August 11, 2015: Berkshire Hathaway’s blockbuster $37bn acquisition proposal for Precision Castparts (stock symbol NYSE:PCP) takes one of the aerospace industry’s major suppliers out of the public trading and into one of the scores of Warren Buffet’s stable of companies under the Berkshire name.
PCP–we’ve always been amused by this stock symbol that shares initials with an illicit drug–is a major supplier to Boeing and other aerospace companies. PCP has grown through acquisitions of its own in addition to organic growth. PCP is a supplier to other industries besides aerospace.
Aerospace analysts have this first take on the acquisition, which is subject to shareholder and regulatory approvals:
|Speculating on Berkshire Hathaway’s rationale for a potential buyout of PCP – Warren Buffet has a history of buying into good cash flow businesses with exceptional management. Berkshire Hathaway currently has a 3% stake in PCP and is very familiar with the management team. CEO Mark Donegan and PCP have certainly had their issues, but Donnegan remains one of the best managers in Aerospace – in our view. Furthermore, a core part of our bullish thesis is that we think PCP is turn-around story – something we also think might be attractive to Buffet.We view PCP as an undervalued Aerospace company with an attractive valuation, but we doubt there will be other bidders for PCP. Historically PCP has avoided the auction process when it makes acquisitions and we suspect Berkshire Hathaway adopts a similar philosophy in this transaction.The $235 offer for PCP represents a 21% premium to Friday’s close of ~$194. In general, typical buyout premiums have ranged from 15-25+%. Our $252 target implies a 30% premium. Consequently, we think Berkshire got a bit of a bargain buying PCP.|
Berkshire Hathaway announced today it had agreed to acquire PCP for $235/share. The purchase price assumes a total deal size of $37B, and implies a 12.5x EBITDA multiple and a 16.1x EPS multiple, based on our fiscal 2017 estimates. The price represents a 22% premium over the Friday close of $193.88. This represents the largest acquisition for Berkshire Hathaway, and the deal is expected to close in Q1/16.
We believe the deal is a bullish sign for the commercial aerospace cycle. While Berkshire is known to take a long view, we believe this points to its confidence in the cycle fundamentals. We continue to see upside as announced rate increases are implemented (737, 787, A320, A350), with risk focused on the 777. We do not read this deal as any indication that PCP management is less optimistic about the health of the commercial cycle, or its prospects in the aerospace sector.
However, we also believe this allows PCP management to focus more on long-term objectives, and less on the quarterly expectations and results. The past 3-4 quarters have been characterized by challenging execution and communication issues, largely caused by market forces (such as oil and gas and customer de-stocking) but also by the disconnect between long-term upside and near-term results, which tended to disappoint. The transition to providing much more detailed guidance was a step in the right direction, but it clearly focused management’s discussion on the near-term and immediate state of the business. Assuming the deal is finalized, management can now fly under the public market radar while it focuses on long-term value creation.
We believe we will continue to see an acceleration of M&A activity and consolidation in the aerospace and defense sector. In our view, this represents the fact that we are moving into a harvest phase of the cycle, as the pace of investment to support new programs slows. Moreover, many of the recent transactions represent the shift in materials and technologies, such as the Solvay acquisition of Cytec, the Alcoa acquisition of RTI, and the PCP acquisition of Composite Horizons. Within our coverage universe, we expect speculation to focus on Hexcel (HXL) and B/E Aerospace (BEAV). While PCP had been aggressively consolidating the aerostructures industry, we do not necessarily see any acceleration in structures consolidation, beyond what we have been seeing.
We see little risk at this time to the deal getting completed. Note that the deal is subject to the necessary regulatory reviews both here in the U.S. and in certain foreign jurisdictions. Moreover, we see no reason at this time why PCP’s major customers, such as Boeing or General Electric, would object to the transaction. And finally the transaction will add Berkshire CEO Buffett’s voice as a supporter of the U.S. aerospace industry, which can be an asset. We are adjusting our price target to $235, reflecting the deal price, and we are maintaining our HOLD rating on PCP shares.
A stock price of ~$250 is a ~30% premium valuing PCP at ~13x EBITDA. PCP’s market cap was $27 bn at Friday’s close and other transactions in which Berkshire has been involved suggest potential for a 25-30% premium (please see Table 1), implying a $35-40 bn deal (including $4.2 bn of PCP net debt), which would be among Berkshire’s biggest ever and by far the largest ever aerospace transaction. This would mean a stock price of $242-252 vs PCP’s all time high of $274 in June 2014. The implied transaction multiple of 12.5-13.0x our FY16 EBITDA estimate of $3 bn (please see Table 2) is fairly consistent with that of other deals in the space, though valuations have varied. The most directly comparable deal is probably Alcoa’s acquisition of Firth Rixson last year, for ~14.3x 2013E EBITDA (please see Table 3.) We cannot say for sure whether anyone else might wish to buy PCP but given its size and Berkshire’s typical approach to deals, it seems unlikely there is an alternative suitor at this time.
Who wins? If a deal occurs, it would benefit multi-year PCP holders as well as those who bought the stock following much of the 2014-15 underperformance. Management might also value the opportunity to join Berkshire and eliminate requirements for quarterly public commentary after a series of earnings misses have led PCP to offer financial guidance for the first time ever this year. For Berkshire, the outcome would depend on PCP’s performance, with opportunities from rising aircraft production rates and especially the ramp on CFM’s LEAP engine. There are also risks, including a more competitive environment as Alcoa and ATI focus on downstream operations, margin pressure from powerful key customers, setbacks in markets other than commercial aero, and the impact of metals market developments on Forged Products earnings.
We see few broader, longer-term aero implications at this point. Berkshire Hathaway typically takes a hands-off approach to the companies it acquires, encouraging existing managers to run the businesses as they see fit. At PCP, CEO Mark Donegan has been in place since 2002 so we would not look for major changes to PCP’s approach if a deal occurs. And while it is possible that a Berkshire investment would be based on a unique thesis about aerospace, this seems unlikely as well. In fact, PCP’s weak organic growth in recent years amid rising aircraft production rates has made it a poor vehicle for aero exposure. In the near term, however, we could see a deal as a modest positive for aerospace stocks: first, the market could view it as a vote of confidence in aircraft demand; and second, the biggest ever deal in aerospace could lead investors to think about other M&A opportunities, especially amid a flurry of smaller announcements recently. We would also be looking for any changes in PCP’s approach to M&A if it is acquired. The company has targeted $3-5 bn of M&A for FY16-17 and we estimate that announced deals thus far total just over $1 bn.
Summary. The Wall Street Journal reported that Warren Buffett’s Berkshire Hathaway Inc. is near a deal to buy Precision Castparts. The article suggested a price that would exceed $30 billion and that a deal could be announced as soon as this week. This would imply a purchase price of at least $220, a 13% premium to the August 7 close. We think this strategic action highlights that the company is worth more than what investors have been willing to pay for the short-term low earnings driven by the oil/gas market and destocking at an engine customer. It highlights that strong companies with high margins and high returns on capital can still command premium prices. We expect this potential bid to help the multiples for the entire commercial aerospace sector, but it should highlight the value in high margin suppliers like Rockwell Collins (COL, Outperform, $85.59) that have experienced a similar short-term earnings slowdown.
Rationale. We think Berkshire Hathaway would be taking advantage of the low stock price driven by lower earnings due to volume and price pressures from oil/gas demand as PCP saw declines of over 30% in that market in FY2016. If the company was to sell now, we would expect the buyers are attempting to take advantage of the lower price due to recent earnings pressures, but be able to capture the value from market share gains PCP has already won on next generation airplanes including the 737-MAX, 777X, A320NEO, etc. The key question is at what price current shareholders would be willing sellers – and we think $220 or $30B equity value is not quite enough.
Potential Multiple. Should the acquisition value PCP at $220, it would have an equity value of about $30.4B and would represent a P/E of 16x CY2016E EPS, 10.8x EBITDA and a free cash flow yield of 5.5%. While this is a 13.5% premium to the close of August 7, we think it would not give full value to Precision Castparts even though 16x earnings is about a 10% premium to the group. If the bid is $240 per share, or closer to the 52-week high of $249.12, it would be $33.2B in market cap, a P/E of 17.5x CY2016, 11.7x EBITDA and a free cash flow yield of 5%–about 20% premium on a P/E basis.
Comparable Multiples. In our coverage universe, the commercial aerospace supplier group trades at 14.6x 2016E EPS, 8.6x 2016E EBITDA and a 6% free cash flow yield (or 16.7x free cash flow).
Other Bidders? We do not see another aerospace supplier that would be willing to pay $30B+ for Precision Castparts.