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PCP: Capital Allocation History & Introduction to Valuation Framework

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PCP: Capital Allocation History & Introduction to Valuation Framework PCP: Capital Allocation History & Introduction to Valuation Framework - Modern Day Value Investing Part 3 Precision Castparts generated over $11bn of operating cash flow, and August 26, 2015 nearly the same amount of net income, over the last 13 years while achieving a 20% EPS CAGR and an average ROIC and ROE of 15% and 18% respectively. Not only is Precision Castparts highly acclaimed in its PRECISION CASTPARTS (PCP:NYSE) operational execution (increasing margins), but it’s also a leading example PRICE TARGET: NA of the power in able to re-invest capital in value creative opportunities CONSIDERATION: NA (profitable growth). Market Information Between FY 2013 and FY 2013, Precision Castparts consistently invested in M&A to drive growth while spending an enviably limited amount on Share Price $ $228.88 maintenance capex. However, at the end of FY 2013, PCP initiated its first 52 Week High $249.12 share repurchase in over a decade. Not only did PCP initiate a share 52 Week Low $186.17 3M Avg Vol. $mm $217.62 repurchase program, but the share repurchase became the largest use of capital through the announced acquisition by Berkshire Hathaway (BRK). Mkt Cap $bn $31.7 Firm Value $bn $36.0 Moreover, the share repurchases took place when PCP traded at a market estimated NTM PE range of 16.5x to 18.5x which is greater than the 10 year historical PCP NTM PE multiple of 16.3x. Was PCP overpaying to acquire its Financials ($mm) 2013 2014 2015 shares or alternatively was PCP taking advantage of a lack of confidence by the market in PCP’s ability to generate net income. More recently, the PCP Revenue 8.378 9,533 10,005 management target EPS declined from a range of $15.50 to $16.50 per EBIT 2,190 2,659 2,604 share to $12.25 to $13.15 per share. % Margin 26.1% 27.9% 26.0% % Growth 20.6% 21.4% (2.1%) Net Income 1,458 1,777 1,530 In November 2012, before initiating a share repurchase program, PCP % Margin 12.2% 24.0% 10.2% announced one of its biggest M&A transactions acquiring Titanium Metals % Growth 19.1% 21.9% (13.9%) (TMET) for $16.50 per share all cash with a total transaction value of nearly EPS 9.94 12.12 10.66 % Growth 18.2% 22.0% (12.0%) $3bn. The transaction value represented over 13% of the PCP value. Morgan Div. Per Share 0.12 0.12 0.12 Stanley acted as the Financial Advisors to TMET and prepared a Fairness Opinion which was published in the transaction filings. Reviewing the Net Debt / (Cash) 3,527 3,210 4,112 fairness valuation performed by Morgan Stanley and applying such valuation Net Debt / EBITDA 1.5x 1.1x 1.4x to PCP today implies a PCP transaction value of $268 to $289 per share. ROE 16.1% 16.6% 13.9% ROIC 13.2% 12.3% 10.2% Despite numerous signals highlighting the undervaluation of the Berkshire 5 Yr Avg ROIC 13.2% offer, the deterioration in the general markets while the PCP share price has remained stable through the turmoil could provide current PCP investors the opportunity to re-invest capital at a higher rate of return. Alternatively, investing in PCP today could provide a safe haven for the duration of the transaction. Soulor Research www.soulorresearch.com Director of Research: Nicolas Carreras [email protected] PRECISION CASTPARTS (PCP:NYSE) MODERN DAY VALUE INVESTING PART 3 1 PCP Financial Considerations Between Fiscal Year 2003 and 2015, PCP generated $11.7bn in operating cash flow (almost equivalent to the generated Net Income of $11.4bn). PCP Historical Cash From Operations ($mm) - Sources of Cash - Lumpy but growing strong 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 PRECISION CASTPARTS (PCP:NYSE) MODERN DAY VALUE INVESTING PART 3 2 PCP allocated the capital across Capex (maintenance capital spend and growth capital spend), M&A (growth capital), Share Repurchases (return of capital to shareholders) and Dividends (return of capital to shareholders). Between the 2003 – 2013 timeframe and the 2014 – 2015 timeframe the PCP capital allocation framework changed dramatically as M&A went from 83% to 36% and Share Repurchases went from 1% to 46%. Capex allocation remained fairly similar at 15% and 18% respectively and the Dividend allocation remained at 1%. Uses of Cash from 2003 - 2013 - M&A is biggest use of capital Capex M&A Dividend Share repurchase 1.3% 0.8% Share Repurchase Dividend 14.9% Capex 83.0% M&A Uses of Cash from 2014 - 2015 - Share repurchase is biggest use of capital Capex M&A Dividend Share repurchase 17.6% Capex 45.6% Share Repurchase 36.0% M&A 0.8% Dividend PRECISION CASTPARTS (PCP:NYSE) MODERN DAY VALUE INVESTING PART 3 3 The Capex allocation over the last 13 years highlights the limited maintenance capex requirements of PCP which ranged from 2.0% to 4.5% of sales. Capex ($mm) - Very steady Capex as % of sales between 2.0% and 4.5% and a small portion of uses 500 Capex % of sales 5.0% 450 4.5% 400 4.0% 350 3.5% 300 3.0% 250 2.5% 200 2.0% 150 1.5% 100 1.0% 50 0.5% 0 0.0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 17.6% PCP increased the nominal dividend per share consistently, however, as a % of Net Income (the payout ratio) dividends actually declined from 5% of Net Income to 1% of Net Income. Dividends ($mm) - Although PCP constantly increased its dividend but the total dividend is insignificant and the payout ratio constantly declined 20 Dividend % of sales 6.0% 18 5.0% 16 14 4.0% 12 10 3.0% 8 2.0% 6 4 1.0% 2 0 0.0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 17.6% PRECISION CASTPARTS (PCP:NYSE) MODERN DAY VALUE INVESTING PART 3 4 Starting at the end of FY 2013, but ramping up in 2014 PCP shifted its capital allocation to share repurchases. The chart below indicates the amount spent on share repurchases relative to the PCP next twelve months (NTM) PE multiple between 2006 and Q1 2016. The average PCP NTM PE multiple between January 2006 and June 2015 was 16.3x. PCP acquire a majority of its shares in FY 2014 and 2015 while PCP NTM PE multiples were between 18.5x and 16.5x. Share Repurchase ($mm) - A vast majority of share repurchases executed between 18.5x and 16.5x NTM PE 1,800 Share repurchase Hist. Fwd PE Multiple 20.0x 1,600 18.0x 1,400 10 year average Hist Fwd NTM PE Multiple of 16.3x 1,200 16.0x 1,000 14.0x 800 600 12.0x 400 10.0x 200 0 8.0x 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Q116 17.6% Did management purposefully choose to pay a higher PE to repurchase shares than the average PE and destroy value? Or alternatively, did management believe that the NTM Earnings (the denominator) was too low and that it was actually buying back shares at a lower PE? In other words, while near term EPS Guidance fell from $15.50 - $16.50 to $12.25 - $13.15 and the share price reacted accordingly, did the PCP board continue to believe in the higher earnings range? The below chart highlights the Berkshire Headline Offer PE multiple of 18.5x at the current EPS guidance which is at a slight premium to the average NTM PCP PE but only in-line with the multiple that PCP was willing to repurchase its own shares. However, assuming the original EPS guidance, the BRK Offer PE multiple is 14.7x which is significantly below the PCP average as well as the S&P 500 last 10 year NTM PE average of 15.1x. PRECISION CASTPARTS (PCP:NYSE) MODERN DAY VALUE INVESTING PART 3 5 At first glance the BRK Offer Multiple appears to be 18.5x but could it actually be 14.7x? 1,800 Share repurchase Hist. Fwd PE Multiple 20.0x Berkshire Offer Headline PE multiple of 18.5x based on most recent 2016 EPS Guidance 1,600 18.0x 1,400 10 year average Hist Fwd NTM PE Multiple of 16.3x 1,200 16.0x Berkshire Offer based on original 2016 EPS Guidance Implied NTM PE of 14.7x 1,000 14.0x 800 600 12.0x 400 10.0x 200 0 8.0x 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Q116 17.6% Throughout the timeframe, PCP has generated strong Returns on Equity and Invested Capital. Between 2005 and 2008 the returns consistently increased but subsequently declined. The average ROE and ROIC remain an envious 18% and 15% respectively. How many investment managers have generated an 18% annualized return over the last 11 years. PCP Generates Steady and High Returns on Equity and Invested Capital 30% ROE ROIC 25% 20% 15% 10% 5% 0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 One possible reason for the decline in the returns over the last 2 years is the timing factor related to obtaining the full earnings of the $3bn Titanium Metals (TMET) acquisition in November 2012. At the transaction time, TMET represented over 13% of the value of PCP and PCP was TMET’s largest customer (15% of sales).
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