To suggest anything other than that past two and a half years have been extremely tough for Babcock International senior management would be an understatement and so it is extremely good today to observe that the huge efforts of CEO David Lockwood and his team to transform this hugely important defence company are showing through in what are a very interesting set of first half year results. That is not to suggest that the extensive actions required and so far taken by the management team in order to place the company in the position it needs to be to move forward with full confidence are complete yet but it is to say that Babcock is now a very much leaner and fitter organisation than it had been in the recent past and that the forward and well thought through strategy put in place by David Lockwood when he arrived as CEO in 2020 are not only working but importantly, have positioned the company well for what I view as being a period of potentially interesting and rewarding long-term growth ahead.
Half year results to 30th September 30th published this morning confirm that underlying operating profits – those that strip out exceptional and other one-off items – rose 10% organically to £121.7m from a previous year figure of £115.3m – this rise is according to the company due to a combination of revenue growth and cost management measures. Underlying operating margin also increased 30 basis points to 5.7%.
With more significant new orders secured during the H1 period Babcock has been able to once again confirm that the strong order backlog has been maintained. The order backlog at the half year end period stood at £9.9 billion and the company says that over 90% of FY23 revenue was under contract as at the 30th September 2022 period end. While this figure is down a touch from the previous year, this is due to the impact of disposals and trading of long-term contracts.
Revenue was up 5% organically to £2,14bn and organic based growth was achieved across all divisions. For the record, statutory operating profit of £72.8 million were recorded in the six month – this compares to £75.4m reported in the previous half year period. Underlying basic earnings per share up 3% to 15.8p. The company says that profit growth and lower net interest costs were partially offset by lower joint venture profits and £6 million ‘other income’ in HY22, which was non-recurring.
Importantly, there was a significant improvement in underlying free cash flow: an outflow of £24.7m against a previous year H1 period £160.6m outflow and which was better than expected due to favourable timing of customer receipts, lower net capital expenditure and other timing related factors. Balance Sheet resilience continues to improve with Net Debt to EBITDA (covenant basis): 1.9x (HY22: 2.8x) which was again better than had originally been expected at this point and within our target range of 1.0x to 2.0x
In respect of the forward outlook, the company is maintaining overall financial guidance for the full year to 31st March 2023 and as stated above, with over 90% of FY23 revenue contracted as at 30th September 2022, the company has good visibility of top line revenue.
No company is without pressures in these increasingly difficult times and Babcock International is no exception. In the H1 statement the company reminds that external macroeconomic challenges remain, including ongoing wage inflation challenges but it also says that for the current year it continues to expect to be able to offset inflationary pressure through operating efficiencies. To that end, the company has placed turning to a free cash flow positive position during the second half year period for FY23 (for retained Group) as being a priority.
CEO David Lockwood said:
“Babcock International has made strong progress over the past six months. We have enhanced our operational efficiency, cash flow performance and financial resilience, whilst improving delivery for our customers. Whilst there is still more to be done, the significant contracts won this year underpin our confidence in our potential to deliver sustained growth and capture margin upside over the medium term” adding that “We are operating in a macro economic and geopolitical environment that remains volatile. We are focused on effectively addressing the challenges our business faces, most notably inflationary pressures, whilst also ensuring we maximise the increased opportunity set we are seeing in a market backdrop that is supportive for defence. Babcock now has a solid, well-defined foundation from which to deliver our customers’ key requirements of availability, affordability and capability.”
In the H1 statement accompanying results and which, due to the significant detail provided, I have chosen to reprint almost fully below Mr. Lockwood said:
“We are starting to see good progress from our focus on better execution, with improvements in both our financial resilience and operational delivery. This puts us on a stronger footing to deliver sustained, profitable growth, with new business wins demonstrating our ability to provide solutions that meet our customers’ needs of affordability, availability and capability. I believe we are now well-placed to capture the near and longer-term opportunities emerging in our core defence market.
The first 18 months of the turnaround have delivered significant improvements in transparency and standardisation across the Group. This has helped us have more control over the activities within the Group, which has become even more important given the increasingly uncertain and volatile macro-economic and geopolitical environment we are facing.
The changes that we have implemented mean we are better placed to manage the challenges our business faces, most notably from persistently elevated inflation (see below for more details), whilst also ensuring that we maximise the increased opportunity set we are seeing in global defence markets as a consequence of heightened national security concerns.
In the period, improvements to both underlying operating profit and operating margin reflect the increased efficiency and cost savings achieved as we continue to embed our new operating model. Although there is still much to be done, overall trading is in line with our expectations with a strong organic profit performance in Marine and Land, up 22% and 40% respectively. This more than offset weaker performance in Nuclear, due to an additional £6 million programme provision, and Aviation, due largely to higher fuel costs. Our stronger focus on cash flow is changing how programmes are negotiated and implemented to improve cash flow in the business”.
Stabilise strengthened base
“We have continued to build on the positive momentum set in motion in FY22, our first year of turnaround. The portfolio alignment programme is now broadly complete, with the agreements to sell our Spanish, Italian, Portuguese and Scandinavian Aerial Emergency Services (AES) and Land civil training businesses, which are expected to complete in the coming months. As a result, defence will comprise more than two-thirds of our portfolio, with the remainder being the provision of critical services in the civil sector.
Our net debt to EBITDA gearing ratio is 1.9x on covenant basis (HY22: 2.8x), lower than we expected at this stage and within our target range of 1.0x to 2.0x, despite significant cash outflow related to pension deficit “catch-up” payments. We have £1.2 billion of financial liquidity headroom following repayment of the €550 million bond that matured on 6 October, and c.£1.5 billion of our bonds and debt facilities do not expire until 2026, giving us a strong funding base with little near-term refinancing risk”.
Execute: improving operational delivery
“We have taken further steps to improve operational delivery across the Group, benefiting from the greater focus provided by our operating model. These revised ways of working are enhancing our ability to deliver effectively and decreasing performance risks within our business.
Whilst our businesses are not all expected to improve performance at the same rate, our focus on operational excellence has been evidenced in Land, for example, where the transformation programme within the DSG contract has led to improved delivery. This has enhanced our ability to support our British Army customer as it plans for the future of equipment support. We continue to drive cultural change across the business with the introduction of new processes and systems. We have formed a centre-led Commercial function to drive commonality and best practice across the Group, with a focus on commercial risk management and the development of our commercial talent.
We are developing a new Internal Audit, Risk Assurance and Insurance function to enhance our controls, governance and risk management across the business, and our global Procurement and Supply Chain function is actively working with the supply chain to manage sourcing pressures. We have established a centre-led Programme Management Function to professionalise the planning, estimating, execution and control of our projects. We have also launched the first phase of a global Business Management System designed to improve execution by standardising processes across the Group. In October, we concluded the first Group-wide survey of employees for more than 10 years.
The wide-ranging survey achieved an impressive response rate of 79%, showing a willingness of employees to get involved. Its results will inform the action plans being developed as part of our comprehensive People Strategy. I am delighted that around 80% of respondents were familiar with our Principles and our Purpose: to create a safe and secure world, together. Our Purpose is also helping anchor our focus on ESG, which increasingly is a differentiated part of our bid submissions. The independent report by Oxford Economics published earlier this month concluded that the Group makes a significant contribution to the UK economy. In FY22 we provided a £3.3 billion contribution to the UK’s GDP, supported 56,800 UK jobs and spent £290 million with suppliers in areas classified as a ‘high priority’ for the UK Government’s Levelling Up fund”.
Execute: managing financial risk
“The actions taken to stabilise the Group’s financial base taken in FY22 have enabled us to proactively manage financial risks and enhance our resilience in HY23 against a volatile macro-economic environment.
On inflation and supply chain:
Approximately 70% of our revenue base has some measure of protection for inflation – either because costs can be fully recovered or there are indexation allowances, or similar, within these contracts. Of the remaining c.30% of revenue the group has assumed the inflation risk through “firm” fixed price contracts.
The largest contract has approximately three years remaining, but many of the fixed price contracts are short term (1-2 years), giving us the opportunity to replace them with improved terms and/or updated pricing. The group’s largest exposure to inflation is rising labour costs (approximately 50% of the cost base of the fixed price contracts), particularly within the UK. As previously announced, the Group addressed labour cost in the UK for FY23 with an innovative pay deal from 1 April 2022 that targeted all but the higher paid employees to assist in the cost-of-living increases. This pay deal resulted in a c.£25 million FY23.
Outside of labour costs, the Group has incurred increases in other costs such as aviation fuel, energy and raw materials. Whilst these are, overall, smaller categories of cost, businesses and programmes incurring such costs intend to offset these increases through efficiencies or commercial negotiation over the course of the year.
Through the new centre-led Commercial function, the Group has limited the commercial risk of future inflation in new contracts where it cannot be mitigated Planning for FY24 is in the early stages and the FY24 pay cycle is yet to commence, so the level of mitigation achievable through other efficiencies and commercial discussions with customers/suppliers has not yet been determined. Once completed, this will then be used to update estimates to complete on programmes that are accounted for as long-term contracts.
Our new Procurement and Supply Chain organisation continues to closely monitor and manage supplier resilience as a key risk. We have implemented technology solutions to monitor resilience within our supplier ecosystem, which is supported by a process to mitigate identified risks. Some of our suppliers are experiencing increases in input-cost inflation coupled with shortages of supply. To overcome this, we continue to work closely with our key suppliers to deliver solutions that can offset costs and de-risk the supply chain.
On the Balance sheet, we have reduced gross debt, repaying the €550 million Euro bond in October 2022 using proceeds from our disposal programme. We further reduced our exposure to current fluctuations in interest rate with around 85% of our £793 million total bond debt now fixed rate, which would have been c.70% without action, and meaning that only £125 million of our drawn debt is exposed to variable interest rates.
On Pensions, we made £76 million of pension deficit payments in the first half as planned. In late September and October, the UK gilt market experienced significant volatility. The Group’s three largest pension schemes have liability driven investment portfolios (LDIs).
The Trustees of these schemes actively managed the collateral positions of these portfolios to ensure sufficient headroom throughout this volatile period. In common with many schemes, the Trustees of our three main UK schemes decided, in consultation with us, to reduced inflation hedging from between 88% and 96% to between 60% and 84% (of the deficits on a self-sufficiency basis) to limit the amount of asset disposals required to fund collateral positions and provide the headroom they felt required in the volatile environment. The intention is to rebuild this hedging position.
Grow: capturing opportunities
The market environment remains supportive for defence, and opportunities continue to emerge as our customers reassess their defence and security priorities. Global financial pressures mean that our ability to provide affordable solutions which still deliver the capability and availability customers require is increasingly important. Our successes in the period include:
Securing two further contracts relating to Poland’s MIECZNIK (Swordfish) frigate programme. We are in active discussions with several other potential Arrowhead 140 (T31 export variant) frigate customers
Signed a major c.£500 million, 10-year contract to upgrade, operate and support Australia’s high frequency communications capability for the Australia Defence Force. Babcock is now a leading provider of strategic defence high frequency communications in the world, built on a common mission system architecture that is both scalable and interoperable o Selected to manage the sustainment of Royal Australian Navy ships at the country’s new Regional Maintenance Centre West over the next five years through our newly fully consolidated Naval Ship Management (NSM) business in Australia.
Won a six-year contract with the UK Royal Navy to install and provide in-service support for the maritime Communications Electronic Support Measures capability on Type 23 frigates o Supporting the UK MOD’s short-term operational requirements in Eastern Europe, including demand for training and equipment refurbishment”.
Bottom Line
“We expect to see continued operational progress from our focus on execution and growth. We are maintaining our overall financial expectations for the current year. The disciplined execution of our strategy, together with a streamlined portfolio, gives the Board confidence in its expectations of delivering increasingly profitable growth and improved cash flow into the medium term.
Over the medium and long-term, we are focused on delivering value for all our stakeholders, including:
Improved outcomes for our customers: consistent delivery and partnering with customers to solve their challenges.
A better place to work for our employees: an open, collaborative and diverse workplace that engages our employees
Returns for our shareholders: a return to growth with improving margins and better cash conversion”.
CHW (London – 22nd November 2022)
Howard Wheeldon FRAeS
Wheeldon Strategic Advisory Ltd,
M: +44 7710 779785
Skype: chwheeldon
@AirSeaRescue