Babcock International: A Buy on Subsea Growth Prospects (BCKIF)

Those who follow my weekly defense bulletin may have seen the name Babcock International Group PLC (OTCPK:BCKIF) (OTCPK:BCKIY) pop up a few times. The company isn’t big when it comes to getting contracts from the DoD, but with a market capitalization of $3.1 billion and over $5.7 billion in annual sales, it is certainly a large company with an important position in the subsea industrial base. With this report, I will initiate financial coverage for Babcock International. I will briefly discuss Babcock’s activities, recent earnings, risks and opportunities, and provide a price target and valuation for the stock.

Babcock International: An engineering-led aerospace and defense company

Babcock International describes itself as an engineering-led defense, aerospace and security company with a growing technology capability. The company is active in four sectors, namely aviation, land, marine and nuclear.

The aviation segment provides solutions for military training, life support of flight equipment and air operations for governments. The field segment provides rail infrastructure works, training solutions for military and emergency services and engineering, design and manufacture of military vehicles, as well as support for these vehicles. The marine segment provides support for Canada’s Victoria-class submarines, naval base and maritime support, and the management and design and manufacture of the next-generation general-purpose frigate, also known as the Type 31. The nuclear segment provides civil nuclear support and sustainment of the Submarine Fleet of Great Britain. The company is also involved in the development of the new submarine as part of the AUKUS pact. The submarine will replace the Astute-class submarines at the end of the next decade.

Profits increase while leverage decreases

FY24 revenue fell 1.1% to £4.39bn on the divestment of the AES business, which provides air emergency services. On an organic basis, revenue increased 11%. The aviation segment saw revenue fall by almost 18% to £342m, while margins of 5.6% led to an underlying profit of £19m. The Lands segment saw organic growth of 17% with revenues of £1.1 billion, driven by higher vehicle engineering volumes, vehicle sales to the mining industry in South Africa, communications equipment sales in Australia and higher income from training. Underlying operating margin improved from 8.5% to 8.8%, resulting in a 15% rise in underlying profit to £96m. The nuclear segment saw organic growth of 29%, taking sales to £1.5bn, driven by a combination of higher civil nuclear power sales, increased submarine support and higher Major Infrastructure Program sales, which aims to upgrade the existing infrastructure in support of the UK submarine fleet. Underlying profits rose from £64m to £109m, driven by higher sales and the absence of £16m in supply costs.

Marine sales were flat at £1.43bn and included a reversal of revenue related to the Type 31 programme, while revenue from warship support fell, partly offset by higher support for Dreadnought submarines. Margins remained at 0.9%, generating a profit of £13m, which was flat year-on-year. Excluding the £90m Type 31 loss, profit would have been £103m, down from £113m last year, when the company saw Type 31 losses rise by 100 million pounds. So on any typical day, the marine and nuclear segment accounts for nearly two-thirds of the profit. The aviation segment is not a big profit driver, and one wonders if this is a segment Babcock would want to stay active in if it can’t grow the business. What we also see is that while demand for defense equipment and new developments is strong, there is still significant cost risk to defense contractors for new programs such as the next-generation frigate. What I like is that the company was able to reduce its leverage from 1.5x to 0.8x, which I think positions Babcock better to return value to shareholders.

What are the risks and opportunities for Babcock International?

The major risk I see for Babcock International is the continued growth of the Type 31 program. The company has eliminated that program and believes it has a better understanding of the cost associated with the program, but it remains a risk. As defense contracts become cost-challenging, it is difficult to maintain adequate cost control for the balance of the program. Opportunities for Babcock International are in the civil nuclear segment, as nuclear power is likely to play a key role in the energy transition.

The slide above also shows the opportunities the company sees in energy security, as well as subsea support and construction opportunities. Subsea platforms will provide contract opportunities for decades to come, not just for construction and support, but also for dismantling submarines at the end of their service life.

Babcock International shares have an edge

To determine multi-year price targets, the Aerospace Forum developed a stock analysis tool that uses a combination of analyst consensus on EBITDA, cash flows and the latest balance sheet data. Each quarter, we review those assumptions and stock price targets accordingly. In a separate blog we detailed our analysis methodology.

EBITDA estimates show that FY25 earnings will be roughly in line with FY23 earnings of around $595 million, with more robust growth loaded into 2026. Free cash flow is expected to be squeezed in FY25 due to rising frigate costs, but should recover. somewhat by FY26.

At current prices, I think the stock has an attractive upside, and even conservatively using the EV/EBITDA average, upside would still be 78%, bringing the price target to $11.52. Babcock has successfully refocused its business, and even if we were to attribute only half the profit, there would still be a 39% return at $9 per share, which I think is a compelling business case. Whether the refocused company with a stronger balance sheet will reach these levels remains to be seen, but I think there is fundamental support for it.

Conclusion: Babcock International could be an interesting submarine piece

Babcock International has successfully divested some parts of its business and I think that is a prudent move. The aviation segment is not a huge segment and most of the revenue is generated in Land, Marine and Nuclear. With continued support for submarines and new submarines to be built for the AUKUS pact, submarine platforms will provide decades of production and service support opportunities, while energy transition requirements could drive civilian nuclear business. While there is some cost overrun from the frigate program, I believe the strength of the defense and civilian nuclear markets provides a compelling investment opportunity for investors.

Editor’s Note: This article discusses one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.