Description

Babcock International Group (BAB LN) is a stock that has been long out of favor for a variety of reasons.  It all started with the acquisition of Avincis in 2014, an aviation business that primarily consisted of helicopters which supported the North Sea drilling operations of oil majors and emergency medical services and firefighting in continental Europe.  Babcock did a significant rights offering to fund this acquisition which closed right before oil prices started to collapse resulting in significant profit misses and forecast reductions on the helicopter fleet servicing the North Sea.  In addition, starting around 2014, a number of UK outsourced servicing companies, with whom Babcock was grouped, started to have significant problems experiencing sales, margin and EPS headwinds as the tailwinds to outsourcing started to slow and potentially reverse..  Most of these companies were exposed to different end markets than Babcock.  Further adding to headwinds, uncertainty around Brexit disruption created an overhang during this whole period as well.  To add insult to injury, a number of short reports came out from Boatman Capital (mysterious unknown publisher) making negative claims, most of which have proven to be inaccurate over time but nevertheless pummeled the stock price and shook investor confidence.  To be fair, BAB LN has faced a number of specific issues over the years including SSRO margin concerns, poor transparency/communication and confusing accounting changes.  The prior management team was finally finished off by covid-19 which was far more disruptive to Babcock’s business on profitability than it was on top line due to the cost issues related to covid-19 compliance and lockdowns in the UK.  This resulted in concerns that Babcock was over-leveraged and would require another rights offering which created a significant overhang on the stock during 2020 and 2021.  Babcock has not only been a value trap, it has been a very poor investment since 2014.

However, we believe the tide is finally turning here and Babcock has found a real bottom.  A new management team came in at the end of 2020. David Lockwood (CEO) and David Mellors (CFO) were both at Cobham PLC (UK defense company) before which also required a turnaround and was ultimately sold to private equity.  They conducted a full review of the contracts, accounting, balance sheet and cash flow generation and came out with a clean set of numbers after their review in mid-2021.  Furthermore, they said that the balance sheet is strong and there would be no need for rights offerings.  The new management reset margin expectations lower to a level from which they can build over time and announced a variety of strategic actions to strengthen the balance sheet.  From here, we believe the business can compound in the mid-20s% over multiple years driven by growth in earnings resulting from a margin recovery and strong free cash flow generation.

Business

Babcock International Group PLC (“BAB LN”) is one of the UK’s leading engineering support services companies. The Company provides specialized services and manages complex assets and infrastructures. BAB LN is currently the second largest supplier to the UK Ministry of Defence (“MoD”). The Company operates under four segments (sales % are based on FY21 rebased financials):

• Marine (30% of sales) ‐ UK’s leading provider of through‐life engineering support services. BAB LN has the capability to refit the entire Royal Navy submarine fleet and 75% of the UK surface fleet (as well as other navies). This segment largely caters to the defense end market, both in the UK and internationally.

• Land (27% of sales) – Involved in the provisioning of critical fleet management and training for customer‐owned defense, emergency services, global airport and commercial vehicle fleets. BAB LN supports and maintains the entire fleet of combat vehicles for the British Army. On the emergency services side, they are responsible for vehicle and asset management of the London Fire Brigade and Met Police as well as firefighter training

• Aviation (20% of sales) – Own, operate, service and maintain a helicopter fleet with pilots and medical staff to provide aerial emergency medical services as well as firefighting and search & rescue across Europe. BAB LN is the #1 provider of aerial firefighting and aerial medical services in Europe. The Company provides the flight training for the RAF and French Air Force. This segment was formed through the acquisition of Avincis in FY 2015

• Nuclear (23% of sales) – Provides major nuclear decommissioning and new build projects in the UK. This includes refueling and defueling of submarines and decommissioning of civil nuclear reactors

Geographically, Babcock’s business has 70% of sales from the UK and 30% from international. Within international, 43% is Europe, 23% is South Africa, 13% is Australasia, 12% is North America and 9% is rest of world.  BAB LN has long term contracts (average length of 8 years) and gets paid when key milestones are delivered.

Based on the strategic actions taken thus far, Babcock has exited the oil & gas helicopter business and is likely looking to sell the EMS/firefighting aviation business as well effectively reversing the Avincis acquisition.  In addition, Babcock also sold Frazer and Nash, an engineering consultancy, for 293mm GBP on a business which generated 14mm of pretax profit.  BAB LN also announced the sale of a minority stake (15.4%) in AirTanker Holdings Ltd for 126mm GBP on a stake which contributed an estimated 6mm GBP in JV profit to Babcock. Obviously, the multiples for the stakes sold have been much higher than where Babcock trades resulting in significant deleveraging.

Thesis

High quality business with stable, long‐term, contracted revenues at consistent margins

BAB LN focuses on highly complex, bespoke engineering solutions for defense/military applications and critical government services (highly regulated environments). BAB LN is a leading supplier (2nd to BAE Systems) to the UK MoD and has increased its share of the MoD’s spending budget over time. Most of the services BAB LN provides to the MoD are nondiscretionary and few competitors have the specialized skill set and infrastructure/facilities required to perform these services. 40% of BAB LN’s 2019 revenues (likely higher proforma for the divestitures) are from the UK Government, of which 50% is sole sourced. Despite MoD’s budget pressures, BAB LN has been able to increase its share of MoD spending over time. Over the last decade, MoD spending has been relatively flat. BAB LN’s share has increase from 4% in 2008/2009 to about 7.5% today. 

Outside of covid-19, Babcock’s margins have been fairly stable since FY2012.  There has been significant concern that BAB LN is over-earning as their margins are significantly higher than outsourced peers and well above SSRO margin base line.  However, much of this is due to the complexity of their business and accounting.  Some of the elevated margin is optics as they include IFRIC income above the line but IFRIC interest expense is below the line.  Furthermore, BAB LN has a number of smaller, but very high margin businesses within that skew up the stated margins including a technology business within the marine segment and a couple of JVs within aviation (AirTanker (which was just sold) and Ascent Flight Training) which had high margins as well but are 10+ year contracts.  When you combine the impact of IFRIC treatment and the high margins of the aviation JVs, the aviation JV operating profit margin looked like ~40%. This alone made margins look optically higher by 100bps.  In addition, there is great misunderstanding around the SRRO margin calculation for single source suppliers. The baseline level was at least 6.81% and up to 11.85%, once you factored in risk adjustments, incentive adjustments and capital servicing adjustments. The outsourced peers are not comparable as most of them provide commoditized services which are just people mark up businesses while Babcock provides services that no other company can provide due to their expertise and owned assets (Devonport and Rosyth dockyards) which are required for the work. While Babcock may have been over-earning somewhat as they had first or second generation outsourcing contracts which may come down slightly on renewal, they are still going to stay well above peer levels and be higher than what investors fear.

Disrupted valuation trading at ~7x normalized P/E once margins normalize for covid-19 disruptions

Company valuation depressed despite steady operating fundamentals due to multiple overhangs, “the perfect storm”

These overhangs have all been mentioned earlier.  The current management team is taking multiple steps to clean up the story including:

• Strategic actions to sell off non-core assets and deleverage balance sheet. Most importantly, they are exiting the old Avincis businesses which are more commoditized and competitive and focusing on their core defense business lines where they are much more specialized

• Eliminating many of the accounting issues related to underlying financials and cash flows versus statutory and simplifying this. Stripping out the JV income and IFRIC 12 income from operating profit

• Eliminating the differential between average net debt and end of period net debt which the company used to manage with working capital fluctuations. Working capital will be less volatile through the year and the reported net debt will be more reflective of actual leverage

Management team has turned around and sold businesses before to private equity. Given valuation and size, Babcock could be a very likely target for takeout once it looks like the situation has been stabilized and leverage is lower

Catalyst

Company finishes strategic actions and gives long-term guidance on overall remaining businesses

Babcock reinstates dividend once balance sheet has been strengthened

Company reports consistent, stable and growing earnings showing ongoing margin stability