A Precision Path to Profits
05/17/2011 5:15 pm EST
The company’s business has clearly turned the corner after a tough calendar 2010. In 2011, Precision Castparts should profit from the recovery in aerospace, and in particular the launch of Boeing’s 787 Dreamliner.
If this were a typical cyclical stock, I know how I’d go about accounting for that recovery and valuing the shares. But Precision Castparts isn’t your typical cyclical, and that makes putting a target price on the shares quite a bit tougher.
Let me explain why.
With the typical cyclical, revenue and earnings plunge when the economy or the company’s industry goes into a downturn. Since cyclical companies tend to have big fixed costs—which they can’t easily reduce when their volume of business falls—earnings tend to plunge even more than revenue as operating margins deteriorate.
But this isn’t what happened with Precision Castparts during the Great Recession. Yes, revenue from its aerospace and power-generation business fell from $6.9 billion in fiscal 2008, to $6.8 billion in fiscal 2009, to $5.5 billion in fiscal 2010. But operating margins actually climbed from 22% in fiscal 2008 to 25.7% in fiscal 2010.
It’s great that the company managed to find ways to increase efficiency so that it could drive margins higher, even as revenue faltered. But it does reduce the company’s leverage in the recovery stage of the economic cycle.
The company’s upside leverage to an increase in volumes would be substantially greater if Precision Castparts hadn’t been so good at increasing margins for all those years. As it is, operating margin actually fell in the most recent quarter, to 24%, from 25.9% for fiscal 2010.
That looks like it will be temporary. Standard & Poor’s, for example, projects a rebound in margins to 26.5% for the fiscal year that ends in March 2012.
As revenue climbs from $6.2 billion in fiscal 2011 to $7.2 billion in fiscal 2012, according to forecasts by Credit Suisse, then $8.1 billion in fiscal 2013 and $9.1 billion in fiscal 2014, the improvement in margins will turn that increased revenue into earnings per share of $8.64 in fiscal 2012, $10.24 in fiscal 2013, and $11.71 in fiscal 2014.
But here’s where things get tricky. Right now, Precision Castparts trades at 22 times trailing 12-month earnings. If the stock were a true cyclical, that P/E ratio would go down as the stock came off the bottom (when it had very low earnings and a high P/E in anticipation of the future recovery) and revenue and earnings grew (in anticipation of a peak in the cycle and the downturn to follow).
For example, 2008 was a peak revenue year for Cummins (CMI), with sales of $14.3 billion. The stock’s P/E ratio that year was just seven. In 2003, however, just before revenue was to go from $6.3 billion to $8.4 the following year, the stock traded with a P/E ratio of 36.
So what’s the proper multiple for Precision Castparts? The stock has a much less volatile P/E than most cyclicals, although it doesn’t escape the cyclical pattern entirely—2008 was a peak revenue year and a low P/E year at just 8.1.
I’d argue from where we are in the aerospace cycle—with Boeing not really going to ramp up 787 production until 2012—and with the power-generation market, a big part of Precision Castparts’ business, just starting to show a big increase in orders, that neither 2011, 2012, or 2013 is going to be a peak year.
The company’s ability to increase margins so consistently adds to my conviction that I can use the current P/E ratio to calculate a target price for the end of fiscal 2012, March of next year.
Applying today’s P/E ratio of 22.2 to that fiscal $8.64 results in a 12-month target price of $192, for a potential gain of 23%.
So, as of May 17, I’m raising my target price for Precision Castparts to $192 a share by May 2012, from $170 by December 2011.
Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Precision Castparts as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.