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Precision Castparts: Part 1 – Overview of an Abandoned Growth Story

Precision Castparts (PCP) has been on a nasty slide down to $100 since tapping $130 when it reported earnings on May 6, 2008. Stocks who supply products going into commercial airlines, including PCP, continued to be sold off. Investors seem spooked by recent fleet downsizing by the major U.S. carriers on the back of high oil prices and struggling consumers. Or, PCP is getting dumped along with all other stocks related to Defense just because Obama won the Democratic nomination, which people take to mean Obama will be president and that the U.S. will never need a single bullet again or sell our weapons of war to the rest of the world. Geez investors are imaginative!

I don’t believe things have gotten worse for PCP since May 6th. The U.S. fleet downsizing has a minimal, if any, negative impact on PCP’s aerospace business. Like other airplane parts supplier, PCP’s aerospace business is levered to GLOBAL commercial airline demand, which is still flying off the charts. PCP’s direct exposure to Defense compared to its overall aerospace business is limited. More importantly, PCP has large exposure to the hot hot hot global power generation and oil & gas infrastructure. This segment, which PCP calls it’s power generation segment, is growing like a weed such that PCP has to expand 2 new factories to meet demand.

Here’s the plan. Overview of PCP, then the opportunities in power generation, and finally addressing the more complex concerns of the U.S. commercial airline exposure.

Part 1: Overview
Precision Castparts makes highly complex metal products under the casted metals, forged metals, and fasteners business segments. From an engineer’s standpoint, I’d categorize PCP as being in the materials science business. As such, PCP is definitely an industrial tech company, or what Cramer has renamed as the “new tech.” Even though this concept of “new tech” is what this blog is all about: not the 2000-Nasdaq tech but real technology, I’ll give Cramer the credit for developing and promoting this concept a billion times better than I could have! Technology is defined by Merriam-Webster dictionary as “the practical application of knowledge especially in a particular area: Engineering” and “a manner of accomplishing a task especially using technical processes, methods, or knowledge.” – basically anything that allows us humans to do more and do it better.

How are the pieces of metal PCP makes new tech? They are EXTREME metals- metals that can withstand extremely high pressures, temperatures, and wear-and-tear while allowing the engine, pipeline, or anything using these metals to perform better. Engines can run at higher speeds, taking the punishment of the stress of rotating at extremely high speeds in the toughest conditions. Furthermore, the engines are easier to maintain and require less fuel due to efficiency provided by the better metal. Turbines can operate at more extreme conditions to produce more power for the world’s growing population.

Believe it or not, these metals are so complex that the specific formula, like a drug formula, are patent protected and require special processes to make. Just as important as the formula of the metals are the metals’ shapes. A microscopic difference in the thickness might mean the difference of an engine’s fanblades running smoothly and the fan blades snapping catastrophically in extreme condtions. Shapes of these special metals doesn’t just mean the physical dimensions but also the metal’s shape on a microscopic level, or the microstructure. Material technology now allows companies like PCP to design metals and materials on a microscopic level so the material will do what the designers want, just as different weaves of fabric produce different cloth of different texture and strength. Two metal pieces may look exactly the same and one will be soft and flexible like a spring while the other solid as a rock. These are not metal parts you get at Home Depot- these metals require millions and millions of investments into the furnaces and other machinery needed to make these metals. PCP is different from metal producers such as Allegheny Tech (ATI), which simply makes chunks of metals…though they’re special metals. PCP’s value is they make the metals useful in a way few companies can for applications essential to global growth.

Personally, I prefer to look at PCP’s businesses not how the metals are made (casting or forging) but in which markets they’re used. FY2008, revenues were$6,852.1 million: 55% aerospace, 24% power generation, 16% industrial, 5% automotive. FY2007, revenues were $5,319.4 million: 53% aerospace, 21% power generation, 20% industrial, 6% automotive. PCP has said it isn’t that automotive business is shrinking, though one might “feel” that way given the dire conditions of the U.S. automakers. International auto business is more than offsetting U.S. declines. Rather, aerospace and especially power generation are a much bigger piece of the pie because these industries are just going gangbusters.

PCP is building 2 new facilities for industrial gas turbine (IGT) part production because demand is so high PCP just can’t make the parts fast enough in their current facilities. So we know revenues for industrial gas turbines (part of that 24% of power generation business) are ready to flood in once the new IGT facilities are up and running later this year. IGT’s will provide the first leg of accelerating revenues while we wait for the delivery of Boeing’s 787. The 787’s scheduled to be delivered 3rd quarter of ’09, meaning PCP should be shipping components to Boeing early in ’09. The main concern the last few quarters have been the volatility in nickel prices. However, nickel prices have stabilized and should stay in a pretty narrow range for the near future given the global economic conditions and demand for stainless steel.

With a forward P/E of 10.9 and a PEG of 0.72, PCP is ridiculously undervalued. Debt is low at a debt/equity ratio of just 0.08, pretty good considering PCP had been investing heavily for the Boeing 787 and Airbus A350 planes as well as 2 new facilities for industrial gas turbines. Now that all the capital spending for future growth is done, any increase in revenue will cause margins to explode to the upside. Operating Margins have already been expanding across all of PCP’s businesses above 20% and should be well above that going forward. PCP’s cash position should also grow significantly, allowing it to pursue acquisitions as it has in the past. In the current environment, any company with low debt and increasing cash positions are golden. Amazingly, most companies with this luxury are “new tech” industrial companies! How about that!

With estimates of future revenues from the aerospace and power generation segments alone, and assuming a P/E of 25 (valuation was P/E of 30 before the 787 delay), I have a price target of AT LEAST $350 over the next two years. Yes, this is a rare anomaly: a severely undervalued company with great growth happing NOW.

- Part 2: Drivers for PCP’s Power generation/industrial markets
- Part 3: PCP’s Commercial Airline and Aerospace markets

**Disclosure: I own shares of PCP and hoarding more as of this post**

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