Orbital ATK (NYSE:OA) has just completed its first fiscal year of operations after its 2015 merger. Since then, the new company proved it has achieved even more synergies than targeted, and is planning on even more cost reductions and revenue growth over 2016 and beyond. Knowing that the company is already placing itself among the top industry performers in terms of efficiency, and that there is still room for improvement thanks to the merger, the stock may continue to outperform and bring more capital returns as the price will adjust to the new financial results and expectations. Its improving cash generation will improve and enable a lot of value to shareholders via increasing dividends and the share repurchase program. Furthermore, the company is going to invest in 2016 in three major growth investments in each of OA's segments to solve the slow growth in sales, and is expected to bring huge returns on investments. Then, the current geopolitical situation, where military expenditures of every key nation is increasing, and where terrorist threats are becoming more and more present, will positively affect the Aerospace & Defense industry. Given all those reasons, OA is in a very good position to grow and gain more and more interest from investors.
The Aerospace & Defense revenue is mostly dependent on the American defense budget. It remains constrained by the 2011 Budget Control Act, which reduced the DoD budget by approximately $490 billion over ten years. In 2015, the Bipartisan Budget Act set base budgets in excess of the limits that would have been imposed by the Bipartisan Budget Act. The defense budget is now forced to rise again due to the resurgence of international threats. The 2016 Budget is set at $585 billion, which corresponds to the first increase since 2010 and a 4.5% increase YoY. The budget outlook for defense and space spending for 2016 is generally positive, as described in the company's 2015 Annual Report. The investment levels of the 2016 DoD budget, including research and development and procurement funding, increased by 15%. The missiles and munitions budget went up by 20%, and a 7% increase has been requested for 2017. The small-, medium-, and large-caliber ammunition budget went up by 40% in 2016, and is forecast to grow at 10% for 2017.
According to Deloitte, industry revenue is expected to grow at 3% in 2016 as military budgets in the US, UK, France, Japan, several Middle Eastern countries, and other key nations are increasing in response to growing threats around the world, like the recent terrorist attacks in Paris and Brussels. The defense budget of Saudi Arabia, which is an important OA customer, increased by 12% YoY. Another very important customer is NASA, whose budget increased by 7% between 2015 and 2016. Other large customers include Boeing (NYSE:BA), Northrop Grumman (NYSE:NOC), Lockheed Martin (NYSE:LMT), Airbus (OTCPK:EADSF), Raytheon (NYSE:RTN), Rolls Royce (OTCPK:RYCEF) and Thales (OTCPK:THLEF).
One major event that may impact the industry is the US political election. If the next president is the Republican nominee, the chances of seeing a huge rise in the defense budget are very high. On the other hand, if the Democrat nominee wins the election, the chances of seeing the defense budget diminish are very low. Even if the next president is willing to stop the rise in military expenditures, the current situation has made it impossible. As the terrorist threat is growing and the defense budgets of non-allies states are expanding, the US is forced to at least expand its budget by at least 1-2% over the upcoming years.
OA is divided into three main groups that are divided into several divisions.
The Flight Systems Group is developing rockets that are used as small- and medium-class vehicles to place satellites into orbit and escape trajectories, interceptor and target vehicles for missile defense systems and suborbital launch vehicles that are place payloads into a variety of high-altitude trajectories. It is also engaged in the development and production of medium- and large-class rocket propulsion systems for human and cargo launch vehicles, strategic missiles, missile defense interceptors and target vehicles. The Group develops other products like illuminating flares and aircraft countermeasures. The Group sales accounted for 33% of 2015 total sales. It operates three divisions: Launch Vehicles, Propulsion Systems and Aerospace Structures.
The Defense Systems Group develops and produces small-, medium-, and large-caliber ammunition, precision weapons and munitions, high-performance gun systems and propellant and energetic materials. It also provides propulsion control systems that support Missile Defense Agency and NASA programs, airborne missile warning systems, advanced fuses and defense electronics. The Group is a leader in tactical solid rocket motor development and production of air-, sea- and land-based missile systems. It is responsible of the production of the US Navy's Advanced Anti-Radiation Guided Missile, or AARGM, and has developed advanced air-breathing propulsion systems and special-mission aircrafts. The Group sales accounted for 40%. It operates four divisions: Armament Systems, Defense Electronics, Missile Production and Small Caliber Systems.
The Space Systems Group is engaged in the development and production of small- and medium-class satellites that are used to enable global and regional communications and broadcasting, conduct space-related scientific research and perform other activities related to national security. It also develops and produces human-rated space systems for Earth-orbit and deep-space exploration, including delivering cargo to the ISS. The Group is also a provider of spacecraft components and subsystems and specialized engineering and operations services to US agencies. The Group sales accounted for 27% of 2015 total sales. It operates four divisions: Government Satellites, Commercial Satellites, Space Components and Technical Services.
Over 2015, OA achieved record sales, profits and free cash flow, and it returned $133 million (or 46% of free cash flow) to shareholders via stock repurchase and dividends. The company is planning on repurchasing between $125 and $175 million of stocks, increasing dividends by more than 52% to $70 million for FY2016. Repurchase and dividends are expected to account for 60-70% of free cash flow over the next years. OA is also planning on paying back $40 million of debt (or 5% of long-term debt). Capital expenditures are expected to double to reach $215 million in 2015 to prepare for future expansion and growth.
In 2015, OA's operating margin was 11.1%. The company expect to see improvement in efficiency due the merger's synergies completion. Sales, operating margin and free cash flow are expected to grow over FY2016. Even if the expectation in sales growth has been reduced to 3-4%, it is still better than the 3% expected growth of the industry, and the new 2016 growth investments' main goal is to boost long-term sales growth. The EBITDA margin is expected to grow at 8-10% - so much more than the forecast sales growth.
Over the last year, OA had beaten its own forecast in terms of cost and revenue synergies, total sales, operating margin and free cash flow. Over the past seven earnings calls, the company reported beating all the EPS estimates, 6 of 7 operating profit estimates and 5 of 7 revenue estimates.
When compared to the overall industries, OA is achieving better results than the industry average and median. Its 14.8% EBITDA margin is better than the 13.5% industry median, achieving more cost reductions. Its profit margin is above the industry average and in line with the median, and its free cash flow margin is more than 1% higher than the industry average and in line with the median. Regarding the valuation ratios, we can see that the EV/EBITDA ratio is in line with the median, but lower than the average, and the EV/Sales ratio is lower than the median and well lower than the average. Only based on such ratios, OA seems to be currently underpriced. That may be explained by the fact that the company just completed its first full year of operations since the merger with better-than-forecast financial results and future improvements that are not totally priced in yet.
2015 Merger Results
On April 30, 2014, Alliant Techsystems announced a merger of equals with Orbital Sciences. Alliant Systems was a leader in manufacturing ammunition, rockets and rocket ships, and Orbital Sciences was a small- and medium-class space and rocket systems manufacturer. Alliant had first spun off its sporting goods business as a separate publicly traded company: Vista Outdoor (NYSE:VSTO). Then, it merged with Orbital into a global aerospace & defense company, Orbital ATK. Alliant and Orbital shareholders received 53.8% and 46.2% respectively of OA shares. On April 28, 2014, both companies' shareholders strongly approved the tax-free merger. 99% of Orbital's votes approved the merger, which represented 85% of the total number of shares outstanding. As a result, the Alliant and Orbital stocks went up by 7% and 16.5% respectively. The merger was completed on February 9, 2015. According to the latest Annual Report, 95% of the 1,350 pre- and post-merger integration milestones were already completed by the end of 2015. The primary objectives of the merger was to expand career opportunities, increase job stability and to boost long-term investment. The merger is creating lots of growth opportunities and cost synergies. The achieved synergies in 2015 exceeded the company's targets. OA achieved over $80 million in cost reductions, and is on track to reduce costs by an additional $100 million over 2016. It also achieved $70 million in revenue synergies in 2015, and is targeting from $150 to $200 million for 2016. In other words, the merger is on the right path to achieve even more synergies over the next few years, by reducing costs and maximizing both its bottom line and top line growth. Over the last fiscal year, OA hired 1,300 employees, including engineers and scientists, to prepare future growth. The fact that the company hired the equivalent of 11% of its total employees is sending the sign of strong activity ready to grow at a faster pace.
New Major Growth Investments
In 2016, OA will start three major new growth investments in each of its segments. The primary objective of these investments is to improve top line growth in the long run. These initiatives capitalize on the technological advantage and market knowledge of the company, and are responsive to well-understood needs on which OA has worked closely with its customers. The investments are expected to generate between $400 million and $500 million in incremental annual revenue by the end of 2019. Dave Thompson, the CEO of the company, highlighted during the latest earnings call, that OA projects internal rates of return range from the upper teens to almost 30%, which is well above its 9% cost of capital (as computed in my pro forma - see at the end of the article), and that the investments will not impact the "vigorous" program of capital returns to shareholders.
The first investment concerns the Defense Systems Group: it consists of a three-year program to develop an advanced ammunition and related small munitions with unmatched precision features. It extends on the technological advancements in guided ammunition, precision artillery and mortar rounds, and electronic fusing. OA will soon release initial versions of new weapons capabilities that are compatible with various calibers on ground, sea and air platforms. Initial deliveries are expected to begin in the first half of 2018.
The second investment concerns the Flight Systems Group: it is a four-year program, jointly funded with the US Air Force, to develop a modular vehicle system or EELV (Evolved Expendable Launch Vehicle) capable of launching national security payloads, scientific and commercial satellites. The company expect the first launches by the end of 2019. The program may start to generate revenues as soon as the end of 2017.
The third investment concerns the Space Systems Group: the program is intended to develop the first in-space commercial satellite servicing system. The company expect to start the first operations at the beginning of 2019.
Orbital ATK is just starting to use and see the impact of its merger on its financials, and also its competitive advantages, including its expertise, technological advancement and innovative solutions. OA is expected to improve its long-term growth with three major investments that are going to bring actual revenue as soon as the end of 2017 or the beginning of 2018, but as the programs are starting this year, the company will be able to release updates during the next earnings calls, and investors will be able to act accordingly. The company will continue to improve its free cash flow along with its share repurchase program and dividends to return 60-70% of its free cash flow to shareholders. The long-term debt is expected to go down. Furthermore, the current and expected geopolitical situation is making defense companies part of the least risky assets by securing their future growth. OA is among the best performers of the industry, with huge potential for growth over the long run. The pro forma computed an intrinsic value of $87.76 and a one-year target of $104 (or a 21% rise), so I recommend a buy below $89.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.