No company is too big for Warren
“I’ve admired PCC’s operation for a long time. For good reasons, it is the supplier of choice for the world’s aerospace industry, one of the largest sources of American exports. Berkshire’s Board of Directors is proud that PCC will be joining Berkshire.”
These words said in August by Warren E. Buffett, Berkshire Hathaway chief executive officer, seem to be the best prospect for the acquisition of Precision Castparts Corp. from Berkshire Hathaway Inc.
This transaction is the fourth biggest acquisition of the 2015 and it is valued at approximately $37.2 billion, including outstanding PCC net debt.
To understand the reasons of this deal and the future scenarios, it is necessary to start with an overview of the two different players:
Precision Castparts Corp. is a diversified manufacturer of complex metal components and products based in Oregon, US. The firm uses advanced engineering technology in producing structural investment castings, forged components and airfoil castings for aircraft engines and industrial gas turbines.
Looking at last year’s data, it is possible to notice that the company generated 70% of its sales from the aerospace industry by selling nuts, bolts and other fittings for giants like Boeing or Airbus. The remaining share of the revenues came from the energy and power sector companies which were the main negative drivers of the firm’s revenues given the plunge in the oil prices over the last year.
It is of note that Precision Castparts has already been involved at the beginning of the year in the acquisition of Aerospace Dynamics International Inc. from Marvin Group. This transaction was a clear example of the effort to increase their scale and bring down the overall costs whilst adding Aerospace Dynamics’ expertise in hard metal machining, assemblies and large complex components.
Regarding the internal organization of the company, it is possible to see that it currently employs 30,000 people and it is expected to reach $10.2 billion of sales with an operating margin of around 27% by the end of the current fiscal year.
On the other side, Berkshire Hathaway, the buyer, is a well-known conglomerate run by arguably one of the best value investors in the world, Warren Buffet.
The Omaha based holding company has a market capitalization of $328.3 billion and its portfolio includes names such as Wells Fargo, American Express, IBM, Coca Cola and so on.
This acquisition is not only the biggest in Berkshire’s history but it will also fasten its transformation process from a company largely dependent on the insurance sector to a one resembling more the broad US economy.
Precision Castparts would fit well in the conglomerate’s portfolio, given the past acquisitions of Berkshire’s of companies from the unglamorous industrial sector, such as the chemical maker Lubrizol or the industrial manufacturer Marmon.
Buffet’s investment thesis can be supported by the growth in the commercial aerospace sector which has experienced new records for aircraft production in 2015.
According to the table we can see that the year of 2015 had an unprecedented wave of M&A activity in terms of deal value, with the largest number of deals occurring in the commercial aerospace sector. This trend was supported by the strong and favorable fundamentals of commercial aerospace companies compared to any other industry. The current low interest rate environment with its availability of cheap capital, lower carrier operating costs, including low oil prices, and the surging demand despite overall macro weakness in key regions has favored this trend. The acquisition of Precision Castparts is a clear indicator of the perceived long-term value in this industry.
Drivers of the deal
The philosophy of Berkshire Hathaway’s CEO Warren Buffet has always been to drive growth in earnings through acquisitions, and the purchase of Precision Castparts represents just the latest display of Buffet’s strategy. Although, looking at past deals, it is clear that Berkshire Hathaway decided to change his target selection strategy. In fact, in the past this company has always been characterized by a stock picking strategy concentrated mostly on insurance companies. On the contrary, in recent years Berkshire Hathaway shifted his strategy towards acquiring controlling stakes in large American conglomerates, mostly operating in heavy industry. This new direction for Berkshire Hathaway was mostly driven by the positive expectations of Buffet on the American economy and in particular on American manufacturing sector. Therefore, the acquisition of Precision Castparts is part of a big flow of deals that started in 2010 with the acquisition of BNSF railroad, and it is just the latest of different acquisitions that transformed Berkshire Hathaway from a company relying mostly on the insurance business towards an industrial and utility conglomerate.
Following this, it is believed that Precision Castparts represents a very attracting target for Berkshire Hathaway for different reasons:
Firstly, Precision Castparts is a company characterized by consistent margins and solid cash flows ($2.7 billion EBIT). This is mainly the result of the fact that Precision Castparts is the supplier of choice of the biggest airliner manufacturer; in fact, its client list includes Boeing, Airbus and GE. Moreover, this company has had long lasting and profitable relations with these clients, and this makes PCC one of the biggest players in the aerospace market.
Secondly, the market in which this company operates is very attractive. That is because this market is characterized by a high level of entry barriers, and this gives a strong competitive advantage to the players already in the market. Moreover, this sector is highly attractive also because its development and trends are strictly related with air traffic trends, which are expected to grow in the coming years.
Finally, Precision Castparts represents a very attracting target for Berkshire Hathaway given the fact that the company has recently struggled with its energy business. In fact, recent trends in commodities prices put a lot of pressure on the energy sector, and Precision Castparts shares suffered a 20% decrease during last year, thus making it a very attractive target for Berkshire Hathaway.
Terms and structure
On August 10th, the Nebraska-based company acquired Precision Castparts Corp. for $37.2 billion, including debt. PCC, the aerospace and oil/gas industry parts supplier, was priced at $235 per share. It is interesting to note that it is at a slight discount from its market value from January 2015, but at a premium with respect to the price from August 7th.
Overall, PCC has seen a drop this year in its stock price due to a slump in energy prices.
Berkshire paid $23 billion in cash using its own reserves and in addition, it took out a $10 billion loan to finance the acquisition. Before this acquisition Berkshire Hathaway was already PCC’s biggest shareholder, holding a stock share of the three per cent.
Warren Buffet’s conglomerate reportedly has $66 billion of cash on hand and does not expect to make any more megadeals in the foreseeable future: this is consistent with Warren’s strategy to hold cash inside the company.
Precision Castparts Corp. has an operating margin of about 27% and its revenues are distributed as follows: 70% from the aerospace industry, 17% from the oil and gas industry, and 3% from other minor sources. From the data of the last year, it is possible to see that it had $2.6 billion in operating income out of $10 billion in revenues.
It is reported that Credit Suisse acted as financial advisor to PCC, it is possible to find Cravath, Swaine & Moore LLP and Stoel Rives LLP while among its legal counsels. Berkshire Hathaway’s legal counsel is Munger, Tolles & Olson LLP.
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