Tuesday, February 4, 2014

GenCorp - Rocket Science


I’ve repositioned the chess pieces in order to raise cash and better balance the portfolio’s exposure to exogenous variables while keeping expected returns constant. I have, in the last month, bought the common stock of GenCorp, Arcos Dorados and Rain Industries, and I’ve sold my equity stake in Hawaiian Holdings. I’ve also bought some January 2015 call options in Procter and Gamble. 

I’ll start with GenCorp because it has been written up several times.


GenCorp is Aerojet and Rocketdyne and some land. The land is either a free option or a red herring, and I therefore won’t say much more about it.  These are the principal merits of the investment case:
  1. Aerojet and Rocketdyne are both in the niche, highly-regulated rocket propulsion business and together account for a large (70% to 90%) share of the market in rocket systems for defense and space applications. Niche + highly-regulated + monopolistic market share of course means pricing power and that’s what these two businesses exhibit.
  2. Both Aerojet and Rocketdyne are beneficiaries of long-term sole-source contracts and rocket technology is expected to grow both absolutely and as a share of the otherwise declining defense budget. This means that they have revenue and profit streams that are predictable and growing over any but the shortest time frames.
  3. Pricing power, large deferred revenue accounts, and healthy growth suggests that free cash flow should grow at a rate of 10% or greater for quite some time.  
  4. GenCorp’s financial statements are burdened with GAAP costs and liabilities that overstate actual future cash claims on the company: some 85% or so of the pension costs (and liabilities) and environmental remediation costs (and reserves) will be borne by the federal government.

So, pulling these threads together and using what I think are conservative parameters – a discount rate of 10%, no synergies to be retained by the company, revenue growth rates between 5% and 10% – it seems to me clear that GenCorp is a bargain.




That its fundamentals are uncorrelated with macro currents makes it an attractive addition to my portfolio. The suggestion that GenCorp’s management, in residence since 2010, will be more communicative in the first half of this year holds out some potential that its intrinsic value will be recognized sooner rather than later.

Other write-ups:

Disclosure: I am long GenCorp

24 comments:

  1. No tax shield in your valuation? Seems like you trad'l add that back when going from enterprise value -> equity value?

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  2. Thanks for noticing. I left out a number of tax-related freebies:there's that and there's the shield on the stock options, on the GAAP environmental costs, and on the GAAP pension expense. Frankly, as long as I could see 2x with no downside, I wasn't too fussed about how much more upside there is/was :)

    While I'm here, and as something of a non sequitur, I'm a skeptic wrt the idea that the benefits of merger synergies will accrue to shareholders. Plain reading of the various presentations and transcripts suggests to me that the approval for the merger was conditional on those cost savings being passed on to the USG.

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  3. great site!
    just a few questions:
    1)Primary question: It seems like you had a $25 price target on HA. I'm wondering about your rationale for selling out of it. Did your thesis change?
    2) How did you go about valuing the Growth option for GenCorp?
    3) What was your rationale for buying the PG calls? Based on cheapness? How cheap is it that you felt compelled to do so?

    thanks!

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  4. Hi Jim and thanks for reading.

    1)

    a) My HA long exposure had been gigantic and is now merely enormous. The tracking portfolio is scaled to $100k, so using that yardstick, the options I hold control 4,500 shares x $9 = $45K => 45% long exposure.

    b) I've held the equity for over two years, it has (more than) doubled from my purchase price and now is as good a time as any to "top slice".

    c) I (almost) never stay for the last mile of the journey on any stock so I doubt I'll own any shares by the time it hits $20.

    2)Growth for GY:

    a) Revenue growth:
    10 yr historical backlog & revenue growth was ~10% (prior to and not including the Rocketdyne acquisition). Growth is accelerating, mgmt says they expect acceleration, etc so there's a reasonable basis for suspecting it indeed might. So I tell myself that the conservative case if for 5% to 10% revenue growth over the next ten years.

    b) I assume that profit growth will be proportional to revenue growth, as it has been in the past. Of that profit, between 11% to 20% needs to be reinvested in working capital and fixed assets to lubricate that growth:

    Investment rate = g/ROIC = 5%/45% or 10%/45% = 11% or 22%

    So distributable cash flow will grow at between [5% x (1-11%)] and [10% x (1-22%] for the next ten years, i.e. between ~4% and ~8%.

    After that, and unless there is a sudden outbreak of world peace for all time, I'd apply a terminal FCF growth rate along the lines of:

    [Profit*(1-investment rate)]/[Discount rate - GDP growth rate]

    The NPV of all that at a 10% discount rate adds up, more or less, to the numbers I posted.

    Alternatively, you could slap a 15x to 20x multiple on after-tax profit and let that be your guide :)

    3) I've planned a post on PG since it is a bit off the beaten path. The nasty brutish & short version is that it looks quite likely that Lafley's cost-cutting will add $1,600m to NOPAT.

    If it does, either PG will trade at multiples below those of March 2009 -- in which case I lose my stake -- or it will trade at or above that multiple, in which case I keep my stake and make some money on top.

    I think $90 to $120 is a reasonable range for PG.

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  5. A follow-up on the tax shield..

    Looking at old posts, it seems like you capitalize normalized profit at the discount rate which = WACC. Therefore, a biz with a 50/50 D&E split would be discounted at a lower rate than 100% equity (all else equal), and have a higher valuation.

    But if you already use a lower discount rate due to debt, isn't capitalizing the tax shield from debt double-counting in valuation? As the tax shield is already embedded in the lower WACC?

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  6. I typically use pretax cost of debt equivalents in estimating av cost of capital

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  7. Can you please explain how you estimate the value of the real estate (i.e. what are the relevant comps etc)? Thanks a lot.

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  8. Well, GY has 6000 acres of usable land in Sacramento and, in 2011, neighboring land was sold to an outfit called AKT for 49k per acre. So that gets you to $300m.

    GY doesn't plan to sell that land as is; it instead plans to develop master planned communities etc and so on. So the true value may be higher than that.

    There's also some Sacramento office space that it rents out for net operating income ~$6m per year. If you think that a cap rate of 8% is fair, that adds 6.8% = $75m.

    So $300m may understate things somewhat and $75m almost certainly does.

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  9. Where did you get the 85% of pension contributions will be funded by the government from?

    In the last annual report it says that 84% of the pension deficit relates to government contracts, but only that a portion these will be reimbursed by the government, without saying what that portion is.

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  10. Compare the net periodic expense on page 97 with the pension expense cash recovery in the cash flow statement. That's the easiest way to get your head around it.

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  11. Hi, Red. Thank you for this very thoughtful blog. Two questions (with apologies if you've covered this elsewhere):

    Which other blogs (if any) do you read and recommend?

    Have you looked at all at SCOO, the reorganized School Specialty? Though the same caveats apply as pre-Ch 11, the common seems to have significantly more cushion now in what isn't (based on a preliminary look) a bad business.

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  12. Hi Aharon,

    I tend to favor the blogs that overlap with my investing style and thinking, so:
    http://montesolcapital.com/blog/
    http://gannonandhoangoninvesting.com/
    http://otcadventures.com/
    http://www.iii.co.uk/news-opinion/blog/share-sleuth
    http://expectingvalue.com/
    http://wexboy.wordpress.com/
    http://valueinvestingfrance.blogspot.com/
    and many others

    I also read
    http://www.valueinvestorsclub.com/
    and even
    http://www.beyondproxy.com/

    The fellows who curate http://www.reddit.com/r/SecurityAnalysis/ do a great job in pointing me to other material that I should read and learn from.

    I haven't looked at SCOO but I'll be sure to do so. Thanks for the heads up and thanks for reading.

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  13. Thanks very much! FYI, SCOO is SEC-reporting, for what that's worth...

    Interesting to see some overlap here with my own bookmarks. You may read them already, but I also recommend (among many others):

    http://reminiscencesofastockblogger.com/

    http://divestor.com/

    I look forward to reading more.

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  14. Hi red, sorry another couple of comments, I've been looking at this in some more detail over the last couple of days.

    Im not sure how you calculated the GY EBITDAP as $147.9m, they report is as roughly $110m from 2010-2012 which is a lot lower.

    Second I'm not sure where the cash figure of $417m comes from, the latest annual report shows $214m in cash of which $104m is advance payments on contracts.

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  15. Well, my doodling has since been superceded by the latest 10-K (which includes 5 1/2 months of Rocketdyne), so I'd pick it up from there

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  16. You mentioned Rain Industries...is it the one which is listed on NSE/BSE? If so can you please elaborate the investment rational?

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  17. Apologies for the delay. Here's someone's write up on Rain:
    http://www.beyondproxy.com/rain-industries-ltd/

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  18. Any change in plan on keeping Rain Industries in portfolio even after not so good Q4 numbers posted by company on 26th Feb?

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  19. Rain is very cheap & has catalysts so I'm keeping it for at least a year or until it approaches R100. And I didn't think the quarter was all that bad.

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  20. Yes it is there but for long their share price is subdued and now aluminium industries is not doing so great because of over capacity in China. It should do well over 2015-2016 when situation improves.

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  21. great job, been going back throgh old posts...enjoying them.

    few questions on GenCorp:

    1) how are u getting cash of 417.3m? 10-k filed in February shows cash of 197.6m?

    2) The 10-k states regarding environmental costs: "approximately 37% of such costs will not be reimbursable and were therefore directly charged to the consolidated statements of operations". So why only add back 14%?

    2a) also, the 10k states that the 37% is because the Northrop limit has been reached, so wouldn't it a 37% number already take into account the NOC receivable? And adding it back would be double-counting?

    3) comment#1 asked about tax shields...wouldn't the correct way to calculate NOPAT using statutory rates (37%), but then add back a tax shield on the full GAAP B/S for debt + pensions (since you get the tax shield on entire balance, even though the gov't picks up the repayment)?

    4) SpaceX?



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  22. I've changed my mind on this stock.

    The more I think about SpaceX the more I worry about future margins (or, indeed, revenues).

    And without certainty about revenues and margins in the rocket business, the stock doesn't offer the risk profile that I feel comfortable with.

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  23. Third Avenue Intl Value Fund 2Q 2014 letter

    Our second new position purchased during the quarter, Arcos Dorados, is the world’s largest McDonald’s franchisee, holding the exclusive rights to own, operate and grant franchises of McDonald’s restaurants in 20 Latin American countries. As we observed in our previous quarterly letter, many emerging market economies and currencies have faced significant headwinds; Latin America has been far from immune, and currencies across the region have depreciated substantially since 2011. While all of Arcos Dorados’ revenues are denominated in a variety of local currencies, the company reports its financial results in U.S. Dollars. Thus, local currency weakness has had a severe negative impact on Arcos Dorados’ reported earnings and shares are down some 60% over the past three years, as the depreciation of most Latin American currencies versus the U.S. dollar has been a virtual one way street. What depreciating currencies obscure, however, is Arcos Dorados’ outstanding operating performance in local currency terms, meaning before they are translated into U.S. dollars, its reporting currency. Since 2011, the company’s reported revenues have grown at a lackluster annual rate of 5%, while reported EBITDA growth has been essentially flat. But in constant currency, Arcos Dorados has grown revenues and EBITDA at very impressive annual rates of 15% and 12%, respectively. Arcos Dorados’ depressed valuation suggests that investors are not giving the company credit for the high returns on capital it continues to generate and the considerable increases in business value it continues to create in constant currency terms. Investors are also overlooking an outstanding management team, led by CEO Woods Staton; this team has over time done an excellent job of restructuring the company’s Mexican business, managing currency exposure and coping with the challenges of doing business in Argentina and Venezuela in clever ways. Furthermore, the longterm fundamentals of the Latin American market remain quite favorable; these economies are home to rising incomes, a rapidly expanding middle class and lots of young people – all things that should be very good for Arcos Dorados’ future operating performance and, in turn, its shareholders.

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