This FTSE frigate is turning around

“Our balance sheet is in a resilient shape, but it could be better,” he said at the defence contractor’s interim results in November 2020. Although the company had a lot of opportunities, “strong, sustained free cash flow” was needed to deliver them, he said.

Yet by the time its full-year numbers were presented eight months later, that resilience had buckled. Shortly after taking charge, Lockwood brought in David Mellors, who had been his finance chief at defence group Cobham until its sale in January 2020. Between them, the pair conducted a detailed review of the value of the company's contracts and its financial position, and when they reported full-year numbers, 140 adjustments were made, sparking £2bn of charges and writedowns.

Contracts were deemed to be less valuable than previously estimated and the goodwill attached to some of its business units could no longer be justified.

Helicopter money

Most notably, the Avincis helicopter business, for which Babcock had paid private equity firm KKR £1.6bn in 2014, had not met some of the lofty expectations set by the deal’s 14 times cash profit multiple. Babcock had also been too optimistic in other projections, leading to “a pattern of underperformance we are determined to address”, Lockwood said.

Other adjustments, such as properly recognising supply chain financing as debt, cleaned up its balance sheet but placed short-term pressure on liquidity. Lockwood bought time by securing an additional £300mn funding lin and agreements from lenders to temporarily ease debt covenants, and pledged to raise £400mn through disposals within 12 months.

And by the time it reported 2022 numbers, Babcock had exceeded this target, allowing it to pay down debt, make inroads into its pension deficit and spend money on improvements at its Devonport shipyard. Yet when full-year results for 2023 rolled around in July, it reported a further £100mn hit taken on a long-running contract for the Ministry of Defence.

The company signed a fixed-price contract to deliver five Type 31 frigates to the MoD in November 2019 at an assumed cost of £250mn per ship. However, materials and other costs have since ballooned and efforts to renegotiate the deal have so far fallen on deaf ears. The two sides are in a dispute resolution process, but Lockwood has been keen to stress that this hasn’t affected their relationship. A £750mn contract awarded to the company by the MoD’s Submarine Delivery Agency in November suggests this is true.

The company is also losing money on other contracts, and management said that 11 per cent of last year’s revenue was linked to work on which it earned a “low- to zero-margin”.

The elimination of these legacy contracts will take time – they only start to meaningfully fall away in 2026 and stretch until 2028. As they do, though, and as the company both delivers projects more efficiently and only bids for work that meets risk and margin thresholds, Babcock is confident of sustainably maintaining an operating margin above 8 per cent. 

A less leaky vessel

Babcock’s underlying operating margin rose above 7 per cent in the six months to September, from 5.7 per cent a year earlier. Even more encouragingly, net debt fell below £480mn, from £1.5bn three years earlier. If a £400mn reversal of “historic balance sheet window dressing” and the inroads made into reducing its pension deficit are included, then debt and debt-like liabilities have reduced from £2.8bn to just £800mn, Lockwood argued.

Babcock’s improved performance, and its decision to re-introduce a dividend for the first time in four years, are behind a 35 per cent uplift in its share price over the past year. Investor sentiment has clearly picked up.

However, with its shares priced at under 10 times forecast earnings, Babcock’s valuation multiple is a third cheaper than domestic peers Chemring (CHG) and BAE Systems (BA.). Is this comparison fair? Joe Brent, an analyst at Liberum, recently argued that, although Babcock’s shares look cheap, “a high and growing exposure to the low-growth UK market” means UK outsourcers Mitie (MTO) and Serco (SRP) – with which it trades in line – are closer peers.

The company has been earning more abroad by licensing designs for its Arrowhead frigate in Indonesia and Poland, though, and Lockwood recently said there were “a number of opportunities for Arrowhead in additional export markets”.

More important is the fact that its focus on cash is delivering results. Operating cash conversion in the first half jumped from 63 per cent to 82 per cent on the back of one-off licence payments from the Polish navy. On a rolling 12-month basis to the end of September, the company generated more than £356mn in underlying operating cash flow. Shore Capital analyst Robin Speakman argues that the company can now “comfortably” meet liabilities including almost £800mn-worth of bonds due in late 2026 and 2027, all from its own cash.

And as debt is paid down, this gives management more options to boost returns, either through growth capex, bolt-on M&A or simply returning spare cash to shareholders. The result is a company with reasonably priced growth prospects, and a balance sheet that no longer bears the battle scars of 2020 and 2021.