Scary Season

All Hallows' e'en finds us looking back on a week that was frightful enough already. As scary making as the action in most of my stocks has been over the past two weeks, we should not be surprised. That a Russell 2000 ( RUT, the index that best exemplifies most of my holdings) should drop nearly 10% in two weeks is perfectly understandable in light of its having levitated 80%+ in the preceding seven months. What we are going through is a lot like what happened in May, June and into July. After a rip-roaring 7-8 weeks through the end of April, the indices basically went sideways for more than two months. The Q2 earnings season found stocks good and ready to respond to a positive catalyst. This time, the Market anticipated the catalyst, frustrating those prognosticators who assured us that September was synonymous with sell-off. The fabulous earnings reports were like a shot of caffeine late into an arduous day, keeping it going through the motions, but to no productive avail. As in the June correction, when the major indices fell peak to trough nearly 10%, the RUT a little more than 10%, the RUT peaked a little earlier. It is now lower than it was on August 1. So to the extent that that element of Price Reality we call "correction" is about time as well as price, we are actually well along in the process.

As always, the Talking Heads find it necessary to come up with substantive reasons why gravity has finally set in. Many of them seem to appear every time the indices dip for more than a day or so to pronounce, one more time, the end of the "sucker rally". It has been my experience (which is starting to become considerable) that there is real wisdom in the maxim that Bull Markets climb a wall of worry. There will be abundant reasons for the Market to roll over and play dead all the way up. Why should 2009 be any different? We hear and read a whole lot of what looks like confusing cause and effect ("The dollar sold off, so investors bought commodities, which..") Who the Hell knows?!  The concerns voiced about how much of the strength in technology spend is inventory rebuild is legit, but probably overdone as a result of forgetting that the "pipeline" is just a metaphor. One wonders about what it would be like to have followed the Tech Sector for the past ten or twenty years. It seems likely that they all have been conditioned to just "know" that if it's good news, it won't last. There is no gainsaying just how cyclical these markets have been since silicon started to stand for something besides beaches and big boobs. So what if big parts of what we call Tech evolved down the same road as autos, airplanes, tractors and trucks (in their early decades both life-changing and wildly cyclical, but eventually less cyclical and more rational)? Would the analysts whose insights seem to determine sentiment at the margin, conditioned by their experiences of the past decade or two, be able to recognize it? I am inclined to expect a wild but ultimately very fruitful ride here.

One common theme that we keep hearing in many of these gangbuster earnings reports which could be causing some heartburn is how much help these earnings got from marked down labor and materials. This is the result of last year's abrupt shift from sellers' to buyers' markets, a fortuitous condition for consumers that is simply not going to last. Users of all kinds of commodities benefitted from a brief period when their suppliers went from hoarding to trying to raise cash, and deals could be had. Similarly, we saw not only a great deal of cost reduction in the form of lay-offs (quite a few of which would have been untenable at any other time in this litigious age) but outright wage & salary reductions as well. (If this was happening in past downturns, I missed it.) These, too, will be reversing in the quarters just ahead. Indeed, there is a whole lot of "offset to inflationary pressures" in the cost of all kinds of things that will probably start to go the other way next year. This adds not only margin pressure against earnings but the specter of outright inflation to our Wall of Worry.

One other thing that the Market is probably holding its breath over is the referendum to be held on Tuesday, November 3. It's a piddling little off-year election, but it will speak volumes about how HopeNChange is going down with the folks who care enough to show up and vote. It feels like piling on to point out how despite the huge imbalance in campaign spending, that the outcome in a state like New Jersey should hang on the impact of a third candidate is not exactly positive feedback for the In party. The Mandate is more or less dead in the water. Its centerpiece, Health Care reform, which our Fearless Leader wanted done by the August recess, has morphed into a 1,990 page political tar baby (like the trickster edifice of folklore, sensible politicians see that they embrace it at their own peril). Expect to see a whole lot of bobbing and weaving, of "we gave it our best shot but the evil obstructionists played dirty", hopefully followed by some bipartisan efforts to effect some badly needed incremental reforms. 

To the extent this referendum forces the Administration to act more like the Clintons post-1994 (somewhere between gridlock and triangulating) a stultifying uncertainty will be abated. That would be the way most small business owners must be feeling right now. In addition to the usual uncertainties faced in a cyclical downturn, these key decision makers are facing a set of moving pieces that mostly boil down to "how much is this going to cost me?". Now it must be admitted that the Administration has done a splendid job of at least one thing. That would be demonstrating that running a successful campaign does not necessarily translate into the competence to govern. As I noted as early as February, their accomplishments will fall well short of their agenda, but damage will be done. We might not be getting the structural changes we worried about, but for the entrepreneurs who, for example, have pay to have OSHA, the wildlife biologists et al weigh in on how they resurface the parking lot, it is a dreary slog, with miles to go. Intrusive government is inflationary not because it unbalances the budget but because it causes producers to say, "To Hell with this, it's not worth the aggravation. I'm done!" and there goes another piece of the latter half of the equation that understands inflation as "too much money chasing too few goods". This genuinely worries me. It's what made the Seventies so "special". Hopefully, the referendum at hand will clear some of this up. If not, there will be a somewhat more comprehensive one in about 365 days.  

A Decidedly Less Enjoyable Phase in the Market

The waning days of October find the Market decidedly into what is at least a Correction-in-Time. The number of days when we are tempted to gloat, to have to remind ourselves that we are not geniuses just because "everything is up!" are decidedly fewer and further between. Ninety days ago, earnings season triggered a strong broad rally. This time, "buy the rumor, sell the news" is definitely back in fashion. The substance of the news embodied in the earnings released this time around has been almost uniformly heartening, the stuff of enthusiasm if earlier this year you were genuinely convinced that global depression was upon us. The Market has shrugged. Case in point: last week's belwether, Intel. While the Q2 release triggered an immediate and enduring revaluation of roughly 18% (from c. $16.50 to c. $19.50), eight trading days after an even more ebullient Q3 report finds the stock at $19.74, down nearly 4% from its close just prior to the announcement. It would seem that despite three months of burgeoning indications of the robustness of demand for all things digital, it was all pretty much "in there" by the end of July.

That glorious, seven month/50%+ rally that was the Market's reaction to our collective underestimation of the resiliency of the global economy is over. In its place we now have a Market that in terms of Price Reality wants to go higher, but in terms of Commercial Reality simply cannot. To the extent that investors do their homework and try to appraise the valuation and prospects of the enterprises underlying the stock symbols, it has become very difficult to muster the nerve to buy. This unwillingness to "pay up" is exacerbated by the extent to which the economic "re-set" inflicted by the Financial Panic has rendered fundamental data much less helpful than we are used to. (It also does not help that memories of being so dreadfully wrong about how cheap stocks can get, regardless of how "conservative" we thought we were being in our analysis, are still very fresh and tender scars.) This is more of a problem in some industries (producers of commodity building supplies come to mind) than others (dominant global technology companies) but it definitely undermines one's ardor for ownership across the spectrum. 

While the fundamentals are holding most investors back from all but a select few "stories", Price Reality continues to exert an upward bias. Price Reality is that part of the equation that is about fear and greed, momentum and sponsorship. It is the reason prices fluctuate so much more dramatically than underlying values do, which is to say hardly at all. I remain bullish about equities in part because of the demonstrable resiliency of many parts of the global economy, but also because of Price Reality. Right now it is more about Fear than Greed (which is probably doing damage to traders who mistook the seven months following 3/9/09 for normal). Its obviously not the same fear that was taking our breath away this time last year. Rather, it is the fear of missing out, of being left behind. Investors focused solely on fundamentals last spring found themselves wishing for a pullback that never really came. It never really came because every time the Market gets a little winded and shorts wade in, the "afraid of missing the boat" crowd jumped in and bid things back up. 

I think this fear based reality has legs and will underpin the Market until conditions evolve to where Greed can take over. Not only are the professional investors going to continue to have to pre-empt the charge of "We don't pay you to sit in cash!" but a mutation of this fear bug is going to make itself felt, a fear that over the next couple of years will reach into millions of households.  Just as we have been enjoying a respite from commodity price inflation, thanks to the 100 or so day undoing of global manufacturing activity early this year, savers (investors oriented to meeting present or anticipated income needs out of their financial assets) got a rare but fleeting windfall out of the Panic. We saw yields on assets debt instruments of moderate risk and duration driven up by the forced liquidation of leveraged players and other manifestations of panic. Astute savers reaped a windfall. With the passage of time, though, asset prices are normalizing and these savers are finding very slim pickings without adjusting their risk tolerances. The free lunch of 5%+  AAA tax-free munis is more or less over. One by one, households presently or prospectively dependent on their savings in order to maintain a standard of living will succumb to the fear that paltry "risk free" yields simply won't get it done. As the credit markets come back to life and the bonds get called, the yield needed to maintain one's standard of living will no longer be there. This, more than anything, will influence the appetite for risk among millions of household savers, which means mountains of money flowing into equities in the years just ahead. 

Expect the remainder of the year to be tough going. There will be stocks that work, but they will probably be exceptions. Perhaps the communal disappointment that follows such an encouraging earnings season being unable to lift the indices will fester into a real 5-10% pullback. This would be helped along no doubt by whispered data suggesting terrible holiday sales (and probably followed by a rally when holiday sales turn out not so awful after all; a familiar pattern, no?) Portfolio performance, or the lack thereof, is likely to determined by fewer issues than in the "just be there" experience YTD. Expect lightning in the form of M&A activity to strike more frequently than we got used to over the past few years. Stocks may be out ahead of themselves as reckoned by security analysis (chastened as its practitioners should be at this time) but not so for those enterprises who are sitting on cash and pondering the "acquire or be acquired" imperative. This Bull Market is more than a little tired right now, but still very young and durable. 

 

The Web 2.0 Belwether

This past week presented an opportunity to write about the one company on my List I thought I was least likely to be writing about (see my July 14 Note.) Intel has once again emerged as a clarion bellwether of global economic recovery. A Market which had been stumbling about looking for a place to rest after a six day sprint was adrenalized by the Q3 results posted by Intel after the close on Tuesday. Revenue and EPS blew away the consensus of the forty or so sell side analysts who purport to follow it, despite the company's "warning" in late September that the rate of recovery was continuing to quicken. The catalytic effect was spectacular on Wednesday AM, though it is proving to be not as enduring as when the same thing happened in mid-July. (Back then, the Market had been in a distinct corrective mode for about a month and so was poised for a protracted soar. We are now well evolved into an era of "whisper estimates" carrying more weight than what dopes like me are reading via Yahoo Finance.) 

Intel's part in the drama of the moment stands out in at least three ways. As the hands-down global leader in the advancement of low-cost microprocessor computing power, something which has found its way into just about every economic activity which is measurable (and some that aren't), it is indeed a worthwhile indicator of how the global economy is faring . It is also what I like to call a locomotive of innovation (akin to Boeing in the aerospace world) which must be moving forward for all the other cars in the train to get anywhere. This "train" moves ahead because it is able to deliver, at declining real cost, something that great and growing masses of humanity want to make more use of, resulting in a virtuous cycle of increased consumption funding further innovation driving lower costs begetting increased consumption. Finally, there is the part about what Intel has delivered these past two quarters that is entirely to the credit of Intel, a company of outstanding DNA which seemed to have lost its way, but once the dose of humility had been swallowed found its way back to its stuff of greatness.

It is not my normal practice to own mega-cap stocks, but INTC presented something of a classic opportunity a couple of years back. At the time (late 2006, early 2007), I was enamored by the observation that the "big blue chips" were at close to record low valuations. I have subsequently come to conclusion that in most cases there are probably good reasons for this apparent "cheapness", but only time will tell us what they are (unless I have a little brainstorm, in which case I will.) The real motivation for looking at and eventually buying INTC was that it was a paragon of world-changing innovation that had seemingly lost its way. In 2006, there was this crazy notion that its one and only competitor of note, AMD, had arrived as more or less of a peer and would inexorably eat into Intel's 75%+ market share. There was just a bit of a kernel of truth for this whopper to take root in, as AMD had achieved a performance breakthrough in a line of server chips that put Intel in a catch-up mode for the first time in a very long time. The stock had been a dog since Y2K. Indeed, in mid 2006 it was not far off of its 2002 Tech Bust/Bear Market low despite solid sales and earnings growth. 

Despite my rather trailing edge orientation to IT and CE (I own one vintage 1993 TV which is used as a monitor for a DVD player.), the life changing nature of that global phenomenon that is Web 2.0 is not lost on me. And as previously suggested, if any company is the locomotive of innovation pulling this construct forward, it's Intel. It was helpful that its financial posture was so strong (lots of cash, with more pouring in daily; minimal debt. Not every so-called "blue chip" has this going for it, and when the wind starts blowing in the direction it did in 2008 the weak holders who own because its a blue chip sell it with about as much thought as went into buying it.) What really helped, though, was that clarity and candor which often takes hold when a great company has been laid low. That opacity which one usually encounters when trying to get to know a typical mega cap was in this case greatly ameliorated. I had the good fortune of connecting with an IR person, since retired, who patiently helped me up the learning curve and arranged for me to participate in some very helpful conversations. The more I looked and listened, the more apparent it was that the DNA which made this company great was still there and that a chastened management was determined to get the company back on its game. I also increased my understanding of how pervasive the roll-out of Web 2.0 was likely to be, and got to thinking about the manifold changes which will occur as a result.

All of this work did not quite get me to a "buy" decision. Despite its modest relative stature, AMD seemed to have done well enough to convince the leading customers that they could be a reliable clear alternative to Intel. With this in mind, as of late 2006 it seemed that past financial performance was unlikely to be replicated. In that world order, it seemed more likely than not that increased competition would cause margins to trend lower over time. All this changed, however, when AMD bet the ranch on a big acquisition. While we had no idea how this would affect AMD over time, we knew that there would be no immediate benefit, and it was crystal clear that AMD had put itself in a position of greatly diminished financial flexibility and so no margin of safety against unforeseeable adverse developments. This lead to a purchase decision which looked really smart for a time, at least until the Financial Panic of 2008 changed everything. 

These past two earnings releases by Intel are telling us many things. They are indicating that while the global economy was rendered briefly catatonic by the financial panic, it is coming back to life. The rising tide is lifting all but the most dry-rotted of boats, but it is lifting some of them faster than others (i.e., the ones which leverage the longstanding strengths of the U.S. economy, such as its deep pools of intellectual capital, to serve truly global markets). Intel is leading the way in this recovery because it is leading the way in providing for a very basic need, that human desire for connectedness on terms of one's own choosing. That is what Web 2.0 is all about. It never really stopped, other than for about six months in the manufacturing chain when folks crawled under their desks and waited for someone else to sound an all clear. Even more so than the economy in general, the resiliency of this has been badly underestimated.

Also underestimated, IMO, is Intel itself. Since arriving at that moment of truth that was 2006, they really went after their costs and their processes. From Q3 08 through Q1 09 the effects were masked, but they came out shining in Q2 and Q3. AMD is still out there, and the customer base will see to it that there continues to be some kind of alternative to the big dog on the block, but Intel seems to be calling the tune as to what prices will be (i.e., bringing them down at a pace which spurs volume but optimizes profitability). If there is anything at all to Web 2.0, this growing connectivity and increasing ubiquity of computing power, in the households of the second richest billion as well as the richest billion people, then barring an economic relapse INTC has a very promising half decade or so ahead of it. One wonders if the analysts who have spent the past decade following INTC are any better equipped to understand its prospects as an investment today than those who followed it through the 1990s were ten years ago.

This consideration of decades gets me thinking about just how long it has been since the Tech sector has had a truly silly season. The Tech Bubble and its subsequent deflation is getting to be a very long time ago. (How long ago does the demise of Lehman et al and the emotions that gripped those days seem already? It feels positively past-life to me.) This is not to say that at least some issues are not at what will prove to be ludicrous valuations already. Who knows what the next ten years will tell us about what GOOG, thus far a one-trick-pony if ever there was one, was really worth. Or MSFT, which hasn't really gotten anything but optimizing its ancient cash machine right for what, fifteen years?, reduced  to a point where the reason to own it is that 7 will not screw them up like Vista did. But when I shift my thinking to Price Reality, to that which accounts for the lion's share of stock price movement, I can't help but wonder if we are not due for something of a reprise of the Tech Bubble, the blow-off phase of Web 2.0.

My sense is that barring the usual unforeseeable disruptors, a silly season revolving around the enablers, purveyors, providers, pretenders and panderers of Web 2.0 is inevitable sometime in the coming decade. This is not the sort of thing that is worth trying to predict, but the experienced investor will equip himself so as to be able to recognize it before it is too well developed to do anything but short the sucker (and probably get killed doing so prematurely). What Web 2.0 is about strikes so deeply into that which makes us human that I feel fairly certain that it will once again be the backbone of a major global Bull Market. Having revisited the sheer proportions of what the NDQ did in the 1990s (about doubling in the first six years, then doubling again in the next three, then more than doubling again in 18 or so months), it is quite clear that it took a very long time to cultivate the degree of silliness which defined 1999. My sense is that Web 2.0 is a little too close to ripe for this much time to play out. More likely, it will be a somewhat less dramatic affair than that, sometime within the next five or so years.

A little more earthbound way of thinking about the prospects for outsized gains in stocks like INTC might derive from the notion that the 1980s did not exactly prepare analysts and investors for how to think about INTC for the 1990s. Likewise, the experience of the 90s was less than helpful in terms of anticipating what it would be like to own most tech stocks for most of the decade that is now drawing to a close. I strongly suspect the tide is way out in the ways that matter most, and that success (outstanding returns) will revolve around financial flexibility but even more around being the "last man standing" (or nearly last, as the customer base goes all out to keep the "clear alternative" in the game) in critical, next-to-impossible-to-replicate technology. My personal orientation to this can be seen in the List, as well as some small holdings in AMAT, DELL, KEME and MSFT. (These aggregate 2.5% of my liquid net worth, and could be described as among the last bits of residue from my prior employment situation.) INTC stands at 2.0%.  If I am right, if the parts of the global technology supply chain which these companies represent have evolved to a point of relative rationality, if the human propensity to desire connectedness on one's own terms is what I understand it to be, and global economic activity does anything but roll over and die, these stocks ought to appreciate over the next five or so years in a way that beats the bejeebers out of whatever inflation starts to rear its ugly head in the mean time. And really, at the end of the day, that's about all we can hope to do in our little affiliation with Mr. Market. 

Gotham Revisited

Last week found us taking something of a sentimental journey to a most unsentimental place. Having been a resident (briefly, at the 47th Street Y and then just off Bay Ridge Avenue in Brooklyn), a commuter from New Jersey for several years and then a more or less monthly visitor from Rustic Upstate for a decade-plus, it was interesting to see the Great Gotham as a pilgrim from the hinterlands. Coming after a five year hiatus, it was not surprising to see this mighty city, as battered about as it has been during the latter half of that interval, with a whole new perspective. (The fixity in Time of that prior visit was assured by the occasion of standing in Times Square, within a day or so of nineteen years from when I first arrived in NYC looking for a job. Gone was the Nathan's Famous just up the block from the welfare hotel I had found in "New York on $15 a Day" and stayed in for the first two nights of my new life. A world class tourist destination had replaced an exemplar of sleaze.) 

I found a city a bit worse for the wear of relentless waves of financial comeuppance, but still emanating a magnetic pull on the ambitious and the well-heeled. For once, I was actually pleased that there was an extra twenty minutes or so of flight time. The circling prior to landing at LGA as afternoon was giving way to evening provided a splendid reminder of why New York City is one of the world's great natural harbors. The bus ride in from the airport was actually about the same price as the van ride in 1985, and immeasurably less stressful. The triggering of memories began in earnest at the Midtown Tunnel, which once you are inside of might as well be the Lincoln Tunnel. This brought back a flood of memories, of catching that 6:18 Lakeland Express out of Dover, NJ, and of stepping out into the freezing cold much more than the relief of stepping into air conditioning after a long summer's slog to and through the Port Authority. The next vivid memory jogger was probably that subway aroma which wafts up through the grates in the sidewalk as I made my way past Grand Central and up to my night's lodging (which set me back more than our  monthly rent was for the first few years we were married).

We might be in the wake of an immolation of consumer net worth of historic proportions, but NYC does not seem to have stopped drawing tourists from all over the world. I overheard one, inadvertently funny as she mangled a familiar riddle to a tour guide, "Where is Grant buried?", and I just might have heard a permutation of "How do you get to Carnegie Hall?". Of course, one also hears an array of peculiar utterances from some of the true (24/7) locals of midtown, such as a remarkably realistic and persistent meowing from one old fellow shuffling along under the scaffolding. The tourists were probably a bit more skewed to foreign than I remember (as were many of the apparent owners of buildings). Midday along the lower edge of Central Park saw the horse drawn carriages hard at work (the horses anyway), as well as a bit of a dust-up between cops and pedicab drivers (which don't strike a chord, memory-wise), which I later found out via the NY Post was part of an ongoing roust. 

Speaking of transportation, the cabs seem to be evolving in the direction of either crossover SUVs or the more eco-friendly but so-small-we-better-take-two direction. A few of them sported a refreshingly candid ad by a law firm, "Complicating Divorce Proceedings since 1971". They also seemed to be much more available than what past experience would have deemed normal, but maybe it only seems that way when you don't need one. One of the great things about midtown Manhattan is that if you are reasonably fit and the weather is not at one of its occasional extremes you can get around very easily on foot. While there seemed to be fewer people to step over than I can remember (from the early years, anyway), there seemed to be more trash to step over, even in parts of town that recollection strikes me as more or less immaculate. The municipal entity that is NYC is clearly straining under pressures it was not feeling in 2004. Building security, on the other hand, would seem to be in about the same overbearing state as it was at that last visit. 

It was a pleasant and productive trip, but I find myself in no great hurry to go back, and not just because pricing of meals, rooms, etc. seem to be set with "someone else's pre-tax dollars", and I am using my own now. The "glamour" of travel went way down hill about 24 hours after arrival, where back at LGA it was ascertained that my flight to ATL would be delayed. (due to bad weather in NY, they said, though whatever rain fell that morning had stopped before noon.) Indeed it was, just enough to induce an unintended extra night on the road. Along the way, I would be reacquainted with that nemesis of travelers, CNN. There seems to be almost no place one can stand in a gate area and not hear the iterative bleatings of a succession of people you could not pay me to voluntarily abide (Okay, maybe for $50/hour, but for no more than two hours a day.) What an inducement to get back home to where such pariahs can be forcibly ejected, were they to have to bad sense to show up at my doorstep. This is one of my lingering doubts about the very long term future of air travel as a consumer good, a very slow and subtle addition to what I have previously referred to as the all in cost of travel.

New York City has clearly been chastened by all that was coming undone on a more or less daily basis this time a year ago. It has been badly stretched, as it was when I was working on Sixth Avenue in 1990 and saw the building under construction out my window just stop going up (and stay that way for a couple of years at least). Something tells me, though, that no matter how badly some of its parts and some of its players might have been mangled, it is a very long way from a breaking point. 

Deal Heat Continues to Glow

While the Market continues to shudder and shake at every little indication of economic activity (or the lack thereof), the warm glow of Deal Heat continues to brighten.  As noted in these pages on September 5, the coming-unstuck of pent-up M&A activity is starting to supplant decompression based on "Oh my, it's not the end of the world after all" as the most likely driver of outsized share price appreciation. Recent days have seen this heat go from reddish to something approaching white, especially in the Tech World. That construct which has divided hardware from software (in the minds of investors, anyway) seems to be disappearing, as one big hardware player after another (HP/EDS, Dell/Perot, Xerox/ACS, Cisco/Tandberg, Viasat/Wild Blue) makes a big grab in the direction of software, with Oracle's pursuit of Sun Microsystems reaching in the opposite direction. 

This seeming gold rush is in one sense nothing more than ongoing evolution, that continuous redefinition of how what once upon a time was called data processing gets done. Distinctions between the legal entities which make up the enterprise have on balance continued to blur, and many of the hazards of vast scale have been substantially mitigated. It only makes sense that these Big Dogs-on-their-respective-blocks are seizing the moment. They are seeing limits to growth in their most familiar pastures, and have been sitting on cash waiting for just a wee bit more clarity than we had when Financial Panic was shaken the foundations. It is also understood that once recovery really takes hold, prospective sellers will start getting greedy again (not that every would-be seller has an entirely reasonable understanding of what his company is worth to begin with). 

Given the plethora of companies who are cash rich but face moderating organic growth prospects, we should expect the Tech sector to dominate the M&A headlines, but it will certainly not be the only part of economy feeling deal heat. One transaction that has really intrigued me of late was the just closed acquisition of privately held Carlton Forge by Precision Castparts (PCP). Especially striking, to me anyway, was the $850MM price tag. PCP has done an outstanding job on the acquisition front (at least under the tenure or Mr. Donegan), so much so that it was hard to believe that they they could have overpaid to a degree that shareholders would eventually regret, but it still struck me as a big number. It probably had something to do with 25+ years of watching deals get done in the aerospace supply chain, memories of so many folks looking askance at anyone paying more than about seven times EBITDA for a metal basher. There was no reason to think that PCP had broken from its pattern of paying 8 to 9.5 times EBITDA, though this valuation metric has always rung a little flat for me. (Besides being susceptible to the dramatic cyclicality of earnings in this little cranny of the economy, it begs the question, "whose EBITDA?" The seller we probably don't know, who might have been on the very top or their game, or might have been sleepwalking? Or, in this instance, what Mr. Donegan and his team will be getting out of it after a few quarters?) As Carlton was private, an exact valuation is not forthcoming anyway. We know that Carlton was a well-regarded forge works, the larger of two in North America capable of producing seamless rolled rings in the size ranges used in jet engines and industrial gas turbines. This market might have exceeded $1B in good years, and Carlton's margins are very unlikely to have compared favorably with PCP's traditional businesses. As such, it is pretty obvious that PCP paid a price that would have been deemed awfully rich not too many years ago, and certainly back when they acquired Wyman-Gordon. 

It occurred to me that $850MM for a forge operation that might have done $500MM in a good year might seem rich to me because it was not so long ago that the market capitalization of the entirety of PCP was right in that very neighborhood. A quick peek at Value Line revealed that, yes indeed, in the late days of 2002 (etched permanently on my memory as a time  spent rooting around for signs of a bottom, but mostly  reminding clients that barring the extreme unlikelihood that aviation turns out to be a fad, a robust up-cycle was looming not so far off in the future), the market cap of PCP was only about $890MM. To be fair, they were carrying about $500MM in debt, but this could be more or less offset by the value of operations which PCP has since disposed of. Perhaps sometimes our experience works against us. In this case, it seems to have provided the basis for a quick inference that an experienced and purportedly rational buyer had just deemed Carlton Forge to be worth more or less what the just a few years ago the Market (in one of its fits of despond, to be sure) adjudged PCP's world-beating ability to make structural castings large and small, airfoils, seamless pipe, refiner plates, and a whole lot more to be worth. Happily, the thought process of addressing the dissonance which arose from this inference resulted in a couple of realizations about the present state of the aerospace supplier base.

There are two really good explanations as to why a smart company like Precision Castparts might pay as much as they seemed to for Carlton Forge. The simplest, and my personal favorite, is: because they can. In my estimation, no other company could pay anything close to what PCP did for Carlton and then get a return anything like what PCP is positioned to get from it. It's not because of PCP's sheer size (which cause any bumps in the consolidation process to get lost in the rounding) or its access to low cost funds (at 6/30, PCP had over $600MM in cash on its books and nearly $1B available on its credit line), although these factors certainly help. What really sets PCP apart in terms of what it can pay for an acquisition is its management systems, which have proven to be very effective at getting good businesses running like great businesses, and something which it only came into a few years ago. That would be its vertical integration into nickel-based alloys, which has been built around its acquisition of Special Metals and, importantly, includes highly developed capabilities in capturing raw material from scrap and revert. These are important advantages. They do not mean that PCP could not possibly overpay for an acquisition, but they do mean that PCP is able to get far more out of certain categories of assets than just about any one else could, including the sellers, and so can afford to pay what some of us out here in the cheap seats might consider "steep". However much they are making out of the Carlton operations a few years from now, when the JSF and 787 are being produced in volume and the A-350 is starting to show up, will be lost in the mix. Expect it to bet will be a considerable portion of a stream of earnings that will make most of us wish we had bought more PCP than we did back in 2009. 

That this acquisition seems rich by my experiential standards is also reflective of the era that constituted that experience. As in many of the niches that make up the aforementioned Tech World, consolidation has been going on for a very long time in the aerospace supply chain. Way back in what for many of us were formative years, ample capacity to make just about anything that might be needed to build military hardware was a given, but in 1990 that started to change. Year by year it was almost imperceptible, and for the longest time did not amount to much, but it was relentless. There had been considerable consolidation by 2001, but we saw that it was still a buyers' market for these kinds of capabilities when the first ever downturn in global air travel took hold. Since the time when traffic subsequently recovered, though, there have been indications that it is no longer quite the buyers' market that it once was (i.e., suppliers' pricing power). The number of companies that can do the highly-engineered, non-commodity "parts of the puzzle" has shrunk considerably. Capabilities like ring rolling, which seem simple enough until you try and do it yourself, might not be quite the commodity that they were a dozen or so years ago. The past two decades have also seen how for some reason these capabilities are resistant to attempts at transplanting them outside of the cultural realm which could loosely be termed "the West" (something about collaborative innovation being utterly dependent on a high-trust culture, IMO). It is not a stretch of the term "knowledge based economy" to include knowing the intricacies of something as seemingly simple as shaping metal into engine parts. Such knowledge has come to reside in fewer and fewer enterprises, and everyone who lives in that world knows it.

$850MM for a respectable ring rolling operation reflects the scarcity value that has taken hold in the aerospace supply chain after twenty years of consolidation. As long as there is a more or less growing population with the means and the desire to consume air travel, this scarcity value will continue to grow. We should not be surprised in the months ahead to see a few more deals in aerospace that would have seemed ridiculously overpriced ten years ago. We should also not be surprised, once the cycle has turned upward, to see the Market ascribe much higher valuations to the publicly traded aerospace suppliers. This will be especially true of the ones who have assiduously carved out a place doing where there is almost nobody else left who knows how to do it.