U.S. stocks are posting solid gains to start off the week (solid in respect to the ultra-low volatility environment we're in), with the Dow Jones Industrial Average (^DJI +0.06%) and the broader S&P 500 (^GSPC +0.12%) up 1.26% and 1.14%, respectively, at 1 p.m. EDT. The Nasdaq Composite was up 1.11%. Traders are no doubt heartened by this morning's announcement that Warren Buffett's Berkshire Hathaway will acquire Portland, Ore., aerospace industry supplier Precision Castparts in an all-cash transaction valued at roughly $37.2 billion (inclusive of net debt) -- one of the biggest deals in a big year for M&A.
Warren Buffett has unloaded his "elephant gun": The acquisition of Precision Castparts will be the largest in the history of Berkshire Hathaway. What did he see in this company that the market may have overlooked? There are at least two attributes essential to any Berkshire acquisition.
1. An economic moat
Precision Castparts manufactures complex metal components and products for the aerospace, power, and general industrial markets. In its most recent fiscal year ending in March 2015, 70% of the company's revenues came from the aerospace industry.
As you can imagine, when you're serving aerospace companies, the requirements on components are very high. This is high-value manufacturing, requiring significant know-how -- that's the root of Precision Castparts' competitive advantage, as explained in the most recent annual report:
[...] we believe our manufacturing processes, technology and experience provide advantages to our customers, such as high quality, competitive prices and physical properties that often meet more stringent demands [...] Despite intense competition, we believe we are the number one or two supplier in most of our principal markets. Several factors, including long-standing customer relationships, technical expertise, state-of-the-art facilities and dedicated employees, aid us in maintaining our competitive advantages.
If you're a buyer on behalf of an aerospace company, and Precision Castparts has been meeting or exceeding the high standards you set in terms of product quality and customer service, and they're competitive on price, your motivation to switch to another supplier to see if they're just as good is going to be extremely low.
2. A fair price
The acquisition price Buffett is paying is by no means a steal; he made that clear when speaking to CNBC this morning:
In terms of price-earnings multiples going in, this is right up there at the top. Now, when we bought Burlington [Northern Santa Fe], that was a high P/E, but it was off a very depressed [earnings] figure, because we bought that in the fall of 2009, when earnings were at a trough. And Precision's earnings have fallen off moderately because of developments in the oil and gas field, where they do some business as well as in aerospace. But this is a very high multiple for us to pay.
The acquisition price of $235 per share is equal to 18.6 times Precision Castparts' estimated earnings-per-share for fiscal year 2016 (ending in March 2016), a small premium to the S&P 500, which is currently 17.6 times the equivalent earnings-per-share estimate.
However, there is a value to gaining control, particularly when that control rests in the hands of a master capital allocator like Buffett -- i.e., Buffett will be able to redeploy the company's cashflows into other high-return investments.
The deal value also represents a premium to comparable transactions:
|
|
Transaction Value / EBIT* |
Transaction Value / EBITDA |
|
Precision Castparts |
14.8 |
13.0 |
|
Median multiple, 10 comparable transactions |
14.0 |
9.8 |
|
Best comparable transaction: RTI International Metals (acquired by Alcoa) |
20.9 |
12.8 |
Source: Bloomberg. *EBIT: earnings before interest and taxes. **EBITDA: earnings before interest, taxes, depreciation and amortization. EBITDA is a measure of cashflow.
(Alcoa's acquisition of RTI International Metals is the best comparable transaction because it is the most recent (the deal was announced in March and closed last month), and because RTI International Metals is one of Precision Castparts' principal competitors in its aerospace titanium market.)
In sum, this looks like a fair price, but that's more than enough to earn superior returns over the long term (what with Precision Castparts being a superior business). There is every likelihood that, with the growth in earnings, when we consider this transaction in five years' time, the price will appear to have been a bargain.
