Description

Merger spin-off with 40%+ upside: Go long “ATK Sporting” spin-off by buying 1 share of Alliant Techsystems Inc (NYSE: ATK) and shorting 2.2272 shares of Orbital Sciences Corp (NYSE: ORB). ATK Sporting currently trades at an implied price of $72.59, representing 6.6x EBITDA and 11x earnings, a significant discount to its intrinsic value of $100.00+. This pricing inefficiency should close by early 2015, once the ATK Sporting spin-off is complete and its trading has seasoned. This investment thesis with graphs can be viewed here: http://www.scribd.com/doc/229682144/ATK-Sporting-Write-Up

Summary

On April 29 2014 ATK and ORB signed a definitive agreement for a proposed Morris Trust transaction in which ATK’s Sporting division will be spun out to ATK shareholders and ORB will merge with the remaining ATK.  The net effect is that ORB will be taking over two of ATK’s three divisions, Aerospace and Defense, while ATK’s management will stay with the spun-out third division, Sporting.  The transaction should close by year end 2014 and ATK Sporting will commence trading as an independent company on the NYSE.  Its name and ticker have yet to be decided.

Company Overview

ATK Sporting is a leading manufacturer of ammunition, accessories and arms (centerfire and rimfire rifles, shotguns) for hunters, shooting enthusiasts and law enforcement.  Some of its key brands include Federal Premium, Savage Arms, BLACKHAWK! and Bushnell.  The company has 5,800 employees and is headquartered in Utah.  The investor presentation for the ATK Sporting spin-off can be seen here: https://www.sec.gov/Archives/edgar/data/866121/000095015714000416/ex99-9.htm

ATK Sporting had CY2013 sales of $2.2bn and adjusted EBITDA of $361mm with a 13% EBIT margin. Ammunition represents approximately 50% of sales, with accessories at 38% and firearms 12%.  Consumer sales represent ~90% of sales with the remainder to law enforcement.  Over the past decade, ATK Sporting had 14% annual organic growth with low capital requirements (management guided to 1.5% of sales).  The company has secured a $750mm senior secured financing commitment from BofA and will dividend $300-$350mm to its parent prior to the spin-off.  Net debt will be $300-$350mm, representing leverage of less than 1.0x EBITDA.

Current ATK CEO Mark DeYoung will become Chairman and CEO of ATK Sporting.  He currently holds $8mm of ATK stock.  At parentco ATK, they have bought back shares at a 1.7% CAGR over the past three years and pay out a dividend at a 1% yield.  Return on equity at ATK has been north of 20% for the past dozen years.

ATK established its Sporting division through a number of acquisitions: Blount International’s ammunition division in 2001, Eagle Industries in 2009 (accessories), BLACKHAWK! in 2010 (accessories), Caliber in 2013 at 5.5x EBITDA (firearms) and Bushnell in 2013 at 10x EBITDA (accessories).

Valuation

A few housekeeping notes:

• ATK’s fiscal year ends on March 31, so its fiscal 2015 began on April 1 2014.
• ATK has an in-the-money convertible bond outstanding.  It recently issued a redemption notice and will settle any notes converted in cash.
• 10% of the ATK pension liability goes to ATK Sporting. No other significant liabilities will be transferred to the spin-off.
• Maintenance capex is estimated at 1.5% of sales.
• Management has guided to mid-to-upper single digit organic growth but thinks it could do better than that

At 6-8% revenue growth and 13%-15% EBIT margin, I estimate ATK Sporting will earn $6.00 - $7.20 per share and $380mm - $440mm of EBITDA this year.  This is quite a bit more conservative than sell side analyst EBITDA forecasts with CS at $449mm and RBC at $455mm.

Using the average of our forecasts, one can currently establish a position in ATK Sporting at 6.6x EBITDA, 11.1x earnings and an unlevered pre-tax free cash flow yield of 13.8% (before working capital commitments).  We conservatively estimate that once the spin-off is completed, ATK Sporting will trade at over $100.00 per share (40%+ upside), representing 15x EPS, 9x EBITDA and a 12% discount rate. 

ATK Sporting will be a unique entity in the public markets as it has no direct comps.  The ammunition division represents half of its revenue.  The commercial ammunition industry in the US is an oligopoly led by ATK Sporting with an estimated $1.2bn in ammunition sales, followed by Winchester (a subsidiary of Olin Coporation, NYSE: OLN) with $780mm in sales and Remington (owned by Cerberus) with $440mm.  Ammunition sales represent only 30% of Olin’s revenue so a large portion of its valuation is based on its volatile Chlor Alkali Products business. 

We view the commercial ammunition business as a niche consumer staples business.  It is a non-cyclical business with steadily growing demand.  Consumers show brand loyalty and quality is very important.  ATK only began showing segmented Sporting results in CY Q2 2009, so we can’t use them to judge its long term performance (especially through the last recession).  Olin provides good segmented disclosure on its Winchester division.  Over the past decade, Winchester has shown steady growth, with only one slight down year and growth through the recession years, while remaining profitable every year:

Since no pure-play ammunition comps exist, for valuation of the ammunition segment we look to a basket of small and mid-cap niche non-cyclical consumer staples companies.  These businesses trade at 9x-12x EBITDA. 

ATK Sporting’s accessories division represents less than 40% of sales.  For this division we look to small and mid-cap apparel and accessories companies.  These businesses trade at 11x-13x EBITDA.  ATK recently acquired Bushnell for 10x EBITDA.

Savage Arms represent a bit more than 10% of ATK Sporting’s sales.  Comparable firearms businesses such as Ruger and Smith & Wesson trade at around 5x-7x EBITDA.

Utilizing these trading comps gets us a blended EBITDA multiple for ATK Sporting of 9.3x - 11.8x, leading to an implied ATK Sporting share price of $107.00 - $139.00.  At a more conservative multiple of 9.0x, ATK Sporting would trade at $103.00.

Industry Overview

The National Instant Criminal Background Check System, or NICS, data is a good proxy for new gun demand.  The FBI launched this program in 1998 to check a firearm purchaser’s background prior to the sale of a gun.  Each time a gun is purchased, a new platform for ongoing ammunition and accessories sales is created for ATK Sporting.  NICS checks have exhibited a consistent upward trend over the last number of years, rising from a 12-month average of 746k in 2005 to an LTM 12-month average of 1.7mm

The increase in NICS checks has corresponded to a steady mid-teens annual increase in ATK Sporting revenue.

Panic gun buying occurred in Q4 2012 through Q1 2013 when stricter gun-control measures were being discussed by the government.  This introduced many new people to gun ownership and has continued to fuel demand for ammunition and accessories.

The Federal Firearms and Ammunition Excise Tax (FAET) is a tax imposed on the sale of firearms and ammunition by manufacturers, producers and importers.  This data is available from Treasury and offers additional insight into the demand for firearms and ammunition.  This indicator has also shown steady growth for ammunition over the past decade, rising from $60mm in 2000 to over $200mm in 2012.

There are numerous factors that have contributed to the increased participation in shooting sports over the past decade, including favorable industry-wide trends such as increased female participation, an increased focus on self-defense and a rise in demand due to legislative concerns:

• American Rifleman magazine says there are now five million women shooters, up over 46% since 2001
• National Shooting Sports Foundation estimates domestic consumer ammunition sales grew at a 12.6% CAGR from 2009 to 2012
• National Sporting Goods Association estimates that there are 36.6mm active shooters in the US in 2012, a 21.8% increase from 2008 (5% CAGR)

This large and increasing installed customer base generates a growing stream of recurring revenue for ammunition and accessories companies.

Given the large influx of participants into shooting sports, the long-term opportunity for manufacturers in the industry looks sound.  However, due to recent rapid growth, some investors are concerned regarding potential softness in short-term demand.  Industry commentary and dynamics indicate continued strong results throughout this year and beyond:

• OLN Q1 2014 10Q: "Based on the elevated level of first quarter 2014 commercial demand, the level of the commercial backlog and the absence of any significant inventory throughout the supply chain, Winchester anticipates that higher than historical levels of demand from its commercial customers for pistol, rifle and rimfire will continue through the third quarter of 2014."
• ATK M&A Call April 29 2014: "So our view of demand has been that, for the most part, in general, demand has remained very robust for really all of our ammunition categories. As we mentioned last quarter, there was some softening in some of the 5.56mm .223 calibers that began to show some softening. There were some comments made by a couple of the publicly-traded retailers that have seen some softening. We've had communication, of course, with those retailers. And it's largely been confined to those kinds of calibers that are rifle calibers. Hand gun ammunition remains very robust. Much of the ammunition associated with rimfire or plinking ammunition for .22lr is very, very robust with significant backlog positions. So generally, we have not seen any wholesale softening for ATK products in the market... So for us, the watchword to date, as of this call, has been stability with continued demand and opportunities for margin improvement and growth in the ammunition business."
• OLN Q1 2014 conference call: "As we look at the Winchester business going forward, we continue to believe that the significant increase in gun ownership has occurred over the past five years as well as the increase in the number of people who become regular target shooters will result commercial ammunition demand in excess of historic levels."
• ATK has had limited order cancellations and backorders still represents over a year's worth of ammunition production
• Winchester’s backlog of $400mm is still three-fold that of 2012 levels and its inventory is 20% below that of 2012 levels
• Remington estimates that between 2009 and 2012, it had an average annual unsatisfied demand of approximately $110 million and $100 million for its firearms and ammunition

DMA Summary

ORB and ATK have entered into a definitive agreement.  Terms of the agreement state that ORB shareholders will receive 0.449 ex-spin ATK shares (reverse spread implies 2.227 ORB shares per ATK share).  Key conditions include a majority vote on both sides, HSR and SEC approval.  There is a $50mm dual break fee and the termination date is April 1 2015.  ORB’s advisors are Bank of America Merrill Lynch and Cravath Swaine & Moore.  ATK’s advisors are Citi and Cleary Gottlieb Steen & Hamilton.  The proxy should be distributed in Q3 with closing by year end.

Why Does This Opportunity Exist?

We believe ATK management and the Board of Directors decided to execute this transaction because the Sporting division has shown strong, consistent and profitable growth amid record product demand while the Aerospace and Defense divisions have shown consistently declining revenues amid sequestration and contract losses.  It appears that ATK management is cutting the fat to establish a high growth entity with significantly more upside.  This deal works for ORB as it is highly accretive because ORB trades at a significantly higher multiple than ATK.

The ATK Sporting Stub is incredibly volatile in the market as there is a dearth of risk arbitrage spread setters involved in the name.  This has led to this pricing inefficiency.  All of the risk arb desks we spoke with did not cover the deal.  The lack of interest in the stub is further supported by the absence of short-selling on either ORB (setting up stub) or ATK (setting up reverse stub). Only 2.2% of ORB’s float is sold short.

On May 20 2014, Dick’s Sporting Goods stock dropped 18% on poor quarterly results and guidance for the year.  They blamed the decline on the golf business, and to a lesser extent hunting.  Within that guidance, they expected hunting to recover within a couple quarters but saw no end to the downturn in golf demand.  ATK sells some of its products through Dick’s.  Analysts are concerned that this could affect short term results at ATK Sporting.   Since the quarterly results were announced, DKS insiders have acquired $6mm in DKS stock.

On May 15 2014, ATK released its Q4 2014 results and hosted a conference call.  ATK Sporting results were good, with “Core Sporting” revenue (excluding Savage and Bushnell) up 13.9% year-over-year against a very tough comp.  However, Core Sporting was down 5.4% from the previous quarter.  With the incredible run in revenue growth ATK Sporting has achieved historically, the market gets spooked at any potential sign of a downturn.  Also, the company guided to only mid-to-upper single digit organic growth (as opposed to 14% shown historically) with the caveat that “hopefully, [they] will be able to even do better than that.” Also, they stated that they are “just a bit cautious with some uncertainties of the market strength.”

There is concern in the market regarding potential peak margins and growth rates in the ammunition space.  Manufacturers have been implementing price increases and are running their factories 24/7 to try to meet record demand.  There have been many instances of ammo shortages in specific calibers.  Some investors are skeptical and think that the recent growth and high margins have overshot and will revert to some lower level.

Conclusion

ATK Sporting is an attractively priced, market leading, non-cyclical, double-digit grower with a conservatively capitalized balance sheet that produces sustainable free cash flow and has a high return on invested capital.  It trades at a 32.3% discount to the market multiple.

The market is offering the opportunity to purchase the ATK Sporting spin-co at a substantial discount to intrinsic value and offers 40%+ upside in the near to medium term.

Risks

• Deal falls apart (superior proposal for ORB, votes not passing, regulatory issues)
• Legislative changes that would hinder demand
• Lead, copper and zinc price increases

Catalyst