Babcock International: A Good Buy on Submarine Growth Prospects (BCKIF)

Those who follow my weekly Defense newsletter may have seen the name Babcock International Group PLC (OTCPK:BCKIF) (OTCPK:BCKIY) pop up a couple of times. The company is not a huge deal when it comes to landing Defense Department contracts, but With a market capitalization of $3.1 billion and over $5.7 billion in annual sales, it is undoubtedly a large company with a significant position in the subsea industrial base. With this report, I will start the financial coverage of Babcock International. I will briefly analyze Babcock's activities, most recent earnings, risks and opportunities, and provide a target price and rating for the stock.

Babcock International: An engineering-focused aerospace and defense company

Babcock International describes itself as an engineering-focused defence, aerospace and security company with a growing technology capability. The company operates across four sectors: aviation, land, marine and nuclear.

The aviation segment offers military training solutions, life support for flight equipment and air operations for governments. The land segment offers rail infrastructure works, training solutions for military and emergency services and engineering, design and manufacture of military vehicles as well as support for said vehicles. The maritime segment offers support for Canada's Victoria-class submarines, naval and maritime support and management and design and manufacture of the next-generation general purpose frigate also known as Type 31. The nuclear segment offers civil nuclear support and maintenance 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 by the end of the next decade.

Profits increase as leverage decreases

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

Marine division sales were flat at £1.43bn and included a reversal of revenue related to the Type 31 programme, while warship support revenue declined, partially offset by increased support for Dreadnought submarines. Margins were flat at 0.9%, generating a profit of £13m, which was flat year-on-year. Excluding the £90m loss from the Type 31, profit would have been £103m, down from £113m last year, when the company saw losses from the Type 31 increase by £100m. On a normal day, therefore, the marine and nuclear segment accounts for almost two-thirds of profits. The aviation segment is not a big driver of profits, and one may wonder whether this is a segment Babcock would want to remain active in if it cannot scale up the business. What we also see is that while demand for defence equipment and new developments is high, there remains significant cost risk for defence contractors on new programmes such as the next-generation frigate. What I like is that the company has been able to reduce its leverage from 1.5x to 0.8x, which I think also better positions Babcock to return value to shareholders.

What are the risks and opportunities for Babcock International?

The biggest risk I see for Babcock International is the continued growth of the Type 31 program. The company has been de-risking that program and believes it better understands the cost associated with the program, but it remains a risk. At the point when defense contracts become challenging from a cost perspective, it is difficult to continue to adequately control costs for the remainder of the program. The opportunities for Babcock International are in the civil nuclear segment, as nuclear power will likely play a key role in the energy transition framework.

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

Babcock International shares have upside potential

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

EBITDA estimates show FY25 earnings to be roughly in line with FY23 earnings of around $595 million, with more robust growth loading into 2026. Free cash flow is expected to come under pressure in FY25 due to frigate cost growth, but should also recover somewhat by FY26.

At current prices, I think the stock has attractive upside potential and even in the conservative case using the EV/EBITDA median, the upside potential would still be 78%, which would push the target price to $11.52. Babcock has successfully refocused the business and even if we were to only allocate half of the upside potential, there would still be 39% upside potential to $9 per share, which I think makes a compelling business case. Whether the refocused company with a stronger balance sheet will reach those levels remains to be seen, but I think there is fundamental support for it.

Conclusion: Babcock International could be an interesting underwater bet

Babcock International has managed to divest some parts of its business, and I think this is a prudent decision. The aviation segment is not a huge segment and most of the revenue is generated in the land, sea and nuclear sectors. With continued support for submarines and new submarines to be built for the AUKUS pact, the submarine platforms will provide decades of opportunity for manufacturing and service support, while the requirements of the energy transition could boost the civil nuclear business. While the frigate program has some additional costs, I think the strength of the defence and civil nuclear markets provide an attractive investment opportunity for investors.

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