Precision Castparts Corp

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4/7/2014 Precision Castparts Corp. (PCP): A Look At How PCP Inflates Earnings Through Acquisition Accounting - Seeking Alpha

http://seekingalpha.com/article/729151-a-look-at-how-pcp-inflates-earnings-through-acquisition-accounting

A Look At How PCP Inflates Earnings Through

Acquisition Accounting

Jul. 18, 2012 9:45 AM ETby: Ken Ruskin

Recently, analysts have been cheering as Precision Castparts (PCP) has gone ona high-priced1acquisit ion binge,having closed on eight companies in the twelve months ending March 2012 with at least six more slated to close bySeptember 2012. Fueled by management commentary, bullish investors believe that PCP has an operational "toolkit"that enables them to significantly improve margins at acquired companies. We believe this "toolkit" involvesaggressive acquisition accounting that creates illusory profits. The increased pace of acquisitions indicates to us thatPCP needs even more of these fabricated profits in order to meet expectations. In this article, we detail how PCPuses "loss contract" reserves and other aggressive accounting to boost earnings without creating any real value.These accounting maneuvers, combined with the high prices paid for acquisitions, have bloated PCP's balance sheet

and caused ROE to drop from 29% in FY 2008 to 16% in FY 2012. Free cash flow conversion has suffered as well.When it comes to acquisitions, PCP bulls should be careful what they wish for.

Primus' Loss Contract Reserves

PCP's August 2011 acquisit ion of Primus was a seminal moment for the company. PCP spent $900 million, morethan they spent on any other acquisition in their history, to gain access to Primus' aerostructures capability and its787 Dreamliner content. Management has called it a new growth platform, and has suggested that they will roll up theaerostructures market as successfully as they rolled up the fasteners market. They have since bought three moreaerostructures companies amid much fanfare, with the latest example being the Heroux-Devtek asset purchasesannounced yesterday.

Given Primus' importance, we were surprised that PCP waited over 10 months before disclosing that the purchaseinvolved an $85.3 million liability for "the fair value of loss contracts." PCP does not disclose any additionalinformation on this item or its significance, but they should: Loss contract accounting can have a profound impact ona company's financials. It allows a company to estimatethecumulative losses from bad contracts and create aliability for them at the time of the acquisition. This liability serves as a "cookie jar" reserve that an acquiring companywill dip into to avoid ever reporting losses on these bad contracts. It's a neat maneuver that divorces PCP's earnings

from reality -- PCP gets to report earnings from the good contracts and avoids reporting earnings from the bad ones 2.

The $85.3 million loss contract reserve is far more than Primus earns in a year. Given the size of this cookie jar, ithas the potential to boost Primus operating profit for years to come. PCP management has saidthat Primus' marginsare below the 22.5% level achieved by their Forged Product business, but that they eventually expect margins to behigher than the company average after they realize $20 million-plus of synergies. We question how PCP is

calculating these margin targets and synergies: Is it before or after the artificial benefit from the loss contract reserve?We find any discussion of margin performance without mentioning the loss contracts reserve to be misleading.

Primus' Other Acquisition Accounting Issues

Loss contract reserves are not the only way that PCP could be boosting earnings through acquisition accounting.

According to PCP's 10K, despite the $900 million price tag, Primus' net tangible assets3were negative $27 million! Itis highly unusual for a quality manufacturing company to have no net tangible assets -- as a producer of tangiblegoods it should have plants, equipment, inventory, etc., that overwhelm any liabilities. But acquisition accounting canallow a company to present an alternate reality. Upon completion of an acquisition, the acquiring company records avalue for every asset and liability of the acquired company. This value doesn't have to be in line with the value theacquired company placed on the asset or liability -- effectively the whole balance sheet including tangible and
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intangible assets is "marked to market" at the discretion of the acquirer. The difference between the purchase priceand this valuation is recorded as goodwill and never hits the income statement. As Tyco showed us during itsaccounting issues (see the fourth paragraph in the SEC settlement announcement), there is plenty of room formanipulation in this process. Indeed, one of the main red flags prior to Tyco's accounting scandal was the fact that it

was valuing acquisitions at zero net tangible assets (see thisNew York Times article).

In our view there are only three possible reasons for Primus to have negative net tangible assets:

1. It is a poorly performing, loss-making company2. Its assets such as PP&E and Inventory are being marked down by PCP and will eventually provide an artificiaearnings boost. For example, lower PP&E leads to lower depreciation, and lower inventory leads to highermargins when that inventory is sold3. Its liabilities are being marked up, thereby creating "cookie jar" reserves that can be released to boostearnings. The aforementioned loss contracts are an example of this, but it could also be happening inenvironmental reserves, accrued expenses, etc.

Given the high price paid for Primus, as well as positive PCP management commentary about the quality of Primus'business, we conclude that the first reason doesn't apply. We are left with the conclusion that PCP has usedaggressive acquisition accounting in order to artificially boost Primus' future earnings.

We'll close this discussion of Primus with one more example of PCP's dubious acquisition driven marginimprovement. Analysts lauded PCP management for achieving strong margins in the March quarter at Primus after

initially disappointing in the December 2011 quarter. We think we have shown enough evidence to suggest that thispraise was misplaced. But it is particularly laughable since in the March quarter PCP lowered their estimate of net

tangible assets arising from 2012 acquisitions by $39.9 million4. This means the company went back through theiracquisition accounting assumptions and revalued their net tangible assets lower. Investors should question whetherthese further markdowns boosted earnings in a quarter where PCP management was under pressure to deliverimprovement at Primus.

A Look at Carlton Forge Works Reveals Similar Issues

PCP also uses loss contract accounting in their acquisition of Carlton Forge Works, their second largest acquisitionin terms of money spent. When accounting for the Carlton acquisition, PCP recorded a $92 million reserve for a "pre-existing revenue sharing agreement." It only became apparent in the 2012 10-K, the third 10-K since the acquisition,

that this reserve was actually a loss contract reserve5.

Given PCP's abysmal transparency, it is difficult to determine when this reserve was actually used (i.e., whenearnings are being boosted by it). Based on PCP's deferred tax asset disclosures, we believe that PCP dipped intothis cookie jar sometime in FY 2012. We note that these two acquisitions were the only ones that PCP made in thepast three years that were large enough to require the disclosure of this loss contract reserve. We suspect that theirother acquisit ions contained them but PCP does not disclose enough details to confirm this.

We also note that PCP valued Carlton at net tangible assets of only $110 million despite the $850 million price tag --a multiple of 7.7 times. Aggressive net tangible asset acquisition accounting can be seen in large acquisitions prior tothe Primus and Carlton acquisition as well (see earnings quality issue No. 3 in our prior notewhere we analyzed theSMC acquisition).

Intangible Asset Mix Also Sheds Light on PCP's Aggressive Acquisition Accounting

The mix of intangible assets also tells us how aggressive a company is with acquisition accounting. After all thetangible assets have been marked, an acquirer is supposed to value all intangible assets and determine how manyare finite lived vs. indefinite. Those that are finite lived must be expensed over their estimated life of the asset. Therest of the purchase price is then allocated to indefinite lived intangibles, and never hit the income statement.Compared to peers, PCP has been quite aggressive in allocating nearly all their intangible assets to indefinite lived asopposed to finite lived. The table in the appendix shows that PCP has allocated over 90% of intangible assets toindefinite lived in FY 2012 and FY 2010 (their two recent years with meaningful acquisitions). That compares to themedian 11% seen in the rest of their peer group -- no other company is higher than 44%. Once again, PCP'saggressive accounting is helping to boost earnings growth.
http://seekingalpha.com/article/248327-a-short-thesis-on-precision-castparts-why-we-believe-margins-will-declinehttp://www.nytimes.com/2002/01/16/business/tyco-shares-fall-as-investors-show-concern-on-accounting.html?pagewanted=2%26src=pmhttp://www.sec.gov/news/press/2006/2006-58.htm


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Conclusion

PCP trades at 19.5 times trailing earnings due to belief in the commercial aerospace cycle and PCP's ability to driveearnings growth through accretive acquisitions. We caution that the cycle has hit a negative inflection point, and thatPCP's recent acquisitions show a pattern of value destruction and ROE dilution. We've written extensively aboutPCP's LIFO accounting fueled inventory binge (inventory up 83% in the past four years while sales are up 5%), andthe parallels to its acquisition strategy are striking. In both cases, PCP is bloating its balance sheet in order to createshort term earnings at the expense of the long term. And in both cases, PCP's disclosures and transparency havebeen remarkably poor. We expect continued fundamental disappointments, related to the cycle turning and

competitive pressures (see the second half of this writeup), to cause analysts to view acquisitions with a moreskeptical eye. When they do, they won't like what they see.

Endnotes

1. PCP's acquisition disclosure is quite poor, so we rely on quotes from competitors to confirm this. The CEO of LMIcalled the multiple PCP paid for Primus "far in excess of what's typically paid in our industry" and "a good 50% highethan we would have expected". (See our note here.)

2. Primus' much admired 787 content may actually be the loss making contracts. CEO Mark Donegan said at a Feb7, 2012 conference that Primus has "such a presence on the 787 that goes -- that's a huge piece of Primus' puzzleunder contract."

3. After goodwill of $422 million and intangible assets of $505 million as disclosed in the 2012 10-K.

4. Goodwill rose $55 million from Q3 2012 to Q4 2012 without any meaningful acquisitions. Unamortizable intangiblesdropped $20.5 million and amortizable intangibles rose $5.4 million, leaving a net impact on tangible assets of $39.9million.

5. The deferred tax asset section of PCP's 2012 10-K shows "acquired loss contracts liabilities" of $35.7 million in FY2011. The 2011 10-K calls this same $35.7 million "acquired revenue sharing agreement liabilities."

Appendix

Click to enlarge image.
http://seekingalpha.com/article/303109-what-is-precision-castparts-hidinghttp://seekingalpha.com/article/248327-a-short-thesis-on-precision-castparts-why-we-believe-margins-will-decline


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Disclaimer:This report is intended for discussion purposes only. It is neither a recommendation nor a solicitation topurchase or sell any security or private fund offered by Temujin. The analysis and opinions of Temujin presented inthis report are based on publicly available information sourced from SEC filings, earnings call transcripts, and otherpublic sources that we believe to be reliable. Judgments have been made based on information sourced on or beforethe issuance of this report. There may be information concerning Precision Castparts that is not publicly available,which could lead the company to disagree with our analysis and opinions. Temujin expressly disclaims all liability forerrors or omissions in, or the misuse or misinterpretation of, any information contained in this report.
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