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04 Jan 24. Babcock – This FTSE frigate is turning around.
Investment Ideas of the Year: After a painful reset in 2021, this defence specialist is now operating from a position of strength
When David Lockwood first faced investors, just 10 weeks after being drafted in to run Babcock International (BAB), he highlighted the need to focus on free cash flow.
Tip style: SPECULATIVE
Risk rating: HIGH
Timescale: MEDIUM TERM
Bull points
- Massive cut in debt
- Growing export opportunities
- Strong cash generation
- Cheap share rating
Bear points
- Margin-denting legacy contracts
- Low-growth UK exposure
“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 £250m 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 £750m 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 £480m, 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 £800m, 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 £356m in underlying operating cash flow. Shore Capital analyst Robin Speakman argues that the company can now “comfortably” meet liabilities including almost £800m-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. (Source: Investors Chronicle)
04 Jan 24. The EU should streamline a defence industry held back by member states’ focus on their own national champions, the head of Italy’s Leonardo has urged — even if it means governments giving up “a bit of national sovereignty”. In his first interview since taking the helm of the Rome-based aerospace and defence group in May, Roberto Cingolani said the Ukraine war had served as a wake-up call for the European industry and companies were now discussing how to foster partnerships within the sector. “A fractured system where each of the EU’s 27 countries invests in its own tanks and jets does not work,” said Cingolani, who served as energy transition minister in the cabinet of former Italian Prime Minister Mario Draghi. “Some will say it’s not ideal for national sovereignty, but we have to look at defence from a global perspective,” he added. Leonardo and Franco-German consortium KNDS in December announced a partnership to build a new generation of tanks, a project initially launched by Germany and France to replace their Leopard 2 and Leclerc tanks. “If you have a lot of companies investing on a lot of different platforms, the average investment on each platform will be low,” said Cingolani, adding that this meant European programmes were inferior to those in the US, which “focuses on a few platforms with large investments”. Experts say the fragmented nature of the EU’s defence industry has hindered upgrades to the bloc’s capabilities. However, Russia’s invasion of Ukraine has prompted some governments to boost defence spending and the EU has rolled out proposals for greater collaboration within the bloc’s industry. Cingolani also hit out at what he sees as overly stringent EU regulations, warning that an excessive focus on “principles and competition rules” would create an industry in which “European companies won’t succeed individually, nor together”. The Leonardo CEO said the reasons behind antitrust and state aid rules were “understandable but limiting” for defence companies. He added that rising energy costs, emissions regulations and the cost of labour in Europe compared with the US and China would weigh on listed European defence companies because “investors will go elsewhere”. “We must start building a critical mass in Europe, we must lay the foundations for continental defence centres . . . the world can’t host too many military vehicles,” said Cingolani. Italy, Japan and the UK in December signed an treaty for the development of their ambitious Global Combat Air Programme unveiled in 2022. Under the plan, Japan’s F-X programme will merge with the Italo-British Tempest project, aiming to deliver by 2035 a fighter jet that is both cheaper and faster than previous programmes such as the Eurofighter. BAE Systems, Mitsubishi Heavy Industries and Leonardo are the programme’s main industrial partners. “There might be organisational challenges, but the opportunities far outpace the challenges.” The fighter jet programme, which is aimed at expanding the three nations’ defence capabilities in the face of rising threats from Russia and China, could also represent an opportunity for Leonardo to expand in Asia, he added. (Source: FT.com)
03 Jan 24. Atos to hold due diligence talks with Airbus on sale of BDS unit. French IT company Atos (ATOS.PA) said on Wednesday it would open due diligence talks with Airbus (AIR.PA) in regards to the sale of its big data & security (BDS) unit. The world’s biggest planemaker has placed an indicative offer price in the range of 1.5bn euros to 1.8bn euros ($1.64bn-$1.97bn) for the unit, Atos said. An Airbus spokesperson confirmed in an e-mailed statement sent to Reuters that it has submitted a non-binding proposal for a potential acquisition of Atos’ BDS business line.
“The acquisition of BDS could significantly accelerate the digital transformation of Airbus, enhance the company’s defence and security portfolio with strong capabilities in cyber, advanced computing and artificial intelligence, and support Airbus’ decarbonisation roadmap,” Airbus said.
Meanwhile, Atos Chief Financial Officer Paul Saleh said the exclusive negotiations with Czech bnaire Daniel Kretinsky’s EPEI on the sale of its Tech Foundations unit are taking “more time than planned”, with no certainty of an agreement being reached.
“Discussions continue around the price to be paid, the structure of the transaction and the transfer of a very large proportion of Tech Foundations liabilities,” the company said in a press release.
Atos said it is in discussions with banks to maintain financing and obtain refinancing, adding that in the first quarter of 2024 it will assess whether these measures are sufficient to cover financing maturities and cash requirements on a long-term basis. ($1 = 0.9128 euros) (Source: Reuters)
02 Jan 24. Xalles Holdings completes acquisition of Artemis Defence Technologies. US acquisition of UK-based autonomous technology provider creates new Xalles Security business group that will operate in defence and homeland security sectors. US-based Xalles Holdings announced in late-December 2023, the acquisition of UK-based Artemis Defense Technologies, which specialises in autonomous and artificial intelligence (AI) related technologies, marking the first corporate members of the newly established Xalles Security business group.
In official filings on 20 December, Xalles Holdings stated that Artemis now operated as a fully integrated subsidiary and was now “set to expand its presence in the US” to align with “key US Department of Defense initiatives” including the Replicator drone programme and contributing to the tri-nation AUKUS programme between Australia, UK, and USA.
Xalles stated that Artemis’ autonomous systems technologies could “significantly influence” the future of scalable autonomy in the defence and homeland security sectors.
Thomas Nash, CEO of Xalles, said: “This acquisition is a game-changer for Xalles, perfectly aligning with our goal to diversify our portfolio and enhance shareholder value in high-growth markets. The defence autonomy and artificial intelligence sector offers tremendous growth potential, and we are poised to be a major player in this arena.”
Carl Cagliarini, CEO of Artemis, stated the deal was a “transformative moment” for the company, which had secured “vital partnerships and projects with Government, defence prime contractors, and Nato defence agencies”.
AI-related patents tumble in late-2023
The global aerospace, defence and security industry experienced a 40% decline in the number of AI-related patent applications in Q3 2023 compared with the previous quarter. The total number of artificial intelligence-related grants dropped by 21% in Q3 2023, according to GlobalData’s Patent Analytics.
Notably, the number of AI-related patent applications in the aerospace, defence and security industry was 325 in Q3 2023, versus 542 in the prior quarter. (Source: army-technology.com)
29 Dec 23. Shield AI, the defense technology company building the world’s best AI pilot for aircraft, today announced the expansion of their Series F funding round to a total of $500m. An additional $100m in equity, raised at the Series F price, and $200m in debt from Hercules Capital were added to the m in equity closed in November.
“The defense and investment communities are seeing the profound impact AI pilots will have on national security and global stability. AI pilots solve the electronic warfare (GPS- and communications-jamming) problem that’s devastating 10,000 drones per month in the Russia-Ukraine War, and they enable the operating concept of intelligent, affordable mass, where swarms of affordable aircraft can accomplish missions normally reserved for expensive, exquisite aircraft.”
“AI pilots are becoming a strategic conventional deterrent in class with our aircraft carriers and guided missile submarines. But interestingly, it’s the first strategic deterrent that is software-defined and has only recently become possible because of advances in AI and compute power. That’s a huge paradigm shift for aerospace and defense,” said Ryan Tseng, Shield AI’s CEO and Cofounder.
“The defense and investment communities are seeing the profound impact AI pilots will have on national security and global stability. AI pilots solve the electronic warfare (GPS- and communications-jamming) problem that’s devastating 10,000 drones per month in the Russia-Ukraine War, and they enable the operating concept of intelligent, affordable mass, where swarms of affordable aircraft can accomplish missions normally reserved for expensive, exquisite aircraft,” said Brandon Tseng, Shield AI’s President, Cofounder, and former Navy SEAL.
Shield AI’s flagship product, Hivemind, is an AI pilot that enables teams of intelligent aircraft to operate and complete missions autonomously in high-threat environments, without the need for remote operators or GPS. Hivemind is an aircraft agnostic autonomy stack similar to the self-driving technology found in cars. It has flown quadcopters, the MQ-35A V-BAT, and the F-16. Next year it will fly Kratos’ XQ-58 Valkyrie. Shield AI has accumulated more autonomous flight hours executing fighter jet maneuvers, like dogfighting, than any company in the world.
Recently, Shield AI introduced V-BAT Teams, a first-of-its-kind software product powered by Hivemind that enables teams of V-BATs to execute missions, autonomously reading and reacting to each other and the environment just as a team of humans would normally pilot them.
About Shield AI
Founded in 2015, Shield AI is a venture-backed defense technology company whose mission is to protect service members and civilians with intelligent systems. In pursuit of this mission, Shield AI is building the world’s best AI pilot. Its AI pilot, Hivemind, has flown a fighter jet (F-16), a vertical takeoff and landing drone (V-BAT), and a quadcopter (Nova). The company has offices in San Diego, Dallas, Washington, D.C., and abroad. Shield AI’s products and people are currently in the field actively supporting operations with the U.S. Department of Defense and U.S. allies. For more information, visit www.shield.ai. (Source: PR Newswire)
02 Jan 24. Anduril plans to double UK presence. A defence company founded by US entrepreneur Palmer Luckey, who sold his virtual reality business to Facebook at the age of 21, will double its UK presence in the next two years as it expects a boom in defence technology.
Anduril develops anti-drone technology, detection equipment and maritime security technology, all centred around its Lattice artificial intelligence-powered software.
The company recently developed a vertically launched jet engine powered drone named Roadrunner which is designed to intercept aircraft and other drones and gather intelligence.
“We have a strong belief that the UK is rife with engineering in defence and aerospace talent. We plan to continue to hire and grow in that market for the foreseeable future,” says Gregory Kausner, Head of Global Defence. “Our focus is on autonomous systems. Robots capable of acting independently based on conditions set by humans with humans.”
The company was founded in 2017 and entered the UK in 2019 as its first international market. It plans to double its 40-strong UK workforce to 80 and “plans to design, engineer and to manufacture products in the UK for the UK”, Mr Kausner said, opening test ranges and offices.
Founder Palmer Luckey sold Oculus, his virtual reality headset startup to Facebook in 2014 for more than $2bn (£1.6bn) and personally made an estimated $700m. He was let go in 2016, reportedly for making donations to an anti-Hillary Clinton group.
The following year, he set up Anduril, named after a legendary sword in JRR Tolkien’s Lord of The Rings books, which is meant to bring modern technology onto the battlefield.
The UK defence sector has seen a wave of investment and expansion since Russia’s attack on Ukraine.
Relatively new technologies to defence, like drones, has meant militaries are trying to adapt quickly to counter them.
Ukraine has proved a productive testing ground for drones, which are used for surveillance and as a cheap, accurate means of delivering attacks on tanks, buildings and personnel.
Before Russia’s invasion, the focus of most weapons makers was to outperform enemy hardware, building equipment that was increasingly fast, stealthy or deadly.
Military drones however, can cost as little as $10,000 apiece, while adapted civilian models can come in under $1,000
Development of domestic jet-powered drones in the UK is also gaining pace. BAE Systems began developing a jet-powered stealth drone called Taranis about a decade ago.
QinetiQ, the defence technology firm spun out of the Ministry of Defence nearly two decades ago, is developing a disposable drone with top British arms contractor BAE Systems called Jackdaw.
Based on the design of the Banshee target, which looks like a mini warplane and is made to be shot out of the sky during missile tests, the jet-powered Jackdaw will help lure rockets away from nearby jets, snoop on targets and jam radio transmissions. This can all be achieved more cheaply than a manned plane. (Source: Google/Yahoo!)
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SPX CommTech, part of SPX Technologies Inc, innovates specialised technologies within the Radio Frequency (RF) spectrum to ensure a smarter, more secure future for all. Formed by TCI and ECS, SPX CommTech’s Battlespace portfolio enables defence and security teams to detect, defeat and exploit RF signals to enhance communications intelligence (COMINT) and counter unmanned aerial systems (Counter-UAS). Additionally, its Tactical Data Link portfolio allows intelligence gathering agencies, special forces, emergency response, and security teams to securely and reliably transfer video and data between enabled-aircraft and ground teams over long distances for airborne Intelligence, Surveillance, Reconnaissance (ISR). For more information visit www.tcibr.com and www.enterprisecontrol.co.uk
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