Sometimes it is the potential energy, not kinetic, that makes the difference.
In the end, the Alliant Techsystems (ATK) gun sport and outdoor division was seen as having too much growth potential not to stand alone, so a corporate split-off was necessary. At the same time, ATK’s aerospace and defense businesses had far more to gain when combined with Orbital Sciences. The result, if approved by shareholders of both companies come autumn, could be a burgeoning sporting company and a robust mid-tier space and missile provider, according to chief executives of both companies.
“I am convinced this merger is the kind of event that is often sought, but rarely found; one with compelling benefits for all of our stakeholders,” said David Thompson, Orbital's chief, who will lead the new “Orbital ATK” once it forms.
So far, Wall Street seems to agree. Orbital’s stock jumped more than 16% in regular closing in New York while ATK’s rose almost 7%. “It’s very clear this deal was very well considered and the explanation is pretty clear,” said analyst Howard Rubel of Jefferies during a joint teleconference by the CEOs.
Thompson – who currently is Orbital’s chairman but will relinquish that role in the combined company to retired USAF Gen. Ron Fogleman – was joined April 29 by ATK CEO Mark DeYoung to announce the “merger of equals,” as well as the spin-off of ATK Sporting, which DeYoung will lead (see related story). The former would have had 2013 revenue of $4.5 billion while the latter notched $2.2 billion.
Still, while the announcements surprised and impressed analysts and shareholders, the split and reasons behind it were foreseeable, starting with Sporting’s prospects. In earlier ATK teleconferences, DeYoung and executives had noted how millions of firearms have been sold in the U.S. over the last five years – since President Barack Obama took office and fears grew among gun advocates over gun control. The customer base, in other words, had built a record installed base of shooters.
In late January and early February – including one note to investors subtitled “a break-up story” – RBC Capital Markets analyst Steven Cahall said his team increasingly saw ATK's earnings and valuation prospects as dependent on Sporting, and how after buying Savage and Bushnell last year, Sporting had driven ATK to become a 50-50 company of guns and ammunition (G&A) versus A&D.
Indeed, earnings before interest, taxes, depreciation and amortization (Ebitda) of the two sides compared well with industry peers. “ATK [stock] trades on 7.8 times calendar 2015 Ebitda – the same as defense and space peers like Northrop Grumman (7.5x), Raytheon (7.4x) and Orbital Sciences (7.9x),” Cahall said Feb. 11. “However, within the $2.5-$3 billion A&D portfolio there is also a high-end composite structures business with around $250 million in turnover that could be worth $8/share on 9x Ebitda (Hexcel is on 10x).
“In the G&A space, where there is arguably the most value to unlock, consumer peers trade on anywhere from 6x (Olin) to 15x (Black Diamond) and we note that ATK paid [roughly] 10x for Bushnell,” Cahall continued. “We think the combined commercial G&A business alone is worth $122/share as commercial ammunition – the jewel in ATK's crown – should be valued more like a consumer business.”
Meantime, an Orbital ATK combination can help that company squeeze its costs and lower business risks through “vertical integration,” in turn better meeting growing affordability concerns at NASA and the Pentagon. And the combination boosts total engineering and production capabilities to go after larger, future opportunities like a new nuclear-tipped USAF intercontinental ballistic missile or in-orbit satellite servicing that the companies could not do alone, Thompson explained. Finally, revenue and earnings per share (EPS) should gain by catalyzing other A&D trends like the use of advanced composites in commercial and eventually military aircraft.
“This is an area that we expect to grow for many years to come,” Thompson said. “We’re at the beginning of several major commercial aerospace programs with Airbus, Boeing and the engine companies.”
As Orbital ATK, the new company predicts a compound annual growth rate (CAGR) in revenue of 4-5% from 2015-17, and an EPS CAGR of 12-15%, according to Thompson. A free cash flow accumulation of $1 billion in that time would allow the company to cut net debt below one year’s Ebitda while still providing cash for stock buybacks, dividends and major corporate investments.
Along those lines, the deal could make for a model in the sequester-capped aerospace and defense (A&D) sector, which last year saw a relative paltry number of merger and acquisition deals and this year is seeing only a few more, many of which remain largely focused on discarding defense divisions. “The positive market reaction could support further moves being contemplated within the sector,” said Byron Callan of Capital Alpha Partners.
“Defense investors mainly seemed content to push [for] capital deployment in the form of buybacks and dividends, but the reaction to this deal suggests other combinations within the sector might prove more value-enhancing,” Callan said. Given the familiarity of firms within the sector, we have to believe that other possible combinations have been long contemplated.”