|Shares Out. (in M):||506||P/E||0||0|
|Market Cap (in $M):||2,800||P/FCF||0||0|
|Net Debt (in $M):||1,376||EBIT||0||0|
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.
Low valuation is its own catalyst.
|Entry||07/08/2019 11:32 PM|
thanks for the interesting idea. can you please be more specific wrt the impact on earnings from the 2 headwinds you mention? If you adjust for that, what do you expect earnings to be going forward? thanks
|Subject||some (bearish) thoughts|
|Entry||07/09/2019 03:16 PM|
i was short this for most of the past 3yrs (not the last 6mos though unfortunately). it is undeniably cheap on headline numbers, but i think your assessment of what is weighing on the stock - the end of the QEC and magnox contracts - is incorrect, and as a result what is required for the stock to work is quite different than what you think it is. both of those concerns you mentioned have been in the market and widely discussed for at least the last 6-12mos, and are not responsible for the ongoing weakness. instead I think it is a combination of the following:
- structural sustainability of margins: i guess this is more of an ongoing drag issue but the point is a huge amount of BAB's earnings come from defence contracts associated with the SSRO (single-source contracts) where the returns are mandated to be at certain levels by the government, annually (because you only have a couple of bidders capable of doing the work, and generally only one provider). the defence department has cut the allowed margin on SSRO work pretty heftily each year for the past 3yrs, meaning the front-book earnings are undoubtedly going to be much lower on a big bit of business than has been the case historically. While of course this only applies when old contracts roll off (which happens in a staggered fashion over a number of yrs), this is why consensus numbers continually march lower (and seem likely to do so) as the underlying earnings power of these kinds of contracts is simply being cut by government mandate over time;
- accounting issues: there has been, and continues to be, a large delta between adjusted numbers and underlying FCF (exacerbated by the large pension overhang and JV earning structure where cash inflow/outflow are not clear). the unwillingness of management to do much to clear the obfuscation, as well as the lack of management change will other comparable businesses are blowing up (Carillon, Capita, etc) has clearly weighed on the valuation;
- Corbyn risk: perhaps this has receded of late but was very much an issue weighing on the name for much of the last yr. All these big government-servicing businesses (whether utilities or contractors) will be ground zero for earnings obliteration if Corbyn gets into power in the coming years, such that underwriting any investment on the basis of pre-Corbyn earnings power is fraught with danger;
- Brexit: clearly a massive factor, look at a ton of other UK-centric businesses where the valuations have been obliterated much more than fundamentals in the last yr.
None of this necessarily makes you wrong on buying the stock now, of course, but it means you're taking a different set of risks than those you outlined in the write-up.I would agree the stock has never been cheaper and the div looks covered - but this is must be predicated on a bullish view on Brexit/Corbyn etc as well as potential housecleaning under new management (long overdue) as otherwise I don't think its quite as hairless as you portray.
|Subject||Re: some (bearish) thoughts|
|Entry||07/10/2019 05:02 PM|
aa123 - based on our model, we think earnings will be the same/slightly higher by 2022/2023 as they were in 19. We are modeling 3 - 4% top line growth and around 11% operating margins from here forward. There's a revenue stepdown from the loss of contracts but overall their businesses are growing, especially aerial EMS. Nuclear could be an additional source of growth though we haven't modeled anything heroic there.
puppyeh - could you help us understand how the margin compression shows up in the numbers? When we look back we don't see a lot of operating margin compression. From 2010 - 2016, op margin in their defense and security segment went from 10.5% to 17.4%, and in support services from 5.2% to 11.4%. There is considerable lumpiness there, but overall the trend seems to be upward.
We think you're right on the reasons for cheapness. Big picture, we don't believe the UK government will put them out of business or cripple their business too much. Brexit could present a buying opportunity and as for Corbyn, we don't really consider politics that much when allocating capital. The accounting with JVs are certainly challenging/non transparent but with some work it can be parsed (not that it was easy for us!).
Let us know what we might be missing on the margin piece. Thank you both for your thoughtful questions/comments.
|Subject||Re: Re: some (bearish) thoughts|
|Entry||07/11/2019 09:55 AM|
hey there - the margin compression hasn't shown up yet completely but inevitably will; this is what has caused the re-rating lower over time against reported numbers (amongst other things), as back-book reported margins/earnings are completely unsustainable given the new earnings paradigm the government is imposing. here is the allowed operating margin progression (per the SSRO website) for new contracts (perhaps 40%+ of BAB's business in Land and Marine, maybe more):
Since the Land and Marine unit back-books are currently earning 13% (Marine), and 9% (Land), as the old contracts roll off new contracts will inevitably get struck at lower fundamental earnings levels, much closer to MSD than low double digits.
Again - that doesn't make the stock expensive (even on pro-forma lower earnings numbers) but given this has been a multi-yr trend (that only just reversed this yr and could be cut again next yr with a different government, etc), it's not like earnings are likely to inflect anything other than downwards on most of the contract book for the next few yrs. Quite the headwind to fight (in addition to all the other stuff)
|Subject||Re: Re: Re: some (bearish) thoughts|
|Entry||07/18/2019 03:15 PM|
Puppyeh - we had a chat with IR about this and our notes are below.
The IR counterpart at BAB emphasized that so far these SSRO haven't impacted their margin. The short/bear thesis is that this step down will inevitably flow through to new contracts, resulting in a permanent margin step-down. In addition to pointing out the recent step up in 19/20, the IR person highlighted that there are a number of allowed step-ups from the SSRO mandated margin which pertain to Babcock. The SSRO margin is a function of an index of UK, US, and EU defense/industrial indices, so in theory these should fluctuate as well. The adjustments to margin include cost/risk adjustments (2%) and capital servicing at 1.3% (there is one more that I didn't track). All these add up to a maximum operating profit margin of 12% (BAB's long term margin target, which we have modeled, is 11%). On top of this, there is a cost-saving adjustment. If Babcock comes in below cost on a given project, the savings are split between them and the client. All of these put their 11% long term operating profit well within reach. Only 15% of their revenue, about £700 million, is subject to these kinds of UK-based margin controls. Of this, only about £100 million goes through the SSRO, as it is a relatively new negotiation-focused agency at about 5 years old, and the balance is still through MoD though this will shift to SSRO over time at least in part . BAB is attempting to spread the cost-saving-sharing contract structure to other countries. We believe they will likely be successful in this.
From their November 18 half year deck, slide 43.