Description

OA is a leading U.S. aerospace and defense firm with a 50-year history of supplying high quality systems and services to both government and commercial customers. OA is a new stock, the result of a transformational merger that we believe will reward shareholders with material revenue and cost synergies and increasing free cash flows. The combined business has tailwinds and management has promised shareholder friendly capital allocation. We expect cash earnings per share to grow by more than 50% by 2017, and believe OA could trade to $125 per share. Ultimately, OA has the potential to be a takeover candidate as the defense industry experiences a period of consolidation, leading to further upside.

Transformational Merger

In April 2014, Orbital Sciences (“ORB”) and Alliant Techsystems (“ATK”) announced an agreement to merge ORB with ATK’s Aerospace and Defense businesses, while simultaneously executing the spinoff of ATK’s Sporting Group division. Given the complex structure of the deal and a general affinity by investors for spinoffs, sell-side analysts focused on the Vista Outdoor (“VSTO”) spin and ignored the new Orbital ATK.

The transaction, which closed in February, created a firm with more than $4.5 billion in annual revenue, selling rocket propulsion vehicles, missile defense systems, ammunition, space launch structures, and satellites to both government and commercial customers including the Department of Defense, NASA, the Missile Defense Agency, satellite owner/operators and other aerospace and defense companies. The combination has vertically integrated OA, creating the low cost player in the industry.

“There are compelling operational and financial synergies that can be realized from year one, allowing us to achieve faster growth and lower cost in ways that benefit both our customers and our investors.” – CEO David Thompson

The company stated that it expects 4%-5% top line growth and several hundred basis points of improved margin over the next 3 years, largely driven by revenue and cost synergies, and we believe management’s guidance could prove to be conservative. OA will share some of the cost savings with its customers, allowing for more competitive bids but at the same time higher margins for OA, driving more project awards and revenue increases in a virtuous circle. OA also believes the merger will be accretive to the firm technologically as collaboration between the two companies drives more innovation. These factors should add up to more contract awards over the next several years and at the same time drive margins higher.

It is also important to highlight that there are organic revenue tailwinds in OA’s end markets. Despite ongoing budget concerns at the U.S. Department of Defense, both space exploration spend by NASA and advanced weapons and propulsion systems spend by the Missile Defense Agency are expected to increase in the coming years. Additionally, commercial satellite owner/operators such as Intelsat (“I”), Eutelsat (“ETL FP”), and SES (“SESG FP”), are all expecting to increase capex spend driven by growth in their businesses and a replacement cycle.

The general perception that defense budgets are shrinking has distracted investors from the reality that OA’s specific end markets are actually expanding their budgets and that revenues should grow mid-single digits over the next few years. Additionally, the market was blinded by an OA failed space launch that turned out to be the fault of a supplier. Since the failure, OA has replaced the supplier and signed multiple new contracts with NASA, giving us confidence the incident is behind them. Therefore, despite the market’s misperceptions of the company’s prospects, our view is that OA’s accelerating top line combined with cost cuts will drive significant free cash flow growth in the near and medium term.

Balance Sheet and Capital Allocation

“We expect robust cash flow generation over the next several years and have put a plan in place that will enable us to return significant value to shareholders while continuing to invest in our business to propel future growth.” – CEO David Thompson

Aware of the ramping EBITDA and free cash flow at OA, CEO David Thompson has no plans of materially paying down the 2x net leverage the company has on its balance sheet. Therefore, OA announced a $75 million share repurchase program for the remainder of 2015 (1.7% of the market cap) and a $1.04 per share annual dividend (1.4% dividend yield). Our expectation is that the buyback and dividend programs will grow significantly in 2016 and 2017 as the company executes on integration and free cash flow ramps. We estimate that OA could repurchase $500 million worth of stock (11% of the market cap) in 2016 and 2017. Alternatively, the company has not ruled out another highly accretive M&A deal if the opportunity were to present itself.

Valuation

“This combination will benefit shareholders in both the short term and long term, by unlocking substantial immediate value and also by achieving sustainable, profitable growth for years to come.” – CEO David Thompson

Our view is that OA will grow cash EPS from $4.50 in 2014 to $6.50 in 2016 and more than $7.00 in 2017, driven by organic revenue growth, synergies, and share repurchases. We believe that as the company executes over the next few quarters, reports higher synergies than originally expected, and continues to increase its buybacks and dividends, the multiple will expand to a level more in-line with its aerospace and defense peers. At a 15x multiple of our cash EPS estimate for 2016 (comparable companies are trading at multiples in the mid-to-high teens), we get a stock price of ~$100 per share. However, we expect that investors will see a path to more than $7.00 of cash EPS and could value OA stock at $125.

Catalyst

• Execution on revenue and cost synergy targets and potential upside to the guidance.
• Fulfillment of the Commercial Resupply Services (CRS-1) program for NASA.
• New awards from NASA, including CRS-2 (scheduled to be awarded in 2015).
• Ramping free cash flow.
• Shareholder friendly capital allocation in the form of dividends, buybacks and potentially M&A.
• Aerospace and Defense industry consolidation.