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.
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