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