Description

Aerojet Rocketdyne (AJRD) Investment Thesis

Overview

AJRD is a leading technology-based manufacturer of aerospace and defense products.

We have spent the past months doing a deep fundamental dive into the company and industry, and have come away fully believing the company is materially undervalued under all valuation metrics. AJRD is also a crucially strategic asset due to its unique exposure to the fastest growing areas in Defense and Aerospace and it being the only, and last remaining, independent supplier of mission critical engines and components. Highlighting this strategic importance, note that all other independent suppliers have been acquired in rapid market consolidation, most recently by Northrop’s purchase of Orbital ATK (leaving AJRD as the last remaining independent supplier of mission critical parts). To concretely display the strategic nature of AJRD, we show an example of the Orbital acquisition’s benefits to Northrop. After the Orbital acquisition, Boeing was forced to drop out of the Northrop/Boeing bidding process for a >$13bn Air Force contract because of the Orbital acquisition:

 (See: Strategic Value of independent suppliers).

Note as well, large strategic acquirers have already tried to acquire AJRD over the past year for these same reasons.

AJRD makes some of the most important, mission-critical, and strategic assets in the industry today. For example, in Defense, they help produce the most advanced missile defense and offensive systems (e.g. THAAD and Patriot systems) in the world today. For Space, they produce the essential required engines for Rockets/Spaceships, the Space Launch System (SLS) itself, and many other parts. For example, NASA’s most advanced mission, Artemis I, launching October 2, has 38 parts made by AJRD, including the 6 main engines.

Fundamental Undervaluation

Aerojet is trading deeply below both the group, and its own historical, multiples – a fact that hold true using all various valuation metrics.

The company trades at a 20%-30% discount to the peer group on both a LTM and Forward EBITDAP basis as shown below.

15x is the Median industry multiple on LTM EBITDAP. AJRD trades <12x. Mere reversion to median equates to a $50/sh, a 25% increase over the current share price.

 On forward multiples, AJRD trades just 10x consensus forward EBITDAP. Consensus is ~$311mm for 2023. Merely trading at the average of peers (not even the premium multiple it deserves due to superior growth), would be ~12.5x or ~$50/share – 25% upside from today’s price. Note this is precisely the same undervaluation on both metrics. Even further, beyond just multiples, consensus estimates are too low, causing the undervaluation to be even greater as we show below.  

 In fact, this discount exists across all valuation metrics. The following website does a good job of pairing growth rates, EBIT multiples, EPS multiples, etc against peers, emphasizing the undervaluation exists across every type of valuation: Industry Valuation Metrics.

 When we see valuation discounts like these, we aim to understand why this exists – we must understand why the market is undervaluing the company, and why we may see an undervaluation when the market doesn’t in order to invest in a business.

 Here, we have identified the cause for the mispricing, which is driven by multiple factors acting at once:

Technical Factors: 

AJRD signed a deal to be acquire by Lockheed Martin in 2021, but the FTC rejected the deal in February. This caused a shake-up in the investor base and uncertainty on what the company would look like on a standalone basis. Then, immediately following the deal’s collapse, there was a highly unusual proxy fight where the Company’s own Chairman waged a proxy battle against the CEO, which lasted until July, further fueling this uncertainty, and thereby causing investors to be unable to invest in the stock until these corporate events were sorted out, and then having to wait to better understand how the Company was performing and its future direction. In addition, amplifying these factors, the company’s sell side analyst coverage is sparse given it’s the last of its kind, with only 1-2 bulge bracket analysts covering the stock.

Broad Misunderstanding of the Business

The other main category of reasons for mispricing is when investors finally heard from the Company in August (less than 2 months ago), there was a broad misunderstanding of the Company’s cashflow cadence due to the unique nature of its contracts, Defense Industry-specific quirky accounting rules that don’t reflect the business reality, and further, a misunderstanding of many macro and company-specific tailwinds. We highlight three examples of such misunderstanding below:

 First, after the company reported earnings in August, typical headlines and stories were all similar:

If one took these statements at face value, these steep headline declines would justify the valuation discounts.  However, there are a number of reasons why these blanket statements do not accurately portray the actual fundamental performance of the Company, thereby providing the opportunity for investors.

For example, EBITDAP is typically adjusted for “EAC” (this is true of the industry; not unique to AJRD). In 2021, the company had +$24mm of favorable EAC, while in 2Q’22 EAC was negative ($29.5mm). This is a ~$53.5mm delta change. Comparing apples to apples by removing EAC adjustments, last year’s EBITDAP would have been $62.6mm and this year’s EBITDAP would be $71mm – an increase, not a decline. More importantly, even including EAC adjustments, the size of the negative EAC this quarter is largely a function of a quirk in Defense company accounting rules vs. being representative of the underlying Business. 2Q’s unusually large negative EAC was substantially driven by how its Standard Missile program is required to be accounted for. As stated by the Company:

Note how the accounting requirements work: because customers wanted to INCREASE production rates (i.e. driving superior future growth), the company had to invest in additional capacity today – this is a good thing. However, due to the additional cost of this investment which was absorbed in 2Q, this cost drove the contract into a technical loss this quarter (which reverses going forward as the flip side of taking it all at once is it is now reset). Technical industry accounting rules state that the Company has to not just reflect this quarter’s technical loss, but also reverse all prior period profit as well, as if it wasn’t made, and mark financials as if a total contract loss will continue to occur – and then do so all in this quarter (versus over the duration of the contract). This accounting fiction naturally reverses itself back in future quarters, which serves as a catalyst on the upcoming quarter’s release to cause the market to realize this broad miscalculation of the underlying business.

 In fact, we can be even more precise. By digging into 2Q financials, we can make the proper adjustments best viewed through the quarter’s EBITDAP margins. Last year, apples to apples, EBITDAP margins were 11.8%. In 2Q, margins were 13.1% - a 1.3% increase in margins. See below from Jefferies’ research analyst post earnings:

     Another example of broad misunderstandings are related to the unique contract structure of independent suppliers like AJRD and its atypical front-loaded cash flow cadence (note because they are the last remaining supplier, there are no comparables, hence driving this misunderstanding as it is unique to public markets).

 Typically, the company signs ~4-5 year contracts, and the cash flow is front-loaded, since the Company needs to invest in capacity, materials, etc to build the parts they are expected to deliver. This means that the FCF of the contract is not evenly distributed as investors and analysts are used to seeing. Instead of cash from the contract being evenly distributed throughout the contract, cash is actually distributed more like 30% in each of the first 2 years, and then a total of 40% (i.e. 13.3% each year vs. 30% previously) in the last 3 years. Applying this to AJRD, a number of large contracts were signed in an 18-month period circa ~2019. Following these signings, the company’s cash flow was an astounding 160% of its net income in the first 2 years as described above, leading to artificially high cash flow numbers in 2019 and 2020. Then in 2021 and 2022, the cash flow still comes in but at lower rates to account for the extra cash flow in the first 2 years. Net/net, this all washes out correctly, but when quarterly periods don’t match to the business reality, general investors miss the opportunity, allowing alpha to flow to more astute investors that spend to time to make these proper adjustments in their model.

`    The last bucket of misunderstandings relate to stale consensus estimates on both a macro and micro level. For example on a macro level, at the beginning of the year, the DoD total budget was expected to increase low single digits. However, due to increased tensions with Russia, China, the Ukraine War, and the Taiwan threats, DoD spend is expected to grow ~9% next year – 4x higher than estimates. These materially higher growth rates in DoD spending have not been updated in numbers, which has consensus, by definition, underestimating the earnings power of AJRD next year. From the Congressional budget: “The House deeming resolution provides for…9 percent more than the comparable FY 2022 level.” See: Defense Budget.

 Further, the errors also exist on a company-specific level. Current estimates are stale due to lack of updating for developments post 2Q and lack of analyst coverage. For example, the Company had ~86mm shares outstanding as of June 30th. On July 15th, they announced they would buy back their convertible debt for cash – this effective buyback reduced the company share count by ~6mm shares. (See: July 15 Buyback) The Company’s true share count now is ~80mm shares: they bought back >5% of the company at $40.15. This automatically would increase full year eps by 10c, and of course as earnings increase next year and going forward, the accretion increases even further compared to current estimates that still use the stale, and elevated, share count.

 In this category we also place the deeper understanding of the business structure where important indicators went under-noticed around headline figures. In 2q’22, the company increased its revenue backlog to a record high $6.9bn – growing it 8% sequentially from 1Q. The company expects to monetize $2.3bn of the backlog over the next 12 months, which is an increase over the previous 12 months; as compared to the optical 5% decline presented in headlines. And as the backlog increases over the year as we are only halfway through, revenue only increases. The company also increased its book-to-bill ratio to 1.2x – further proof of not just growth, but increasing growth. 

 Finally, we point investors to AJRD’s own Chairman’s presentation he outlined less than 3 months ago, detailing conservative estimates showing AJRD’s standalone value to be >$65 within 3 years. The presentation gives greater detail by segment of increasing profits as well as the ability for the company to repurchase over half of the company’s current market cap by 2025, especially when sharp increases in FCF begin in 2023/2024 as contracts are increased and updated, highlighting precisely why in addition to the undervaluation described above, consensus estimates are materially lower than they should be, increasing the fundamental value of the Company. The Chairman also put his money where his mouth is: owning 5% (>$150mm) of the Company, which is more than 2x the rest of the Board, the CEO and all management combined.

 As if this weren’t compelling enough, the Company has a hidden asset as well. The Company has a real estate segment of ~4,500 acres of land in the Sacramento area which they can monetize through sales in the coming months and years. We have even dug into values and can estimate this value based on previous parcels of land sold. Taking just two representative examples, AJRD has previously sold 703 acres for $57mm ($81,000/acre) (See: Sacremento Business Journal) and last year they sold 187 acres at ~$31,300/acre (See: Sacremento Business Journal 2021) .  This implies a sale of the land would easily generate >$300mm, or 10% of the Company’s market cap. The land can also be rented, as a small portion is now, or can be used as collateral for debt to repurchase shares or in getting an increased price from current bidders of the company, which we discuss next.

 Near-Term Strategic Unlock of Value

 AJRD’s aforementioned deal with LMT at $56/sh was blocked by the FTC in 1Q due to Lockheed-specific particulars (namely their status as a large customer of AJRD and size) which would cause potential detrimental effects to competition. Note, however, there are many other strategics interested that can buy the company without the same FTC concerns – the same holds true of PE acquirers.  From AJRD’s own Chairman, after the Lockheed deal had broken:

Immediately after the Lockheed deal was terminated, the Company received multiple inbound inquiries by other acquirers, but was in the middle of its proxy fight and needed to sort that out before making another sale. (“Private equity firms are said to be "circling" Aerojet…after Lockheed's failed attempt to purchase the company.” See: February Bidders).  More importantly, the Company has recently received multiple inbound inquiries again, and is “currently in preliminary discussions with multiple strategic acquirors”, which have likely escalated beyond preliminary discussions since the story broke (See: https://seekingalpha.com/news/3875888-aerojet-rocketdyne-gains-on-report-of-talks-with-strategic-buyers).  We also believe PE bidders have also approached the company, consistent with the PE interest the Company received in February.

 We should note here that the Company has nearly 25% of its stock held by activists, with 40% of this amount purchased over the past 6 months. Lichtenstein still owns 5% of the company, Gabelli has filed at 13-D and just 2 weeks ago increased its stake at a purchase price of $44-$45 per share to ~8% of the company. Further, a third prominent activist, Elliot, disclosed a large position (just under the 5% filing threshold) as of June 30th. However, a more carefully detailed reading of the filings show the position was significantly higher than 5%, and based on volume analysis, historical patterns, and other factors, we believe it’s likely they currently own ~10% of the company. (Some may be curious as to why there wasn’t a required filing if they own 9.9% of the company: the reason is by using complex derivative instruments, they can hold stock, but not in their own name, to avoid tipping the market. (See: Monga, A., Using Derivatives to Manipulate the Market for Corporate Control, Stanford Journal of Law, Business & Finance)

Note that Elliot has already stated its desire to purchase a midcap defense company. In fact, just ~6 months ago, they attempted to buy the only other existing midcap defense company, MRCY (see: https://www.bloomberg.com/news/articles/2022-03-02/activist-elliott-is-said-to-make-bid-to-acquire-mercury-systems?leadSource=uverify%20wall) but MRCY was not a seller. Elliot is known to be quite capable of forcing a company to do what it wants, but in the interim the large stock dislocation began happening at AJRD, and as such they sold their entire MRCY stake in 2Q and instead started purchasing AJRD, a far better/cheaper and more strategic asset. Notably, also in 2Q, it was reported that Elliot specifically raised an additional >$2bn in capital for a buyout in addition to their existing >$60bn in cash/assets (https://www.bloomberg.com/news/articles/2022-04-25/elliott-seeks-over-2-billion-war-chest-for-private-equity-deals?utm_source=pocket_mylist&leadSource=uverify%20wall).

This shows us that large and reputable stockholders also see this same thesis (note Gabelli raising its stake at all-time highs in the stock price and Elliot’s new 9-figure purchase of AJRD) while serving as a positive check on the Company’s improving performance and bidding process.

Of course, it has been reported, and it is strategically logical, that there are numerous other deep-pocketed bidders in both PE and strategic acquirors. For an example of just one bidder, LHX just last week specifically stated it is on the verge of buying a “midcap” in the defense space for “a few billion dollars”. Only two possible companies fit this criterion: AJRD and MRCY, and we already know MRCY is not a seller and AJRD is much better strategic fit.

Importantly, there are important signals astute investors can see as things developed in real time. For example, AJRD has had Thomas Corcoran as a Director since 2008. However, he is also a Director at LHX – given LHX’s potential interest and Corcoran’s deep information about AJRD from serving as an AJRD Director for 15 years, it becomes a conflict if LHX is indeed bidding (note AJRD’s chairman also made the same point: “Lichtenstein recommended that Corcoran not stand for re-election due to…a conflict with his position on the board of L3Harris, a potential acquirer” (this quote describes the Chairman of AJRD’s board raising this issue both prior to and after the Lockheed deal was signed, implying strongly LHX showed interest at the time. (See: “In re Aerodyne”). If LHX were not bidding, then there would be no conflict. So what did we see happen? In June, this overlapping director with LHX, Corcoran, suddenly stated he was stepping down “for personal reasons” – thereby avoiding a conflict due to LHX’s interest in bidding. Even further, these sudden and odd “personal reasons” are quite curious, as not only did he suddenly say this just days prior to the board election, but these same personal reasons apparently did not apply at the potential acquiror as he has continued staying on as a Director at LHX – a clear signal of LHX’s intent to acquire the company. By doing this, it avoids a conflict, and he can discuss with LHX his superior knowledge of AJRD’s business and its current undervaluation.

 Even more transparently, LHX’s CFO gave investors the same answer just last week. LHX CFO stated at the MS conference on 9/15:

We highly suggest speaking to the MS Analyst who can describe body language and intonation in the CFO statements that go beyond the written works on the page. Particularly her pushing the company on buybacks vs. M&A of which the response was “M&A” and seemingly in the near-term.

Interestingly, through our deep dive of digging through financials, we see even further and stronger signals of strategic interest in AJRD.  For example, LHX authorized a $6bn share repurchase program on January 28th (the same time they said looking for $1bn-plus acquisitions, which the CFO made a point to say that “$1bn plus” is actually, “$1bn plus a few billion dollars” – squarely in AJRD territory). With this $6bn share repurchase program, the company was extraordinarily aggressive. They repurchased an astounding $4bn in just the following ~4 months (nearly $1bn a month!) before suddenly ceasing all buyback activity in mid-June as they preserved cash for a transaction and cannot buyback stock while in possession of material info (namely bidding for AJRD) (See LHX 10-Q ). Note their repurchases stopped at the exact same time Thomas Corcoran stated he was stepping down from AJRD’s board – unlikely to be a coincidence.

 Of course, this is merely one example of one strategic acquirer. The August 23rd article described that AJRD was already in preliminary discussions with multiple strategic acquirors, and mentioned other potential bidders, such as GE Aerospace. Then there are the PE acquirors: It appears likely Elliot is bidding, and many other PE firms are active in this space (e.g. Carlyle).

 Conclusion

To summarize:  AJRD is a net cash balance sheet company whose underlying business structure and FCF cadence is misunderstood; AJRD is the last remaining independent supplier, a highly strategic asset who is discussions with multiple interested acquirors and where activists own nearly 25% of the company. There is strong downside protection with YTD low share px of ~$39 and the company buying stock at $40.15, making the ~$39-$40 range a strong technical bottom, combined with its deep fundamental discount to peers, and near-term takeout optionality.

Catalyst

Multiple Catalysts:  1) Earnings Call that explains the stronger than expected business; 2) NASA successful Oct 2 launch and other Space-related news 3) 13-D filing 4) Updated stories on the AJRD acquisition process 5) Announced Merger 6) Investors realizing some of the missed positives that we have unearthed, such as the DoD budget 7) Sept 30 10-Q showing updated share count