Subscriber Pick: Precision Castparts (PCP)

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December 5, 2008 | SIN Picks | | Author Asif

We started the month of December with the National Bureau of Economic Research officially declaring that the recession we are currently in started in December 2007. The Dow reacted with a massive 679.95 points or 7.7% sell-off, only to recover most of that drop over the next two trading session. The crazy volatility we have been experiencing is very much alive and well. At this point, the current recession is already longer than the 8 month recessions we experienced in 2001 and 1990/1991. The interesting thing about this declaration is that if we consider the classic definition of a recession, which is two quarters of negative GDP growth, we are still not in a recession. Second quarter 2008 GDP increased 2.8% before falling 0.5% in the third quarter. Quite clearly the official version has gotten it right and many stocks like Emerson Electric (EMR) and Precision Castparts (PCP) in the cyclical Industrial sector started falling last December.

In this environment, I am sure that the last thing the majority of you want me to discuss is even more stocks. But instead of participating in the doom and gloom (I already went into that in great detail in the December newsletter), for those you who still have capital and are still bargain hunting, a company that a subscriber brought to my attention recently is worth sharing with all of you.

A couple of weeks ago, a subscriber who has periodically been in touch with me since the early days of SINLetter, wanted to know my thoughts about Portland, Oregon based Precision Castparts (PCP). My short response to him was,

“I just got a chance to review PCP and without digging in deep about future business potential, the company looks awesome. The balance sheet is strong, there is little debt (not sure about the $376.4 million in other liabilities though), operating margins are awesome considering gross margins are under 30%, operating cash flow is off the charts and there have been small insider purchases. “

I decided to dig in deeper and like what I see. Precision Castparts is a company that creates everything from fasteners to “the world’s largest diameter stainless steel, nickel-based superalloy, and titanium components” according to their website. The company primarily services the aerospace, power generation (gas turbine, coal and nuclear) and automotive industry. More than half their revenue (51% to be precise) comes from the aerospace sector, while power generation represents 23% of revenue. Given the current state of the automotive industry, thankfully the company only derives 5% of its revenue from the automotive sector as you can see from the chart below.  Over the last two years, the company has been shifting its revenue mix to reduce its dependence on the aerospace sector.

Source: PCC’s 11/19/2008 presentation (PDF) at Credit Suisse

The company makes parts that are used both in Boeing and Airbus aircraft as well as military planes and choppers. To mitigate its risk from rising metal prices, the company acquired Nickel alloy producer Special Metals Corporation in 2006. Beyond this direct exposure to the commodity market, the company should actually benefit from the recent drop in metal prices. Management appears to be confident about its business pipeline and based on this positive outlook, Moody’s upgraded Precision Castpart’s corporate debt from Baa2 to Baa1.

The stock has dropped from a high of over $150 last December to yesterday’s close of $50.77. Since the company is in the cyclical industrial sector, a drop makes sense but the magnitude of this drop is already bigger than the roughly 56% drop the company experienced during the last two recessions. The company is currently trading at a forward P/E of just 5.85 and a PEG ratio of 0.43. The company is also trading at a discount to peers like Emerson Electric (EMR) and Eaton Corporation (ETN).

I am going to add Precision Castparts to the SINLetter model portfolio and if I can free up the capital through year-end tax loss selling, will also buy it in my personal portfolio. To make room for PCP, I am going to sell our position in Johnson & Johnson (JNJ). While Johnson & Johnson did not do much for us in terms of gains since we added the stock to the portfolio in 2006, the stock has held its value while paying out an above average dividend. The portfolio will continue to have enough exposure to the consumer non-discretionary sector through Procter & Gamble (PG) and Unilever (UL) even after we sell Johnson & Johnson. Changes to the portfolio will be based on the closing prices on Friday.

A note of caution. Even though the stock looks attractive and has taken a harder hit than the overall market, in this kind of environment the cheap often get cheaper. To put that in context, according to Princeton University professor Burton G. Malkiel in his book A Random Walk Down Wall Street, during the bear market following the 1929 crash, General Electric (GE) fell from a high of $396.25 to a low of $8, which works out to the stock losing 98% of its value (prices not adjusted for subsequent splits). Given that some economists expect this recession to continue at least until the end of 2009, there may still be room for the industrials and PCP to fall further.

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