Description

Babcock International, founded in 1891, is one of the oldest and largest defense contractors in the UK. It provides engineering services in four areas: marine – it services the nuclear reactors of UK submarines and aircraft carriers; land – it provides services from the training of military staff to vehicle management to the designing of baggage systems in airports; air – BAB flies firefighting and emergency helicopters for governments around the world and trains pilots. And finally, in its Nuclear segment, the company decommissions nuclear power plants (though they also have the ability to build new ones).

BAB is not a spring chicken and is growing revenue only a few percent a year. But its business is incredibly sticky and predictable. Nuclear submarines will need servicing and fires will need to be put out in any economy. BAB has a very unique and incredibly difficult-to-replicate skill set. Also, a lot of services BAB provides require security clearance for its employees, which limits the ability of governments to shop for alternative contractors (defense is two-thirds of BAB’s revenues).

BAB is attractive because of its incredible in-your-face cheapness. Its market capitalization is £2.5 billion, and it generates £320 million of free cash flows a year. It trades at only 8 times free cash flows (similar businesses in the US are trading at 13 to 17 times free cash flows). Adding to its cheapness, in its recent Capital Markets Day, the company indicated it will generate £1.4 billion in free cash flows over the next 5 years.  It has a very solid balance sheet – £1.1 billion of net debt. It can pay off its debt in four years. It pays a 5.6% dividend that the company raised in 2018 and that it can easily cover with its abundant free cash flows.

Babcock is cheap because a large, long-term contract to build the UK’s flagship aircraft carrier (the contract is referred to as QEC) is coming to an end and the market is concerned about a step-down in the company’s revenue profile going forward. Additionally, the UK government decided to in-source a key nuclear decommissioning contract (called Magnox). As the government made clear, this decision had nothing to do with BAB’s performance, which was satisfactory.

These are short term contractual headwinds, not the permanent business impairments the market fears. It is important to note that Babcock plays an essentially indispensable role for the UK Department of Defense, giving them a cash flow stream protected by a moat (moat sources: switching costs and barriers to entry) which can be leveraged in other areas. This is precisely what Babcock International is doing.

Babcock is a credible bidder on global defense, aviation, and nuclear (both decommissioning and new build) contracts around the world. For example, they are helping train the French air force in a project called FOMEDEC; they have aerial emergency medical service (EMS) contracts in Spain and Canada; and are already present in Japanese nuclear decommissioning sites, including Fukushima. All these businesses are considerably sticky – a client government will not switch suppliers midway through a defense, aerial first response, or nuclear decommissioning project unless there are huge problems. Babcock’s entire business is built around avoiding those problems and delivering value to governments. Across their business lines, Babcock enjoys a 90% rebid win rate on existing contracts.

The most compelling growth area for Babcock is their aviation business. Their model is to buy assets such as sophisticated search and rescue helicopters, execute a sale and leaseback transaction with a third party, and then upgrade the leased assets with equipment and supplies to make them a highly competitive asset rather than just a commodity. For most clients, when they go to rebid on a contract, they are often already servicing the client and their assets are deployed in the air during the bidding process, creating a compelling logic to sticking with the existing supplier (Babcock in this case). The global market for aerial EMS is a growing, and overall indexed to GDP growth as governments look to provide citizens with secure access to hospitals and first response care no matter their location. This segment also includes Babcock’s firefighting assets.

Babcock is committed to a progressive dividend and return of capital to shareholders as well as debt holders. Babcock has been paying down debt and will continue to do so; having a low debt burden is an asset (no pun intended) in the markets in which BAB competes because government clients want to know they will be around no matter what. In a sense this creates a virtuous flywheel of successful bids, successful execution, debt reduction, and successful rebids.

Excess free cash flow is returned to shareholders via dividends. One drawback of Babcock is their aversion to buybacks, though in our opinion this is not sufficiently problematic to warrant a sale of the stock. Another drawback is low insider ownership, but we believe management has done well executing in technical, high stakes and often capital intensive businesses.

Babcock is currently trading at 443 pence on the London Stock Exchange, and we believe it could earn 66 pence per share at the end of 2023, while you collect 130 pence per share of dividends in the interim. Applying a 12x multiple to our 2023 earnings estimate yields a price per share of 792 and a total value (including dividends) of 922 pence per share – more than a double in 4 years.

Catalyst

Low valuation is its own catalyst.