Last month, Berkshire Hathaway announced the largest acquisition in aerospace history, a blockbuster deal to buy Precision Castparts (PCC) valued at $37B. Why did Warren Buffet, arguably the world’s greatest investor, make his biggest bet to date on an aerospace supplier? And was it a good move?
PCC appears to be an ideal fit for Berkshire Hathaway, which is seeking market diversification and buys well-run companies with an investment horizon of…basically forever. PCC is the epitome of a well-run company with revenue in excess of $10B and a whopping 25.8% EBIT margin. It is one of a handful of aerospace suppliers with productivity embedded in its corporate DNA. Its relentless pursuit of “lean” not only underpins phenomenal earnings, but also enables a hyper-aggressive acquisition strategy. Because PCC can create more value than competing buyers, it consistently outbids them for attractive companies. It acquired eight firms in 2013 alone. As highlighted in my September 2013 Aviation Week & Space Technology column, PCC has created a new type of supplier by vertically integrating from mill product to specialty processes to components and subassemblies. It is the chief protagonist of one of the largest trends in the aerospace supply chain: sub-tier consolidation. Today, it is one of the top two suppliers of nickel alloy, rotating-grade titanium, investment castings, forgings, fasteners and large structural castings – all products with high entry barriers.
There is also a relatively high degree of certainty in PCC’s revenue stream. Approximately 70% of its revenue is from aerospace, which enjoys a seven-year backlog in jet transports. And it is well-positioned in new aircraft models that have a long future production horizon; its shipset value on the 787, for example, is $10M.
Another reason to like the deal is timing. Berkshire Hathaway bought PCC after its stock tumbled 20% in recent months – largely on concerns that the other 30% of its revenue derived from power generation, oil & gas and industrial markets will be negatively impacted by plunging energy prices. Surely oil prices won’t be in the range of $40-50/barrelin the long run, and energy CapEx will eventually recover. And the secular trend of power generation from coal to natural gas will benefit PCC’s industrial gas turbine portfolio.
In summary: fantastic earnings, a large backlog, high entry barriers, and fortuitous timing. What isn’t to like about this deal? It may be contrarian, but I have several important concerns.
The first is leadership. CEO Mark Donegan, now 58, forged PCC’s unique culture and relentless drive for productivity. How much longer will he remain with PCC following the acquisition, and will the culture persist after he retires? This is the same question that bedevils Berkshire Hathaway investors who worry that the firm will lose its mojo when the 85-year old CEO Warren Buffet retires. Succession planning will be key.
A second worry is supply chain counter-strategies to offset PCC’s considerable bargaining leverage as the sub-tier gorilla. Many OEMs (including some of my clients) are pursuing tactics to increase the leverage and/or reduce their dependence on PCC. This includes qualification of new suppliers to outright vertical integration. Recent acquisitions by Alcoa and Allegheny Technologies are creating new super suppliers to counter PCC’s dominance. Pricing pressure on large sub-tier suppliers is likely to increase as major OEMs strive to meet demanding shareholder expectations. This means that PCC will need to balance carefully its pricing power with its customers’ drive to reduce costs.
Another concern is that PCC’s current focus on highly engineered metallic parts may limit its ability to grow through acquisition. It has already scooped up many of the solid aerospacefirms in its core marketsat Tier 2 and below. Where does it go from here? Should it move into major aerostructures, where suppliers typically scratch out single digit profit margins? Should it expand into new downstream aerospace market segments (e.g., aircraft systems), or entirely new industries where it has less familiarity? Eventually it will need to redefine its corporate strategy as it cannot maintain its earnings growth momentum on organic expansion alone. This may be why it recently acquired Composite Horizons, an aerospace composite component supplier and a rare foray into the world of non-metallic products.
Finally, a longer term concern is the influence of disruptive technologies on PCC’s core markets. Additive manufacturing has the potential to upend some of PCC’s key products, including investment castings, machined parts, and forgings. And GE is aggressively pursuing ceramic matrix composites, which threaten some of PCC’s profitable engine components. Even if these disruptive technologies don’t become mainstream for another decade or more, OEMs can use the threat of introducing them to enhance their bargaining leverage on the next aircraft program.
These concerns aside, I believe that Berkshire Hathaway shareholders will be pleased with the PCC mega-deal in the long run. PCC’s relentless focus on productivity positions it well in what is sure be a cost-driven decade ahead for aerospace suppliers. It has time to prepare for disruptive technologies, and to groom a successor to its CEO. And energy and industrial markets will eventually recover.
Aerospace insiders have long marveled at the unique Precision Castparts business model. Now, the world’s greatest investor has joined the chorus.
