 4,000 EBIT 2,600 0
TEV ($): 34,500 TEV/EBIT 13.3 0

Sign up for free guest access to view investment idea with a 45 days delay.

 

Description

 Precision Castparts

With Buffett’s takeover romour story posted in the WSJ this weekend, the timing is far from perfect. I wanted to post this already last week, but waited to get more proof on some market share data, other minor issues and needed time to finish certain parts. Anyway, now I’ll post it with slighlty more untested data, and a higher share price... If it does not go too high this is still a good buy @ 220$ or below - current prices in Europe. Depending on where this opens in the US, this can still be a good buy for a small stake, or turn into a great buy if romours are not true and the prices declines again towards or below 200$. @220$ one has a chance to get a quick takeover premium if the romours are true or a stake (and likely also the opportunity to add more) in an undervalued high quality business that is likely to generate mid-teen returns for a quite some time. If it shoots up too high, and gets takenover this write up is obviously worthless... I have no real opinion on wether we will see a takeover or not. Buying it now is certainly not super compelling, but maybe this writeup is still helpful to some. If it is just a rumour and we see prices around 200 again, I think this is a great opportunity. Anyway here is the origional write up on PCP whith price adjustments.  

Idea: 

Precision Castparts (PCP) is a very well managed best-in-class business with a dominant position in a growing market. The current valuation even at roughly 17 times earnings (@220$) now still fails to properly reflect the quality, growth prospects and M&A value creation potential of the company. I believe the recent downturn in the company’s cyclical non-core oil/gas business and destocking issues of one key costumer have created a buying opportunity to achieve a solid mid-teen return over at least the next 5 years. Just like in the past, the market beating returns should come from organic growth in its attractive core business plus very well executed meaningful acquisitions along the way. New in the mix to drive the returns are only recently started share buybacks

I was surprised that no one has written up Precision Castparts on VIC before. With historic returns of over 400% for the last 10 years and over 2800% since 2000, it could not have been due to a lack of opportunities to make a lot of money. However, as a member of the S&P500, some prominent longs in it (like Buffett) and a market cap of over $25b I think PCP is no stranger to many VIC members. In case you are unfamiliar with this metal components manufacturer, consider the following numbers before stop reading further.

Long-term CAGR per share (3-y. averages):

 

15 years

10 years

Revenue

8.7%

11.5%

EBITDA

13.2%

17.2%

EBIT

14.7%

18.2%

Earnings

16.8%

24.6%

FCF

16.8%

19.5%

 

Average 5-year Operating Income / Tangible Assets ~ 30%

Maintenance capex at 50% of current capex ~ 2% of sales

Adjusted FCF (based on MCX) of ~ 19c for every 1$ of sales

 

 

Business Outline

Precision Castparts is a supplier of high-quality metal components for critical applications that need to meet strict tolerances and can perform under harsh conditions. The bulk of its costumers - 72% of revenue - are in the aerospace market. A further 15% of sales are to the energy market with a 50/50 split between IGT (industrial gas turbines) and Oil & Gas market. The reaming 13% of sales are components for certain niches in the general industrial market like automotive, industrial machines, chemical, pulp and paper, medical etc. GE is its biggest costumer with 13% of sales.

PCP consists of a collection of different businesses that bring difficult to handle metals like nickel and titanium into complex shape. The company has a rich takeover history and over the last 15 years PCP built a very broad scope (both horizontally and vertically) to serve itself and its markets best. PCP has by far the highest margins in its markets and operates its facilities much more efficient and intelligent than its peers. The assets range from one of only three 50,000 ton forging presses in the world, over unique capabilities to from the largest and most advanced investment castings demanded by engine OEMs to the broadest ranges of titanium and nickel alloy aerospace fasteners in a consolidated market with only 2 noteworthy competitors.  Most of the business, especially the aerospace business, is based on long term supply arrangements. Part of PCPs strategy is to offer price deflation over time in exchange for additional business secured by LTA contracts. So far this has worked very well, the incremental margins more than make up the lower prices. PCPs market share in all of its key markets is very strong. On average for the whole company I’d say it is over 40% (but I can’t fully back this at this point in time). All off the businesses have a good load of growth in front of them, but more on that later. The company breaks out 3 segments - Investment Cast Products, Forged Products and Airframe Products.

Investment Cast Products

The Investment Cast Products business is the oldest segment of the company. It consists of the structural casting and airfoil casting businesses. PCP is a world leader in both fields and there are not many competitors around. Alcoa is the principal competitor and lacks only some of the largest casting capabilities. Next comes Allegheny Technologies (ATI), but compared to PCP and Alcoa, ATI is already relatively small, has poor margins and is financially quite weak. Other companies offer only a limited number of the many casted components that go into an engine. Future competition could arise in Asia and some engine OEMs could start do more in-house - both needs to be monitored midterm.

PCPs investment casting is specialised on the most advanced metal alloys. The casted components are used in both the cold and hot section of engines and are certainly critical key components of the engine. On some of the largest structural castings PCP is the only option in town. The airfoil casting business is also very attractive. The shapes need to meet very high accuracy, some are exposed to extreme temperatures and failure would bear tremendous costs. This is also a reason why engine aerofoils need more periodic replacement and why roughly 30% percent of PCPs airfoil sales are aftermarket.

Investment Castparts segment

Sales by Market

F2006

F2007

F2008

F2009

F2010

F2011

F2012

F2013

F2014

F2015

Aerospace

1019.9

1133.2

1310.5

1314.5

1045.1

1304.8

1487.4

1579

1572

1605

% of Total

65%

65%

61%

58%

57%

62%

64%

64%

64%

63%

Power

371.8

409.5

562.3

686.2

580.6

555.8

623.5

718

714

768

% of Total

26%

23%

26%

30%

31%

27%

27%

29%

29%

30%

General Industrial

166.5

205.6

265.1

271.4

225.6

235

216

183

176

163

% of Total

10%

12%

13%

12%

12%

11%

9%

7%

7%

7%

Total Sales

1571.8

1748.3

2137.9

2272.1

1851.3

2095.6

2326.9

2480

2462

2536

Operating Income

315.2

382.3

517.4

582.7

560

665.5

766.4

838

874

913

% of Sales

20.1%

21.9%

24.2%

25.6%

30.2%

31.8%

32.9%

33.8%

35.5%

36.0%

 

 

 

 

 

 

 

 

 

 

 

 

The segment has seen very nice margin improvements over the last couple of years and you would think; when will this be over? If you ask the CEO Mark Donegan he will tell you it would be time to quit his job if he couldn’t improve it more. Current incremental margins run very high, probably in the low 50ties and the commercial aircraft ramp should provide nice head room over the coming years (more on that later). This is the wording from the most recent annual report for this segment.

“The Investment Cast Products segment has solid content on most major aircraft production platforms. Fiscal 2016 sales gains are expected to be driven by the next step-up in commercial build rates on platforms such as the Boeing 787 and Airbus A350 and narrow-body re-engining. We expect to leverage higher commercial aerospace volumes by adding incremental capacity to meet higher demand and at the same time, improve our overall efficiency and cost structure. We expect IGT growth to continue into fiscal 2016 due to growth in high-efficiency, large-capacity new IGT platforms, IGT upgrade programs and higher spares activity. Overall, we expect mid-single digit sales growth with incremental operating margins above our typical 35 to 40 percent.” – Annual Report F2015 

In Q1 F2016 another acquisition that adds an additional layer of capabilities (ceramic) in this segment was made and margins came in slightly above 37%. This is an interesting section from the last CC. on the margins.

Myles Walton - Deutsche Bank Securities: Morining. Thanks for squeezing me in. Mark, once the investment cast margins go up they tend to be pretty sticky on the upside. Is this 37%-plus range kind of a sustainable range from which to regrow from for the rest of the year

Mark Donegan - Chairman and CEO: Yeah, obviously most of that product is under LTA. I want to make sure it’s abundantly clear, there is deflation built in that we have to overcome, as there is every single solitary year and quarter, so kind of as you’ve seen the progression there’s deflation that’s built in there. We just have to have cost plans in place that are equal to or greater than whatever we’re doing from a deflationary standpoint. So is it exact every single solitary quarter. No, there are gives and takes as we hire people to do whatever it is. But I’d say as a general rule there’s nothing there that’s kind of out of the ordinary and there’s still opportunity to offset whatever deflation we have to give, so I’d say that they should be able to continue to progress over time.

Forged Products

This segment consists of two massive forging presses (35,000 tons and 50,000 tons) that are among the world’s largest forging presses. In North America only Alcoa also 50,000 ton forging press. Russia has another one and recently a Japanese consortium also built one. PCP with lean frugal operating style and the greatest market share is the low cost supplier. Another asset in this segment is TIMET with is the biggest titanium producer in North America with around 25% global share. Alcoa has recently bought RTI which supplies around 10% of aerospace titanium. ATI also is also a competitor in this segment and has close to 25% market share, but again their margins suck. The biggest titanium supplier is Russia’s VSMPO with a 30% share and most of its titanium concentrate coming from the Ukraine. I believe TIMET, which was acquired as recent as 2012 currently has a rich environment to continue to take market share under the PCP model of doing business. The OEMs should be keen to reduce some exposure VSMPO exposure. The following table taken from EU regulatory filings looking at the TMIET takeover offers a nice insight into PCPs market shares in the titanium field. The casting shares are also included.

 

Here is some background on Wyman-Gordon: http://www.autospeed.com/cms/article.html?&title=The-Wyman-Gordon-50000-ton-forging-press&A=113049

Besides Wyman-Gordon and TIMET, there is Specialty Metals Corp which offers a large range of Nickel alloys, Caledonian alloys that handles revert management other assets with different scopes that fit into the collection to serve the aerospace market well.  Also this segment has seen some nice margin improvements. Recently the oil and gas market has chipped some of the gains off again, but I view this as a temporary phenomenon.

 

Forged Products segment

Sales by Market

F2006

F2007

F2008

F2009

F2010

F2011

F2012

F2013

F2014

F2015

Aerospace

556.4

1024

1476.1

1158

956

1317.1

1692.4

1960

2478

2498

% of Total

62%

44%

47%

39%

42%

47%

53%

55%

59%

58%

Power

254.6

704.1

1064.1

997.6

857.2

775.3

864.9

891

920

921

% of Total

28%

30%

33%

33%

37%

28%

27%

25%

22%

22%

General Industrial

83.1

622.5

627.9

822.8

469.8

687.3

632.2

701

791

840

% of Total

10%

26%

20%

28%

21%

25%

20%

20%

19%

20%

Total Sales

893.1

2350.6

3168.1

2978.4

2283

2779.7

3189.5

3552

4189

4259

Operating Income

113.3

409.5

699.5

652.9

529.7

539.4

686.2

779

1,075

1,008

% of sales

12.7%

17.4%

22.1%

21.9%

23.2%

19.4%

21.5%

21.9%

25.7%

23.7%

 

“Similar to the Investment Cast Products segment, the Forged Products segment is aligned with large commercial aerospace build rates. We expect increased demand in fiscal 2016 in aerospace and IGT markets, with TIMET share gains favourably impacting sales, partially offset by foreign currency headwinds. However, given the continued uncertainty in the oil and gas market, we cannot predict then this market will recover, and further sales reductions may occur. All those inputs net to our expectation for a low-single digit sales decline versus fiscal 2015. Furthermore, in March 2015, the TIMET Morgantown facility suffered a serious incident and an electron beam furnace will be out of commission for an extended period of time. We anticipate this will have a $25 million to $30 million negative impact to operating income in fiscal 2016. The segment will benefit from the impact of restructuring actions taken at the end of fiscal 2015. As is the case every year, we will perform maintenance during the second quarter, and in fiscal 2016, we have a planned press upgrade, which will result in an extended outage occurring at our Wyman-Gordon UK facility. Taking into consideration all of the factors above, we expect modest margin expansion at Forged Products versus fiscal 2015.” Annual Report F2015

Airframe Products

A big part of the airframe product segment is made up of the aerospace fastener businesses – which is another attractive business for PCP. It offers decent returns, has good growth in front of it, a short list of competitors and a good portion of aftermarket sales (I currently think this is 50%). Over the last 15 years the aerospace fastener market saw a good deal of consolidation. It is now dominated by only 3 large players. I think roughly 80% of the market is supplied by PCP, Alcoa Fastening and Lisi Aerospace.

PCP played a key role in the consolidation of the fastener industry. It entered the market with the acquisition of SPS Technologies in 2003, followed by an acquisition of Air Industries 2005, Shur-Lok in 2006 and Cherry Aerospace in 2007. All of the acquisitions not only increased PCPs size, but also broadened the scope of PCP and paved the way to the dominated position PCP holds today. The other assets is a small collection of Tier 2 aerostructures suppliers. This is the area where I think we will see most acquisitions over the coming years. The aerostructures market is one of the most fragmented in the aerospace segment and is ripe for a player like PCP consolidate it. The most recent acquisition in Q1 F2016 was also in this field. Going forward PCP expects to deliver strong leverage on its growth in the airframe product segment with incremental margins above the typical 35 – 40% level.

“Airframe Products is expecting a strong fiscal 2016 year, with sales up mid-single digits, reflecting higher aerospace build rates, share gains, and further contributions from recent acquisitions, partially offset by foreign currency headwinds. Demand to support current build rates is expected to drive sales in the fasteners operations in fiscal 2016. New business wins have secured market share for the aerostructures operations, and we anticipate that the contracts in place will lead to increased production in the second half of fiscal 2016. Build rate increases on platforms such as the Boeing 787 and Airbus A350 and narrow-body re-engining should provide further upside over the next 24 months. We expect the segment to deliver strong leverage on its growth, with incremental margins above the typical 35 to 40 percent level.”Annual Report F2015

Airframe Products segment

Sales by Market

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Aerospace

467.9

668

976

1134.2

989.9

950.1

1279.8

1933

2497

2858

% of Total

47%

60%

69%

73%

75%

71%

75%

84%

87%

89%

Power

14.9

18.8

18.4

19.4

16.8

17.2

23.6

24

34

33

% of Total

1%

1%

1%

1%

1%

1%

2%

1%

1%

1%

General Industrial

532

435.1

418.2

397.1

318.2

377.5

394.8

358

351

319

% of Total

52%

39%

30%

26%

24%

28%

23%

15%

12%

10%

Total Sales

1014.8

1121.9

1412.6

1550.7

1324.9

1344.8

1698.2

2315

2882

3210

Operating Income

174.2

251.7

373.6

459.1

440.2

411

488.1

687

863

968

% of sales

17.2%

22.4%

26.4%

29.6%

33.2%

30.6%

28.7%

29.7%

29.9%

30.2%

 

Outstanding management

Precision Castparts is run by an outstanding management team. The current CEO Mark Donegan is only the third CEO in the company’s over 60 year long history. He is unarguably a key reason why PCP has done so well over the last 15 years and also a main reason to own this stock today. Some background info http://www.precast.com/overview/history/ here. Before he became CEO in 2002 he, already did an incredible job at one of the divisions.

I consider him an absolute champion at running manufacturing operations, but he has also proven to be a very good capital allocator by generating high-teen returns on billions of acquisitions so far. He has created a frugal, decentralised structure with no more than 150 people at PCPs headquarter and put a lot of responsibility in the teams that run the individual factories. The plant managers have to show continuous relentless improvements and work as hard as possible to get the most out of the assets. Donegan himself and other experienced managers routinely show up at the factories, check the progress and give further advice. He still spends an enormous amount of his time visiting plants, rarely talks to the press and seems to know every single detail of the business. He is someone you really want to run your manufacturing business.

Here is Forbes article about the culture of PCP: http://www.forbes.com/forbes/2008/0128/050.html The article is already quite dated, but the takeaways are still relevant today. Mark Donegan and his team have created a culture of relentless continuous improvement of the critical drivers of this business. Average performance is simply not acceptable. I believe PCP is crowed with A-Players, has little B-Players and hardly any C-Players.

His genius can also be observed in the way he has grown the business with acquisitions. Donegan stayed in his circle of competence and only bought assets that broadened PCPs scope and had room for improvement or a good potential for synergies at the same time. There were no acquisitions just for the sake of size. It seems as if every single acquisition since he is CEO made economic and strategic sense. PCP has been a great roll up story so far and I think we haven’t seen the end of it the story yet.    

Incentives seem also pretty aligned. Bonuses for top level management are tied to EPS and Return on Net Assets. Mark Donegan owns approximately 226,000 shares of stock, which is currently valued at about 27 times his base salary of Fiscal 2015. Additionally he holds options for about 850,000 shares that vest sometime between now and 2024. I think he will try his best to make sure that the stock will do well.

Apart from top management cash bonus structure runs deep through the organisation, with quarterly and yearly cash bonuses down to the shop floor. Higher level employees also see stock participation programs. The payment system is quite performance driven and fits the picture. Employees that don’t perform are not kept for long. The working environment is certainly not for everyone (Glassdoor comments are an interesting read), the business is certainly managed to maximise profits for shareholders.

A strong competitive position

Due to the unfortunate timing of Buffett’s takeover rumour, I will be a light in this area. Like in so many successful roll ups (Danaher, Roper Industries, Transdigm, Jarden etc.), the biggest advantage that PCP has over its competitors is superior its management, execution, culture, cost focus etc.

The business has some economies of scope and scale. With its high market share, PCP is able to leverage the substantial fix costs in this businesses over more units than its peers. In some areas there is even a 100% market penetration.  

Some aspects of switching costs. While price is important almost all of PCPs products have in common that they need to meet very high accuracy and have to operate under very harsh (extreme heat or fatigue loading etc.) conditions. I think it is quite unlikely that engine and aerospace suppliers would switch to an emerging Chinese player for a small discount. There is simply no error for failure.

The products are most often tailor made, once an OEM has decided to go with PCP they can’t easily switch. The Long-term supply arrangements are also a barrier to entry. I think that great majority of PCPs value contend on the new generation aircrafts is looked in with LTA and it is overall save to assume that this won’t be threatened due to new entrants. New entrants would be more of a threat for the next generation thereafter.

Promising growth prospects

PCP core market is set to grow. The demand for airplanes is increasing across the globe and PCPs key customers need to increase their future production rates to catch up with the growing demand. At the moment, Airbus and Boing have both unseen record order books that have built up over time. In the last 10 years airplane orders have outpaced airplane deliveries by roughly a factor of 2. In the previous decade the factor came in at just 1.35.

Net orders vs. deliveries in %

 

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Airbus

167%

115%

99%

93%

116%

279%

182%

296%

161%

54%

113%

266%

142%

240%

231%

Boeing

120%

60%

66%

85%

95%

346%

262%

320%

177%

30%

115%

169%

200%

209%

198%

Total

138%

81%

81%

89%

106%

308%

220%

308%

168%

42%

114%

220%

171%

224%

214%

 

Even without any new net orders, Boing would need around 8 years to clear its backlog at current production rates. Airbus would need slightly more than 10 years. However, an absence of new net orders seems very unlikely. The lowest ratio of new net orders vs. deliveries since I have numbers (1990 - for deliveries and orders) came in at 42% in 2009.

Slightly more than 40% of airplane deliveries in the last decade were for replacements, the rest to support worldwide fleet growth. I’d say the average economic live of commercial airplanes is somewhere at 25 years and has remained stable over the last 15 years. Taking a 25 years average life and historic deliverers to project the coming replacement demand one gets close to what Boeing and Airbus assume for the next 2 decades. The total commercial replacement demand for the next decade should be around 5500 aircrafts and over 8000 aircrafts for the decade thereafter.

The aircraft production rates should climb higher for the next 5 years. Thereafter, higher production rates will probably become more unsustainable or production at least more cyclical again. The current record order books should mitigate the risk of aircraft production cuts in an economic downturn. The last decade has already shown great resilience. Production rates climbed relatively smoothly throughout the financial crisis. I expect similar resilience for at least the next couple of years. The order backlogs are longer and geographically better diversified than ever. Record high average airline load factors should make the buyers of aircrafts a little bit less vulnerable to downturns and also underpin the need for additional airplanes more than ever. Today worldwide average load factors stand at roughly 80%. Load factors have steadily crept up from slightly more than 60% in late 1970s.

Based on already communicated and partially initiated capacity increases from Boeing and Airbus, the commercial aircraft industry (I am not including regional jets) should go form currently roughly 1350 planes/year to slightly over 1800 planes/year in 2020. However once the two companies reach 1800 there is not a lot of room left for growth and the market will probably become more cyclical again.  

Airbus, Boeing and other sources have a ton of detailed long term forecasts for aircraft deliveries for the next 2 decades. One can have some issues with them, but I think overall the demand picture will be supportive enough for this to play out well over the next 5 years.

Few words on the underlying market demand drivers

In my opinion the underlying airplane demand drivers are 1) An increasing world population 2) Increasing GDPs per capita all around the world that provide more discretionary income for air travel 3) Ongoing business globalization that leads to increased business travel and cargo across the globe and 4) A decreasing total cost of flying, which again ponds well for increased air travel.

I consider all of the demand drivers quite healthy and they point to a good run way. The desire to travel and explore the world is strong across all cultures. As long as we have an increasing world population with increasing wealth, the demand for air travel should only go up (unless we quickly invent teleport, or Elon Musk successfully goes on a Hyperloop building spree across the world ;-)). Other factors like for example decreasing lead and transfer times should also continue to make flying more attractive.

From the listed factors, the decreasing cost of flying assumption is probably the most uncertain. Today close to 30% of the operating expenses of an airline are fuel costs. 15 years ago this stood at 15%. As a result, future increases in jet fuel prices may not be as easily offset by new advances in technology. However, directly and indirectly PCP and other aerospace companies are working hard to lower the total cost of flying. Historically this has worked out wonderfully. Over each of the last 3 decades (and I guess this is also holds true all the way back to when the first commercial airplane took off) flying has always become cheaper. At least for the next couple of years, increasing fuel costs don’t seem to be big threat to the thesis with oil supply/demand where it is. Another long-term issue could be something like a massive carbon emission tax to take external costs of flying into account. However I’ll focus on more predictable drivers again.

New generation airplanes

The industry desire to lower the cost of flying creates a nice tailwind for PCP. To achieve longer lasting, more reliable, lighter weight solutions with better aerodynamics, newer airplane and engine design make an increasing use of more complex materials, shapes, composites and alloys. This trend increases the potential content value per plane for PCP businesses. As the dominant leading supplier, PCP has successfully captured additional share on new generation planes. The company has already secured strong positions on the new generation planes which are going to roll out in increasing numbers over the next decade.

The most drastic example is the new B787, the first big commercial airplane to really “go composite”. PCP sells more than twice the value content ($10m vs. $3,5m) to the new B787 compared to the predecessor plane, the B767.

One theme is more titanium. The titanium content on new planes is increasing and the timely acquisition of TIMET, the biggest titanium producer in North America in 2012 was another very smart strategic acquisition of PCP. Titanium is quite an attractive material to use in aerospace applications. It has very high strength (greater than steel), but is light in weight (at only 60% of steel) at the same time. It is also very heat resistant (usable everywhere except in hottest sections of the engines) comparatively corrosion resistant and shows low thermal expansion. The combination of properties is a perfect fit for aerospace applications. The only real downside is the price. The greater use of composites also leads to higher titanium content as it works fine with composites (Aluminium has certain corrosion issues when combined with composites).The B787s titanium content stands at 15% of total weight. That is roughly double the amount compared to the predecessor B747 at 8%. Airbus is also using increasingly more titanium one its planes. The titanium content on the new A350 makes up 14% of the total weight. 

Another theme is the need of more complex metal to drive engine efficiency higher. Especially the new LEAP series makes the greatest use of more complex metal alloy components. Compared to Rolls-Royces, P&W and GE with their 2 shaft engines are ahead with this development. Rolls-Royce is less aggressive. Their 3 shaft engine design seems to still hold other ways to drive greater efficiency.  

PCPs share gains and acquisitions have increased the content value on new generation aircrafts. The following table shows content values on new versions and the comparison against predecessor models.

 

Increasing build rates on new aircraft programs

The following production increases are my best guess after looking at Boeing and Airbus future plans. Wikipeadia has good numbers of historic delivers to put it into perspective. I think the industry will go from currently 1350 planes/year to roughly 1800/year in 2020 and likely continue to grow in the low single digits from there. 

Future monthly production rates of new generation planes

 

B737

B777

B787

Total Boeing

A320

A330

A350

A380

Total Airbus

Total

 

 

2015

42

8.3

10

53

42

8

1.25

2

60

121

 

2016

47

8.5

11

58

45

6

5

2

67

133

 

2017

49

8.5

12

65

50

5

8

2

70

139

 

2018

52

8.5

12.5

65

50

4

9

2

73

146

 

2019

52

8.5

13

73

55

3

13

2

74

147

 

2020

55

8.5

15

75

55

3

15

2

79

157

 

 

The build rates on the new large commercial planes, the B787 and the A350, should see substantial increases over the coming years. The smaller aircrafts the B737 and A320 will see a shift to re-engineed MAX (first delivery early 2017) and NEO (first delivery late 2015) version and higher productions rates. The B777 and A330 will be re-engineed to X (target delivery 2020) and NEO (target delivery 2017) version in future years. The production increases are supported by a massive backlog of orders as shown in the table below. I left out the B747 and B767 because they are not material going forward (the B787 has taken their place).
 

Backlog of new generation planes as of Dec. 2014

 

Backlog

B737

B777

B787

A320

A330

A350

A380

Dec.2014

4299

564

843

5129

313

779

165

 
Ongoing Aerospace supplier consolidation

As already mention, Precision Castparts has a strong history of value creation via M&A transactions and the company played key roles in certain parts that are now highly consolidated. In the last 10 years alone, PCP has spent over $10b on acquisitions and the returns on invested capital average in the high teens.

The past consolidation is clearly observable in the decreasing number of suppliers, the airplane and engine OEMs have been using over time. Rolls Royce is a good example, the number of suppliers went down with each new engine generation. In the late 70s Rolls Royce had 400 suppliers for its engine series. In 2002 the Trent 500 had roughly 250 suppliers, the Trent 900 (2007) had roughly 140 suppliers, the Trent 1000 series (2011) had around 60 suppliers and Rolls Royce’s latest version, the Trent XWB has around 50 suppliers.

I don’t think we have reached the end yet. The OEMs still like to see more supplier consolidation (to bring down costs and improve reliability in the supply chain), as programs like partnering for success and a vocal push for consolidation indicate. Historically, both Airbus and Boeing had their problems with weak suppliers. The Dreamliner B787 with all the delays provides a good recent example.

One area where PCP wants to extend its reach in the coming years is in the aero structure components. I think the market has a size of around $60b and is it ripe for consolidation since it is still quite fragmented. PCP intends to spent $4-6b in M&A over the next 2 years and aims especially for the aero structure segment. The Primus acquisition in 2012 and the recently announced Nabroco acquisition are likely only the beginning of many more acquisitions in this segment. I think the 2 biggest players in the market have a combined market share below 20%.

Short version on valuation

So at @220$ we are roughly at 17 earnings, which is still a resaonable good price a market multiple for an above average business with an outstanding leadership. PCPs businesses generate a nice amount of cash. According to Management maintenance capex runs at roughly 50% of capex. This would translate in to roughly 1,8b in distributable FCF in a current steady state.  The announced $2b share repurchase program will likely take the share count below 137m shares. So this translates into a roughly FCF 6% yield. With the organic growth opportunities, some additional operating leverage and a successful ongoing roll up in its markets PCP should be able to generate mid-teen returns for quite some time.   

 

A short version of some risks

Adaptive Manufacturing – 3D printing: 3D printing sometimes gets mentioned with this name, but I think the risk that 3D printing will disrupt PCPs business is low. I am far from an expert in 3D Printing, but the following explanation from Mark Donegan, resonates with me. 3D Printing is not a cost efficient solution for highly standardised parts that are churned out in high numbers.  

Ronald J. Epstein - BofA Merrill Lynch, Research Division: There's been a lot of discussion lately, and I don't know if it is hype or whatever, about additive manufacturing and 3D printing and potentially what impact that could have on aerospace. Just curious, I mean, what opportunities does that present, if any, for Precision Cast? And I mean, and if you're already playing in it in terms of the powders that you guys do, if you can just give us more colour there?

Mark Donegan - Chairman and Chief Executive Officer: Yes, Ron. I mean, obviously, there is quite a bit of hype or buzz. I mean, if I look at additive manufacturing, it is a process that we've been using for years. When I ran Structures back in '90, we actually started the additive manufacturing process. And we used it for really, before that, we used that to make a tool. And if you get into large structurals, a tool can be in the millions of dollars. And then we would run a part and we would try it and we'd redesign it, and the end customers would go -- and it would be a reiterative process that it wouldn't be uncommon for us to do 10 trials and rework the tool 5 times. We started using it, and we still use it very aggressively today to make multiple parts, 6, 7 parts that we can provide different shapes, configurations to our customers without the investment of tooling. Now there is a very high cost to that model, so it's very good for speed, very good for running. But when you start getting a defined process, the tooling starts to become the way to go, and we get out of the additive manufacturing as quickly as possible. If you take that down the stream kind of to where it is right now and you apply it against our particular components, we do use it in some cases to make cores. We do use it sometimes to make a shell, again to try it out. As soon as we can get away, it becomes cost prohibitive on a high-volume basis in today's world. You start looking at the cost of the material, the power to run the machines, the time it takes. The more complex the part is, the longer the time takes because you're going to build it up in small segments. So if I look at, does it have a place? Absolutely. For us, it's been more in the R&D in giving speed, cutting down the cycle times of tool development. But it becomes very costly as an ongoing bank of machines doing a single piece at a time. And we look at this model all the time. We're metals people. We know the cost of making a particular material input. You start off with a huge increase in just the cost of material to begin with. And then from there, you go through a very costly process to make a part. So if I look at for us, on our components -- and there are a lot of components in an engine that we don't make. But if you look at our components through right now, what's going to fly through 2025, all of our value and share in everything is growing in those programs. So I'd say through that time frame, again, our technology stays well intact.

New entrants in forging: This is seems to be a risk that needs close attention. The industry has certainly worsened a bit and competition for future generation aircrafts (the ones after the current ones) is likely to heat up. A consortium of Japanese companies has built another 50,000 forging press, and the Chinese even went to 80,000 tons. A big forging press is a strategic asset for military purposes, so it’s understandable that the Chinese wanted one even when the economics suck. PCP with its great scope and efficiency could undercut the entrants on every bid. So form an entrant’s standpoint this doesn’t seem like an attractive use of capital. However, I guess OEMs certainly wanted some supplier diversification. Airbus has already given some work to the press in Japan. I think for the current aircraft series which will roll out over many years to come, PCP is safe. Most if not all the business should be covered with LTAs.

Destocking of a key costumer :This seems to be an issue of the past, according to the last CC the behaviour changed to normal. The management more than once stated that they are certain that it was not market share loss. Since PCP has 100% share on certain parts, they can track that and I have confidence in them being honest.   

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Potential takeover

Time to compound value

    show   sort by    
      Back to top