Description

Investment Thesis          

Aerojet Rocketdyne Holdings, Inc. (“AJRD” or the “Company”) is a $2.1B market cap manufacturer of propulsion systems for the defense and aerospace industries. Aerojet is a growing, high quality business trading at 8.5x EV/ EBITDAP and an 8% FCF yield, a substantial discount to its relative and absolute value. The convergence of a number of factors has led to this mispricing including complex financials (e.g. it does not screen well nor appear inexpensive at first glance based on GAAP earnings and ROIC), confusion and misperception of various factors and the generally underappreciated presence of real estate holdings that are being entitled, developed and sold. Improving but very limited corporate communication (no earnings calls, etc.) and institutional following (cursory sell-side coverage) has not helped and likely compounded the price-value disconnect. The reality is Aerojet has strong fundamentals as missile defense is a top priority for DoD and US allies. It is in fact a monopoly in several areas and has multi-year contracts that provide high financial visibility with very limited exposure to the economic cycle. We believe the stock has +50% upside from its current price.       

Catalysts                                                                                                                                                                                     

Near and medium-term catalysts to value realization include: 1) margin expansion and an acceleration in free cash flow conversion from cost saving initiatives, debt refinancings and transition of programs; 2) improved corporate communication (new CFO previously led IR at UTX); 3) increased institutional awareness and appreciation of this high quality, specialized niche business; 4) growth in existing programs and large new contracts ramping-up later this year; and 5) real estate sales.    

Business Background & Overview

From 2008 to 2013, the Company shed a number of ancillary business lines and began harvesting its non-essential real estate in order to exclusively focus on its core propulsion business. In 2013, AJRD acquired United Technologies’ (UTX) rocket engine business Pratt & Whitney Rocketdyne for $550M. This doubled the size of the Company and gave it an effective monopoly in the medium and large rocket engine industry. In conjunction with the merger, GenCorp (GY), as it was then known, changed its name to the present Aerojet Rocketdyne (AJRD). At the time of the deal the stock attracted the attention of event driven funds that put out very ambitious synergy assumptions. The shareholder base has since turned over and the stock is trading at those price levels despite a much improved profile and numerous positive developments.The Company produces all four primary jet propulsion systems (solid, liquid, all-breathing and electric) as a prime and subcontractor to the DoD and foreign allies. Portfolio by end-user: USAF (24%), Army (18%), MDA (15%), Navy (9%), NASA (24%) and commercial and foreign allies (10%). Major subcontracting partners are Lockheed Martin (27%), Raytheon (20%) and ULA (21%). Within that concentrated customer set, however, AJRD is well diversified with over 500 active contracts. The Company’s knowhow across missile types provides it a significant competitive advantage and also hedges its exposure to any one engine type. For instance, its largest single platform is the Standard Missile program (12% of revenue) but under this program, AJRD has multiple contracts with different government agencies for different generations of the missile. AJRD’s +50 years of knowhow, programs that entail lengthy supplier qualification and certifications create a very high barrier to entry for competitors. Approximately 62% of revenue is derived from fixed-price contracts, 32% from cost-reimbursable contracts and 6% from commercial contracts. In 2016, 92% of its R&D expenditures were customer-funded. AJRD’s land assets are substantial but real estate activities only account for 3% of revenue.

Investment Rationale   

• Stable and Visible Financial Performance: AJRD’s long-term contracts and backlog provide financial visibility and stability. The Company’s next-twelve month revenue guidance is $2.0B based on its existing $2.1B funded backlog. This does not, however, include any new business wins nor the transitioning of existing programs to funded status.

• Defense: US missile defense systems will remain a DoD priority given the advances and proliferation of ballistic rockets by North Korea, Russia (S-300/S-400 missiles), China and Iran. The DoD’s Missile Defense Agency (MDA) is one of the few defense agencies which has seen its budget increase even through sequestration periods. Tactical missile platforms have been an area of strength for LMY and RTN. Raytheon’s missile defense segment is its most prized business. On RTN’s Q2 call the CEO said this about the SM program, “missiles has a very healthy pipeline that is increasing. So we’re very up on missiles over the next five years.”  HASC noted “the GMD system is currently the only missile defense system that protects the US homeland from long-range ballistic missile attacks. The committee believes the Defense Department must prioritize the GMD system and allocate sufficient resources to sustain, test, and evolve it.” AJRD’s two largest programs are Standard Missile and THAAD (20% of LTM revenue).

• The new administration is increasing the defense budget with MDA outlays to all AJRD’s programs increasing. The State Department has also reduced impediments for sales to foreign allies. Large orders from Western Europe, the Middle East and East Asia have just begun and will be a major growth tailwind for AJRD starting later this year. Below are the most significant recent announcements:       

• June, Saudi Arabia order includes $6.7B for enhancements to Saudis’ Patriot anti-missile system (with a scope of work from 2018-2027) and $13.5B for seven THAAD batteries (with an estimated delivery time of 2023-2026).

• July, Poland announced an $7.6B order for eight Patriot interceptors to be delivered in stages through 2022.

• Following the announcement of the Poland deal, it was announced that the State Dept approved a $3.9B Patriot missile order from Romania.   

• Japan’s Defense Ministry’s recently released FY2018 budget includes large orders for SM and PAC-3 missile systems (link to summary story).  

• Ground Based Strategic Deterrent (GBSD): This is a massive +$85B program to upgrade ICBM capabilities over the next two decades. Earlier this week the USAF down-selected BA and NOC to proceed with the first phase of this program ($350M to each prime, an estimated 10-20% of which will be for propulsion). AJRD is a subcontractor to NOC and if selected for production in three years could equate to $4-8B over the program life or $500-700M per year to AJRD (based on estimates from management).

• Other Defense: AJRD has multiple hypersonic propulsion patents that make it essentially the sole provider of these engines. Most of the details surrounding these programs are classified but in June it was announced that AJRD will be working with Boeing to produce the main engine for least 10 vehicles. On the orbital side, the ever-evolving cyber risks and expanding use of precision strike and tactic communication should keep the DoD focused on satellite investments, supporting AJRD’s heavy satellite launch engine business for the foreseeable future.  

• Confused Competitive Dynamics: These favorable dynamics on the defense side have been partially overshadowed by headlines from a smaller part of the business that has led to confusion surrounding competition. SpaceX (backed by Elon Musk) and Blue Origin (backed by Jeff Bezos) are the first companies to attempt to enter the rocket propulsion business in decades. Both entities have very ambitious commercial space goals but have had mixed results thus far. Regardless of their success, it is important to note that neither entity intends, and for various reasons cannot, enter the ballistic missile business. Further the US space program is undergoing a complete restart from zero so there a lot of incremental business up for grabs for all participants. Meanwhile, AJRD continues to win contracts and maintain its position in Space propulsion. Last year the Company was selected to supply NASA’s Space Launch System rocket with upper stage RL-10 engines (equating to $240-375M in revenue to AJRD based on the price per engine and estimated launch cadence for the rocket). NASA cited the RL-10s proven performance as its reason for choosing AJRD. This is a clear validation of one of AJRD’s main aerospace products that industry pundits had been saying may be replaced. More broadly, the market does not seem to realize that large rockets require multiple stages. While an incumbent may be able to compete away a contract for a smaller stage, it does not mean the entire program is lost, as was the case with the strap-on booster for the Atlas V and Vulcan programs.  

• Atlas V & Vulcan: AJRD is competing with Blue Origin to supply the first stage engines for the next generation launch vehicle (Vulcan). ULA is a joint venture between Boeing and Lockheed and the prime contractor to NASA on the program with either AJRD or Blue Origin being the subcontractor. Historically AJRD was the only supplier of such engines to ULA. In order to improve its negotiating leverage, ULA’s very public CEO has made this competition into a bit of a soap opera, downplaying AJRD’s capabilities and its preference for Blue Origin. All tests so far for the new AR-1 engine AJRD is developing have been successful while Blue Origin’s BE-4 engine has been experiencing delays. A decision from ULA is scheduled for later this year. Most appear to have written AJRD off in this competition. We do not have any particularly unique insights on this matter but if they were to be down-selected it could result in $600-900M in revenue over five years--100% of which would be incremental to its backlog and none of which is assumed in our or any Street projections. Even if ULA retires the Atlas V as is planned and chooses BE-4 over AJRD for Vulcan, the AR-1 engines can still be used for other customers.

• Cost Cutting Programs: It should be noted that in March 2015, the Company began an efficiency improvement program, the benefits of which are only beginning to get realized. AJRD’s Competitive Improvement Programs (CIP I and CIP II which subsequently launched in April 2017) are on target to annually save an estimated $230M ($145M for CIP 1, $85M for CIP II), beginning in 2018-2019. This consists of operating improvements, the closing of several plants and a consolidation of management (headquarters moved, mid-level staff eliminations). In the near-term, AJRD is collapsing six business segments into two (Defense and Space) to reduce costs by an incremental $8M annually starting next year. Separately, in June 2016, AJRD and Raytheon announced a deal with the DoD whereby its Tomahawk Missile, Standard Missile 3, Standard Missile 6 and Patriot Missile systems programs were extended and granted permission to reduce redundant bureaucratically required overhead costs that exist between the two companies. The elimination of these redundant administrative costs are going to save at least $25M per year. Likely part of which will accrue to AJRD. Last fall the Company just completed the implementation of an ERP system. Management has not provided specific numbers around this upgrade but has indicated the system is already providing insights into organizational redundancies which will lead to potentially “sizable” cost reductions across the business. As an example, it has shown that the acquisitions from the early 2000s were never fully integrated.

• Margin Expansion: It appears there is a lot of opportunity to streamline operations and improve profitability. For competitive and customer sensitivity reasons, management is purposefully not forthcoming in disclosing future margin estimates. While management does not explicitly provide margin guidance, the following signal that there is at least 200-300bps of improvement to come over the coming couple years: 1) earlier this month at the Jefferies Industrials Conference when asked about margins, CFO Lundstrom said, “potentially a couple points of margin expansion over the next two years”; 2) at the June investor meetings management pointed out that AJRD’s margins lagged its peers and that they were working to close that gap; 3) S&Ps November 2016 credit rating report (the estimates for which were presumably provided by management) assumes EBITDA margins improving to 14-15% over the next two years (pre-pension this would obviously imply even higher EBITDAP margins). AJRD’s LTM EBITDAP margin was 12% (A&D, ex-RE). It should be noted this includes some temporary drag from electric engine cost over-runs and one-time stock comp to the former CEO. EBITDAP margins of 15% within two years seems quite likely.  

• Confused Balance Sheet and FCF Profile: AJRD’s cash earnings and FCF are obscured by non-cash pension charges and environmental expenses, D&A being 50% greater than capex, lower forward interest expense and the underappreciated fact that 85% of its R&D is customer-funded. The Company’s pension is underfunded by an estimated $581M. This large balance sheet liability itself likely creates investor aversion but it overlooks the fact that 82% of the Company’s pension obligation are in fact borne by the US Government as result of legacy contracts. The environmental reserves on its balance sheet create a similar dynamic whereby they appear large but less than 25% of it is recourse to AJRD with 75% being reimbursed by the prime contractors per historical contract agreements. Consequently AJRD’s annual cash pension contribution is approximately $10M, significantly less than the >$70M impact on its financial statements under GAAP. Even as recently as March a sell-side analyst initiated coverage of AJRD and somehow failed to factor this into their valuation, thus understating cash earnings materially. These factors combined with complex, seasonal and lumpy contract accounting and an immaterial restatement (related to purchase accounting of the 2013 Rocketdyne deal).

• Real Estate: AJRD owns over 11,300 acres of land as part of an historical need to keep a buffer between its aerospace and defense research and the surrounding civilian community. Modern changes in propulsion technology along with the relocation of its test facility render the need for a buffer obsolete. Consequently, in 2012 the Company began to position this land for development and sale. Currently 5,600 acres of its holdings are being monetized, of which 3,756 is entitled (either partially or fully). This land is located 15 miles east of Sacramento between Rancho Cordova and Folsom along a highway. AJRD is seeking a partner to develop the land into a master-planned community with a team solely focused on these efforts. Based on current comps and ascribing value only to the entitled land implies its worth $125-175M today if developed and sold in 3 years (vs. $60M on the balance sheet).

Valuation  

The current stock price is very appealing on an absolute and relative basis. AJRD’s current market cap is $2.1B (fully-diluted) and EV is $2.3M (including capitalized future cash pension contributions). The Company’s next-twelve month revenue guidance (ex-real estate) is $2.0B (based on its existing $2.1B funded backlog). Note AJRD’s actual forward revenue has historically meaningfully exceeded its forward guidance by $150M-$210M. Assuming no new revenue, the forward backlog implied EBITDAP is $280M (14% margin) with FCF of $170M or $2.28 per share (fully-taxed). This equates to 8.4x EV/ EBITDAP assuming zero value for the real estate and 7.8x ascribing $150M to the real estate. Meanwhile peers RTN, LMT, LLL and OA trade at 12-14x forward EV/ EBITDAP. So AJRD trades at two-thirds the comp multiple despite more attractive backlog growth and limited exposure to the aerospace spending cycle.

On a sum-of-the-parts basis, we believe AJRD is worth $42-43 per share or +50% above the current $28 per share. This is based on a 12x EV/ EBITDAP multiple for the core business and $150M for the real estate (likely conservative at $8,000-13,000 per acre for the California land).

Given the potential integration costs savings alone, AJRD would be a logical acquisition target for one of the larger defense contractors such as LMT, RTN, NOC or OA. For a sense of perspective, last year when RTN and AJRD were granted approval by the DoD to eliminate redundant administrative functions, they estimated it alone would cut $100M in overhead. Such a scenario could result in close to double from the current stock.  

Other Investment Considerations & Risks   

• Management: The Company’s lack of investor communication appears to be a result of successive CEO replacements. The current CEO, Eileen Drake, came on in 2015. She has a solid reputation in the industry, but she has never led a public company and thus seems to have been reluctant to begin holding earnings calls and investor days until she has her feet fully under her and her team in place. She now has both and has begun taking steps forward with investor outreach. Last November the Company hired a new CFO from United Technologies where he led IR—a strong indication that investor communication will improve. He, in fact, presented at the Jefferies Industrials Conference earlier this month, the first major conference the Company attended in years.    

• Litigation: There are two significant environmental legal cases: 1) Sacramento site shared with Boeing - estimated range of anticipated costs $147M - $249M, accrued amount is $147M; and 2) BPOU site - estimated range of anticipated costs $133M - $176M, accrued amount is $133M. Expenditures from BPOU are partially recoverable from Northrop and the US Govt - $86M reimbursed so far with $104M of future reimbursements. $140M worst case legal exposure. Timing of settlements and reimbursements is unclear. Given what is known assumed zero net impact to AJRD as accruals seem reasonable and reimbursements may offset existing reserves/ future expenses.

Catalyst

1) margin expansion and an acceleration in free cash flow conversion from cost saving initiatives, debt refinancings and transition of programs

2) improved corporate communication (new CFO previously led IR at UTX)

3) increased institutional awareness and appreciation of this high quality, specialized niche business

4) growth in existing programs and large new contracts ramping-up later this year

5) real estate sales