Description

Trading at an undeserved discount to defense peers and having spun off its more controversial firearms segment, Orbital ATK is worth a second look. The company was written up in April 2015 on VIC and while the stock has performed relatively well (up 14% vs the S&P 500 up 1% and peer group index performance of up 8% from the time of the posting) there are still a number of catalysts to unfold which should unlock value over the next 12 months. OA is growing at a higher EPS CAGR than peers on the back of mid-single digit top-line growth and still has opportunities in fully integrating the merger which created the current company.

Orbital Sciences (“ORB”) and Alliant Techsystems (“ATK”) closed a merger of ORB with ATK’s Aerospace and Defense businesses In February 2015, while simultaneously executing the spinoff of ATK’s Sporting Group division (new ticker VSTO). The companies had partnered for more than two decades on several successful programs and among other drivers, the opportunity to vertically integrate was a key rationale for the transaction. Per their merger conference call, “over 400 ATK provided rocket motors have been used on more than 150 Orbital built launch vehicles since the late 1980s. More recently, about 100 Orbital produced satellites have incorporated over 250 ATK provided solar arrays, communication antennas, propellant tanks and composite structures, since the mid-1990s.” Today, OA “designs, builds and delivers space, defense and aviation-related systems to customers around the world both as a prime contractor and as a merchant supplier. [Their] main products include launch vehicles and related propulsion systems; satellites and associated components and services; composite aerospace structures; tactical missiles, subsystems and defense electronics; and precision weapons, armament systems and ammunition.” The company is organized into three segments: Flight Systems Group, Defense Systems Group, and Space Systems Group.

Flight Systems (33% of 2015 revenues) is the leading provider of small- and medium-class space launch vehicles for civil, military and commercial missions. It is also the premier producer of solid rocket propulsion systems and specialty energetic products. Defense Systems (40%) is an industry leader in propulsion and controls for air-, sea- and land-based tactical missiles and missile defense interceptors, fusing and warheads for tactical missiles and munitions, as well as a supplier of advanced defense electronics for next-generation strike weapon systems, missile-warning and aircraft survivability, and special-mission aircraft, in addition to various-caliber ammunition. Finally, Space Systems (27%) is an industry-leading provider of commercial satellites used for global communications and high-resolution Earth imaging, as well as a provider of commercial cargo delivery services and logistics to the International Space Station and developer of advanced commercial space-launch systems.

OA currently has a total contract backlog of $14.8bn which provides for strong revenue visibility (equivalent to over 3 years of run-rate revenues). In 2015, the company’s revenues were split 48% to national security markets, 30% to commercial and international markets, and 22% to NASA and civil government markets. 

Guidance - for 2016, the company has provided the following:

EPS $5.25-5.50

FCF $275-325mm

GAAP tax rate ~30%

Average share count ~58mm

The company has also provided explicit capital allocation plans for this year, with share repurchases of $125-175mm planned in addition to $70mm of dividend payments and $40mm of debt repayments (after $200mm of capex). With current net debt of 2.2x estimated 2016 EBITDA, leverage is a minimal concern for the company and with EBITDA expected to grow into 2017 / 2018, I would anticipate more capital being allocated to share repurchases in future periods. The company’s general policy is to return 60-70% of FCF back to investors in the form of dividends and repurchases.

Note, in Q1 OA already managed to post a consolidated EBIT margin of 11.8%, above the full-year guidance range. The Flight and Space segments were ahead of guidance for the full-year while Defense trailed. Defense also saw declining revenues on a difficult comp but this is expected to normalize through the remainder of the year.

The other key data from the quarter was book-to-bill of 152%, suggesting that revenue visibility is actually increasing and adding more conviction to our out-year estimates (firm backlog was up 8% while total backlog was up 23%). We also gain confidence in projections based on the company’s merger integration progress – they achieved $85mm in 2015 cost synergies and expect >$100mm in 2016, while revenue synergies – a category often ignored by the market – were already $75mm in 2015 and are targeted to be $150-200mm in 2016 and beyond (over 4% at the high end relative to 2016 revenue guidance). The two categories are linked in the sense that lower costs allow the company to bid more aggressively (much of the defense / space business is based on RFPs and bids), winning them more revenues, and increasing economies of scale, thus driving costs down further. The majority of integration costs have already been incurred with only $10mm remaining this year.  

OA has embarked on a number of growth initiatives which they expect to accelerate top-line growth over the next 3-5 years. For instance, the company is spending R&D dollars to further develop advanced precision ammunition, and it also just signed up its first customer, Intelsat, for their new in-space commercial satellite servicing system. These initiatives combined with long-tail contracts – e.g. their recent win of the CRS-2 contract with NASA starting in 2019, which will allow them to carry on their work from CRS-1 which has been extended until late 2018 – helps underpin revenue growth assumptions. Another example is the company’s exposure to the A350 and 787 programs from Airbus and Boeing, respectively, which both have multi-year backlogs, as well as the Joint Strike Fighter (F35) which is a key driver of Lockheed Martin’s growth over the next decade.

From a high-level perspective, OA has advantaged growth prospects vs the general defense industry for a few reasons, some already touched upon: exposure to commercial aero structures; commercial and environmental satellites; and precision-guided weapons. Each of these markets are growing significantly faster than the DoD procurement budget and thus OA is not as correlated with the stagnant growth backdrop of overall US defense spending.

Valuation:

With FCF likely to surpass $400mm next year, OA has a FCF yield above 8% - significantly higher than NOC / RTN / LMT at ~5.5-6.5%. At the time of the Orbital / ATK merger, the company laid out a projection of cumulative FCF of ~$1bn in 2015/16/17, which they are currently reiterating inclusive of new growth initiatives to which they have decided to allocate incremental capex – this informs our view of 2017 FCF. There is also a strong possibility that beyond core FCF generation, large receivables related to the CRS and A350 programs will start to convert to cash as milestones are met and while there is a benefit in 2017, this will carry on in 2018 / 2019 as well.

The company trades at 15.3x / 13.4x 2016/2017 consensus EPS, vs defense primes at 19.6 / 17.7x (incl LMT RTN NOC LLL HII; I have excluded GD and BA due to their heavy civil aero exposure). Applying a 16x multiple (still a discount to the group) to our 2017 EPS gets us to a target price of over $109 for approximately 30% upside. At that target price, using our estimate of average share count for 2017, the implied FCF yield would be 6.5%, a valuation we are comfortable underwriting. One could argue that OA should actually trade at a premium to the group based on differentiated growth, but I understand the large-cap defense companies do get some benefit from yield-chasing (though, to its credit, OA does have a yield of 1.4%, not far off NOC’s 1.6%).

Catalyst

Guidance for 2016 seems conservative. In management’s own words, “there's some opportunity there for improvements” based on the success of their CRS cargo mission this month. With operating margins already ahead of target and part of Defense’s weakness in Q1 related to timing (more 2H revenues than 1H, particularly from Middle Eastern customers), there appears to be scope to see an increased guidance later in the year (either on the Q2 or Q3 call).

2017  + 2018 Street projections are likely too low. We model EPS at 5.65 for 2016, 6.82 for 2017, and 7.83 for 2018 vs Street consensus at 5.53 / 6.32 / 7.09. We are slightly ahead of this year’s margin guidance at 11.7%, and we grow this to 12.6% and 13.3% over the next two years. We are less than 2% ahead of consensus revenues in FY17 and FY18 with the delta mostly stemming from margin assumptions, i.e. execution, though with potentially some small benefit at the tax / share count lines.

M&A – OA is both a potential acquirer of smaller companies but also a target itself for the larger primes. At a $5bn market cap OA is large enough to be meaningful but small enough to be considered lower-risk as an acquisition for one of the defense primes, who themselves have arguably limited growth prospects but low costs of capital and generally high-capacity balance sheets. The company is also active in seeking out accretive M&A targets.