This Acquisition Strategy Makes Sense

08/01/2013 11:00 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Even though growth stocks fueled by acquisition can sometimes hide the true or even negative trend, MoneyShow's Jim Jubak, also Jubak's Picks, feels that, in regards to this company, this time could be different.

On July 25, Precision Castparts (PCP) reported earnings for the first (June) quarter of its fiscal year of $2.88 a share. Earnings were up 22.6% from the June quarter of 2012. But the results were two cents a share short of the consensus earnings estimate on Wall Street. Revenue climbed by 20.4% year over year to $2.37 billion. That was below the $2.52 billion consensus.

On the miss, the stock dropped back from its record closing high on July 11 of $237.27. The shares closed at $221.69 on Tuesday, July 30. That's a drop of 6.6% from the high.

The drop seems like an attractive buying opportunity and the stock is cheap on its earnings growth rate of 22.6% and trailing 12-month price to earnings ratio of 21.5.

I'd suggest buying, but you need to be clear that the next six to eight months aren't going to be the easiest on the stock or your nerves.

Precision Castparts' impressive growth in the June quarter was largely a result of acquisitions. Organic sales growth year over year came to just 2%. Most of the time I don't like growth stocks that are fueled by acquisition since these deals can hide the true (frequently negative) trend in core sales and earnings growth. But in the case of Precision Castparts, an acquisition strategy makes sense to me, because it is a reflection of what's going on in the aerospace sector. Companies like Boeing (BA) and Airbus (EAD) are looking to simplify their supply chain and to deal with fewer suppliers. Rolling up part of the supply chain under one roof, which is what Precision Castparts is doing right now, is a way to gain a bigger share of the business of these big end customers.

In the long term, I think this is a great strategy for a company that knows how to execute-and that is one of Precision Castparts' strengths.

The problem for Precision Castparts in the short term, however, is that delays in the very complicated business of getting new generations of aircraft to market, from both Boeing and Airbus, have led to bloated inventories at engine makers. As the manufacturing rate for planes like Boeing's 787 increase over the next year-Boeing has talked of doubling its production rate on the 787-engine makers will sell down their inventories of turbine components from Precision Castparts and begin to order again.

Destocking looks like it will be over sometime in the first half of calendar 2014, with growth in orders resulting in increased sales in the second half of 2014.

And that should be enough to push organic sales growth well above the current 2%.

Until that happens, though, Precision Castparts' shares will rise or fall on management's ability to wring higher profits out of slow sales growth. On its track record, I think betting that management can pull that off is a sound move. In this quarter, management grew EBIT (earnings before interest and taxes) margins to 27.2%, a one percentage point gain. Margins in the casting segment (34.6%) and in the forged product segment (25.1%) were both records for the company.

Precision Castparts is a member of my Jubak's Picks portfolio. With this post I'm moving my target price up to $242 by December from the current $238.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of Precision Castparts as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund's portfolio here.

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