Babcock International Group PLC (BAB) Earnings Call Transcript & Summary

Hello, and welcome to the Babcock International Type 31 Program Investor Briefing. My name is Lydia, and I will be your coordinator for today's event. Please note this conference is being recorded. [Operator Instructions] I will now hand you over to your host, John Howie, to begin today's conference. Thank you.

Thanks, Lydia. So good afternoon, and welcome to the Babcock Type 31 program briefing. My name is John Howie. I'm Chief Executive of Babcock's Marine sector. The purpose of today is to give you an update on our progress with the Type 31 frigate program since we're almost a year into the contract. Ideally, we would have been welcoming you to our Rosyth site this afternoon. However, the current situation with COVID-19 means that we're all having to do things a bit differently at the moment. So rather than postpone, we decided to try something new and meet you virtually. So thanks for your attendance in these alternative circumstances. I should just emphasize at the start, this is an operational update, so there'll be no new financial information disclosed. And as a reminder, we are in a closed period, so we are not able to talk about current trading and the business. And if you do have any investment-related questions, Simon McGough and Sam MacGregor are on the call to step in, if we need them. So hopefully, you can see the slide pack. I'll pass by Slide 2, which has got the standard disclaimer. You'd be pleased to know, unlike a radio ad, I won't read it overly fast. And I'll move on to Slide 3, which is the agenda. So let me tell you about the flow for the next hour. I'm going to run through a short high-level overview to give you a flavor of where we are currently with the program. Then we have some really interesting video input from the business leads who are actually running the program to give you an operational perspective as well as a word from our customer. After that, we'll open the session up to question and answer, and we'll give you the chance to ask any questions that you may have. And as I said, should be about an hour in total. So moving forward to Slide 4. Most of you will be aware of what Babcock does and be familiar with the role. So just a very brief word on that and where Type 31 fits into our business. As you can see here, we are really proud of the work we do that help save lives, support national defense and protect our communities. And in doing this, we deliver bespoke, quite complex engineering services. And we do that for customers in the U.K. and increasingly around the world with a focus on helping to improve capability, reliability and availability of their most critical assets within our 4 sectors of marine, land, aviation and nuclear. And of course, we underpin all of that with a deep understanding of technology integration, some quite unique infrastructure and some complex specialist training. Moving on to Slide 5. We are the MOD'S second biggest supplier in the U.K. We provide long-term program support across all of the armed forces, and it's right at the heart of the business we have. Many of the things we do are unique and are absolutely critical to our customers' operations, and that gives us good, long-term certainty. As does the fact that we have visibility of their 30-year procurement and support program and the 10-year equipment plan that sits behind that. So we've got really good long-term visibility both in workload and in likely funding. And that allows us to maximize opportunities and drive value for money solutions for U.K. taxpayers. And of course, increasingly, these days, we have a growing international footprint, and it's both growing in size and growing in importance to us as a business. And technology and innovation increasingly underpins everything we do. Moving on to Slide 6. I'll just talk a bit about the Marine sector in total. So the next couple of slides are really an overview of the Marine business' 3 main pillars. Firstly, supporting the Royal Navy in the U.K. and wherever they operate, and that's a sort of foundation for our business. We're focused on building our international footprint. We've got positions in Canada, Australia and New Zealand that are right at the heart of that. And we're growing our position in Oman, and we've now opened a facility in South Korea, which is a growing market for us, both in defense and in energy and marine markets. And in a technology sense, for those of you who might have been at DSEI last year, if any of you were able to visit that, you may have seen our iSupport technology. And what we're doing on digital trends, data analytics, predictive modeling of warship systems and structural analysis have got the potential to completely transform the way we deliver through life support, building higher barriers to entry and sustaining the sort of margins that our shareholders have come to expect from us. Moving on Slide 7. The Marine business has got a really strong U.K. base with about 7,000 employees across the U.K. and internationally. This slide doesn't include our U.K. nuclear submarine business in Clyde, Bristol and Devonport, which employs essentially about the same number of people again. So there's real strength and depth in this business. Rosyth for Marine is our manufacturing center. Our gas handling business is based there, but that's where the Type 31 program is centered, and it's our place for advanced modular manufacturing. We've got a number of RN training sites. Although we operate the Clyde submarine based operations through our nuclear business, at Marine, we provide submarine escape and rescue training as well as operator and maintainer training for the Astute-class submarines. Our equipment business is headquartered out of Bristol, providing weapons handling and log systems for submarines, as well as payload handling systems for surface warships like Type 26. And then in the South Coast, we have the rest of our naval training business and our warship support business based out of Devonport, as well as our war support in the Royal Navy's principal weapon systems such as fire lines and the large caliber guns. And you can see there internationally, our footprint is mainly Canada, Australia and New Zealand, but with a growing presence in Oman and Korea, as we said. So moving on. Page 8. Let's now talk about the Type 31 specifically, which is the purpose of the briefing. Slide 9. Just to give you a better background on the program. Many of you will be aware that we won this contract after a really robust competitive tendering process, stiff competition. And at the end of that, Babcock's Team 31 and Arrowhead 140 solution were down selected by the U.K. MOD to build 5 Type 31 frigates, and that happened in September last year. We signed the contract in November. And that contract requires us to deliver 5 general purpose frigates at an average unit price of GBP 250 million per ship with all 5 ships being delivered by 2028. Crucially, Type 31 is seen by government and by Babcock as a pathfinder program for the delivery of a new shipbuilding model, which we think will help invigorate and sustain the U.K. maritime enterprise and give the MOD a different way of procuring less complex warships. The programs built around a core of U.K.-focused ship design and build, and that aligns quite closely to the government's Prosperity agenda, and we do think it's got significant export potential. We are the prime contractor and the program leads. We have Thales as our main partner, as the combat system provider and integrator, but we also have other major suppliers like MTU, BAE Systems, MAN, Renk, [ Elfie ], Typhoon, Raytheon and others. A bit about the team. Team 31 is made up of Babcock; Thales; OMT, who are the original developers of the platform design we're using; our own Frazer-Nash; and BMT. And together that is a highly accomplished team that comes from across defense and commercial ship design and has got combined experience and capabilities needed to deliver a program with vast complexity. The 2 blue boxes at the bottom of Page 9 tell you what the Royal Navy are looking for in this platform. They're looking essentially for a ship that is both capable and adaptable. Technically, it has to be affordable. Defense budgets, like all other government budgets, are always tight. And they wanted something that had the capability to be exported, and we'll come back to that later. And I won't dwell on the box on the right, but that's the operational requirements, but out of this essentially is a general purpose frigate. Its role is to take part in counter drug operations, maritime security, convoy support in the Gulf. So it's a general-purpose ship. It's not a specific antisubmarine warfare or a warfare ship. Moving on to Slide 10. So where are we in progress terms? Well, the good news is that we are in line with our contract schedule. And that's despite the issues we had with COVID-19. The whole country -- the whole world has been impacted by the pandemic. We have been able to sustain our contract schedule, and that's a huge testament to the teams that are involved in this and how quickly they adapted to the situation. I'm also delighted that our spend is in line with our program assumptions. And that's despite the fact we've now placed subcontracts for 73% of the material value, including nearly all of the more complex packages, such as the combat system, propulsion, heating and ventilation and the main guns. And if you've seen any of our media releases in recent months, you'll see these autos as have been placed. That includes some of the long lead items like main engines and diesel generators from MTU, gearboxes from Renk, shaft lines and propellers from MAN Energy Solutions and the guns from BAE Systems, all placed in accordance with our schedule. We've had every milestone in the contract in accordance with the time and scales we agreed with the MOD. It's important to say that the Arrowhead 140 design we offered the MOD is based on a proven wet design, proven in-service design, the Danish Iver Huitfeldt frigate, and I'll come back to that in a few minutes. But it's also really important to bear in mind that we've built into this program the fantastic experience we had of being a core part of the U.K. Aircraft Carrier Alliance. And lots of the lessons about how to effectively design and build warships, how to engineer out cost and time have been built into our plans for this program. And a big part of the program is also about the investment we're making in advanced manufacturing equipment and technology, and you'll hear some more about that from our engineering director in the video sequence. I'm sure you remember the program has got an export element to it. It was called Type 31e, E for export, and we are continuing to work with U.K. government on potential opportunities. And there are a lot of countries interested in this program. I can't go into any detail at this stage, but some of those opportunities are live and quite exciting. And they cover a range of people who just want to buy a design through to people who want ships built in the U.K., ship people who want ships built in their own country with technical support, people who want to help with supply chain. So there's a whole range of them, but they are a great way to introduce Babcock into new markets. If I move on to Slide 11 now, the Iver Huitfeldt -- why did we choose that? Well, it's an in-service NATO standard frigate. We've enhanced it to bring it up-to-date with modern legislation and to make changes to it that make it suitable for the Royal Navy's operating profile, which is slightly different to some other countries. It's a proven hull, it's in water, and the customer has got 9 years operational feedback on it. The Royal Navy know that ship well from the operational sea training, what they do, and we knew that they liked it. It's a proven design. It's 50% bigger than the Royal Navy requirement, which makes it significantly easier to build because there's lots of space. It's been deliberately designed to be modular. And that takes both time out of the build sequence, but also critically cost. Moving into the Type 31 variant of that, what we're offering is an adaptable, cost-effective, modern global frigate that meets the Royal Navy requirements now but also has the space to modify and grow those requirements in the future. Its smart build credentials mean that it is optimized for pre-outfitting with open compartments that enable rapid assembly. And again, that helps take cost and time out of the program. We're using commercial off-the-shelf equipment, and that's embedded into all the onboard systems, which crucially minimizes through-life cost with a support contractor, so we do care about through-life costs. But it also means that we are carrying very little development risk on equipment. We are buying proven equipment, often equipment that's been -- that's modern versions of their equipment already installed in these ships and a significant design margins for upgrade through life. And that's really important. It means that we have absolute confidence that we can hit the performance requirements of the contract. Actually, we've got significant margin beyond them. So we know we've got grounds there. And that also means the Navy can adapt the ship through life known that it's got the capability to be modified. At the heart of the decisions we've made is Thales' TACTICOS combat management system. That's a proven and service open architecture system. Most of the combat system equipment that will be fitted to it has already been integrated because this CMS has been sold to 24 different navies. It's installed in 150 different ships. And so most of the functional integration has already been done. And again, that's another huge derisker for us. So again, fairly low nonrecurring costs, which help keep the cost of the platforms down. Moving on to Slide 12. I won't dwell on this, but the slide is intended to just give you a flavor of the capability. The ship has got a baseline machine system, but it has the ability to be modified to add other equipment, should either the U.K. or an export customer want it. The ship has got quite a flexible combat system. You have 3 guns, surface to air missile system, a new 4D radar that the Royal Navy are really quite excited about, and a range of other capabilities. So this is -- it's not intended to be a high-end war fighting platform like Type 26, but neither is at a gunboat that some people have suggested. That's quite a kit. So at least it's capable as the Type 23 that it replaces. Getting on to Slide 13. Some of you might think this slide looks familiar. It's the same slide that we shared with you at our half year results last November. As I said earlier, the program is on track and the financials that we set out before still apply. The key thing that's happened in recent months is we've successfully undertaken a whole ship preliminary design review. That's a major review of the robustness and maturity of the design. That pass -- we passed through that gate. It went really well. The review was undertaken by an independent panel. So it's not Babcock convincing ourselves that it's all in good shape. It was an independent panel made up of ex-BAE Systems employees and people from other parts of industry who've got proven expertise, and the feedback on that was really quite heartening. Of course, we've got things to do. Any good review will always give you actions, but fundamentally the design is in good shape. High level program says that the first cut of steel is in mid-2021, first ship in the water 2023, all 5 ships delivered to the customer by 2028. Moving on to Slide 14. We'll just talk a little bit about the infrastructure investment in Rosyth. As a result of the pandemic, the majority of the Type 31 team have been working from home. But despite that, as I've said, we've been able to keep hitting our milestones. And that just proves the adaptability and flexibility of our workforce. But we've also been able to keep our on-site preparations going to ready for the start to manufacture. We're building a new 145-meter assembly hall. The piling work for that started at the end of August. That consists of setting approximately 5,000 piles to various depths throughout the building and hub standing area in front orbit to prepare the ground for the appropriate boards and the foundations for the building itself. So that's quite a key part of the infrastructure development. The other piece of it is the enabling works to some of our manufacturing base in order to allow us to install a new pulse line, which is a state-of-the-art automated panel manufacturing line. And that's a cornerstone of our digital transformation program for Rosyth, and it will create significant efficiencies in the manufacturing process. Lots of the steel preparation and assembly work that's traditionally done by hand on Type 31 will be done robotically. And the ship's design is optimized for that. So we should get significant gains out of that. Moving on to Slide 15. I mentioned earlier the challenges around Prosperity. As I said, Type 31 is a pathfinder program for the U.K. National Shipbuilding Strategy. And part of that was about making sure there's a strong warship both set in the U.K. for the long term. It's also about ensuring that we've got something we can export and to make sure that we spread the benefits of shipbuilding around the U.K. And I know that's something U.K. government are getting increasingly excited about, the role of shipbuilding as a job creation and prosperity vehicle. The program is as much of a people as about product. It will build in the successes we've already made with our supply chain. We're mobilizing the team in Rosyth, Bristol, Devonport and in the Thales facility in Crawley. And we'll get up to a maximum headcount of about 1,250 people across the U.K., together with a further 1,250 in the wider supply chain in the U.K. We're invested in the U.K. supply chain, and that will support the next-generation of apprentices and graduates through the partnerships we have placed with universities and colleges and will sustain a number of highly skilled jobs across the country. And we'll be putting in place about 150 new technical apprenticeships on back of this program as well as upscaling our existing employees so that they can provide the levels of efficiency and quality that this program will require. Moving on to Slide 16. I put this slide in because -- so I think it's important to acknowledge, there's been some skepticism out there about how we can possibly deliver a program like this, the time and budget. And so I thought I'd put this together just to talk you through it. There are really sets of reasons in my mind why historic ship procurement programs have ended up with cost and program overruns. The one at the top of the left is probably 1 of the 2 that hops the most. And that's when we euphemistically recall it concurrent engineering, which basically means designing the ship and building it at the same time. And the legacy of some programs is that you can spend significant percentage of your plan manuals and reworking the production product to take account of design change and, of course, modifying the design itself. Because we're using a proven in-service design and we have access to a detailed 3D design model, we already have a mature design. We are only modifying it to bring it up-to-date with current legislation to reflect the current RN requirements and to build in a new combat system with a relatively minor changes in the grand scheme of things. The other thing that punishes warship builders is the functional integration of the weapons and sciences with the combat management system. In the case of Type 31, the tactical system is open architecture, so the interfacing process is much more straightforward. And because it's in service with 24 navies, nearly all of the equipment we're planning to fit has already been functionally integrated with the core software for another program. So the software integration risk for us is relatively modest. Weather is a big problem, especially if you're in Scotland. I'm listening outside, and it's raining at the moment, surprise, surprise. All of our build and assembly will be undertaken under cover, except for fitting the ship's mast. That's a huge productivity gain because we won't lose time through wind and rain and the cold. And you can see that somehow. I would also just mention that the customer recognized their role in previous programs and the impact that customer change can have. This contract was deliberately written by them and by us to inhibit the customer's ability to introduce change. Yes, the platform might get modified, but that will happen after it's been handed over by us. What they want here is for us to get on and design and build the ship cleanly without disruption. So I think that's a good place for us to be in overall terms. So I think that's probably enough for me. I think now probably time for us to hear from the experts and for those of you watching on the webcast to get a chance to see our progress. [Presentation]

[Operator Instructions] Our first caller has come through, Joe Brent of Liberum.

Two questions, if I may. Firstly, could you give us some indication of how fixed the price is? And if there will be some sort of variance -- potential variance on that? And secondly, clearly, a lot of capital investments. Could you give us some indication of what the kind of financial cost of that is and over what time period?

Yes, no problem. So if I take the price, so you've seen the part about average production cost of GBP 250 million. The MOD have set through the National Audit Office their total budget for the project is GBP 2 billion, which includes a lot of their costs, but also includes costs for the government furnished equipment, et cetera. But another key thing that's in it is to deal with some of the inflationary elements. So the contract has got a mix of firm and fixed price elements. So there will be some inflationary escalation as we go through. And on the CapEx front, the total investment that we're putting into the program is a shade over GBP 50 million. And that investment has been made, not specifically for this program. It's been done, a, to deliver the program, but it gives us a capability that we can deploy on other future projects, be it export programs or energy and marine projects. So we'll recover part of the cost through Type 31 because it's obviously providing us program benefit. But beyond that, we will recover the balance through future contracts.

[Operator Instructions] Our next caller is Sash Tusa of Agency Partners.

I've just got a couple of follow-ups, just so we're absolutely clear. Production cost, average production cost, GBP 250 million. That is the -- what Babcock books directly, but you're clearly also purchasing some of the government furnished equipment. I mean the BAE statement on the armament said that you had acted as the procurer for that. So does that go through your GBP 250 million per ship? Or is that -- is it just that you are providing the paperwork for that?

Yes. So there's 2 categories of equipment in the program, Sash. There's equipment that we are providing as part of the program, and that includes the guns, the Thales mission system, the integrated nav and bridge, et cetera, and then those -- the government furnished assets, which would include things like the sea set, the missile program. And a lot of actually is information as well as equipment. So our GBP 250 million doesn't include the cost of the GFA, but it does include the cost of effectively the baseline equipment fit, including the guns, the engines, gearboxes, propellers, et cetera.

Great. And then another question. What sort of learning curve should a shipbuilding program of this length? Because clearly 5 ships, assuming that they are all absolutely identical, is the sort of production length that any warship builder would be delighted to get. What sort of learning curves are you targeting? And how does that differ from what you achieved on the carrier program?

If I was being honest, I can't remember what the learning curve is. Yes, we have built a learning curve in, as you would expect, on a 5-ship program. I think -- so there's a couple of key -- if I just tackle the carrier comparison, the learning curve we achieved in the carrier was actually quite significant between ship 1 and ship 2. But you do have that challenge that you've only got 2 ships, so you get basically 1 chance to refine the way you did it the last time. And once that was quite successful for carrier, we should do quite a bit better here because we get to repeat it over 5. And any of you who've been to Devonport and looked at the Type 23 frigate life extension program, we've improved ship on ship as we retain and tweak the way we do things. I think the other part of it is looking at how you bring down the UPC overall by using things like undercover build, design and the build methodology, so that you don't use any scaffolding, which was a big cost driver on the build of the carrier. So we've tried to engineer out a lot of the things that are big variable costs. We talked earlier about the -- reducing design rework. But to take your core point, yes, there is a good learning curve across the 5 ships. I can't remember off the top of my head what percentages, but we have built that assumption. And partly on the basis that we having built 4 ships for Ireland and some of us have got experience of things like Type 30 -- sorry, Type 23 build, Type 45 build, so there are reasonably well understood norms for these things.

I've just got 1 last question. You said that the Arrowhead 140 design that you are building was -- I think you said it's 50% bigger than the Royal Navy's initial requirement or at least initial specification. I know that a previous First Sea Lord, I think, talking about the carrier program, said steel is cheap and the air is free. But I find it quite hard to believe that 2,000 tonnes of extra steel plus scaling up the entire propulsion and heating and ventilation system and so forth to cope with that net free. So I just wonder if you could talk about those trade-offs as well.

Yes. So first of all, why did we pick a bigger ship and it sort of goes to the second part. We picked a bigger ship because we knew it was a design that customer wanted. I've also had a bee in my bonnet for a long time about the importance of building things which are more capable than you can currently see and need for on the basis that things change. Type 23 frigates are not performing anything like the role today. In many cases, they were originally designed for -- because the world is a changed place. And that sometimes brings a price with it. And this is the point where I get to give credit to people like Mark Harvey and Sean Donaldson and the project team because I originally had the same concern as you, yes. Steel is cheap and the air is free, but chilled water is a propulsion. What they demonstrated to me quite effectively with the Arrowhead design is that whilst you're paying extra for some of those facets, you needed some of the men who need to build in design margins for end of life. But actually, the extra cost that you incur is more than offset by the production benefits you get from the fact that the ships being designed really quite cleverly to be simple to build. I've never seen a design like this that's got such straight pipe and cable runs, such big airy compartments like main machinery spaces where the impact you get on the outfit cost of actually assembling the equipment into the ship are really quite dramatic. So in the round, although it sounds counterintuitive, a big ship proved to be more cost-effective to build than a larger ship. And that's why we offered the competition a ship that was 50% bigger than the other 2 competitors. We're often -- because we've been able to prove to ourselves that you can take account of the extra materials through the production benefits you get of making it much easier to build. We talked about the panel line, the steel work going through the panel line because the panel sizes have been optimized for a standard panel line, because they're flat plate, they are much easier to fabricate and assemble. I have to say I was really quite impressed by what OMT have done with this design. Sorry, a long-winded answer to your question.

[Operator Instructions] And at this time, I'll return the call over to your host.

Great. So I think just to say, thank you for joining the call. Thank you for your interest in the program. I hope that gave you some valuable update on the program. And reassured you that despite what some people say in the market, this program is running exactly as we hoped it would. Of course, there are challenges ahead. There always are in complex programs, but we've got a really good team and a good set of subcontractors. And hopefully, that success will continue. Well, thanks for joining us, and have a great weekend.

Thank you, everyone, for joining today's event. You may now disconnect your lines.