Babcock International: A Buy On Submarine Growth Prospects (BCKIF)

Those that follow my weekly Defense newsletter might have seen the name Babcock International Group PLC (OTCPK:BCKIF) (OTCPK:BCKIY) appear a couple of times. The company is not big when it comes to securing contracts from the DoD, but with a $3.1 billion market cap and over $5.7 billion in annual sales, it is definitely a big company with an important position in the submarine industrial base. With this report, I will be initiating financial coverage for Babcock International. I will briefly discuss the activities of Babcock, the most recent earnings, the risks, and opportunities and provide a price target and rating for the stock.

Babcock International: An Engineering-Driven 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 military training solutions, service life support for flight equipment and aerial operations for governments. The land segment provides railroad infrastructure works, training solutions for military and emergency services and engineering, design and manufacturing of military vehicles as well as the support for those vehicles. The marine segment provides support for the Canadian Victoria-class submarines, naval base and maritime support and management and design and manufacturing of the next-generation general purpose frigate also known as Type 31. The nuclear segment provides civil nuclear support and the sustainment of the UK submarine fleet. 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 late next decade.

Profits Jump While Leverage Comes Down

FY24 revenues decreased 1.1% to £4.39 billion, driven by the disposal of the AES business, which provides aerial emergency services. On an organic basis, revenues grew 11%. The aviation segment saw revenues decline by nearly 18% to £342 million, while margins of 5.6% led to underlying profit of £19 million. The land segment posted 17% organic growth with revenues of £1.1 billion driven by higher vehicle engineering volumes, vehicle sales to the South African mining industry, communication equipment sales to Australia and higher training revenues. Underlying operating margin improved from 8.5% to 8.8% resulting in underlying profit growth of 15% to £96 million. The nuclear segment saw 29% organic growth bringing sales to £1.5 billion driven by a combination of higher civil nuclear sales, submarine support growth and higher sales on the Major Infrastructure Program, which aims to upgrade existing infrastructure in support of the UK submarine fleet. Underlying profits increased from £64 million to £109 million, driven by higher sales and the absence of £16 million in provision costs.

Marine sales were flat at £1.43 billion and included a reversal of revenues related to the Type 31 program, while war ship support revenues declined, partially offset by higher Dreadnought submarine support. Margins remained at 0.9% generating a £13 million profit, which was flat year-on-year. Excluding the £90 million Type 31 loss, the profit would have been £103 million, down from £113 million last year when the company saw Type 31 losses increase by £100 million. So, on any normal day, the Marine and Nuclear segment account for nearly two thirds of the profits. The aviation segment is not a huge driver of profits, and one can wonder whether this is a segment that Babcock would like to remain active in if it cannot scale the business. What we also see is that while demand for defense equipment and new developments is high, there remains a significant cost risk to defense contractors on new programs such as the next-generation frigate. What I do like is that the company has been able to bring its leverage down from 1.5x to 0.8x, which I believe also 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 continued growth on Type 31 program. The company has been derisking that program and believes that it better understands the cost associated with the program, but it remains a risk. The moment defense contracts become challenging from a cost perspective, it is difficult to properly continue controlling the costs for the balance of the program. The opportunities for Babcock International are in the civil nuclear segment, as nuclear energy likely will play a key role in the energy transition framework.

The slide above also shows the opportunities the company sees on the topic of energy security, as well as opportunities for submarine support and construction. The submarine platforms will provide contract opportunities for decades to come, not just for construction and support, but also for dismantling submarines at the end of operational life.

Babcock International Stock Has Upside

To determine multi-year price targets The Aerospace Forum has developed a stock screener which uses a combination of analyst consensus on EBITDA, cash flows and the most recent balance sheet data. Each quarter, we revisit those assumptions and the stock price targets accordingly. In a separate blog I have detailed our analysis methodology.

EBITDA estimates show that FY25 earnings will be roughly in line with the FY23 earnings of around $595 million, with more solid growth being loaded into 2026. The free cash flow is expected to be pressured in FY25 due to the frigate cost growth but should also recover somewhat by FY26.

At current prices, I do believe that the stock does have an appealing upside and even in the conservative case using the median EV/EBITDA the upside would still be 78% bringing the price target to $11.52. Babcock has successfully refocused the business and even if we would only assign half of the upside, there would still be 39% upside to $9 per share, which, I believe, makes for a compelling business case. Whether the refocused company with a stronger balance sheet will hit those levels remains to be seen, but I do believe there is fundamental support for it.

Conclusion: Babcock International Could Be An Interesting Submarine Play

Babcock International has successfully shed some parts of its business, and I think that is a prudent move. The Aviation segment is not a huge segment and the bulk of the income is generated in Land, Marine, and Nuclear. With continued support for submarines and new submarines to be built for the AUKUS pact, the submarine platforms will provide decades of opportunities for manufacturing and services support while energy transition requirements could drive the civil nuclear business. While there is some cost overhang from the frigate program, I do believe the strength in the defense markets and civil nuclear market do provide a compelling investment opportunity for investors.

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