|Shares Out. (in M):||82||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,437||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||354||EBIT||0||0|
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The recent sell-off following the release of the 1Q14 quarterly report provides a compelling opportunity to own Gencorp (GY) shares at a meaningful discount to intrinsic value. We believe the company’s effective legal monopoly in the domestic propulsion industry combined with their underappreciated real estate holdings make the company materially more valuable than what is suggested by the current Enterprise Value. We are aware that other members of Value Investors Club have written about the long-term merits of owning GY shares, so it is our intention to review the salient points of the core-business investment thesis while expanding on the real estate opportunity.
Central to our thesis is that Gencorp has created nearly insurmountable barriers to entry. The company dominates the propulsion systems market with 75% to 100% share in all categories. This moat is a result of the Company acquiring Rocketdyne and merging it with its Aerojet division. Rocketdyne seller United Technologies (Pratt & Whitney) sold this division in part to fund the acquisition of Goodrich. Initially the FTC objected to the merger based on anti-trust concerns. Ultimately they relented to the DOD who highlighted concerns about other potential acquirers’ capabilities and the need for program continuity:
“Where, as here, there are no reasonable substitute products and there is little prospect of significant new entry, a consolidation of the only two market participants is likely to create a durable monopoly. In such a situation, a high likelihood of anticompetitive effects is presumed...”
“That being said, we understand from our discussions that the Department of Defense has identified potential non-economic benefits that may result from the transaction, including sustainment of certain industrial base assets and capabilities necessary to meet the Department of Defense's space launch requirements.”
Quotes are from FTC letter to the Department of Defense a day before the FTC approved the transaction - (GenCorp Inc.'s Proposed Acquisition of Pratt & Whitney Rocketdyne from United Technologies Corp., FTC File No. 121-0182)
Basically, the DOD allowed the formation of a legal monopoly to protect long-term programs. That’s not to say that Gencorp will be allowed free reign to charge whatever they want – the Federal Government is the end customer for most of Gencorp’s products and over time GY will likely be limited to 12%-14% EBITDAP margins. Even so, we like the prospect that GY will garner the overwhelming majority of domestic propulsion spend. In addition, there are a number of other things we like about the propulsion business and this transaction:
There are also a host of factors that that make GY stock look less attractive than it is but we believe these will soon be cured or at least will be better understood by investors:
From our perspective, a large part of the recent sell-off - beyond market related volatility - surrounds the transitory impact from accounting changes with revenue recognition procedures. Given the nature of government contract structuring and timing, business is expected to be lumpy quarter-to-quarter and thus we believe that the recent financial underperformance in 1Q14 is not reflective of an underlying structural issue. In fact, it’s quite the opposite. Annual revenues from programs related to the Standard Missile will be greater than those achieved during the development phase once production ramps to normalized levels. This, along with other contract wins, has been reflected in the encouraging amount reported 1Q14 total backlog of $3 billion (up 20% from FY13 ending levels).
The characteristics of this business suggest sales and profitability should be evaluated on an annual not quarterly basis. While the company does not issue formal guidance, they do share a historical relationship that may help forecast annual sales:
We also use a more straightforward analysis of the funded backlog levels:
Real Estate Opportunity
We have completed a significant amount of primary diligence work on GY’s real estate portfolio and believe further transparency of this underlying value could serve as an intermediate-term catalyst. GY has over 6,000 acres of valuable land held for sale in the Sacramento area which has been in the entitlement process for years. Gencorp has segmented this land into five major projects of varying size, value, and timelines. Our analysis of each of the projects based on stage of development, mix of property type, and market comps suggests a consolidated price/acre of $77:
Overall, we believe that the disparate natures of these assets and the core-business contribute to a complexity discount in the stock price. With coming real estate sales and greater clarity on value we think this discount disappears.
Furthermore, since the cash flows from GY have historically come from the Aerospace and Defense side of the ledger, institutional coverage has spent a disproportionate amount of mindshare on these assets instead of real estate. One analyst estimate simply multiplies the total acreage by $50k/acre to derive $300mm in pre-tax value. The $/acre used in this case comes from a distressed property sale in the Sacramento County area in 2011 that is not comparable to the land GY owns. If this is reflective of the market perception of the underlying real estate value, then by our math there is at least 50% upside to the contribution of this asset to total Enterprise Value.
Real estate sales and corporate actions to create transparency around this asset - i.e. a REIT formation, increased investor communication - should add clarity to the underlying intrinsic value and drive the share price higher over the long-run. Our channel checks suggest that GY is unwilling to sell one-off acres of these properties and thus we expect the company to realize this value by striking large developer agreements as conditions continue to improve in the Sacramento area real estate market.
From a valuation perspective, pro-forma for the land value and adjustments to the pension/environmental liabilities, we believe investors are paying 6.0-6.5x forward EBITDAP. This is derived by the following:
We view this multiple as too low for a one-of-a-kind, niche leader (legal monopoly) with a number of pending catalysts. Eventually we think a large defense or industrial company may want to own Gencorp (such as GE Aviation’s Military Engine division) and we’d expect to north of a 10x EBITDA multiple if such a transaction were to occur. In the nearer-term we see upside to $27.50 per share with relatively conservative assumptions.
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