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

Good morning, and welcome to the first, and I hope last virtual results presentation by Babcock. So my name is David Lockwood. I'm the CEO of Babcock for the last 10 weeks. I'm going to start with a brief business overview and then hand over to Franco, who will take you through the numbers before we move to Q&A. So I thought I'd start with how I've seen Babcock after 10 weeks. It is -- was described to me as a complicated company when I started but I have to say that's not what I found. We might not always explain ourselves terribly simply, but actually, we have 3 fundamental business models. So the first is we are a full-blown marine and naval business. So we develop product with some very high-technology in. We build ships, the Type 31. We support ships and submarines, some of the most complicated military systems outside the U.S., and then we decommission. So a full shipyard in the U.K. We have strong maritime operations in Australia, in Canada, growing in Korea. So it's not only a U.K. business, but it's a strong global maritime business. The second is we do high-end engineering support of platforms for a range of people we do that mostly in the U.K., but we do it across all domains. And then finally, we have a more traditional services business that does flying as a service in medical and firefighting and also does things like training. And that's it, that's who we are, 3 business models delivered into 4 sectors. So not complicated at all. And that business has a wide range of strengths. First and foremost, it is a resilient business. We are a strong business that delivers long-term programs with some very capable people. It could have been hit even more badly by code than it has been. But it -- we've managed to cope with adapting working practices to minimize the impact on our customers. We have deep customer understanding. The majority of our people work on sites shared with customers, hand in glove with customers to deliver complex solutions. There is and remains strong demand for our expertise across the whole range of everything we do. There are some, some less good spots, civil training at the moment due to COVID, but the long-term dynamic is good, and I'll come back to that. And then finally, I've been really impressed with some of the areas of innovation I've spotted in the group. And one of the things we want to do is get those to travel around the group more so they can be applied more widely. Of course, nothing is perfect, so there are areas to address. We've operated a federated model, and that has served us well for a long time. But as the customer joins up, so we need to join up, so we need to look at our operating model to work out how expertise travels around the group, and in particular, to get a common culture to make it easier for people to move around the group. The federated model didn't lead to strong collaboration. And what we are seeing is bids increasingly coming through and customer demands coming through across our internal boundaries so that we need to be able to collaborate more effectively to meet those demands. And then finally, we need to focus on free cash flow after everything. Our balance sheet is in a resilient shape. But it could be better. We have lots of strategic opportunities and to deliver all of that value, we need to have a strong, sustained free cash flow. So every incoming CEO to any business is going to have a look at the strategy, and it would be perverse if I didn't. So there's nothing odd about having a strategic review. But there are some things that are fundamental to the old strategy that will be fundamental to the new. So focus on cash, I've already touched on, being a strong strategic partner to the U.K. government, we have a position now where for the MOD, we are the second biggest supplier by value and the biggest by the number of programs we participate in. And they need us and we want to be a forward-leaning partner, not only in responding to needs, but in helping to shape them. International growth was fundamental to the old strategy and it's difficult to see how it can't be fundamental going forward. So that will be a key priority. And against those 2, I recently appointed John Howie to take a new corporate role to look at how we best deliver that collectively. I've already mentioned, driving innovation across the group. We do have some really strong pockets of innovation, particularly digital innovation, which to be honest, I wasn't expecting to find at the level of maturity I found, the digital twin of our customers' platforms so that we can do predictive rather than responsive maintenance and support, a whole range of things. We need to get that to travel across the group. So John Howie was appointed to take responsibility for making that come alive. And then finally, because we've run a separate entities, we don't have an integrated people strategy or an integrated ESG strategy. We want to make that come alive. We want that to be at the center of our strategy, not to be a compliance activity. It's been the principal area of concern by the employees who I've communicated with, customers talk about it, investors talk about it. This isn't a compliance issue anymore. This is fundamental to our strategy. In general, notwithstanding the challenges of operating in a COVID world, the macro environment is probably improving quite -- improving beyond what we were expecting. So we have defense spending growth in Australia, a key market for us, obviously, the recent announcement in the U.K. with a significant focus on shipbuilding, which is obviously very important to us. We still got the integrated review to come through to fill out the details, but the backdrop to that is very positive. So our half year revenue is resilient, but we did have declining profits as was expected. Really 4 things affecting that: disposals, obviously, a part of the cash self-help, but you lose the profit contribution; the in-sourcing of the -- what I might think of as sim prime, so the management primes in the nuclear industry; COVID-19, that was -- had a big impact as was previously announced in Q1. We've been learning to manage it on a weekly basis, almost improving and improving. We have a weekly COVID call, so we can be responsive to all of the impacts of different governments view of COVID; and then weakness in civil aviation that has been highlighted before, and Franco will look at later. We haven't been sitting idly by. So the in-sourcing by the NDA, the decommissioning authority of the Tier 1s has led us to relook at our Civil Nuclear business, how it addresses the decommissioning and the new build market, and there's been a significant restructuring there that is still ongoing. Civil aviation restructuring, we've been going through a fleet rationalization program and looking at how we operate support more broadly to our fleet, so we can offer a better service for lower cost. And obviously, the cash self-help through the disposals. So with that thumbnail of the business as I see it, Franco will now color in the details on the financials.

Thank you, David, and good morning, everyone. I'm going to go straight into the financials. Revenue was substantially maintained in the half. But operating profit was down 40%, and I'll cover that shortly. There was a small net charge to exceptional items recognized and a continued cash impact from prior year charges. Free cash flow was GBP 58 million, which was above our first half expectations. EPS was 15.7p. And net debt was at GBP 871 million, which is lower than the end of last year and significantly lower than September last year at both period end and as an average for the period. With a net debt-to-EBITDA at 2x, we are in a strong balance sheet position. Moving on to some of the detail then. Revenue was GBP 2,244 million and was down 9% on last year. If we exclude FX and disposals, that's 7% down. And this mainly reflects the impact of the end of Magnox last year. And if you were to exclude this, the rest of the business was down 2%. Underlying operating profit was GBP 143 million. And as David has said, there are 4 main drivers of this performance: firstly, FX and disposals; secondly, the decline in the nuclear JV profits of GBP 12 million, and I will cover this in detail in the nuclear slide, a bit related to the ending of Magnox last year; and the shortened time scale of Dounreay. If we exclude these, operating profit was down 34%. The third driver was then was COVID, and I will go into detail on this shortly. Of course, the final driver was the performance in our civil aviation business. Again, I will come back to this. Free cash flow was better-than-expected and included GBP 40 million of VAT timing benefit across Europe. Net debt, as I said earlier, was GBP 267 million lower than a year ago. So the biggest driver of performance this half was the impact of COVID-19 across the business. As David said, we are a people business, and so had a particularly acute impact of COVID-19, given the necessary constraints on close proximity working. The impact varied by business and sector, but all sectors suffered from lower activity and inefficiency. But on here, we are showing the main drivers of profit performance in the half, which for 3 sectors was overwhelmingly COVID, related -- COVID-related after a length of disposals and nuclear joint ventures. In Marine, the biggest driver was lower efficiency. For example, progress on warship support was heavily impacted in the early months of the pandemic, as access to customer sites, distancing requirements, PPE restrictions all led to a low -- earning a lower margin as we achieved fewer milestones. It's a similar story in nuclear, progress on work programs continued, but the pace was slower. And additional costs were incurred, leading to a lower margin. The civil business also had an impact from customer site closures and hence, reduced activity. The main story in land is activity levels, work in many civil areas such as airports, training and South Africa came to a near stop. And so revenue was heavily impacted and operating profit with it, made worse by the operational gearing of these businesses. In Aviation, COVID-19 impacted both activity levels and efficiency. These pressures combined with the existing business challenges to cause the performance in the first half. And I will expand further on each sector as I go. So moving to a revenue bridge. You can see here the impacts of FX and disposals and then the movements by sector. Good growth in Marine, led by Type 31 and ventilators, and a decline in nuclear that is all Magnox, with growth excluding Magnox; decline in land from lower civil activity in the COVID-19 environment; and broadly flat in aviation, though there was an adverse mix impact there, which I will cover later. On to the operating profit bridge. You can see the impact of FX and disposals, then the movement by sector. Marine's decline reflects the COVID-19 impact on efficiency. The movement in nuclear is partly the movement in the nuclear JVs and partly COVID-19. The moving in land is directly linked to the revenue decline. And as Aviation, there's GBP 34 million profit shortfall. Part of this is COVID-19, but part is the ongoing challenges of the profitability of the business. In October with COVID restrictions lower, performance has improved. On the -- now we move on to exceptional items. On the left, you can see a summary of the exceptional items in the half. In summary, exceptional costs were offset by the gain on business disposals. Many of these costs related to the ongoing programs David has discussed. Going through each of them then. Exit and disposal costs of GBP 9 million were more than offset by the net gain on the business disposals. We recognized GBP 11 million of new restructuring charges mostly in the aviation sector as we look to move forward our programs further forward. We started to progress our fleet rationalization program in the half, with fleet transactions approved to reduce the fleet by 7 and to reduce the number of types by 2 to 31. This created a GBP 7 million charge, but more importantly, has realized cash. We closed our Rosyth pension scheme to future accrual, derisking our pension position, and this noncash charge is the curtailment accounting loss. With the associated tax credit of the above, the net impact was a GBP 2 million charge in the period. On the right-hand side, I laid out the exceptional cash costs. Both those incurred in the first half and those incurred in prior years. These are net of tax and represent our best view as of today. They are subject to change. For example, the Rosyth pension payments have shifted to the right since we spoke in June. We have also pulled out the disposal proceeds from these numbers, so you can see the 2 separately. Now to the detail of the sectors. Marine saw strong revenue growth of 12% led by Type 31 work ramping up and helped by the continued strength of our LGE business and revenue from the ventilator challenge. Operating profit was, however, lower. COVID-19 had a significant impact on efficiency across the sector, particularly in warship support and in Oman. Where in Oman, activity stopped and cost continued. The lower margin of 7.8% represents both the COVID-19 impact, but also the revenue mix, with growth in lower initial margin work such as Type 31 and a decline in our consultancy activity, one of our higher-margin businesses. Revenue in nuclear was down 17%, reflecting the loss of Magnox last year. Excluding this effect, revenue was up 4% with strong growth in defense, led by increased infrastructure work, but lower revenue in civil as COVID-19 led to lower activity. Operating profit was down 45%, and the margin was at 6.5%. This reflects the swing in nuclear JV profits, where last year included Magnox plus profit in Dounreay. This year saw a GBP 5 million loss in Dounreay as we adjusted our assumptions around contract milestone profit achievability. Given the shortened time frame of the contract, which now ends in 2021 rather than 2030. The lower margin in nuclear in this half also reflects the COVID-19 challenges on efficiency and costs, particularly acute when working in close proximity on nuclear submarines. And the lower margin on the MSDF transition year and initial infrastructure work. Results in land show the impact of COVID-19 on activity, with a revenue decline of 23% coming from a significant reduction in work in airports, civil training and the South Africa business. FX also had a GBP 37 million impact on revenue. Operating profit was down 43%, with a flow-through of the revenue fall and the operational gearing. Moving to Aviation. Despite some COVID-19 pressures, profit from joint ventures was slightly up year-on-year. However, within the group business, profits were down GBP 34 million in the period. There was some inefficiency in our defense business as experienced in other sectors, but the main weakness came in our civil aviation business. Revenue for the sector as a whole was lower with lower flying hours in aerial medical services and oil and gas, particularly in the early stages of the pandemic, offset by growth in firefighting at the busy end of the season. There are many drivers of this decline in trading. But in simple terms, there was a significant COVID-19 impact, and we are only part way through fixing this business. Looking at some of those details. The cost base and fleet are too large for aerial emergency services. Oil and gas is a tough breakeven market in normal times but the lower flying hours that COVID-19 created led to a loss in the period. COVID-19 had a range of impacts from lower flying hours through to additional costs such as PPE and refitting aircraft. It also reduced efficiency, for example, with reduced aircraft capacity. There was also a mix, both in terms of timing and market. For example, higher firefighting activity does not contribute sufficient profits to offset the impact of limited medical flying in the early period. And the most efficient and usual model is stable flying hours rather than stop and start flying. We have not been able to get most of the additional COVID-19 costs and inefficiencies covered in our contracts. A summary here of our joint ventures. On the left-hand side, you see the profit contribution of each one and in total JVs contributed GBP 31 million operating profit in the half. And we received GBP 15 million in dividends, given a no GAAP against profits after tax of the JVs. Our share of JV net debt stood at GBP 266 million in September, mostly in AirTanker. And note here that both Dounreay and ALC finishing 2021, so there will only be 2 big JVs left, which are AirTanker and Ascent. And on AirTanker, you should note that we increased our stake by 2% and this month for GBP 9 million using our preemption rights. Moving to cash flow. I will pull out the big movements here. Working capital was better-than-expected with our GBP 50 million outflow compared to GBP 107 million outflow last year. This includes a GBP 40 million benefit from VAT timing across Europe but also reflects a collection of receivables ahead of expectations and lower inventory levels. We had limited discretionary CapEx spend during the COVID-19 pandemic to preserve cash. And net CapEx to depreciation was 0.9x, although it will edge up in the second half. There has been no sale and leasebacks in -- during the period as the aircraft market remains unattractive. This is before IFRS 16 leases, these were lower year-on-year, reflecting the lower new leasing activity in aviation. On to free cash flow. Interest was flat year-on-year with lower average debt, offset by the higher interest rates incurred post financing -- refinancing. Tax paid was lower, reflecting the lower full year profit expectations. And dividends from JVs was also lower as last year included the Magnox exit dividends. Excess pension contributions are higher, partly as the underlying P&L charge for the DB schemes was lower in the period. All of this led to a free cash flow of GBP 58 million. And if we take the last 12 months, a free cash flow of GBP 244 million in the last 12 months. Pensions. 2 movements in pensions in the period. The accounting position went one way and the technical provisions -- position the other. The IAS 19 position is now GBP 104 million deficit, with a reduction in corporate bond yields and higher inflation assumptions, changing the position from March '20. On the funding side, our technical provisions deficit is now around GBP 450 million. Reflecting the deficit contributions in the period. We still expect pension contributions in excess of the income statement to be around GBP 75 million this year. And the Rosyth top-ups within exceptional cash flows will be around GBP 90 million, but the timing of this has shifted a year as discussed before. Here is the bridge of the movements in net debt since March. You can see the positive free cash flow and the proceeds from the sale of Holdfast, more then offset by the exceptional cash costs and FX movements -- more than offset by exceptional cash costs and FX movements. So then looking at the net debt position and liquidity. The self-help actions of disposals, CapEx control, VAT deferral as well as not paying a final dividend for the last financial year led to a lower net debt. And so despite the falling profits, our net debt-to-EBITDA in September was 2x. This is above our target range but is well within our covenant levels. We extended our RCF by a year, and our credit rating was confirmed at BBB by 2 agencies in the period. Bottom left chart shows our debt maturities. You can see the GBP 307 million USPP that we will pay off in March. And note, we had around GBP 1.4 billion of liquidity headroom on our balance sheet in September. And so we are well covered for this and future requirements. So to summarize, revenue was resilient in most areas. Operating profit was in fact impacted by disposals, nuclear JVs, COVID-19 and the performance in civil aviation. Despite this, we reduced net debt and have significant liquidity and headroom so we are in a strong position to manage the challenges and uncertainties ahead.

So thank you, Franco. 2 more slides from me. So there are uncertainties ahead in the short term, particularly around COVID-19 and the restrictions under which our global business will operate which most governments are mapping through to the end of our financial year and having looked carefully, that's led us to a position where we're not providing guidance for the balance of this year, although we do have the position -- start position that Franco has just outlined. So what to expect looking forward? The outline strategy review in May with the full year results to reconfirm our priorities of free cash, strategic partner to the U.K. government, driving international growth, using innovation across the group and transforming our ESG and people agenda to put it at the heart of our strategy. But the most important factor of all is the long-term delivery of sustainable free cash flow. So what happens now is we're going to run a short is 90-second video, so people can get off this system and onto the Q&A system. That will happen when I raise my hand to the guy operating the video, and then we'll reconvene for Q&A. So thank you for listening to this presentation. The video. [Presentation]

Thank you very much. So we're ready for quick Q&A now. So if we can have the first question.

[Operator Instructions] Our first question is coming from the line of Kean Marden from Jefferies.

I have 2 questions for David, please. The first touches on the free cash flow point that you repeated during the presentation. I guess I'm wondering how much of the free cash flow discipline is cultural. So I'm wondering in your view, who in the organization should take responsibility for generating sustainable free cash flow? And is that embedded in Babcock's bid processes currently? And then also on free cash flow, how wide is the range of free cash flow outcomes across divisions and contracts within the organization currently? I appreciate COVID has impacted that to some degree, but maybe if you can adjust? And then the second question, does Babcock have the skill set and the assets to fully benefit from the recent U.K. defense budget increases?

Okay. Thank you for the question. I should have said in introducing the question thing because of this environment, if we could have questions one at a time and not test mine and Franco's memories, that would be helpful. The -- I'll take the second one first. Yes, we do. Against all of the scenarios that we can see. And in fact, a lot of groundwork is going in to make sure we can step up to an even bigger position. So I feel very confident we have the -- we have all the groundwork in place for that. In terms of free cash flow, I'll -- my initial view is that we could do more. There's definitely more we could do in terms of how we train people to think about cash. David Miller said when I first met him that cash is a cultural issue for the whole business. And until that is fully embedded everywhere, you don't achieve your maximum cash flow. And I think he's right. So you can always do more. And as I said earlier, we ran in a federated way and therefore, culture is federated, therefore, the cash culture is federated. So I'm sure we can do more but a lot of your questions are about the past. So I guess, Franco will probably want to comment on that.

I mean, the question of free cash flow is, yes, I think it really is embedded in the big process. It really is, but we definitely can improve and we can improve. And I think that's driven by our relationship with customers, our relationships in markets. So it has to be all encompassing, and we can do better. I think avoiding exceptional cash flows will -- is also a big driver. So you can -- if you can avoid the mistakes, then you can certainly drive a clean free cash flow, which is what we're talking about here, and that's the key importance. So I think that's very important. In terms of the businesses. I think they all generate good free cash flows. I think you could probably guess which ones are the most capital intensives, i.e., aviation, and that probably be a little bit lower. And that comes down to the lease versus buy model and how that works. And how -- so I think we can drive improvements in free cash flows. I think it's difficult times at the moment. But even if we take that over the last 12 months, pre the exceptional items, which, as I said before, we should not excuse those. That we did generate over GBP 240 million of free cash flow. So this is a business that's capable of generating a good free cash flow.

The next question is coming from the line of Joe Brent from Liberum.

I've got 3 questions as well. But if I could, I'll take them one at a time to help everybody. First of all, you've talked about cash flow. But given consensus debt isn't really changing today and given that it doesn't look like you'll be paying the Italian fine this year, can you tell us what has gone worse or might have gone worse to mean that the overall result is unchanged?

Okay. I'll take that. And in terms of net debt, the FX has moved against us really. So that's about in -- as at September, that's worth about GBP 33 million against us. If you took today's FX, that would go away. But -- so that's where -- but that's the main movement, I think. That's question answered. That's it, Joe.

Right. Okay. So that sounds quite cautious then. Secondly, you've talked about, David, a new sort of vision of how you see the group. Will that be reflected in the divisional structure going forward?

So my view of companies is that they comprise 3 elements. They comprise a strategy, an opt model and a culture. And you can't sort out the opt model until you've worked out the strategy you're trying to deploy. So that could be or might not be an output of the strategy review. It's too early to say.

And then finally, very big thing on the horizon is the FMSP. Could you give us an update on where you think we are with that?

Yes. Well, as you can imagine, in my first 10 weeks, I've had more than a few conversations with the customer on that. I think we are probably broadly heading to a sensible place.

And timing on when you think we might get some clarity?

That's a bit of a forecasting question. No, I think we're not forecasting.

The next question is coming from the line of Anvesh Agrawal from Morgan Stanley.

I just have a couple of questions. The first is just on the Slide 14 that you have the exceptional cash cost laying out for FY '21 to '23, which is really helpful. But I just want to confirm, is this -- are these numbers fully comparable to what you presented at the time of full year results or the tax inflow is making a material difference there? And the reason why I ask is like the Italian fine is around GBP 45 million. And if I look at the outflow of FY '22, FY '23, which is like GBP 7 million and GBP 16 million doesn't quite reconcile with that number. So wondering if there are any sort of inflows that are in your expectation there? That's the first one.

Okay. I'll take that. No, I think it's on the same basis, but it's an update on what our thoughts are. And on the Italian fine, the appeal was meant to be in November, and it's now moved to February. So that we might do slightly better than this as the fine gets moved into next year. We probably expect the fine now not to come in one lump, but to be paid over a period, and that's reflected in these cash flows. So it is there, but it's over there -- but it's within these 3 years time frame that you've got here. So that's where we are.

Okay. And maybe just to clarify, what is the tax benefit that you have on the exceptional charge over these 3 years?

Yes. Well, the tax benefit will be across all of the ranges, the number with all bar the -- all the charges will be liable to tax as opposed to -- except to the fine, obviously, and then -- so the rest of them are all taxable with the exception of the Rosyth pension scheme because of the U.K. pension accounting tax over the first year of a top-up is not really allowable and you get it over time. So most of it is as I say is allowable to tax, but with some timing difference on the pensions and none at all from the fine is what I would say. So you can work out the numbers from there.

Okay. That's clear. And David, just on the announcement by the U.K. government, which is obviously positive for Babcock. I was wondering if you had, had chance to have any sort of preliminary conversation with MOD in terms of when that spending can really start to come through, how that sort of feeds into your pipeline for next year or a year after that?

Yes. So obviously, I mean, the good thing about the John Howie appointment is we have more bandwidth to engage with government, and that's already paid some benefits in the few weeks he's been in post. So we are in discussion. Clearly, the detail of that comes out of the integrated review, which is early next year. So we had that on our uncertainty slide because that will affect the sequencing of events, I think. So I think we'll have to wait and see that to see exactly how the money is spent.

The next question is coming from the line of Allen Wells from Exane.

Just a couple for me. First one, just back on the cash flow side of things. Obviously, cash flow seems a bit better-than-expected in our first half, and part of this is due to timing. Just thinking about the things like the VAT deferrals, the lower CapEx, you're pushing the exceptionals into the outer years. Is there -- are you in a position to comment on how this potentially impacts, I guess, your overall thinking around the sort of the medium-term guidance around cash generation for the business? And maybe just linked to that, on that CapEx side, which obviously looks low in the first half. Would we expect a decent step-up in CapEx either in the second half or into next year? As I noted in the release, you talk about additional production facilities to support Dreadnought, et cetera. So maybe that's my first one. So cash flow, CapEx, and that's fine.

Yes. The answer -- yes, look, it doesn't change my view as to what the deliverability of a good free cash flow from this business, pre-exceptional items and post-exceptional items should be. I think that the VAT deferral is a timing difference that will flow out at some point. CapEx will edge up slightly from 0.9 as we have to build the Rosyth facilities and the Bristol thing. So both of those will edge and step up -- CapEx up. But I think, overall, it will still be under control -- under tight control. Yes, I think the focus -- some of those are timing differences in terms of where we are for the half year versus the full year. But we are ahead of where we need to be. So I'd rather be in that place than having to do catch up. We always have second half weighting on cash flows. I would hope that we are a little bit ahead of the game this time.

And then second question, just on FMSP and the transition there. I think you guys have previously talked about an expectation that the transition from FM to FMSP wouldn't necessarily or would it be a negative impact to your marine margins? I noticed in the comments today, you talk about a step down in MSDF, which I think has moved to like a 1-year transition period. When we think about FMSP kicking in, I guess, from next year, would there be a step back up again then off the back where original MSDF is or is this the current baseline to start thinking about FMSP, please?

I think it's quite a challenge to answer a question to speculate on the margins of a contract we have yet to negotiate. So I think by the time we get up in May, we should be able to answer the structural questions in marine because we'll have much more certainty.

Okay. And final question, just on Dounreay, please. And the adjustment on the profit milestones, which results in a GBP 5 million loss. Could you maybe just talk a little bit about the background here? It sounds like to me that obviously, the profit take was maybe a bit higher in the early years and the early conclusion of that contract that you had to book some losses? Just to understand exactly how you've managed to take a loss this year versus where we were expecting.