September 20, 2011 - 1:54pm EST by
2011 2012
Price: 4.00 EPS $0.28 $0.38
Shares Out. (in M): 59 P/E 14.3x 10.5x
Market Cap (in $M): 237 P/FCF 3.4x 3.2x
Net Debt (in $M): 162 EBIT 90 95
TEV (in $M): 399 TEV/EBIT 4.4x 4.2x

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GY is a supplier of propulsion technologies to the aerospace and defense industries.  Its core business, Aerojet, is well positioned, consistently profitable, and unlike many of the large defense prime contractors, should experience healthy growth over the next several years.  GY has two additional characteristics that we believe are leading it to be misunderstood by the market: 1) accounting complexity is causing GAAP net income to understate free cash flow and certain balance sheet liabilities to overstate long-term obligations; and 2) in addition to the cash-flow generating aerospace and defense business, GY owns excess real estate assets that are not currently contributing to earnings but are material in relation to the Company's market value.  Taking all of this into account, we believe fair value for GY to be as much as $13.50 per share, representing 238% upside from the recent price of $4.

Investment Thesis

Core Business is Well-Positioned and Growing

Aerojet, GY's core operating business, is one of three suppliers of propulsion technologies for the aerospace and defense industry, and the only one able to deliver each of the four major propulsion systems (solid, liquid, air-breathing, and electric).  Aerojet was founded in the 1950s by Cal Tech scientists, and has long been a highly regarded supplier to the aerospace and defense industries; its technologies were used on NASA missions since the inception of the U.S. space program.  Its end products include rocket, satellite, missile defense, and in-space propulsion systems.  Its customers include Lockheed, Raytheon, and Boeing.  End-users are the DoD, NASA, and foreign governments. 

Propulsion systems are typically sole-sourced from a single vendor.  When a contract for a certain weapon system comes up and is bid and won, the vendors on that contract will produce that system for the life of the program, as switching costs can be very high.  As a result, many of Aerojet's systems are embedded in aerospace and defense programs that have life cycles of a decade or more.  About half of revenue comes from cost-plus contracts, resulting in margin stability - pre-corporate EBIT margins in GY's Aerospace segment have consistently been between 9.8% and 11.7% for the past 7 years.

Unlike many of the large defense prime contractors, GY is likely to experience healthy growth over the next several years in spite of DoD budget pressures.  Conversations with industry participants have confirmed that missile defense is becoming an increasing national priority, and even though the overall defense budget is not growing over the next several years, money is flowing out of certain subsectors of the budget (e.g., tanks, aircrafts, submarines) and into other subsectors, such as missile defense.

There are other public sources that confirm this prospective growth.  One of the nice things about Aerojet being a niche supplier of specialized technology to a relatively small number of programs is that it is much easier to diligence the business' prospects than it is for the large defense primes that are diversified on hundreds, if not thousands, of different products and programs.  Every year the Department of Defense publishes a detailed document outlining its Program Acquisition Costs by Weapon System, and the FY12 document shows healthy growth planned for Aerojet's most important programs - 6.9% growth, on average, for all of Aerojet's programs listed in the document (Standard Missile, GMLRS, PAC-3, Ground Based Mid Course Defense, Tactical Tomahawk, THAAD, Javelin, JAGM, Aegis).  Most importantly, Aerojet's most important program, Raytheon's Standard Missile platform, which makes up 26% of Aerojet revenue, is projected to grow 19.1% in the FY12 budget document. 

This growth is consistent with our conversations with industry participants, and is further supported by GY's own published total backlog, which had increased 21.9% on a year-over-year basis at the most recently reported quarter.  It is worth noting that, while the composition of the reported total backlog has seen an unfavorable shift from funded backlog (the amount for which money has been directly appropriated by Congress or for which a purchase order has been received from a commercial customer) into unfunded backlog (firm orders for which funding has not been appropriated), the Company has explained that this shift was solely a result of the Continuing Resolution under which the government was operating during the early part of 2011, and the backlog should see a shift back to historical levels of funded vs. unfunded as soon as the third quarter.

A final point worth mentioning on the core operating business is that the Company has a new CEO who started roughly 18 months ago.  He came from Northrop, where he was very familiar with the Aerojet business, and has 40 years of operating experience in the aerospace and defense industry.  He has indicated that he sees various opportunities to improve inefficiencies in the operating business, and believes he can drive margin expansion without much topline growth.  He has already made substantial progress in leaning out the Company's working capital over the past 18 months to historically low levels, which he believes are sustainable.

Accounting Complexity Causing GAAP Net Income to Understate Free Cash Flow

GY's Free Cash Flow significantly exceeds its reported GAAP Net Income, for four separate reasons.  First, the Company does not pay cash taxes and has said it does not expect to pay material cash taxes for at least the next 5 years.  This is due to a combination of NOLs (the Company has $235m of gross deferred tax assets) and other various tax planning strategies including Section 59-E elections which will allow the Company to deduct previously spent R&D costs in the future. 

Second, the Company has substantial non-cash GAAP charges on its income statement from a discontinued pension program, to which we estimate the Company may never have any cash funding obligations.  To give a sense of the magnitude, in 2010, the Company had $69m of reported EBITDA, but $42m of non-cash pension costs, so true cash EBITDAP (EBITDA before pension) was $111m.  While the pension obligations are large relative to the Company's size ($1.6bn), the plan was actually 96% funded at the most recent measurement date.  The Company is required to maintain a 96% funded level under the Pension Protection Act (PPA), but were the funded level to fall, the Company has $63m of prepayment credits that it is allowed to contribute to the plan before contributing cash, and would also be allowed make up the shortfall over a 15 year period thanks to President Obama's 2010 Pension Relief Act.  As such, we do not expect the pension to represent a material cash funding need in the foreseeable future.

Third, the Company's D&A of $28m exceeds its ongoing cash capital expenditures of ~$20m, and fourth, there is about ~$11m of non-cash interest expense running through the income statement due to amortization of debt discounts and financing fees.

In 2010, the Company reported GAAP Net Income of $7m, or $0.11 per share, so the stock looks like it is trading at a P/E multiple of 36x, but adjusting for the four effects described above, true cash net income was $68m, or $1.16 per share, such that the stock is actually trading at a cash P/E multiple of 3.4x.  Moreover, the Company has $135m of gross debt that will be paid down before the end of 2011 using cash that is already on the balance sheet ($75m of 9.5% senior sub notes callable 8/15/11, and $60m of 2.25% convertible sub notes puttable 11/11, which will almost surely be put to the Company since they convert at $20 / share and are consequently far out of the money).  Pro forma interest expense will thus be in the range of $10m, adding another 25 cents / share to earnings and further lowering the Pro Forma cash P/E multiple to 2.8x.

Accounting Complexity Causing Balance Sheet Liabilities to Overstate Long-Term Obligations

We believe many investors who look at GY are scared off by two optically large liabilities on the Company's balance sheet, neither of which we actually believe to be a future net cash obligation of the Company - the pension (discussed above), and ~$220m of environmental remediation cost reserves. 

Aerojet's main test site facilities are in Sacramento, and beginning in the 1950s, it tested propulsion systems there.  These tests ended with used rocket fuel (mainly ammonium perchlorate and other chemicals) that needed to be disposed of.  For decades, Aerojet disposed of it on its land in accordance with accepted regulations and standards at the time.  In the early '90s, authorities realized that the land had been polluted, and designated it a Superfund site.  Under a 1997 global settlement, Aerojet agreed to clean up the land, and the federal government agreed to reimburse Aerojet for 88% of all of its cleanup costs.  Additionally, Northrop Grumman agreed to reimburse Aerojet at 88% for some of its cleanup costs allocated based on work it had performed for Northrop.  The timing of the Northrop reimbursement, though, was subject to annual caps, which the Company has recently exceeded, such that Northrop now owes the Company for previously spent cleanup costs, in addition to future cleanup costs.  The result of this is that from today onward, the Company actually expects its net cash flow from cleanup expenditures and reimbursements from the government and Northrop to result in a slight net cash inflow over time.  In other words, it expects to spend less in the future than it will receive in reimbursements from the government and Northrop.  This can be seen on the balance sheet, as the Company has receivables from the government and Northrop that exceed its environmental liabilities. 

Consequently, we have excluded both the pension liability and the environmental liability from our enterprise value calculations.

Excess Real Estate Assets

In addition to the cash flow-generating aerospace and defense business, the Company owns several excess real estate assets, most notably 12,000 acres of contiguous, developable raw land adjacent to a major highway in the Sacramento, California metropolitan area.  While Aerojet originally acquired this land to test its propulsion systems, it stopped all tests there over a decade ago, and while ~6,000 acres are environmentally restricted, the other ~6,000 are clean and in fact were never used for testing, but rather were a buffer between the test sites and civilization.  In the 55 years since Aerojet acquired the land, civilization has encroached around it such that is now in a very desirable location, adjacent to a main highway, adjacent to public transportation, and close to schools and retail and commercial districts.  GY has extensive plans to turn the 6,000 clean acres into a master planned community called Easton, in 5 separate phases (Glenborough, Easton Place, Rio del Oro, Westborough, Hillsborough).  The land is in various stages of zoning with detailed plans prepared for residential, commercial, and office property development on an initial 1,400 acres (Glenborough and Easton Place).

Given current real estate conditions, this large, non-core asset is not currently contributing to earnings, but, given the vast acreage, its value is material in relation to GY's market cap.  Because the Company acquired the land in the 1950s, its book value is low (~$33 million).  Earlier this year, prominent Sacramento developer AKT paid $49,000 / acre for 17,000 acres of comparable raw land at the intersection of I-5 and Highway 99, very close to GY's Easton lands, but in an obviously worse location.  Applying the same per acre values to GY's 6,000 developable acres implies a value for GY's land of almost $300 million, more than the Company's entire market cap.  Looking at a wide range of other recent comparable raw land sales in the area implies a range of $20,000 - $50,000 per acre.  Taking the very low end of this range implies a value for GY's land of $120 million, still more than half the Company's current market cap. 

In addition to the Sacramento raw land, GY also owns 310,000 square feet of excess Sacramento office space that it leases to third parties.  This leasing activity generated $5m of operating income in the LTM (and has generated as much as $10m in previous years).  Applying an 8% cap rate to this NOI implies a value of $63m for the office space.  Finally, the Company also owns 580 acres of land in Chino Hills in southern California.  We have ascribed no value to this land since it is still being cleaned up from years of previous testing activities, but the Company believes that the land will eventually be developable.

Adding together the Sacramento land and the Sacramento office space, we conservatively believe GY has $200m - $350m of excess real estate assets in addition to its core Aerojet business.  This represents anywhere from $3.30 - $5.80 per share of value, relative to the current stock price of $4.

Attractive Valuation

At the current share price of $4, GenCorp has a market cap of $240 million and an enterprise value of $400 million. Due to the misleading pension accounting convention, we favor an EBITDAP (EBITDA before Pension) metric for valuation purposes. At the company's current run-rate EBITDAP of $113 million and normalized CapEx of $20 million, GY is trading at 3.5x EBITDAP and 4.3x EBITDAP - CapEx. The Company doesn't pay cash taxes, and interest expense Pro Forma for the upcoming maturities should be roughly $10 million.  Assuming working capital is a modest use of cash, we estimate free cash flow of $70m, representing a free cash flow yield to the equity of 29%, or 3.4x cash earnings. We consider this an attractive valuation for a business with the characteristics described above (well positioned competitively in an important national security niche, consistently profitable, and growing topline MSD for the next few years). Furthermore, at the current price we believe we are getting the real estate for free, which we conservatively estimate to be worth $200 - $350 million, or roughly 80% - 145% of the Company's market value.

We believe fair value for GY shares to be between $11.50 - $15.50, based on 10x - 12x current cash earnings of $70m, plus real estate value of $200 - $350m, less net debt of $160m (and factoring in potential dilution from a subordinated convert that strikes at $9 / share).  This represents 188% - 288% upside from the current share price of $4.  Even under an extremely conservative case, applying an 8x cash earnings multiple and valuing the real estate at $100m, the stock should be worth $8.50, representing 113% upside.


GenCorp has a strong core business that is consistently profitable, growing, and competitively well positioned as an important niche supplier to the aerospace and defense industry.  Accounting complexity is causing reported GAAP earnings to materially understate the Company's free cash flow and balance sheet liabilities to overstate the Company's true long term obligations.  The stock is trading at a 29% free cash flow yield (just over 3x cash earnings), and earnings should grow nicely over the next few years.  In addition, the Company owns excess real estate assets that aren't currently contributing to earnings, but could be worth the entire market cap of the Company today, and significantly more in the future as residential real estate markets recover and the Company makes progress on its development plans.  We think that in the case of GY, accounting complexity and misguided fears about defense spending are creating an extremely compelling opportunity to purchase a collection of high quality assets at a significant discount to fair value.



Free Cash Flow generation

Upcoming debt maturities, which should lower Pro Forma interest expense

Demonstrated revenue and earnings growth in current defense budget environment


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