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.

Fundamental Overview

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:

• Foreign competition is basically a non-starter.  For example, China will never be allowed to compete to build propulsion for U.S. missiles (the programs are of “National Interest”)
• Gencorp owns the overwhelming majority of the critical IP and institutional knowledge/learning on propulsion.  This makes it very difficult for a competitor to try to get into the business
• Many of the programs that GY is involved in are essential to the national interest and as such are less subject to recent DOD budget constraints
• Propulsion systems often go into very long life programs and the propulsion piece is seldom re-competed.  For instance, the propulsion system that is designed into a particular surface to air missile will basically never be swapped out with a competitor’s propulsion system.  If the system works from the outset it is not changed. If it needs an upgrade then Gencorp gets the business.  Finally, many of these DOD and NASA programs can last up to twenty years or more creating nice visibility for GY

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:

• Management has chosen a very passive approach to investor communications (for instance they don’t do quarterly calls or provide guidance). Based on our conversations they will start a more active investor communications effort in 2H14
• Only two sell-side analysts cover the stock (in a somewhat limited fashion).  We think this will change with improved investor communications and transparency
• Also, both the pension and environmental liability are overstated from an economic perspective as a large percentage of each is actually funded by the Federal Government or by government contractors (subject to certain factors/limitations).  For a better understanding of why it is appropriate to partially discount these liabilities investors should read the footnotes in the 10k.  Again, more robust communications will help investors better understand these factors

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:

• A: Take 51% of previous FY total backlog = 51% x $2.5 billion =  $1.3 billion
• B: Calculate the amount by which, on a percentage basis, annual sales has exceeded 51% of previous FY backlog on average over a long-term period and multiply this number by 51% of previous FY backlog. Using 40% implies = 40% x $1.3 billion = $0.5 billion 
• Forecasted Sales = A + B = $1.3 billion + $0.5 billion = $1.8 billion
• (Note – the 40% factor we use is a conservative number based on a ten year history of this relationship)

We also use a more straightforward analysis of the funded backlog levels:

• At the time of this writing, FY13 ending funded backlog is 99% of the Street’s FY14 sales of $1.68 billion,
• Basically, for Street Analyst to be correct only funded backlog will convert to revenues in 2014
• However, based on ten year historical ratios, a given year’s sales are typically 17.5% higher than the funded backlog at the begging of the year suggesting that there may be upside to analysts revenue estimates

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:

• Glenborough & Easton Place (Total Acreage of 1,392) --- This project is the furthest along in terms of readiness for development, with approved specific plans laying out prospective development details. The property mix is approximately 38% residential, 11% mixed use, and 4% commercial/office with the remaining land allocated to parks, schools, and roadways. Based on discussions with brokers, developers, and other industry participants we believe that the weighted average value per acre after accounting for property type is ~$160k, which yields a total value of $225mm for this development. Additionally, GY disclosed in its most recent filing that the Sacramento County Board of Supervisors voted to amend the countywide affordable housing ordinance. Our conversations with management indicate that the previous mandatory 15% allocation of residential development to low-income housing has been effectively reduced to zero. This gives us comfort that our value/acre estimate is relatively conservative in nature          
• Westborough at Easton & Hillsborough at Easton (Total Acreage of 2,288) --- Hillsborough is the second furthest along its project timeline of planned communities, and the company just received 80 acres of valuable land previously allocated to a private school. We value these two properties collectively at $70/acre which contributes $160mm of value
• Rio del Oro at Easton (Total Acreage of 2,309) --- While this development is the largest in terms of total acres, we ascribe limited value to this acreage due to the relatively raw status of the land. At $30/acre, Rio del Oro contributes approximately $70mm to our estimate    
• Office Park and Auto Mall (Total Acreage of 55)  --- Based on available-for-sale land and relevant comps, we believe this land has been largely marketed and expect to see sales of approximately $2-3mm in the near-term out of a total $10mm in value
• Based on all of the above – we see the total real estate as being worth roughly $465mm pre-tax or $300mm after tax (note – this analysis ignores an additional 5,900 owned acres that may someday be held for sale)

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.

Valuation

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:

• Revenue of $1.8 billion achieved on a TTM basis within the next two years based on backlog levels with 13% EBITDAP margins
• Using market values for traded debt and treating the converted debt as equity given that it’s highly in-the-money
• Treating the unfunded portion of the pension liability for which the company is responsible as long-term debt (this has averaged around 15% of the total)
• Backing out approximately $300mm in after-tax real estate value

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.