Description

Business Overview

BWX Technologies (BWX) is organized into three segments:

o  The Nuclear Operations Group (NOG) represented 75% and 81% of 2019 sales and operating income, respectively

o  The Nuclear Services Group (NSG) represented 7% and 4% of the same

o  The Nuclear Power Group (NPG) represents 18% and 15%

The core Nuclear Operations Group is the monopoly provider of nuclear power plants for the US Navy’s nuclear submarine and carrier fleet. The Nuclear Services Group performs nuclear materials processing and site remediation services to the US Government and manages some government nuclear production facilities. The Nuclear Power Group provides services for the fleet of Canadian nuclear power plants (CANDU reactors) as well as commercial services for other (mostly nuclear) power production facilities. Recently this segment has expanded into the production of medical isotopes (generally derived from processed nuclear materials)

BWX Technologies is a very high-quality business with a monopoly franchise surrounded by a set of specialized service businesses derived from the core NOG business (albeit more competitive in nature)

o  Since the spinout of the Babcock & Wilcox E&C business in 2015 ROIC has averaged   ̴30%

o  Core NOG activities were barely impacted in the 2009 great recession

o  Within the NOG business lead times are very long with a typical plant build lasting 6-8 years. There is also a non-trivial aftermarket component

o  Other than a heavy recent capex cycle FCF has generally matched adjusted net income

Thesis

BWX is the clearest beneficiary of what will be a multi-decade buildup of the US naval fleet. This buildout is specifically focused on bolstering the nuclear submarine and carrier groups, where BWX is the monopoly provider of nuclear-powered engines. The company is starting to complete significant capex ramp to prepare for this growth in activity, which will drive improved FCF along with earnings. Additionally, the company is uniquely positioned to be one of the core domestic providers of Molybdenum-99 for diagnostic scanning. Currently, effectively all of the US’s needs are served by imports, but recent supply disruptions to reactors in South Africa and Australia have panicked the market. BWX has a solution we see serving most of the US market within three years. We see a low double digit to mid-teens EPS CAGR through 2025 with a near 30% FCF CAGR. At 18x-22x FY25 EPS the stock could be up 2-3x by the end of 2024.

Why does the opportunity exist?

BWX is still off the radar. Before July 2015 BWX also operated the Babcock & Wilcox engineering and construction business. While that was seemingly a long time ago, investors still seem to have not fully looked at BWX on a standalone basis. They have also had two missteps in the past two years. The first was welding issues in the production of missile tubes for the Columbia class nuclear (a capability the US has not had since the early 1980s). The second is delays in the commercialization in Moly-99, which we see as perfectly natural. These coupled with general defense budget concerns and a more specific concern that the President’s budget called for one less Virginia class submarine (which is a non-starter for Congress, in our view) provides a very nice entry point into the stock.

Thesis Points

The US is committed to a robust buildout of the nuclear submarine and carrier fleets

The US Navy submarine fleet peaked in the mid-80s at 140 units: 101 attack submarines (SSNs) and 39 ballistic missile submarines (SSBNs). By 2000 the attack fleet was down to 56 units and the ballistic missile fleet 18. The 1997 Quadrennial Defense Review (QDR) concluded that a near-term attack submarine force below 55 boats and a 2025 level below 62 would “leave the [Navy] with insufficient capacity to respond to urgent crucial demands”. It also concluded that a force of 68 SSNs in 2015 and 76 in 2025 would meet “all of national intelligence community’s highest operational and collection requirements.” Since that time after years of heavy funding for various Middle East skirmishes, Navy estimates for a sufficient fleet of SSNs have generally been in the 45-50 boat range with stress tested levels as low as 37. The number of SSNs has dipped to 51 (with 49 active) and the SSBN fleet has held steady at 14 boats.

In 2016, the Navy revisited its force level requirement and is targeting 66 SSNs and 12 SSBNs by the late 2030s, in-line with past needs estimates. Procurement has shifted to 2 nuclear-powered Virginia class submarines per year, which are replacing Los Angeles class submarines. (The current SSN fleet consists of 31 Los Angeles class subs, 17 Virginia class, and 3 Seawolf class). The 12 SSBNs will all be the new Columbia class submarine replacing the 14 Ohio class now in service. BWX supplies the power plant for all of these ships, and we see nothing that could change this monopoly position well beyond anyone’s investment horizon. The current budget reflects two Virginia class submarines per year with the first Columbia class being built in 2021, followed by another in 2024, then one per year starting in 2026.

The Navy has also begun procurement of the new nuclear-powered Ford class carrier. Similar to the history of the submarine fleet, the carrier fleet peaked at 15 boats in 1991 and now sits at 10. The Navy believes it needs 12 carrier groups. The Navy is now procuring two new Ford class carriers through the end of the decade and then one every four years after. This plan appears to have board bi-partisan appeal having begun under Obama and continuing today under Trump.

BWX has a record backlog to forward sales with NOG backlog of $4.52b versus estimated 2020 NOG sales of $1.56b. We see a HSD CAGR for BWX’s Nuclear Operations Group sales between 2019 and 2025 in a Base Case. We model some decline in operating margins from 20.9% in 2019 to 19.5% in 2025 to account for a decline in pension income post 2023, which is likely conservative. There is some potential upside to these numbers. Last year in the initial proposed 2020 budget the Navy requested procurement of a third Virginia class submarine in the years where a Columbia class submarine is not being built, which would add four units total in 2020, 2022, 2023, and 2025. Relatedly the Navy proposed accelerating Ford procurement adding a unit to be built already starting in 2021. There is some affirmative history for funding to be accelerated like this (specifically four carriers have been procured this way in the past). At this point we do not count on this upside even in a Bull Case. Rather in our Bull Case we model slightly higher margins of 21% and a small bump to revenue from new programs like micro-reactors for standby power and space.

The medical isotopes business has considerable potential and is misunderstood by the defense analysts covering the stock

The United States currently imports almost 100% of its molybdenum-99 (Mo-99) needs, which is produced from a byproduct of nuclear reactor waste. Moly-99 is used in various medical diagnostic scanning equipment. Via a DOE grant BWX has entered the moly-99 business on a trial basis. In July 2018 BWX acquired Sotera Health’s Nordion Medical Isotope Business. We estimate this acquired business along with the recent start of sales of two new isotopes is responsible for roughly $60m of revenue within the Nuclear Power Group (16% of estimated 2020 NPG sales).

BWX is very well positioned to capture the $500m Mo-99 market ($225m of which is in North America). It sources nuclear material through the Candu reactors in Canada on which it is already doing maintenance. It has developed a proprietary process to irradiate nuclear material to generate Mo-99, which then is injected into a proprietary generator to create technetium-99 (Tc-99), which is the product that is delivered by radiopharmacies to the medical end user. BWX unveiled its technology in 2017 and has pushed the timeline for commercialization twice, most recently when reporting Q4 2019 earnings. Our work suggests BWX’s technology works and that they are deep into partnership negotiations with radiopharmacies. The company will require FDS approval for its Tc-99 generator, but we believe they will not have any issues receiving this by the end of 2021. What appears to be the bigger holdup at the moment is ramping production of the Tc-99 generators. This requires a number of foreign sourced components. We don’t see this recent shift as being material to the long-term story, but on the back of the missile tube misstep and a earlier delay in the Mo-99 commercialization timeline investors are fatigued.  

Our work suggests BWX is far ahead of the competition while having a superior solution. Companies like Shine are underfinanced. NorthStar has had more success raising money but their solution requires investment by radiopharmacies, whereas BWX’s drops right into their processes. Nine analysts cover BWX, with Barclays, Credit Suisse, and BAML the only large brokers. The coverage is almost all defense related analysts who have done little work on the medical isotopes business. In our Base Case NPG assumptions, we assume a modest rebound in thermal power work (which is down in 2019 due to the roll-off of some projects) and roughly $100m in revenue from medical isotopes by 2025. In our Bull Case we assume $180m in revenue by 2025. These revenues could come in at > 50% incrementals.

BWX is becoming a cash deployment story given declining capex intensity and a predictable growth trajectory

Between 2013 and 2016 BWX spent a roughly equal amount on capex as D&A (adjusted for the spin of B&W). In 2017 capex ramped to $97m versus $57m in D&A. In 2018 capex went to $109m versus $60m in D&A and in 2019 capex was $182m versus $62m in D&A. The company has guided to $270m in 2020 capex, lower in 2021 with maintenance levels towards the end of year, then 3-3.5% sales thereafter. On our numbers maintenance capex is < $90m, which still includes investment beyond D&A. BWX has completed three acquisitions since 2014 but otherwise has spent capital on buybacks while growing the dividend incrementally (the current yield is 1.7%). We assume BWX uses excess cash for buybacks and some dividend growth with a leverage staying just below 2.0x through 2025 in the Base Case and below 2.5x in the Bull Case. The company has said they see little reason to be levered < 1.99x.

Valuation / Expected Return:

·  In a Base Case, we see BWX earning $5.27 in 2025. At 18x, which is below the average of 22x since the BW spin, there is 122% upside. Including a roughly 2% dividend this produces a close to 20% IRR

·  In our Bull case, BWX’s earns $6.26 in 2025 earnings producing 222% upside at 22x. With dividend the IRR is close to 30%.

·  Should BWX have another performance hiccup or push growth out a year the stock could de-rate to 13x a forward $2.81 number for 15% downside

Catalyst

-Continued growth in the Naval submarine budget

-FDA approval of BWX's Moly-99/Tech-99 process and progress on commercialization including radiopharma partnership announcements

-Completion of missile tube production without further production issues