What precisely does Berkshire Hathaway CEO Warren Buffett see in Precision Castparts Corp.? It’s understandable that investors are asking themselves that question, given the renowned investor’s penny-pinching reputation.
Clearly, Berkshire Hathaway’s $235-per-share deal for the airplane component maker, announced Monday, was no fire sale. The price represents a 21.2 percent premium over its previous close. The price-earnings multiple of Precision Castparts, at 22.2, stands well above that of the Standard & Poor’s 500 index, which is 19.2, as well as the company’s own five-year average of 20.5, according to Morningstar data.
“In terms of price-earnings multiples going in, this is right up there at the top,” Buffett told CNBC Monday in an interview. “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.”
And the purchase is a monster bet, totaling $37.2 billion, including assumed debt — making it Buffett’s biggest purchase ever. The deal depletes enough cash on Berkshire Hathaway’s balance sheet to the point that it may curtail big acquisitions for a healthy spell.
Still, Precision Castparts is a classic wide-moat business — the kind that value investors like Buffett salivate over. The Portland, Oregon–based company manufactures critical castings and components for jet engines and turbines. Rivals find it difficult to wrest market share because customers such as the Boeing Co. and Lockheed Martin Corp. are loath to switch to unproven suppliers, especially when the cost of doing so is expensive. Accordingly, as is the case with a lot of wide-moat companies, operating income margins are fat. For the fiscal quarter ended June 30, they were 25.7 percent.
There may be turbulence ahead for Precision Castparts. Despite forecasts of rising commercial air travel, net income from continuing operations was $399 million, off 17.7 percent in the fiscal quarter ended June 30 from $485 million a year earlier. Sales of $2.4 billion were down slightly from $2.5 billion a year ago. And in addition to the weakness in the energy sector that Buffett mentioned, there was a falloff in military sales as well as currency headwinds.
Precision Castparts shares were down more than 19 percent this year before the bid, following a double-digit decline in 2014. All this may have combined to make a sale more attractive to Precision Castparts’ CEO, Mark Donegan. Some of the company’s shareholders are probably delighted by the announcement.
A key thought for Berkshire Hathaway shareholders to ponder is that Buffett’s company certainly hasn’t shot the lights out with its aerospace investments over the years. In 1989 Berkshire Hathaway bought $358 million in preferred stock of USAir Group, which yielded 9.25 percent, just as the highly unionized company was coming under increased competition. In 1994, after years of USAir losses, the preferred payments were suspended and Berkshire wrote down its investment by 75 percent. “My analysis of USAir’s business was both superficial and wrong,” Buffett wrote in his 1996 letter to shareholders. Still, the preferred holdings were probably worth about par by that point, and Berkshire had received $240.5 million in dividends. So no one should complain too loudly.
Berkshire Hathaway had a somewhat better experience with FlightSafety International, a top-notch pilot-training business that it bought in 1996 for a reported $1.5 billion in stock and cash. In his 2007 annual report, Buffett wrote that at the time of its purchase, pretax operating earnings were $111 million, which grew to $270 million. Since its acquisition, depreciation charges totaled $923 million and capital expenditures $1.635 billion. Still, Buffett characterized the return on the FlightSafety investment as only “good,” given the amount of reinvested earnings it required.
The biggest aerospace problem was Executive Jets, a fractional jet ownership business, which CEO Richard Santulli sold to Berkshire Hathaway in 1998 for about $725 million in stock and cash. Over ten years, Berkshire Hathaway helped bankroll the renamed NetJets’ expansion in Europe, losing a cumulative $212 million on the build-out before turning a profit, Buffett wrote in his 2007 letter to shareholders.
Things, however, soon took a turn for the worse. In his 2009 letter, Buffett revealed that in the 11 years that Berkshire had owned the company, NetJets had recorded an aggregate pretax loss of $157 million. Debt rose to $1.9 billion in 2009 from $102 million at the time of purchase. “Without Berkshire’s guarantee of this debt, NetJets would have been out of business,” he wrote. “It’s clear I failed you in letting NetJets descend into this condition.” In 2009 alone, NetJets lost a “staggering” $711 million, Buffett added.
David Sokol, who led the expansion of utility giant MidAmerican Energy Holdings Co., renamed Berkshire Hathaway Energy, replaced Santulli and returned NetJets to profitability. Sokol later left Berkshire Hathaway after successfully lobbying Buffett to purchase Lubrizol Corp., a chemical company in which he had only days earlier bought shares.
Characteristically, the story-loving Buffett waggishly traces the aviation industry’s problems back to the days of the Wright brothers. “If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down,” Buffett concluded in the 2007 letter.
So, why the change of heart on aerospace? A glance at the Berkshire Hathaway’s June 30 results, released just last week, may provide a clue. The conglomerate posted an insurance underwriting operating loss of $38 million for the quarter, versus a profit of $411 million for the year-earlier period. For the six months, underwriting operating profits fell by nearly half, to $442 million.
Whereas property and casualty rates are cyclical, Berkshire Hathaway is facing secular headwinds at its insurance subsidiaries, which include National Indemnity Co., GEICO and General Re Corp.. Excess capital is flooding into the industry. Disciplined, Berkshire Hathaway is renowned for eschewing market share in favor of profitable underwriting. That portends declining earnings.
Berkshire’s insurance float — paid-in capital that it may pay out in claims some day but in the meantime can be invested for profit — grew just 1.4 percent year-to-date, to $85.1 billion. “Reinsurance isn’t as attractive as it used to be because of an abundance of capital,” says Mark Curnin of White River Capital, a Chappaqua, New York, hedge fund firm that invests in financial stocks. “All this means, Berkshire will have a much more diverse stream of capital.”
Precision Castparts, like Berkshire Hathaway’s myriad other industrial businesses, including its utilities, BNSF Railway, Marmon Group, Lubrizol and IMC International Metalworking Cos., will be able to help deploy plenty of that money. Precision Castparts’ Donegan has a strong track record of successful tuck-in acquisitions — with two announced just last quarter.
That’s something to think about as Buffett marches through his ninth decade.
