Why I Valued This Company
Gencorp (GY) has historically posted very volatile earnings and their EPS has been declining since 2009 when it reached a high of $0.96. Gencorp's EPS has since ranged from $0.05 to $0.10 and ended 2012 at -$0.10 a share. The stock has taken a hit from 2009 to 2012 as the company shows signs of being in financial distress. We value investors love to buy in times of financial distress when the market has overreacted.
Value Investor Activity
Other value investors and hedge funds are buying this company which has increased the stock price by 50.8% in the past 90 days. Mario Gabelli also known as 'Baby Warren Buffett" has recently purchased a 15% stake in GY which may indicate that the stock is undervalued and is a potential buy.
Low Analyst Coverage
- The company has very few analysts following them. From 2000 to 2004 Gencorp had coverage from JP Morgan (JPM), Deutsch Bank (DB) and Credit Suisse (CS), but those firms have not rated Gencorp since 2004. This tells me that GY is quite an obscure stock that is likely to be undervalued.
The Cherry on Top
Gencorp needed a place to test their military products in the 1950's, so they bought a bunch of land near Sacramento. Since then new technology has allowed them to test their military products on a simulator and they no longer need these 6,000 acres of excess land (from annual report). This land is worth roughly $1.05BB but is currently listen on their balance sheet at the 1950 historical cost of only 33MM. The market has not priced in this land into the stock.
Gencorp's primary line of business is in the aerospace and defense industry. For defense suppliers and contractors in the United States the total volume of sales is directly tied to Congressional Budget allocations, since the US government is the end consumer in an overwhelming majority of cases.
Most deals are structured with a prime contractor, such as Lockheed Martin (LMT), Raytheon (RTN), or Northrop Grumman (NOC), bidding on a government program and then subcontracting suppliers to produce various components. When selecting subcontractors, prime contractors usually base their decision on the grounds of technology, quality, service, and price. Customer relationships are vital in the sense that once a prime contractor associates a subcontractor with a high level of quality, they are unlikely to switch for future bid proposals.
Research and development is essential in this industry. The majority of the R&D in this industry is customer funded through government research contracts. Under these arrangements, a contractor will perform research and development activities for a cost plus fixed fee structure. These research and development contracts can often span many years and create barriers to entry for new entrants.
Competition within this industry is relatively concentrated. Historically, Gencorp's main competitors were Alliant Techsystems (ATK) and United Technologies (UTX). With the recent acquisition of Rocketdyne, United Technologies is no longer a major competitor, further consolidating the propulsion industry. Alliant Techsystems has a strong focus in solid propulsion, while Gencorp is more diversified across the four propulsion types.
-94% of Gencorp's 2012 sales came from the Department of Defense, NASA, and other government agencies. Although government defense spending is decreasing in the United States due to budget deficits, it will not affect Gencorp as much as its competitors since the majority of its programs are aligned with the DoD's budget priorities.
Gencorp's margins are extremely low compared to other competitors. Its gross margin has been in the 12% to 13% range for the past three years, but other companies in the aerospace/defense industry have gross margins that are 1.1x to 2.1x higher than Gencorp's. In addition, its operating margins have steadily decreased from 4.4% to 3.5% since 2010. These margins also match up poorly against competitors, as other companies have operating margins that are 1.1x to 3.8x higher than Gencorp's. However, Gencorp's asset turnover of 1.08x is one of the highest in the industry.
|Gencorp||Alliant Techsystems||EADS||United Technologies|
With research and development costs at approximately 30% of revenue (adjusted), it shows that Gencorp puts a lot of emphasis on innovation in order to meet the diverse and demanding needs of its customers. This also allows the company to obtain more patents for its technology giving them a cost advantage, which helps create higher barriers to entry. Gencorp's proven track record coupled with its diversified product portfolio of specialized technology as a result of its high R&D spending, has led to very high contract renewal rates.
Gencorp has certain items that may have adverse impacts on its financial health such as a massively underfunded pension program and several active lawsuits.
Strategic Valuation Analysis
The involvement of Mario Gabrelli holding a 15% stake and other large hedge funds recently buying the company's stock increases the probability that management will place emphasis on improving its operations.
Gencorp management capitalized on the disadvantaged position of United Technologies when they acquired Rocketdyne for $550 million, which was expected to be sold for upwards of $1 billion, since United needed to liquidate assets to fund their $16.5 billion purchase of Goodrich (GR). Consolidating these two companies will likely reduce excess capacity and is a very good sign for GY. Revenues are expected to double with this cheap acquisition.
Valuation: Buy or No Buy?
My models gave me an Intrinsic Value of $7.14/share for the business and $11.59/share for the land. This gives me a total intrinsic value of $19.13.
I then apply a 2/3rds margin of safety to the business portion (2/3 * $7.54) and get a final entry price of $16.62.
The stock closed at $13.38 today which is much lower than my entry price of $16.62. This company is a Buy.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.