Written by Alex Hughes
First published in StocksInValue on 29th May 2015
“PCP’s products are used in every model of every jet engine currently in production and planned for future production”
We have been aware of Precision Castparts Corp (view our valuation), the global manufacturer of complex metal components, for some time. However, when word dropped that super-investors Warren Buffett, Dan Loeb and Lou Simpson all purchased shares between January and March at prices similar to today, a closer inspection was warranted.
PCP was founded in Oregon, USA in the early 1950’s as a division within a chain saw company. By 1953, PCP had gained sufficient scale which prompted a separation from the parent company to allow PCP to operate as a standalone. By the 1960’s, PCP was beginning to secure contracts to provide parts for jet engines, with its first contract with General Electric in 1967 followed by one with Boeing in 1968.
Since that time, PCP has consistently expanded whilst concentrating its efforts on the aerospace industry. During the 1990’s, a number of acquisitions were completed which added further capability and increased the level of vertical integration. To this day PCP remains a continual acquirer of small businesses which broaden its offer to existing customers and increase operating efficiencies. PCP was listed in 1968 and became a member of the fortune 500 40 years later in 2008 and today trades with a market cap of $31B, representing 16.9x times forecast earnings.
PCP’s strong financials stem from its ability to make highly engineered titanium and alloy components better than anyone else. Management believe their strength lies in their perfection of a form of ceramic-mold casting, a simple process in theory (involving a wax pattern which is used to make a ceramic mold, which is then filled with molten metal) which in practice is very difficult to do with large designs and at high volume.
PCP’s main products include investment castings, a stationary product which is required to provide the structural integrity of a jet engine, and airfoils, vanes and blades which are operating components used in the hot section of the engine. PCP has pioneered the use of lightweight titanium in blades, an important development considering the continual push for higher use of lightweight materials to boost fuel efficiency. As airfoils, vanes and blades wear out due to use, it is estimated that 40% of orders are for replacement, a feature which helps to build a level of recurring revenue into the business.
An important takeaway of PCP’s operating process are the high barriers to entry, due to the difficulty of the manufacturing process and high quality and delivery requirements of customers. A high proportion of costs are fixed, which builds a high degree of operating leverage into the business, and hence asset utilisation is very important. PCP’s variable costs are largely based on nickel, titanium and cobalt. It hedges forward purchases and is able to mitigate commodity price risk with contractual pass through pricing. As the biggest player in the space, PCP has scale advantages with input cost purchasing, R&D and capital costs. As displayed below, each of PCP’s operating units has exhibited strong growth with strong margin expansion over the long term.
|Figure 1: Segment EBITSource: Annual Reports||Figure 2: Segment EBIT MarginsSource: Annual Reports|
While PCP derives the majority (68%) of revenue from the aerospace industry, it generates the remainder from power and industrial markets. The downturn in the oil price has been a negative for the power division especially, which supplies seamless pipe and other titanium component used in oil and gas. Management have aggressively cut costs to align with lower revenues, recording impairment charges in the recent quarter and sending the stock down roughly 25% from its highs. We suspect long term investors have become attracted by the opportunity to acquire a great aerospace supplier at a good price, while it is suffering from short term setbacks in its smaller divisions.
PCP has established itself as the industry standard for jet engine castings and blades, evident through its 40 year business relationships with General Electric (GE.N), United Technology (UTX.N) and Rolls Royce (RR.L). An important component of its competitive advantage is the barriers to exit faced by its main customers. PCP’s products are used in every model of every jet engine currently in production and planned for future production. This virtually ensures PCP’s revenue in future periods as their products are highly ingrained in jet engines and the average engine model remains in production for many years. Replacing PCP’s component would be no easy feat, likely upsetting years of intricate planning, design and regulatory approvals. Hence, staying with PCP is the path of least resistance for the engine manufacturers. Consider the personal incentives of a General Electric executive manager. Suggesting a replacement that goes on to disappoint would be met with a high degree of career risk, in addition to the personal cost of severing a 40 year old business partnership.
Due to PCP’s embedded position, its revenue is largely a function of how many aircraft engines are sold multiplied by revenue per engine. A growing world economy is virtually certain to need more jet engines as rising populations and income levels correlate with increased air travel, and larger aircrafts like the Airbus a380 require an increase in engines to offset the increase load. As we discuss later, estimates from Boeing suggests the world will need an investment of $5.2 trillion in airplanes in the 20 years to 2033 to meet estimated demand.
Predicting industry growth is important, however identifying who captures the majority of the value from that growth is critical. As we see in the chart below, despite being lower in the food chain, PCP is able to extract vastly more value out of plane expenditure than each of its aircraft and aircraft engine manufacturer peers. Conventional wisdom would suggest the majority of value would reside with the larger manufacturers as they are in a position to leverage their buyer power, however this is not the case as PCP generates profit margins almost 100% better. If you are bullish on plane expenditure, it seems PCP may be the best way to gain exposure.
Figure 3: NPAT Margins
Source: Annual Reports
A 2014 study from Boeing estimates that in the 20 years to 2033, world GDP will increase 3.2% annually, airline passengers numbers will increase at 4.2% and airline traffic will increase 5.0%. To serve this rising demand, Boeing predicts the world will require an additional 36,800 planes, equivalent to a cost of $5.2T at market value.
The effect of rising populations is also interesting when you consider how flights paths will develop. At present there are 42 mega cities in the world, defined as one which has in excess of 10,000 daily air travel passengers. Basic maths tells us that 861 flight paths exist between these cities. By 2033, it is estimated that there will be 91 mega cities, which leads to in excess of 4x the number of flight paths. This suggests that a linear increase in cities is likely to require a nonlinear increase in planes in order for the world to stay connected.
|Figure 4: Industry GrowthSource: Boeing||Figure 5: Forecast Plane Demand|
In addition to the demand for more planes, airlines are increasingly demanding planes with greater levels of fuel efficiency, increased thrust and lower noise and exhaust emissions. In order to meet this requirement, greater use of high performance alloy components will be needed in engine construction. For this, PCP remains well placed, and management predict the trends in aircraft engine design will continue to increase PCP’s revenue per engine.
We value PCP at $225, which compares favourably to the current price of $219 at the time of writing. We have adopted a NROE of 18%, in line with the 5 year average and a required return of 10%. Management have provided the following guidance for the FY16 year.
- Sales $10-10.4B
- Op Income Margin 26.6-27.3%
- EPS from continuing operations $12.50-13.40
- FCF $1.4-1.5B after $550m capex
- 137.9m diluted shares
Oil and Gas Exposure – PCP derives 18% of sales from power applications, a portion of which is contributed from oil and gas markets. This segment has been challenged of late inducing a small divesture program and asset write-down.
Cyclicality – PCP has a cyclical revenue profile which stems from the economically sensitive purchasing patterns of airlines, a risk to earnings that is compounded due to operating leverage. While Boeing and Airbus currently have record order backlogs (representing 5,700 and 6,399 aircrafts respectively), investors should be mindful that industry conditions can deteriorate in line with economic conditions.
Customer concentration – PCP has risk which arises from its concentrated customer list. General Electric is the largest comprising 13-15% of revenue while United Technologies, Rolls Royce, Airbus and Boeing all individually contribute less than 10%. We think the likelihood of a customer loss is low, however if it did occur it is likely to cause a material decline in business performance and be indicative of greater problems.